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Transfer Pricing Worldwide Crackdown

As global trade continues to increase, multinational corporations are faced with what may be the single most important tax issue today.

Transfer pricing, or what the affiliates of multinational corporations charge one another when exchanging goods, property and services, continues to be a controversial topic. In the United States, Congressional critics of the Internal Revenue Service (IRS) continue to urge the agency to crack down on transfer pricing practices that have allowed foreign corporations doing business in this country to avoid paying U.S. taxes.Outside the United States, transfer pricing practices are a major target of investigation by international revenue authorities, according to ErnstandYoung Transfer Pricing Monitor, an annual study of transfer pricing issues affecting multinational corporations.In fact, about one-half of the more than 200 multinational companies studied by ErnstandYoung 90 percent of which were based in the United States said that they are currently involved in audits in which transfer pricing is a central issue, a figure that remains steady from the first pricing monitor conducted by ErnstandYoung in 1995.More than two-thirds of multinationals surveyed consider transfer pricing to be the single most important tax issue they face today; followed at a distant second by foreign tax credits.In the United States, General Accounting Office auditors contend that transfer pricing abuse is responsible for the fact that 73 percent of all foreign companies doing business in this country are able to avoid all U.S. income taxes. This trend is reportedly costing the U.S. Treasury hundreds of millions of dollars annually, though the exact amount of the transfer pricing-related tax avoidance is open to considerable debate. International Transfer Pricing

