owned subsidiariesTransfer Pricing
Section 482 of the Internal Revenue Code (IRC), authorizes the Internal Revenue Service (IRS) to distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among businesses that are owned or controlled directly or indirectly by the same interests to prevent evasion of taxes or to clearly reflect the income of any such businesses. IRC §482 was created to prevent related parties from shifting income to low tax jurisdictions by requiring that arm’s length pricing (the price negotiated between two unrelated parties) be used when engaging in transactions between commonly controlled businesses.
The main types of transactions covered under these rules include:
- Transfer of tangible property
- Transfers of intangible property
- Patents and inventions
- Formulas and processes
- Designs
- Patterns or know-how
- Copyrights and literary, musical, or artistic compositions
- Trademarks, trade names, or brand names
- Franchises, licenses, or contracts
- Methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data
- Other similar items intangible in nature
- Intercompany services
- Loans
The IRS has issued regulations that provide the methods which may be used in determining an arm’s length amount charged in a controlled transfer of property or services. The pricing methods differ depending on the type of transaction involved. There are six pricing methods that can be used when pricing tangible property. These include the comparable uncontrolled price (CUP) method, resale price method, cost plus method, comparable profits method (CPM), profits split method, and other methods not specifically described in Treasury regulations. There are four pricing methods that can be used when pricing intangible property. These methods include comparable uncontrolled transaction (CUT) method, comparable profits method, profit split method, unspecified methods not specifically described in the Treasury Regulations.
The taxpayer is required to apply the “Best Rule Method.” The “Best Method Rule” requires the use of the pricing method which provides the most reliable measure of the arm’s length result. However, if the IRS determines that another method will produce a more reliable measure of the arm’s length result, the IRS’ method must be used. As a practical matter, taxpayers must apply as many different methods as possible. This will allow the taxpayer to evaluate the risk of the IRS determining that the best method was not applied.
Under the current transfer pricing rules, adequate documentation is necessary in the event of an IRS audit to prove that a transfer pricing policy is at arm’s length. Companies that have not properly documented their pricing methodologies are at risk for penalties. There is a statutory exclusion on the imposition of penalties for those transactions where the taxpayer has contemporaneously documented the particular pricing method used and has applied that method in a reasonable manner. This documentation must be in existence at the time the taxpayer files their income tax return. Taxpayers must produce such documentation to the IRS within 30 days of a request.
There are nine categories of principal documents that are used in the documentation of transfer pricing. The purpose of the documents is to “accurately and completely describe the basic transfer pricing analysis conducted by the taxpayer” to meet the requirements of Treas. Reg. §1.662-6(d)(2)(iii)(B). The nine categories of documents are:
- An overview of the taxpayer’s business, including an analysis of the economic and legal factors that affect the pricing of its property or services
- A description of the taxpayer’s organizational structure (including an organization chart) covering all related parties engaged in transactions potentially relevant under IRC §482, including foreign affiliates whose transactions directly or indirectly affect the pricing of property or services in the United States
- Any documentation otherwise specifically required under the regulations of IRC §482
- A description of the method selected and an explanation of why that method was selected
- A description of alternative methods that were considered and an explanation of why they were not selected
- A description of the controlled transactions (including the terms of sale) and any internal data used to analyze those transactions
- A description of the comparables that were used, how comparability was evaluated, and what, if any, adjustments were made
- An explanation of the economic analysis and projections relied upon in developing the method
- A general index of the principal and background documents and a description of the record keeping system used for cataloging and accessing those documents
