+

Transfer Pricing: A Primer

Fernwood Global Kalbian Hagerty LLP

Transfer pricing in the news

Excerpt from Bloomberg BusinessWeek (October 21, 2010):

To reduce its overseas tax bill, Google uses a complicated legal structure that has saved it $3.1 billion since 2007 and boosted last year's overall earnings by 26 percent. While many multinationals use similar structures, Google has managed to lower its overseas tax rate more than its peers in the technology sector. Its rate since 2007 has been 2.4 percent . According to company disclosures, Apple (AAPL), Oracle (ORCL), Microsoft (MSFT), and IBM (IBM) which together with Google make up the top five technology companies by market capitalization reported tax rates between 4.5 percent and 25.8 percent on their overseas earning from 2007 to 2009. All of these arrangements are legal. Google's practices are very similar to those at countless other global companies operating across a wide range of industries, says Jane Penner, a company spokeswoman who declined to address the particulars of Google's tax strategies.

Fernwood Global Kalbian Hagerty LLP

Media reaction to Google story

The tactics of Google depend on transfer pricing,
paper transactions among corporate subsidiaries that allow for allocating income to tax havens while attributing expenses to higher-tax countries. Such income shifting costs the U.S. government as much as $60 billion in annual revenue, according to Kimberly A. Clausing, an economics professor at Reed College in Portland, Oregon.
- Bloomberg News, October 21, 2010

Its called transfer pricing and technically its legal. But hows it mesh with that whole dont be evil thing?
- Kai Ryssdal, American Public Radio, October 21
Fernwood Global LLC Kalbian Hagerty LLP

Scope of this presentation

An Overview of Transfer Pricing

Terms of Art Best Method Rule Comparability

Types of Controlled Transactions Examples Recordkeeping Requirements Advance Pricing Agreements

Fernwood Global LLC Kalbian Hagerty LLP

Overview of transfer pricing

Fernwood Global LLC Kalbian Hagerty LLP

What is transfer pricing?

Transfer

pricing is a set of rules that looks at whether the pricing on a transaction between related parties is the same as the arms length price that would occur in a comparable transaction between unrelated parties.
Designed

to prevent tax avoidance among related entities

Concern

about tax avoidance likely to occur only when controlled parties are subject to different tax regimes

Fernwood Global LLC Kalbian Hagerty LLP

Terms of art

Taxpayers

For purposes of 482, a taxpayer is any person, organization, trade or business, whether or not subject to US taxation. Treas. Reg. 1.4821(i)(3). Foreign persons are therefore taxpayers for purposes of these rules. Any control, direct or indirect, whether legally enforceable or not, and however exercisable or exercised, including control resulting from the actions of two or more taxpayers acting in concert or with a common goal or purpose. Treas. Reg. 1.482-1(i)(4). It is the reality of control that is decisive, not its form or the mode of its exercise. A presumption of control arises if income or deductions have been arbitrarily shifted.

Controlled

Controlled taxpayers

A controlled taxpayer means any one of two or more taxpayers that are controlled directly or indirectly by the same interests and includes a taxpayer that owns or controls other taxpayers. Treas. Reg. 1.4821(i)(5).

Fernwood Global LLC Kalbian Hagerty LLP

Terms of art (cont.)

Controlled group

The taxpayers owned or controlled directly or indirectly by the same interests. Treas. Reg. `.482-1(i)(6).

Transaction

Any sale, assignment, lease, license, loan, advance, contribution, or any other transfer or interest in or a right to use any property or money, however such transaction is effected, and whether or not the terms of such transaction are formally documented. Treas. Reg. 1.482-1(i)(7).

Controlled transaction

Any transaction between two or more members of the same group of controlled taxpayers. Treas. Reg. 1.482-1(i)(8).

Uncontrolled transaction

An uncontrolled transaction is any transaction between two or more taxpayers that are not members of the same group of controlled taxpayers. Id.

Fernwood Global LLC Kalbian Hagerty LLP

Key concept: arms length price

The

price at which two unrelated and nondesperate parties would agree to a transaction.

