A U.S. parent company may provide legal, accounting, tax, or other professional services to its related companies in various countries. Since the foreign subsidiaries benefit from these services, the U.S. parent charges them a service or management fee.
Under the arm’s length standard, the fee should be similar to what an independent accounting or law firm would charge an unrelated customer for providing the same services.
If the U.S. parent invoices less than the arm’s length fee, it reports less income in the United States. As a result, more profit remains with the foreign subsidiary, which may reduce the group’s overall tax liability if the foreign country has a lower tax rate.
Let’s understand the legal or accounting service-related transfer pricing through a simple example.
Example
A U.S. parent company provides accounting and legal services to its Irish subsidiary. The amount the parent charges the subsidiary is called the transfer price.
Suppose an independent accounting or law firm would charge $200,000 for the same services. Under the arm’s-length principle, the U.S. parent should generally charge a similar amount.
Suppose the U.S. parent charges its Irish subsidiary only $50,000 instead of the $200,000 arm’s-length price.
Let’s compare the following two situations:
The following table compares both situations and shows the difference.
| Item | Arm’s-Length Price (A) | Actual Price (B) | Difference (C) | Calculation |
| Fee charged and paid by Irish subsidiary | $200,000 | $50,000 | $150,000 | A – B = C |
| Income reported by U.S. parent | $200,000 | $50,000 | $150,000 | A – B = C |
| Additional profit remaining in Ireland | N/A | $50,000 | $150,000 ($200k-$50k) | C |
In the above table, it is obvious that the U.S. parent reports $150,000 less income, while the Irish subsidiary has $150,000 more profit if the price charged is $50,000.
In simple terms, if the U.S. parent charges $50,000, then $150,000 of profit remains in Ireland instead of being reported as income by the U.S. parent.
Now let’s compare what happens when the U.S. parent charges $200,000 versus $50,000 for the same services.
Assume:
U.S. tax rate = 21%
Irish tax rate = 12.5%
If the U.S. parent charges $200,000, then the U.S. parent reports $200,000 of income.
U.S. tax on the arm’s length price of $200,000 will be as follows:
$200,000 × 21% = $42,000
So, the total tax in this example is $42,000.
If the U.S. parent charges $50,000, the U.S. parent reports only $50,000 of income.
U.S. tax on the actual price of $50,000 will be as follows:
$50,000 × 21% = $10,500
If the U.S. charges $50,000, then the remaining $150,000 is left as additional profit in Ireland.
Irish tax on the additional profit:
$150,000 × 12.5% = $18,750
Therefore:
$10,500 U.S. tax + $18,750 Irish tax = $29,250 total tax
| Fee Income | |||
| Paid by U.S. | $200,000 | $50,000 | |
| U.S. tax | $42,000 | $10,500 | |
| Irish tax | $0 | $18,750 | |
| Total tax | $42,000 | $29,250 | |
The tax difference between the total tax paid if the price was at arm’s length and the actual price is as follows:
$42,000 − $29,250 = $12,750
In this simplified example, charging $50,000 instead of $200,000 results in $12,750 less in combined tax. Also, the U.S. tax goes down from $42,000 to $10,500.
However, the U.S. parent generally cannot simply choose the lower price. The price charged between related companies should follow the arm’s-length principle.
This illustrates why transfer pricing is important when related companies operate in countries with different tax rates.
If the IRS determines that the arm’s-length price should have been $200,000, but the U.S. parent charged only $50,000, the IRS can potentially make an adjustment under IRC Section 482.
The IRS may also assess interest and, where applicable, penalties.