Transfer Pricing: A Primer for International New Entrants to the US

October 1, 2015 | Download PDF

Regardless of structure and revenue levels, the operations of corporations with related entities across international tax jurisdictions inevitably involve intercompany transactions.[1]  International and local rules and guidelines require that arm’s length standard be met in the pricing of intercompany transactions, and require contemporaneous documentation.  International transfer pricing rules and guidelines are established by the Organisation for Economic Co-operation and Development (OECD) as set forth by the OECD Guidelines.[2]  In the case of the U.S., transfer pricing rules and regulations are established by the U.S. Department of the Treasury, Internal Revenue Service (IRS) and as set forth by Section 482 of the Internal Revenue Code (hereinafter IRC§482).[3]

As established by IRC§482 and by the OECD, sufficient documentation must be maintained to demonstrate that the pricing structure for intercompany transactions meets the arm’s length standard.  The type, content, and structure of contemporaneous documentation, however, may vary depending on the circumstances of each multinational enterprise (MNE). 

Take, for example, the two following circumstances:

A) Corporation ABC is an established business outside of the U.S. and has been in operation for many years in the non-U.S. market.  Its related entity ABC-US has been in operation in the U.S. for 10-15 years and has generated revenues in excess of $5 million per year for several years.  ABC and ABC-US market and sell home décor that is manufactured outside of the U.S. and placed in the U.S. market through ABC-US.  ABC sources the manufactured products and provides financing and management services, including the use of a proprietary software platform to maintain customer information, order tracking, and other key business operations data.

B) Corporation XYZ has long-established presence outside of the U.S. and entered the U.S. market 2 years ago through its subsidiary XYZ-US.  XYZ-US has a sales team and a marketing department, with U.S. revenues under $2 million per year.  XYZ sources retail products that are placed in the U.S. via the sales team at XYZ-US. All customer data, order tracking, planning, and bookkeeping is conducted by the management team outside of the U.S.

Both of the above corporations are faced with transfer pricing issues as they operate across international tax jurisdictions.  However, they differ greatly in circumstances, type of intercompany transactions, revenues, and the characteristics of internal data and scope of operations. 

To better understand the documentation requirements under specific sets of circumstances, the following key segments of IRC§482 must be considered: 

(1) “A controlled transaction meets the arm’s length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (arm’s length result).  However, because identical transaction can rarely be located, whether a transaction produces an arm’s length result generally will be determined by reference to the results of comparable transactions under comparable circumstances.”

(2) The “Standard of Comparability” establishes that a selected uncontrolled transaction does not have to be identical to the controlled transaction, but it must be sufficiently similar in order to provide a reliable measure of the arm’s length result.  The comparability between uncontrolled transactions and controlled transactions is determined via the functional analysis, which evaluates the functions performed and the resources employed “… by the taxpayers in each transaction.”

(3) Under the “Best Method Rule” of IRC§482, the “… arm’s length of a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable measure of an arm’s length result.”  The methods set forth by IRC§482 are based on type of transactions.  Depending on the circumstances, interrelated transactions may be analyzed via joint method, or may have to be analyzed separately.

Accordingly, because the analysis of intercompany pricing requires the identification of comparable transactions, the initial step must be the determination of the economically significant intercompany transactions so that comparable, uncontrolled transactions may be identified.  Comparable uncontrolled transactions may be existing transactions with third-party vendors or customers, or they may be identified via external databases that provide such information. The comparability of ABC/ABC-US to external data will likely differ greatly from the comparability of XYZ/XYZ-US to external data. While there is common ground relating to some of the documentation that must be maintained, what constitutes sufficient documentation for ABC/ABC-US will likely differ from what constitutes sufficient documentation for XYZ/XYZ-US.

In order to adhere to the IRC§482 and OECD Guidelines requirements, generally speaking, transfer pricing documentation should include the following components:

  1. Functional Analysis: A description of the organizational structure, covering all entities, and a description of the business activities, markets, and geographic locations, as well as sufficient details regarding each type of economically significant intercompany transaction.   Organizational charts, the history and evolution of the corporation, and information on structural changes should be considered as part of the functional analysis.  The functional analysis should also include a discussion of the economic circumstances affecting each of the related entities.  IRC§482 states that the determination of the degree of comparability between controlled and uncontrolled transactions requires a comparison of all functions performed by the taxpayers and the identification of the resources utilized by the taxpayers in performing such functions.  The objective is to identify “economically significant activities undertaken, or to be undertaken, by the taxpayers in both controlled and uncontrolled transactions.”  The functional analysis should provide information on all resources utilized or to be utilized, and give consideration to all tangible and intangible assets used.  Information regarding any transaction with third-party vendors or customers that may be comparable to the intercompany transactions should also be discussed.  The functional analysis, however, does not provide a method and does not establish whether the arm’s length standard is met.    
  2. Economic Analysis or Benchmarking:  This segment of the transfer pricing documentation focuses on the identification of the appropriate methodology for the analysis of each set of intercompany transactions.  While the OECD Guidelines are to be considered in the economic analysis, in the case of the U.S., the specific rules and the specific methods set forth in IRC§482 are to be applied. The “Standard of Comparability” as well as the “Best Method Rule” need to be considered and discussed as part of the economic analysis.  The economic analysis segment of the contemporaneous documentation must also include the identification and analysis of comparable, uncontrolled transactions.  Comparable, uncontrolled transactions establish the market price range for intercompany transactions. 
  3. Financial Analysis:  This segment of the analysis requires the evaluation of the historical financial data for the tested party. Generally speaking, the price charged for intercompany transactions is expected to fall within percentiles 25 and 75 (the inner quartile) of the price range identified through the applicable comparables search.  

