A tax-optimized international business structure often includes two or more companies in different jurisdictions controlled by the same owner. When those related companies do business with each other, performing a transfer pricing study is a necessity. Transferring goods and services between companies under common control without a transfer pricing study puts you at risk with tax authorities.
Business between related companies “at arm’s length”
Let’s say we have an Amazon seller, who owns a foreign company in Hong Kong and a U.S. company. The Hong Kong company buys products at a low price in China. It then transfers those to the U.S. company that sells the goods on Amazon in the USA at U.S. market prices.
One might be tempted to transfer the goods at a high price to realize the bulk of the profit in Hong Kong. However, you cannot transfer the goods at an inflated price to keep the profit in low-tax Hong Kong and out of the higher-taxed U.S. The transfer price between the Hong Kong and the U.S. companies must reflect the fair market value of the product as if sold between independent companies.
The two companies must deal with each other “at arm’s length”, like two companies that are not controlled by the same owner.
A transfer pricing study helps in a tax audit
The IRS and foreign tax authorities closely examine cross-border transactions between related companies in different countries. The transfer prices of any products, services, intangibles like IP, and financial transactions between these companies receive extra scrutiny. You must allocate the appropriate portion of the income to the correct entity and pay tax accordingly. A transfer pricing study offers reasonable cause or reliance in a tax audit.
A transfer pricing study analyses the market value of transferred goods and establishes inter-company pricing according to transfer pricing rules of the countries involved. This study serves not only as a foundation for determining the transfer prices. It also demonstrates proper intent to the tax authorities.
In the U.S. you don’t have to submit the transfer pricing study together with the tax return. However, the IRS requires that you completed one and are able to produce it to the IRS upon request. Without transfer pricing documentation you cannot demonstrate that you acted with reasonable cause or in good faith. Therefore you could face significant penalties, up to 40% of any tax underpayment resulting from an IRS examination.
Transfer price – The price of the product, service, IP, or other intangible that is transferred cross-border between related companies
Related companies – Two or more companies in different tax jurisdictions that are controlled by the same person or entity, e.g., a foreign corporation owned by a U.S. corporation
At arm’s length – Doing business between related companies as if they were not related
Transfer pricing study (TPS) – Analysis of fair market value to establish the transfer pricing
Transfer price rules – Each jurisdiction has its own rules and regulations for transfer pricing
Tax treaties and transfer pricing
It often is more complex than the simple case above, for example when the owner manages the company from yet another tax jurisdiction. If the owner of the company lives in a country with a tax treaty, he or she pays tax in the country of residency.
Let’s say, the owner of the Hong Kong and U.S. companies is a resident of Australia. He makes all company decisions in Australia, where he also has an office with full-time dedicated employees. Therefore he pays tax in Australia and not the U.S., even though he has a U.S. company. Due to this fact pattern and the U.S. Australia tax treaty, his permanent establishment is in Australia and he will pay taxes there. Accordingly, he must comply with all Australian tax laws, and do the transfer pricing study in line with Australian tax guidelines.
Transfer pricing study done right
A transfer pricing study is not a mere comparison of market prices or a brief legal opinion. It is an in-depth economic study of your business, your products, services, and intangibles. The U.S. has specific standards for evaluating the “arm’s length” nature of pricing between related companies.
For example, whether using comparable royalty rates from royaltysource.com or searching for competitive transactions or margins from publicly available data, it must be done correctly and with sufficient support.
U.S. regulations don’t require that you use a third party to develop the study. However, the study has to adhere to specific methodologies and evaluation techniques. Furthermore, experienced experts may recognize risks that company insiders don’t see.
Transfer pricing as a tax and structuring planning tool
Developing a transfer pricing study is not only a defensive move to protect in case of a tax audit. It also serves as a key planning tool in structuring your international business.
For example, you could achieve significant tax savings by changing the ownership of IP or relocating certain activities from one tax jurisdiction to another. Of course, the compensation for the use of such intangibles or management activities must be at arm’s length. It can still lead to a more tax-efficient distribution of profit within an international structure.
If you have transactions between related businesses, you should speak to a structuring expert who fully understands the tax implications.
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