Fernwood Global LLC Kalbian Hagerty LLP

10

Key concept: best method rule

Every controlled transaction must be judged under the pricing method that provides the most reliable measure of an arms length result. All methods rely on the assumptions the taxpayer uses. The key to supporting the best method is the soundness of those underlying assumptions. There is no hierarchy of methods. Primary factors to determine best method:

Degree of comparability between the controlled transaction and any uncontrolled transactions; The quality of the data and assumptions used in the analysis; and A higher degree of comparability results in a smaller chance that differences could render the analysis inaccurate.

Fernwood Global LLC Kalbian Hagerty LLP

11

Key concept: comparability

Taxpayers can determine the most reliable price by comparing to transactions that occur between unrelated parties. Comparability of transactions depends on:

Functions performed by parties; Risks undertaken; Contractual terms; Economic conditions; and Nature of goods and services.

Relevancy of factors

Adjustments must be made to account for any differences in comparability.

Fernwood Global LLC Kalbian Hagerty LLP

12

Types of controlled transactions

Fernwood Global LLC Kalbian Hagerty LLP

13

Types of controlled transactions

Loans or advances
Performance of services Use of tangible property

Sales of goods and other transfers of tangible property

Use of intangible property Global dealing operations

Fernwood Global LLC Kalbian Hagerty LLP

14

Loans and advances

The IRS can make a 482 allocation if one member of a controlled group makes a loan or advance to another member of that group but does not charge an arms-length rate. Treas. Reg. . 1.482-(2)(a)(1)(i).

The IRS may determine that the rate is too high or too low. The IRS may impute interest on accounts receivable if they are not promptly paid.

Debt terms between controlled taxpayers is at arms length only if it bears interest at a rate that would be charged in independent transactions with or between unrelated parties under similar circumstances. Treas. Reg. 1.482-2(a)(2)(i).

Fernwood Global LLC Kalbian Hagerty LLP

15

Loans and advances (cont.)

Exceptions to general rule:

Safe harbor (Treas. Reg. 1.482-2(a)(2)(iii))

Available if the creditor is not engaged in the business of making loans. Stated interest is deemed to be arms length if it is not lower than the applicable federal rate (AFR) or higher than 130% of the AFR. If there is no stated interest, the AFR may be used. If the stated interest is higher than 130% of the AFR, 130% of the AFR may be used.

If a taxpayer borrows money from an unrelated party and relends to a controlled party, the stated interest on the unrelated debt should be used for the controlled transaction. Treas. Reg. 1.4822(1)(2)(ii).

Fernwood Global LLC Kalbian Hagerty LLP

16

Performance of services

If a member of a controlled group performs marketing, managerial, administrative, technical or other services for another member, the parties must establish an arms-length price as compensation for those services. Treas. Reg. 1.482-2(b)(1).

An arms-length service fee must be charged whether the services are performed for the benefit of one particular member or to benefit the entire group. Treas. Reg. 1. 482-2(b)(2)(i). The arms-length fee must be based on the benefits expected when the services are performed, rather than the benefits actually realized. Id.

No charge required in the following situations (Treas. Reg. 1.482-2(b)(ii)):

Parent company performs services in its capacity as shareholder of subsidiaries; and A member performs services that are duplicative of activities performed by another member on its own behalf.

Fernwood Global LLC Kalbian Hagerty LLP

17

Performance of services (cont.)

A member of a controlled group that provides intercompany services to another member must charge an amount equal to the amount that it would charge if the two parties were unrelated and dealing at arms-length. Treas. Reg. . 1.482-2(b)(3).
Preferred methods for calculating arms-length rate

Comparable uncontrolled price (CUP) method; and Cost plus method.

If services performed are not integral to either the performer of the services or the recipient, the arms-length charge is equal to the cost of providing the services. Id.

For example, head office costs incurred by a parent company may be allocated to subsidiaries that benefit from those services but are typically not marked up because those administrative services are not integral to the parents business.

Fernwood Global LLC Kalbian Hagerty LLP

18

Performance of services (cont.)

Services are treated as an integral part of the business activity (Treas. Reg. 1.482-2(b)(7) if any of the following apply:

Services are considered integral to the business of a service provider or recipient if either party is engaged in the trade or business of rendering similar services to unrelated persons; or

Services are considered integral to the business of the service provider if the performance of such services for related persons is one of its principal business activities.

