Transfer pricing can seem complicated, especially when a U.S. business has related companies in different countries or a foreign business has its related business in the United States. At its core, however, the basic idea is simple, which is as follows:
Related companies should generally price their transactions as if they were independent businesses dealing with each other.
In the United States, transfer pricing is governed primarily by Internal Revenue Code (IRC) Section 482 and the related Treasury Regulations. These rules apply to transactions between related or commonly controlled businesses, such as the sale of goods, services, or intellectual property, or the provision of financing.
The IRS can adjust the income, deductions, credits, or allowances of related companies if their transactions do not produce results consistent with the arm’s-length principle.
Below are some of the most common questions businesses have about U.S. transfer pricing.
Generally, yes. You may need a transfer pricing policy if your business has transactions with related parties.
Section 482 applies broadly to transactions between businesses that are owned or controlled, directly or indirectly, by the same interests. This can include both cross-border and domestic transactions.
Common examples of related party transactions include the following:
There is no general threshold below which Section 482 simply does not apply. In other words, a company does not automatically escape the transfer pricing rules just because its related-party transactional value is small.
However, the level of transfer pricing risk and the need for detailed analysis generally increase when transactions are large, complex, cross-border, or have a significant effect on taxable income.
For example, a U.S. company that buys products from its foreign parent should generally consider whether the purchase price is consistent with what independent companies would have agreed to under similar circumstances.
Separately, certain large U.S.-headed multinational groups may have additional reporting obligations. For example, a U.S. ultimate parent entity of a multinational enterprise group generally should file Form 8975, Country-by-Country Report, if the group meets the applicable $850 million annual consolidated revenue threshold and other requirements.
The starting point to determine the correct transfer price is the arm’s-length principle.
This means that a related-party transaction should generally produce a result similar to what independent businesses would have agreed to under comparable circumstances.
The U.S. transfer pricing rules require taxpayers to use the “best method”. This method provides the most reliable measure of an arm’s-length result based on the facts and available information.
There is no automatic ranking that requires taxpayers to use one method before another. The most appropriate method depends on the type of transaction and the facts involved.
Common U.S. transfer pricing methods include the following:
Choosing a method is only part of the process. The taxpayer should also perform a comparability analysis.
This analysis looks at factors such as:
For example, let’s say a U.S. subsidiary performs routine distribution activities while its foreign parent owns the key intellectual property and bears significant business risks. In that case, the U.S. subsidiary may not be expected to earn the same level of profit as the company that owns the valuable intellectual property and assumes greater risks.
For transactions involving valuable intellectual property, the U.S. rules also require consideration of whether the income earned from the intangible property is appropriate in relation to the income attributable to that intangible.
Selecting the right method and comparable companies can be complicated. That’s why many businesses use transfer pricing professionals to perform the functional analysis, select the appropriate method, conduct benchmarking, and determine an arm’s-length range.
The United States takes a somewhat different approach from many countries.
The U.S. generally does not require taxpayers to attach a Master File or Local File to their tax return. It also does not generally require taxpayers to submit a transfer pricing study with the return simply because they have related-party transactions.
However, documentation is extremely important if a taxpayer wants to protect itself from certain Section 6662 transfer pricing penalties.
To obtain this protection, taxpayers generally need to maintain contemporaneous documentation showing that they reasonably selected and applied a transfer pricing method that provided the most reliable measure of an arm’s-length result.
The required documentation generally must be in existence by the time the tax return is filed, including extensions, and must generally be provided to the IRS within 30 days of an examination request.
Important documentation generally includes:
A transfer pricing report by itself does not guarantee protection against penalties. The analysis should be reasonable, complete, and consistent with the actual facts and conduct of the related companies.
Intercompany agreements should also accurately reflect what the companies actually do in practice. A contract that says one thing while the companies actually operate differently can create problems during an IRS examination.
Businesses may also have separate information-reporting obligations. For example, certain related-party transactions involving foreign corporations, foreign partnerships, or foreign-owned U.S. corporations may require Forms 5471, 8865, or 5472.
Transfer pricing adjustments can result in significant penalties.
Under IRC Section 6662, accuracy-related penalties may apply when an IRS transfer pricing adjustment results in a substantial or gross valuation misstatement.
The penalties can generally be:
The rules use specific thresholds to determine whether an adjustment qualifies as substantial or gross.
For example, a substantial valuation misstatement can generally arise when:
A gross valuation misstatement generally involves bigger differences, such as:
These penalties can be significant because they are generally nondeductible.
Taxpayers may generally avoid the net adjustment penalty by satisfying the requirements for the reasonable-cause/penalty-protection documentation rules, including selecting and applying a reasonable transfer pricing method, maintaining the required documentation by the time the return is filed, and providing it to the IRS within the required time when requested.
However, simply having a transfer pricing report does not automatically eliminate penalties. The documentation must satisfy the applicable regulatory requirements and support a reasonable transfer pricing position.
Other penalties may also apply if a taxpayer fails to file required information returns, such as Form 5472.
There is no general U.S. rule requiring a taxpayer to prepare a completely new transfer pricing study every year.
However, transfer pricing should not be treated as a one-time exercise.
Businesses should generally review their transfer pricing policies and supporting documentation at least annually, particularly when they have significant related-party transactions.
A company should consider updating its analysis when there are material changes in:
Financial information for comparable companies should also generally be updated regularly so that the taxpayer can determine whether its actual results remain consistent with the arm’s-length range.
A full benchmarking study or comparable-company search is often refreshed every two to three years when the business and economic circumstances remain substantially unchanged. However, it may need to be performed sooner if there are significant changes in the business or market.
The key is to make sure that three things remain consistent:
What the agreement says → What the companies actually do → What the transfer pricing analysis supports
Regular reviews help a business identify problems early and reduce the risk that its transfer pricing policy becomes outdated.