The first step for, and the first challenge that arises in, maintaining transfer pricing documentation is the complete identification of all economically significant intercompany transactions, which precedes the identification of comparable, uncontrolled transactions either via existing third-party relationships or via external databases, and which, in turn, precedes the application of the best method to the analysis of financial data.   Intercompany transactions that are not documented may present reporting issues and, if economically significant, will impede the proper identification of comparable uncontrolled transactions, and will hinder both the economic and financial analyses.  Therefore, the identification of the applicable documentation must commence with complete identification of all economically significant intercompany transactions.

IRC§482 defines intercompany (controlled) transaction as any transaction occurring between two or more related entities, and it specifically defines intercompany (controlled) transactions as “… any sale, assignment, lease, license, loan, advance, contribution, or any other transfer of any interest in or a right to use any property (whether tangible or intangible, real or personal) or money, however such transaction is effected, and whether or not the terms of such transaction are formally documented. A transaction also includes the performance of any services for the benefit of, or on behalf of, another taxpayer.”

While the transfer of tangible goods and the licensing of intellectual property, for example, may be obvious types of intercompany transactions, other transactions may not be as easily identifiable, particularly in the case of entities that are start-ups in a new market, such as the U.S.   Such is the case for a corporation as delineated through the XYZ/XYZ-US example above.  Transactions such as services provided by management and the administration team, access to centralized databases, and the use of proprietary data and systems platforms or other intellectual property, sales and marketing, and financing, to name a few, may be involved in the cross-border operations to varying degrees. 

All of the necessary identification of economically significant intercompany transactions may be more readily available and more clearly defined for larger corporations and for those with a longer-standing history of operations, or for segments of a corporation with longer-standing history of operations.  For newer entrants, or for newer segments or markets for an established corporation, identifying intercompany transactions may pose a significant challenge as there may be significant overlap in duties of management and operations personnel across the related entities.   In addition, the resources and costs associated with intercompany transactions may not be sufficiently recorded.  Moreover, structural changes are typically more frequent for newer corporations or those corporations with a limited number of years in operation and more limited revenue streams.

While transfer pricing considerations are relevant for all MNEs, transfer pricing offers significant planning opportunities surrounding the preparation of contemporaneous documentation for U.S. subsidiaries of foreign entities at their early stages (U.S. MNE start-ups),[4]  and careful evaluation of the circumstances should be geared towards defining sufficient documentation fitting the realities of the specific U.S. MNE start-up.  As a place to start, U.S. MNE start-ups should prepare, update, and maintain documentation to be used for the preparation of the functional analysis.  In order to do so, the following information should be maintained and updated as necessary: 

  1. Documentation on the organizational structure, structure of operations, functional responsibilities and assets/resources utilized or to be utilized, as well as documentation on any structural or market changes affecting the roles and responsibilities of the related entities.
  2. Documentation identifying all economically significant intercompany transactions, and updates to such documentation as roles and the use/provision of resources change as the corporation evolves.
  3. Documentation detailing the resources provided by each entity for each aspect of the operations of the corporation and for each of the identified economically significant intercompany transactions.  This includes the identification of the individual(s) at the management and operations levels who may dedicate time for the benefit of a related entity, and clear and sufficient records of the time dedicated for the benefit of each related entity, as well as records of all associated direct and allocated costs.
  4. Documentation on any third-party transactions similar in nature to the intercompany transactions as well as descriptive information on third-party transactions not comparable to the intercompany transactions.
  5. Documentation on any intellectual property that may be utilized across the related entities, such as methods and know-how, as well as systems/software/platforms or any other intangibles.

As stated earlier, what constitutes sufficient transfer pricing documentation may differ depending on the circumstances of each MNE, and it will be contingent on the availability of the required information.  The functional analysis requires that all economically significant intercompany transactions, functions, responsibilities and assets used be properly identified.  The economic analysis (benchmarking) requires that comparable transactions under comparable circumstances can be identified.  And the financial analysis requires the availability of sufficient and reliable financial data for all entities analyzed, as well as for the comparables.   Reliable and sufficient documentation can only be established when sufficient data is available and maintained for each of the three above components of documentation.

When structural changes are more frequent, as is the case for more recent MNEs, i.e., those organizations that can be considered U.S. MNE start-ups, or for MNEs entering new markets, meeting the requirement of maintaining sufficient transfer pricing documentation will likely result in more frequent updates to the functional analysis.  For these entities, the financial data, as well as data on comparable, uncontrolled transactions may not be sufficient for or conducive to a full and complete financial analysis.  However, sufficient documentation must still be available to satisfy the requirements under the rules.  In contrast, for more established MNEs with more stable markets of operation, more established intercompany interactions, and fewer structural changes, the functional analysis and the identification of comparable transactions may be relatively more stable as well, in which case the preparation of transfer pricing documentation may focus more on the financial analysis, accompanied by relatively more brief updates to the functional analysis and corresponding updates on the identification of comparable, uncontrolled transactions. 

This article, "Transfer Pricing: A Primer for International New Entrants to the US", was originally published in Morison International's quarterly tax newsletter, Global Tax Insights, Q3 2015. It was reprinted by permission in Global Tax Weekly, October 15, 2015, published by CCH, a Wolters Kluwer business


[1] While transactions across local tax jurisdictions may also be subject to transfer pricing considerations, this article focuses on international intercompany transactions.

[2] OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, July 2010.

[3] Section 482 of the Internal Revenue Code of 1986, as amended.

[4] For purposes of this discussion, we define U.S. MNE start-ups as U.S. subsidiaries of foreign entities with only a few years of operations and with revenues under $2 million.  This, however, is solely a practical definition by the author and not a formal definition.  


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