For example, a controlled member whose sole purpose is to provide marketing services in a target market and provides such services to members of the controlled group will be subject to transfer pricing rules.

Fernwood Global LLC Kalbian Hagerty LLP

19

Use of tangible property

A member of a controlled group that uses or occupies tangible property that is owned or leased by another member of the controlled group must pay an arms-length rental charge. Treas. Reg. 1.482-2(c)(1).

Relevant factors to be considered:

Period and location of use; The owners investment in the property or the rent paid; Expenses of maintaining the property; The type of property involved; and The condition of the property.

Treas. Reg. 1.482-2(c)(2)(i).

If one controlled subleases the property to another member, the armslength price of the sublease is deemed to be the lease amount that the lessee pays to the unrelated party plus any other expenses associated with the property, such as maintenance, repair, utility, and management costs. Treas. Reg. 1.482-2(c)(iii).

Fernwood Global LLC Kalbian Hagerty LLP

20

Sales of goods

If a member of a controlled group transfers tangible property to another member, the parties must establish an arms length sales price
An arms length price for the sales of goods between two members of a controlled group must be tested using one of five methods:

Comparable uncontrolled price method (CUP); Resale price method; Cost plus method;

Comparable profits method;

Profit split method; or Any other method if the taxpayer can demonstrate that such method is the most reliable measure of arms length results. 1.482-3(a).

Fernwood Global Reg. LLC Treas. Kalbian Hagerty LLP

21

Sales of goods (cont.)

CUP Method

The arms-length price is calculated as the price that the seller obtains in a comparable uncontrolled transaction. Treas. Reg. 1.482-3(b)(1). The CUP method will usually be the best method if there are no differences between the controlled and uncontrolled transactions that would affect the price or there are only minor differences for which appropriate adjustments to price can be calculated. Treas. Reg. 1.482-3(b)(2)(ii)(A). The most important comparability factor for purposes of this calculation is similarity of product. Treas. Reg. 1.4823(b)(2)(ii)(A). Contractual terms are also key here, such as scope of warranties, sales volume, credit terms, and transport terms. Treas. Reg. 1.482-3(b)(2)(ii)(B)(2).

Fernwood Global LLC Kalbian Hagerty LLP

22

Sales of goods (cont.)

Resale Price Method

The arms-length price for a sale between controlled taxpayers is the price at which the goods are resold by the buyer to an unrelated person, less a gross profit comparable to that earned by a comparable uncontrolled distributor in comparable circumstances. Treas. Reg. 1.482-3(c)(2)(i). This method is appropriate for entities that buy and resell goods without adding substantial value by physically altering them. Treas. Reg. 1.482-3(c)(1). This method is inappropriate for a controlled buyer that owns intangible property that adds substantial value. Id.

Fernwood Global LLC Kalbian Hagerty LLP

23

Sales of goods (cont.)

Cost Plus Method

The arms-length price for a controlled sale under this method is the sum of the seller s cost of goods sold and an appropriate gross profit markup determined from comparable uncontrolled transactions. Treas. Reg. 1.482-3(d)(1).

The appropriate gross profit is the product of the controlled seller s production costs and the gross profit markup expressed as a percentage of cost, that is earned in comparable uncontrolled transactions. Treas. Reg. 1.482-3(d)(2)(ii).
Controlled and uncontrolled transactions are comparable only if the manufacturing functions, capital investments, risks, and contract terms do not differ materially or reliable adjustments can be made for material differences. Treas. Reg. 1.482-3(d)(3)(ii)(A).

Fernwood Global LLC Kalbian Hagerty LLP

24

Transfers of intangible property

For licenses and other transfers of intangible properties, the primary method authorized by the 482 regulations to determine the appropriate arms length price is the comparable uncontrolled transaction (CUT) method. Treas. Reg. 1.482-4(a).

The other permissible methods are:

Comparable profits method; and Profit split method.

Id.

