In our previous post we discussed the initial considerations that fictional U.S. company “Parent” need to make after acquiring fiction subsidiary “Sub.” After the initial considerations are made and Sub is up and operating, the pricing of intercompany transactions between Parent and Sub will need to be determined.
The pricing of international related-party transactions is referred to as transfer pricing. The IRS will use transfer pricing rules to determine that the appropriate amount of income of a multinational company is subject to U.S. taxation. Transfer prices do not affect the total combined income of multinational corporations, but they do affect how income is allocated among the countries in which the corporation is conducting business. Because transfer pricing is used to allocate income to different countries, they affect the amount of income taxed in each country. For example, if a country has a lower tax rate than the United States, transfer prices could potentially be used to allocate more income to the foreign country and less to the United States.
Transfer pricing rules require the pricing of transactions between Parent and Sub be determined using an “arm’s length standard.” The arm’s length standard is used to determine the true taxable income of a corporation by considering what the income would be if the U.S. corporation dealt with an unrelated party.
There are several methods for estimating an arm’s length price for transfers of tangible property between companies. When considering the methods available, Parent should consider the economic functions performed, contractual relationships, risks incurred, prevailing economic conditions, and the nature of the transactions involved.
Often times the subsidiary will perform administrative services for the benefit of the parent. The subsidiary must charge an arm’s length fee for these services which can include all costs and a reasonable markup. This is commonly known as a “cost-plus” arrangement. An appropriate arm’s length markup percentage to use with a cost-plus method should be based on observed gross margins of comparable transactions involving unrelated companies in similar industries or markets.
Once a transfer pricing method has been selected, it is important to retain the documentation related to its selection and application. If the IRS were to audit the transfer prices used by Parent and Sub, it often examines the books of each company and considers whether the companies acted reasonably in selecting and applying a method. By using transfer prices that are supported by sufficient documentation and allocating to each affiliate a reasonable profit, the companies can possibly avoid any penalties that could be assessed by the IRS.