You are a non-US based firm and you’ve taken the plunge by deciding to set up your business in the US. Now you are designing your business model and your budget for the next few years.
High on your “to do” list is estimating sales revenue, marketing, wages and office space and other expenses so that you can determine the potential profitability or loss of your business globally.
The difficult task is then to determine how much of this profit or loss is taxed in each country where you are operating. Since tax rates vary from 12.5% in Ireland to 39% in the US, the tax rate will makes a big difference to your profits after taxes and therefore your cash flow.
Transfer pricing comes into play in determining tax liabilities.
As transactions among related parties grow across the globe, so does Governments’ focus. Fueled by the OECD (Organisation for Economic Co-operation and Development) Base Erosion and Profit Shifting initiative (BEPS), Governments around the world are stepping up enforcement of related transactions because each country wants its fair share of the global tax revenue pie.
Transfer Pricing Planning – Getting Started:
Fundamentally, related parties must treat each other as they would if they were dealing with an unrelated 3rd party. This is called the arm’s length principle. The following example may illustrate this concept:
A UK Ltd company has designed and developed a SaaS product in the UK and has gotten some traction, it is generating revenue in the UK as well as in a number of other countries in Europe. A US corporation (INC.) was then created to tap into the US market and scale the business.
- The LTD wants to capitalize the INC. What would be an acceptable debt equity ratio and a suitable interest rate for the LTD to charge to the INC.?
- What royalty rate should be applied for the use of the LTD’s intangible property?
- What price should the INC pay to the LTD for the SaaS product?
- The LTD performs administrative services for the INC such as HR, legal and accounting. How much should the INC pay the LTD for these services?
If you do not establish Transfer Pricing Policies and Practices, document such policies in a written Inter-company Agreement and benchmark your pricing methods and rates with other companies that are comparable to yours, you may find that you may either overpay or underpay your taxes. More importantly, if you do not design your Inter-company Policies and Practices at the start of your operations, Governments may do it for you later on. That is rarely a good thing for the taxpayer!
The Marks Paneth global network is a multi-lingual and multi-disciplinary team of experienced professionals who can work with you to get started by designing an efficient transfer pricing model and pricing methodology that aligns with your business.
Implementing and Complying with Transfer Pricing Policies and Practices:
Once your inter-company prices have been established, they need to be monitored regularly. Businesses pivot and grow and internal employee turnover in a company may result in a change in focus. At year-end, it is important to review the evolution of the business model in order to determine if the Transfer Pricing Policies and Practices, as well as the Inter-company legal agreements require additions and modification. It is also important to review the books and records in case year-end adjustments are required before closing the books of each of the related parties in order to reflect the transfer pricing adjustments required in each country.
In addition to making adjustments in the books, more and more countries require, that even Micro MNEs, substantiate and document their transfer pricing policies and practices. In the US, for example, to avoid substantial penalties for underpayment of tax upon audit, all taxpayers must prepare contemporaneous documentation to show adherence and compliance with the arm’s length standard and IRS Transfer Pricing Regulations.
Two types of documents are required: Background documents, which include information about the business and discusses why the particular transfer pricing method was selected and others were rejected. Principal documents are required, which include a description of the related party transactions as well as description of comparables examined.
Finally, an explanation of the economic analysis relied upon in developing the selected transfer pricing method is needed. This documentation must be in existence when the income tax return for that tax year is filed in order to claim an exemption from certain onerous IRS penalties.
- Overview of the business.
- Description of the organizational structure of all related parties engaged in transactions potentially relevant according to the IRS.
- Documentation explicitly required by the regulations.
- Description of the transfer pricing method selected and explanation of why it was selected.
- Description of the methods that were considered and explanation of why they were not selected.
The Principal Documents:
- Description of the controlled transactions.
- Description of the comparable that were used.
- Explanation of the economic analysis and projections relied upon in developing the method.
- Description of any relevant data that as obtained after the end of the tax year and before filing a tax return, and which would help determine if a specified method was selected and applied in a reasonable manner.
- Index of the principal and background documents and a description of the record keeping system used for cataloging and accessing those documents
Managing Transfer Pricing Controversy – It is not too late to get help:
Faced with a challenge from a government tax authority or the risk of incurring a 40% gross valuation misstatement penalty from the IRS, Marks Paneth is here to help you. We can assist in resolving disputes and work with tax authorities to build your defense and negotiate a resolution.
This material has been prepared for general informational and educational purposes only and is not intended, and should not be relied upon, as accounting, tax or other professional advice. Please refer to your advisors for specific advice.