Fernwood Global LLC Kalbian Hagerty LLP

25

Intangible defined

An intangible is all property that has substantial value independent of the services of any individual and is within one of six classes:

Patents, inventions, formulae, processes, designs, patterns, or know how;

Copyrights and literary, musical or artistic compositions;

Trademarks, trade names, or brand names; Franchises, licenses, or contracts; Methods, programs, systems, procedures, campaigns, surveys, customer lists, or technical data; or Other similar items where the value derived comes not from its physical attributes but from its intellectual content or other intangible properties.

Fernwood Global LLC Kalbian Hagerty LLP

Treas. Reg. 1.482-4(b).

26

Type of transfer of an intangible

A controlled transfer of an intangible may be either a sale, a license, or some other permission to use the intangible. The IRS typically respects the form of the transaction if it is consistent with the underlying economic substance. There are some exceptions to this treatment, however:

If a transferee pays little or no consideration and the the transferor retains a substantial interest in the property, the transaction will be analyzed as a license. Treas. Reg. 1.482-4(f)(1). The IRS, even if it accepts the form, may consider the other alternative forms for purposes of determining the correct amount of consideration. Treas. Reg. 1.482-1(d)(3)(iv). Sec. 482 requires that the income with respect to the transfer or license of an intangible must be commensurate wit the income attributable to the intangible. Treas. Reg. 1.482-4(f)(2) interprets this clause to mean that such a transaction will be subject to periodic review.

Fernwood Global LLC Kalbian Hagerty LLP

27

CUT method

The arms length consideration for the use of any intangible under the CUT method is the amount charged in a comparable uncontrolled transaction. Treas. Reg. 1.482-4(c)(2)(i).
The CUT method is likely to be the best method when the intangible transferred in a controlled transaction was also transferred in an uncontrolled transaction. Treas. Reg. 1.4824(c)(2)(ii). Two intangibles are considered comparable only if they are used in connection with similar products or processes within the same industry and have similar market potential. Treas. Reg. 1.4824(c)(2)(iii)(B)(1). The reliability of the results under the CUT method depends on the quality and completeness of the underlying data and assumptions. Treas. Reg. 1.482-4(c)(2)(iv.)

Fernwood Global LLC Kalbian Hagerty LLP

28

Global dealing of financial service firms

Special methods apply to financial services firms:

Gross Margin Method Comparable Uncontrolled financial transaction method Gross Markup Method

Profit Split Method

Fernwood Global LLC Kalbian Hagerty LLP

29

Transfer pricing example

Fernwood Global LLC Kalbian Hagerty LLP

30

Transfer pricing example

U.S. SUB is a wholly-owned subsidiary that distributes toasters on behalf of its Foreign Parent, FP, in the U.S.
FP also sells toasters to unrelated Company C for U.S. distribution.

Products sold to U.S. SUB are of higher quality than those sold to Company C. The effect on the price of the toasters cannot be accurately determined.

U.S. SUB also purchases blenders from unrelated parties for resale in the U.S.

Distributions functions between toasters and blenders appear to be similar. Products are sold to the same type of customer, purchased under similar terms and volumes and have similar resale values.

Fernwood Global LLC Kalbian Hagerty LLP

31

Questions to ask yourself

Step One: Are there controlled taxpayers? Step Two: Is there a controlled transaction? If so, what kind? Step Three: Which pricing method should be used to determine the most reliable transfer price? Step Four: Do you have data from comparable uncontrolled transactions? Step Five: What is the arms length price after applying the most reliable pricing method chosen in Step Four?

Fernwood Global LLC Kalbian Hagerty LLP

32

Step 1: Are there controlled taxpayers?

In our example, the parties we have are U.S. SUB and its foreign parent, FP. U.S. SUB and FP are clearly related and therefore will be treated as controlled taxpayers.

Step 2: Is there a controlled transaction?

In our example, U.S. SUB purchases toasters from its foreign parent, FP. This transaction is a sale of tangible property between two controlled

taxpayers and therefore constitutes a controlled transaction.

Fernwood Global LLC Kalbian Hagerty LLP

33

Step 3: Determine the most reliable pricing method

Several pricing methods potentially apply to a sale of tangible goods:

Comparable Uncontrolled Price; Resale Price; Cost Plus; Comparable Profits Method; and Profit Split Method.