According to the ErnstandYoung survey, Canada, Australia and the United Kingdom continue to lead the list of nations demanding that companies provide documentation of the transfer prices applied to specific transactions, an onerous and potentially expensive task. Of all the requests for transfer pricing documentation reported by multinational corporations, 44 percent were generated by the tax authorities of Canada, compared to 22 percent from Australia and 19 percent from the United Kingdom.On December 7, 1998, Argentinas legislature enacted major transfer pricing legislation that will, according to its sponsors, bring Argentinas transfer pricing regime closer to Organization for Economic Cooperation and Devel-opment (OECD) pricing guidelines.Transfer pricing reforms were needed in Argentina because under prior law, the national tax agency, Administracion Federal de Ingresos Publicos (AGIP), had the authority to determine taxable income in transactions between economically linked parties and to make income adjustments. However, there were no specific rules regarding transfer pricing on specific methods to test transfer pricing among related entities, practitioners said.In Mexico, an August 1998 deadline for that countrys new transfer pricing documentation rules was extended for seven months when tax authorities realized that few of the thousands of foreign firms operating in the country were ready to comply.Mexicos deadline extension was accompanied by a warning to companies that the audits and fines for non-compliance would be swift and expensive. Penalties for violations will range up to 100 percent of the amount of tax not paid originally, plus the tax itself.The message is clear. Mexico is intent on becoming the latest country to join a movement by many of the worlds governments to gain more control over the taxes paid by global companies, ranging from the largest multinationals to small manufacturers. Battling Tax EvasionMany government regulators the United States being the most vocal argue that multinational parent companies shift income from high-tax to low-tax jurisdictions through such methods as overpricing sales to subsidiaries. In the past, the IRS has not been among the most aggressive when it comes to pursuing transfer pricing manipulators.To ensure that companies pricing policies with affiliates abroad are conducted on an arms length basis, the IRS established new transfer pricing rules in 1993. Known as Section 482 and buried deep within the U.S. tax code, these opaque regulations touched-off an international firestorm with other countries that do not agree with the IRSs views.The IRSs intercompany pricing penalty regulations were intended to stop what the U.S. government perceived as abuses by multinational taxpayers in determining their intercompany transfer prices. Companies that have not reviewed their transfer pricing methodology or those companies whose documentation is insufficient to meet IRS requirements, are now subject to stringent penalties, should the IRS find reason to to make an intercompany transfer-pricing adjustment.As already mentioned, the OECD has established a series of transfer pricing guidelines and recommendations for multinational enterprises. However, that ErnstandYoung survey revealed some 50 percent of multinational companies continue to use profit-based pricing methods such as the Comparable Pricing Method (CPM), which was set forth originally by the IRS but that the OECD considers to be a methodology of last resort. The widespread use of the IRS-endorsed calculation method is not surprising considering that 89 percent of multinationals surveyed pointed to potential IRS penalties as their primary motivation for documenting the prices used for intercompany transactions. Sixty-four percent reported that they sought to document appropriate transactions in anticipation of an actual IRS audit. Under the current U.S. tax rules, the IRS is authorized to make adjustments to a companys income, deductions, credits or allowances. It is also authorized to assess substantial penalties from 20 to 40 percent against those taxpayers who understate or overstate their intercompany transfer prices by certain amounts.The tax regulations contain specific documentation requirements divided into two parts principal documents and background documents. This documentation must be gathered prior to filing the operations income tax returns, and is substantial and must be provided to the IRS within 30 days of a request.According to the tax rules, a substantial valuation misstatement occurs where the IRS makes an intercompany transfer pricing adjustment and (1) the intercompany transfer price for any property or services on the tax return is 200 percent or more, or 50 percent or less, of the determined price (transaction penalty), or (2) the total intercompany pricing adjustments are greater than the lesser of $5 million or 10 percent of gross receipts (net adjustment penalty).A gross valuation misstatement occurs where the IRS makes an intercompany transfer-pricing adjustment and (1) the transfer price for any property or services on the tax return is 400 percent or more, or 25 percent or less, of the determined price (transaction penalty) or (2) the total intercompany pricing adjustments are greater than the lesser of $20 million or 20 percent of gross receipts (net adjustment penalty). Obviously, even relatively small companies with intercompany transactions can have transfer-pricing adjustments that exceed these present thresholds.The overall costs of documenting a companys transfer pricing practices, according to the ErnstandYoung survey, depended largely upon the company's sales and intercompany transactions. For example, a large multinational with an overall sales volume of between $1 billion and $5 billion spent a median of $100,000 while a smaller company with a sales volume between $500 million and $1.5 billion spent a median of $50,000.Survey results also showed that foreign multinationals spent approximately 50 percent more than U.S. multinationals ($75,000 and $50,000 respectively) in documenting transfer pricing. What To DoThe ErnstandYoung survey reported that external economists and/or tax advisors were rated among the most useful documentation tools for multinationals, used by 62 percent of those surveyed. Over three-quarters of the 62 percent said that they were satisfied with the results of the documentation assistance received.In order to avoid the penalties associated with a transfer pricing adjustment, U.S. textile, apparel and fiber companies must prepare, or have prepared, contemporaneous documentation of the following: a description of their industry and both the parent and subsidiarys operations in the business, including an analysis of the economic and legal functions that affect their intercompany transfer pricing policies (i.e., a functional analysis); an organizational chart showing how the company and its affiliate(s) are linked; documents required by transfer-pricing regulations such as cost-sharing agreements, economic analysis, financial data, etc.; a description of why a specified transfer pricing method was employed; an explanation of why each other pricing method that was considered, but not used, was rejected. Nothing else needs to be disclosed if no other methods were considered; a description of all terms associated with the sale of products from the U.S. company to the subsidiary, including payment terms, warranties, adjustments for currency fluctuations, etc.; a description of third-party data used to form the resale price; an explanation of the economic analysis or other projections relied upon in establishing the resale price and how those projections were used in conjunction with the data on comparable resellers in forming the resale price; and an index to the principal and background documents and a description of the record keeping system used to catalog and access those documents.Examples of background documents required by an IRS auditor might include invoices, canceled checks, contracts, articles of incorporation, bylaws, minutes of board of directors meetings, annual reports, current transfer-pricing studies, prior transfer-pricing studies and data on comparables. The selection and application of any transfer pricing method will be judged reasonable only if, in the eyes of the IRS, the textile company reasonably concluded that the method used provided the most accurate measure of an arms length price.Transfer pricing audits have traditionally been focused on the largest of companies. In Mexico, the focus has also been on large companies, with an emphasis on maquiladoras.Increasingly, tax authorities around the world are training inquiring eyes on smaller size companies. There is one positive note: the IRS has introduced rules to allow these smaller firms to avail themselves of a tax planning tool that until recently was used mainly by only the largest multinationals. Advanced Pricing AgreementOne way in which a U.S. company can limit exposure to both intercompany transfer-pricing adjustments and valuation misstatement penalties is to participate in the IRSs Advanced Pricing Agreement (APA) program. The APA process allows the taxpayer and the IRS to discuss matters in advance, in a less stressful setting.Since the programs inception, the IRS has considered APAs involving intercompany transactions dealing with the sale of goods, the provision of services and the transfer of intangibles in a wide variety of industries.While, in general, an APA is intended to be prospective, the transfer-pricing methodology agreed to can also be applied to prior years. The program also offers taxpayers the possibility of avoiding international economic double taxation of income. The IRS is continuing to encourage U.S. tax treaty partners to enter into bilateral advance pricing agreements or similar measures, as Canada has recently done.An APA assures everyone that the IRS will not question their intercompany transfer pricing methodologies and likewise prevent any exposure to penalties relating to intercompany transfer pricing adjustments. Whether this ammunition will reduce or increase the transfer pricing battles now raging remains to be seen.

September 1999