When a good is manufactured in a number of countries by a United States (US) company and its foreign subsidiaries, the controlling US company tries to lower its taxes by pricing the inputs of the manufacturing process so that profit only occurs in low tax jurisdictions. The transfer price is the price of intermediate products in the manufacturing process that are manufactured in different countries or different tax jurisdictions.
Example: a US shirt manufacturer cuts cloth for a shirt for $6 per shirt, sends the cuts to its Vietnamese subsidiary to have it cut and sewn for $5 per shirt, then sells it in Europe for $35 per shirt resulting in a profit of $24 per shirt. If Vietnam has low taxes, then the shirt manufacturer can arrange for transfer pricing of $6 per shirt when it's shipped from the United States to the Vietnamese subsidiary. When the Vietnamese subsidiary ships the shirts to a European subsidiary of the US shirt manufacturer in Europe, it can arrange so that the transfer pricing is equal to the European price of $35. Thus, the entire profit of $24 would be recognized in Vietnam and subject to a low tax. There would be no recognition of income in the United States or in Europe because the transfer price would be equal to the cost of the product in the US and to the market price in Europe.
IRC §482 allows the Internal Revenue Service (IRS) to change transfer pricing so that it includes a reasonable profit that would occur in a true arm's length transaction. Section 482 not only applies to transfer prices of inventory or raw materials but also to any taxable item that affects taxable income between controlled entities, such as income, deductions, credits, or any other allowances. It applies to transfers of tangible and intangible property, rental profits, financial operation profits, provision of services, and the shifting of expenses.
If transfer prices are adjusted under §482, then §6662 provides for a 20% accuracy penalty for net mispricing that exceeds the lesser of $5 million or 10% of gross receipts. There is also a 40% penalty for rank mispricing.
Transfer pricing rules attempt to equalize prices that are charged between related parties to that which would be charged in a comparable uncontrolled transaction, meaning a transaction between unrelated parties.
However, in many cases, a sufficiently comparable uncontrolled transaction is not available to make a comparison, especially for comparing prices of input parts between related corporations. IRC §482 lists 5 factors to assess the comparability of controlled and uncontrolled transactions:
- functions performed by controlled and uncontrolled taxpayers;
- contractual terms of the transactions;
- the risk in each transaction;
- the economic conditions in which the transaction takes place; and
- the similarity of property or services transferred.
Generally, the tax code stipulates that the best method rule should be used that most accurately measures the arm's length result. In any case, the transactions would have to show some profit on each transfer, since a business is not going to sell a product willingly at cost, for no profit.
Generally, the comparable uncontrolled price method will be used if a comparison can be made, since it is considered the best method to ascertain an at-arm's-length transaction involving the same components. If that method is not available, then the other methods must be used.
Transfer prices of intangible property generally present the same problems as those for tangible property. Intangible property most often consists of patents and licenses. So if a controlled subsidiary uses a patent or trademark in the foreign country, then the subsidiary should pay an appropriate amount to the United States corporation.
Transfer Prices Of Tangible Inventory
In the usual case of the transfer of tangible property, the tax code provides more specific guidelines:
- comparable uncontrolled price method;
- resale price method;
- cost-plus method;
- comparable profits method;
- profit split method; and
- any other credible method proposed by the taxpayer.
Comparable Uncontrolled Price Method
As discussed above, the comparable uncontrolled price method is the preferred method if it is available, since it compares the transfer prices with the transfer prices of an unrelated corporation in a similar business with similar intermediate products that are priced for unrelated entities. If this method is not available, then 1 of the remaining methods must be used that would best reflect uncontrolled transactions.
Resell Price Method
The resale price method compares the gross profit margin earned on the transfer prices to other transactions by the corporation with nonrelated parties. If those transactions do not exist, then the comparison is made with resellers in a similar business selling to unrelated parties.
The cost-plus method adds the profit percentage made on uncontrolled transactions that are similar to the cost of the controlled transactions to determine if the corporation is charging a normal profit. So, for instance, if a company sells blue widgets to an uncontrolled corporation at a 25% profit margin and the cost for producing red widgets that is sold to a subsidiary of the corporation is $100, then the transfer price of $100 plus a 25% profit margin will yield the transfer price of $125.
Comparable Profits Method
The comparable profits method uses the profitability of uncontrolled taxpayers who are engaged in similar transactions and imposes that profitability on controlled transactions to arrive at a transfer price. The tax code allows different measures of profitability including the ratio operating profit to sales, the ratio of gross profits to operating expenses, and the rate of return on capital. In most cases, the IRS allows a taxpayer to choose the method.
Profit Split Method
The profit split method examines the total profit earned on all the transactions from input to output then divides that profit among the various transfers according to the amount of work done at each stage. Generally, this is very difficult to do, so it is rarely used.
The tax code does allow taxpayers to choose some other method if the taxpayer can show that the method better represents real-world profits on the transfers. If the IRS agrees, then the taxpayer's chosen method will be allowed.
Advance Pricing Agreements
Because of the complexity of determining transfer prices and because IRS audits generally span several years involving questions of transfer pricing, to reduce or eliminate disputes, the taxpayer can arrange an advance pricing agreement (APA), so that the method used to determine the transfer pricing can be agreed to by both the company and the IRS. If the subsidiary receiving the transfers is in a country that has a tax treaty with the United States, then that country may also accept the terms of the APA in calculating its own taxes.
The IRS began approving APA's in 1991, the 1st one being with Apple Computer (later, it changed its name to just Apple). To be approved for an APA, the company must provide the requested information, which the IRS evaluates and if it agrees, then the company has a safe harbor that it can rely on.