For purposes of example, we will compare two methods: CUP and Resale Price Comparability factors:

Functions performed, contractual terms, risks, economic conditions and property being sold or services performed CUP most important factors are similarity of product, contractual terms and economic conditions Resale Price most important factors: similarity of functions, risks borne and contractual terms

Fernwood Global LLC Kalbian Hagerty LLP

34

Step 4: Using data from comparable uncontrolled transactions

From the facts in our example, we know that the toasters sold in the controlled transaction differ significantly from the toasters sold in the uncontrolled transaction and that the effect on price cannot be accurately determined. Further, the facts show that the distribution functions for the sale of toasters and the sale of blenders by the controlled reseller are similar. The products are sold to the same customers, purchased under similar contractual terms and have similar resale values. Analyzing the comparability factors, we can conclude that the resale price method will be the most reliable.

Fernwood Global LLC Kalbian Hagerty LLP

35

Step 5: Apply pricing method to transaction

U.S. SUB Revenues from Resales of Blenders of Toasters Cost of Goods Sold 1000 1000

COGS-Blenders (unrelated)
COGS-Toasters (related) Gross Profit Blenders Toasters Gross Profit Margin-Uncontrolled Blender transaction

750
800

250 200 25%

Fernwood Global LLC Kalbian Hagerty LLP

36

Step 5: apply pricing method to transaction (cont.)

Applying uncontrolled gross profit margin of 25% to the tested transaction .U.S. Subs gross profit for toasters should be $250 (25% x $1000) Using $250 as the arms-length gross profit, we can determine what price U.S. Sub should pay FP for the product:
1,000 (250) 750

Revenues Less: arms-length profit Total COGS for toasters

Fernwood Global LLC Kalbian Hagerty LLP

37

Recordkeeping requirements

Fernwood Global LLC Kalbian Hagerty LLP

38

Overview of Recordkeeping Requirements

There are two key costs associated with a taxpayers failure to keep adequate transfer pricing records:

Tax penalties; and Increased audit costs.

NB: Remember that a controlled transaction subject to the transfer pricing rules will have to deal with a minimum of two separate taxing jurisdictions. Therefore, the taxpayer will have to factor in potential audit costs and penalties in not only the U.S. but in each jurisdiction in which it has a controlled transaction.

Fernwood Global LLC Kalbian Hagerty LLP

Transfer pricing penalties

If the IRS determines that there is a substantial underpayment of tax as a result of a incorrect transfer pricing, the taxpayer will be subject to a penalty equal to 20% of such underpayment. This rule only applies if the IRS determines the transfer price is 200% or more (or 50% or less) of the transfer price the taxpayer used. IRC 6662(e)(1)(B).
If the IRS determines the transfer price is 400% or more (or 25% or less) of the transfer price that the taxpayer used, the underpayment will be treated as a gross valuation misstatement and will be subject to a penalty of 40% of the underpayment. IRC 6662(h)(1). Exception: Neither of these penalties apply if the taxpayer can show that, given the available data and the applicable pricing methods, the method (and its application of that method) provided the most reliable measure of an arm's length result, and can establish that it had specific and adequate documentation of the transaction at the time it filed the return. Treas. Reg. 1.6662-6(d)(iii).

IRS audits

IRS auditors now request as a matter of course at the beginning of any examination that the taxpayer provide copies of all detailed transfer pricing documentation. Taxpayers therefore cannot start thinking about their transfer prices only when the IRS issues the first Information Document Request.
If the taxpayer fails to maintain documentation and timely provide it to the IRS, the threat of a penalty may impact the entire examination, not only the transfer pricing issues. Wellprepared taxpayers will plan their transfer prices during the taxable year, prepare thorough documentation when the tax return is filed, and organize supporting documents to be provided to the IRS. The stronger the documentation, the greater the likelihood that its disclosure will discourage further IRS inquiry into the taxpayer's transfer pricing practices. It is therefore critical that the taxpayer maintain the specific and adequate documentation required by the IRS.

