Transfer Pricing

Recently, there has been a great deal of news surrounding the IRS' increased focus on international tax compliance, most notably the IRS reorganization in August, 2010. The primary change under this plan was the addition of 875 employees to the existing staff of 600 in a new "Large Business and International Division." According to IRS Commissioner Doug Shulman, the realignment will strengthen international tax compliance in several ways, including centralizing and enhancing the IRS' focus on transfer pricing.

In general, transfer pricing involves the price at which goods, intangibles, services and capital are transferred across tax borders between related entities. The question is whether the price charged in such transactions is "arm's length" – i.e., the price that would have resulted if two independent parties to the transaction had agreed to the price.

Corporations today routinely have business operations all over the world. For example, a chip manufacturer might have its headquarters in Taiwan, a manufacturing plant in China and be conducting R&D in the United Kingdom. In order to sell its goods to U.S. computer manufacturers, this manufacturer would normally not sell directly from its Taiwanese entity to the U.S. customer. Instead, it might establish a separate U.S. legal entity to serve as its distributor in the U.S.

There are many reasons for this. An independent distributor may not have sufficient knowledge of the product to provide specialized training to its sales staff while the manufacturer would. Moreover, the independent distributor might not want to deal with the complexities of import/export trade.

The transfer pricing rules were established in order to prevent controlled parties from manipulating intercompany prices to lower their worldwide tax liability. Using the example from above, let's assume the Taiwanese manufacturer is taxed at an effective rate of 20%, and the U.S. distributor is taxed at a 35% rate. It is easy to see where the company could, on a worldwide basis, significantly reduce its overall tax liability by charging an inflated price on the sale of its product from the Taiwanese manufacturer to the U.S. distributor.

This ability to shift income to lower tax jurisdictions has recently come to light in an article from Bloomberg.com, which discussed a strategy employed by Google (as well as other companies) called the "Double Irish". This strategy enabled Google to shift income from the U.S. and Europe by establishing entities in Ireland and Bermuda, and then paying royalties to those entities. Ireland currently has one of the lowest corporate tax rates in Europe, and Bermuda is a popular tax haven. Google, with the help of their tax advisers, received the consent of the IRS to operate under this structure, which allowed the company to defer significant taxes over the last three years.

The U.S. Internal Revenue Code contains guidelines which prescribe methods to be used to determine an arm's length price for the transfer of goods, intangibles, services and capital; each of the methods is based on what a comparable, uncontrolled company would charge, or how much profit they would typically earn, under similar circumstances.

If your U.S. business has related party transactions with cross-border entities, you should contact your RINA representative to discuss how we can assist you in determining an arm's length price for these transactions.