Transfer Pricing: What You Need to Know to Stay Out of Hot Water

As globalization has progressed and large multinational conglomerates have become the norm, generally-accepted estimates suggest that about 60% of international trades occur between subsidiaries of single multinational corporations, and there are some indications that the figure may be closer to 70%.  While there is nothing inherently wrong with that, the omnipresence of intra-company trading presents an opportunity to illegally evade taxes through transfer pricing.  Consequently, responsible executives need have a thorough understanding of transfer pricing standards to avoid potential liability.

What is transfer pricing, and how is it used improperly?

The free market is one of the most fundamental concepts in business, and sets the price of goods and services through the tension between supply and demand.  But the free market principle is premised on trade occurring between two distinct and unrelated entities, each of which is operating exclusively according to its own interests.  The principle begins to break down when the lines between the trading partners begin to blur, and the entities begin to act considering interests other than their own.

For example, suppose the Californian manufacturer GuacamoleWorks produces its guacamole in Los Angeles using avocados from the Mexican farm AvocadoLife.  Traditionally the price of the avocados would be a market price, and their taxes would be based upon that price.  But if GuacamoleWorks and AvocadoLife are both owned by SuperFoods, they have an incentive to cooperate to maximize SuperFoods’ profit on the transaction even if that means reduced profits for either GuacamoleWorks or AvocadoLife individually.  The process of setting prices for goods traded between affiliated businesses is known as transfer pricing.

Now suppose that SuperFoods cooks up a scheme to increase overall profits by reducing taxes.  Instead of selling avocados directly from AvocadoLife to GuacamoleWorks, they will go through a shell company in a country with low taxes, or none at all.  AvocadoLife will sell their avocados to the shell company at a very low price, thus earning very little profit and consequently accruing a small tax liability.  The shell company then sells the avocados to GuacamoleWorks at a very high price, meaning GuacamoleWorks will also earn very little profit in the US and will have a smaller tax bill.  But the shell company has bought low and sold high, earning tremendous profits for SuperFoods in the country where they are not taxed.  This is known as transfer mispricing or transfer pricing manipulation, and it is illegal.

What can I do to protect my business?

The best way to avoid allegations of tax evasion through transfer mispricing is to conduct business between related companies as though they were not affiliated in any way.  This approach is known as the “arm’s length” principle, and is designed to ensure that transfer prices are essentially similar to market prices.

The arm’s length approach can be very difficult to implement, however.  In some cases, there simply isn’t a market to compare to.  Consider a manufacturer who produces specialized parts that are only used by a single company, or a product whose value is substantially contained in its brand.  How are appropriate prices to be determined?

In complicated transfer pricing scenarios, documentation and transparency can be two saving graces.  An appropriate arm’s length analysis determines where in the corporate chain value is created or transferred, and submits to taxes as appropriate based on that analysis.  Businesses should document considerations made in arriving at transfer prices, for instance use or consumption of assets or potential liabilities incurred by the various parties.  Additional direction should be taken from the regulations and other guidance produced by the IRS.

Transfer pricing is a hot topic in modern business tax circles, with evaluation and enforcement efforts on the rise.  And with the potential liability from adverse rulings so high, it’s critical for companies to be certain their transfer prices are on the level.  Our firm’s attorneys are seasoned experts who have been assisting businesses manage their tax liabilities for years, and are available to guide you through the transfer pricing maze.  If you have questions or concerns about your businesses’ transfers and would like to speak with an attorney, contact us today to schedule a consultation.

Posted in: International Tax

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