Required documentation

Documentation must be in existence when the return is filed. The IRS may excuse a minor or inadvertent failure to provide required documents, but only if the taxpayer has made a good faith effort to comply, and the taxpayer promptly remedies the failure when it becomes known.

The required documentation is divided into two categories, principal documents and background documents. The taxpayer must keep a general index of the principal and background documents and a description of the recordkeeping system used for cataloging and accessing those documents.

42

Principal documents

The principal documents should accurately and completely describe the basic transfer pricing analysis the taxpayer has conducted. The documentation must include the following:

An overview of the taxpayer's business, including an analysis of the economic and legal factors that affect the pricing of its property or services; A description of the taxpayer's organizational structure (including an organization chart) covering all related parties engaged in transactions potentially relevant under section 482, including foreign affiliates whose transactions directly or indirectly affect the pricing of property or services in the United States; Any documentation explicitly required by the regulations under section 482; A description of the method selected and an explanation of why that method was selected, including an evaluation of whether the regulatory conditions and requirements for application of that method, if any, were met; A description of the alternative methods that were considered and an explanation of why they were not selected;

Fernwood Global LLC Kalbian Hagerty LLP

43

Principal documents (cont.)

More required principal documents:

A description of the controlled transactions (including the terms of sale) and any internal data used to analyze those transactions. A description of the comparables that were used, how comparability was evaluated, and what (if any) adjustments were made; An explanation of the economic analysis and projections relied upon in developing the method. for example, if a profit split method is applied, the taxpayer must provide an explanation of the analysis undertaken to determine how the profits would be split; and A description or summary of any relevant data that the taxpayer obtains after the end of the tax year and before filing a tax return, which would help determine if a taxpayer selected and applied a specified method in a reasonable manner.

Fernwood Global LLC Kalbian Hagerty LLP

44

Background documents

The assumptions, conclusions, and positions contained in principal documents ordinarily will be based on, and supported by, additional background documents. Documents that support the principal documentation may include:

Books and transaction records of original entry; Applicable profit and loss statements; Documents relating to transactions involving the same or similar products or services; Shipping and export documents; Commission agreements; Third-party and intercompany purchase and sales invoices; Manuals and specifications; Documents describing or setting out the functions, responsibilities, and risks of the various related and unrelated parties; Documents relating to the transactions that the taxpayer or a related entity filed with foreign countries; Records of loans, guarantees, and hedging or other risk-shifting agreements; and Records of research and development sharing agreements and agreements for the provision of management services.

The taxpayer need not provide background documents to the IRS in response to a request for principal documents. If the IRS subsequently requests background documents, a taxpayer must provide that documentation to the IRS within 30 days of the request. However, the IRS may, in its discretion, extend the period for producing the background documentation.

Fernwood Global LLC Kalbian Hagerty LLP

Advance pricing agreements (APA)

Taxpayers can choose to negotiate the best transfer pricing method for their controlled transaction with the IRS through an APA. Google famously entered into an APA with respect to its controlled transactions.

Taxpayer must file a request for an APA before filing its tax return Types of APA Unilateral APA Between the taxpayer and the IRS Bilateral or multilateral APA Among the taxpayer, the IRS, and the taxing authorities of one or more foreign jurisdictions Term: Usually a minimum of five years Benefits: The taxpayer does most of the work to establish the best transfer pricing method and therefore has a chance to establish the most favorable transfer pricing method. The taxpayer will have a certain tax position that allows it to decide whether to enter into the transaction in the first place. Minimizes compliance and audit costs.
45

46

Cost sharing agreements

Most common proactive tax planning tool (e.g., Google)

Allows companies to treat intellectual property as owned offshore for tax purposes Requires a sophisticated set of calculations High scrutiny by tax authorities

Fernwood Global LLC Kalbian Hagerty LLP

+ Conclusions

Almost every country has transfer pricing rules. Therefore, your client will have to calculate the correct transfer price in compliance with the laws of every country in which the transaction takes place. Document, document document. Taxpayers must proactively manage their potential transfer pricing exposure. There are potentially significant financial risks associated with failure to manage transfer pricing exposure Operating in multiple jurisdictions presents your client with tax planning opportunities.

Fernwood Global LLC Kalbian Hagerty LLP

47