US companies often have commercial transactions with their overseas affiliates in the form of financing, supply, manufacturing, services, or other agreements. Each of these common intercompany transactions can be the cause of significant US or foreign tax liability and penalties if the US company does not adhere to the strict requirements applicable to US taxpayers conducting business with related parties. To reduce the risk of tax assessments, penalties, and litigation costs, every US company should ask themselves three questions when expanding into new markets or engaging in transactions with related companies.
Companies doing business with their affiliates have the opportunity (and in some cases, the incentive) to shift income and expenses between affiliated companies in ways that minimize federal income tax liabilities. As a result, federal tax laws require that the commercial terms used between related parties must be similar to the commercial terms that would apply if the parties were unrelated and were dealing at “arm’s length.” The process of identifying the “arm’s length” price that should be used in agreements between related parties is usually referred to as “transfer pricing.” Because intercompany transactions with foreign affiliates represent an opportunity for US taxpayers to shift profits beyond the reach of US taxing authorities, transfer pricing is a top enforcement priority for the IRS.
For example, in the first quarter of 2022 American biopharmaceutical company, Amgen, Inc., reported a $3.6 billion tax deficiency, plus $2 billion in penalties, for allegedly misstating the income and expenses attributable to its affiliate’s operations in Puerto Rico. The short version, for those of us that are not privy to Amgen’s internal workings, is that the IRS disagreed with the commercial terms used in the transactions between Amgen and its affiliates.
Recognizing the importance placed by the IRS on intercompany commercial transactions, and the possibility of exceptional penalties related to transfer pricing valuations, every company with overseas affiliates—particularly companies without a significant track record of overseas operations—should be asking three threshold questions:
Question 1: Do you have a transfer pricing policy?
A transfer pricing policy directs the organization’s approach to transfer pricing across all of its existing transactions, as well as those anticipated in the future. Among other things, a good policy sets the corporate tone by identifying a person tasked with oversight of the company’s transfer pricing, a routine approach to new transactions, and a schedule for reviewing existing transactions.
Question 2: Do you have an appropriate transfer pricing strategy?
A transfer pricing strategy is the approach taken in a specific transaction or organizational structure. Strategy is implementation of the transfer pricing policy, and should be tailored to the operational model for the enterprise. A dated strategy or one that is not appropriate for the operational model is about as useful as having no strategy at all or merely hoping for a good result. When the transfer pricing strategy matches the organization’s operating model, it can decrease tax risk and produce real opportunities to improve the organization’s financial results.
Question 3: Are you satisfying the minimum substantiation requirements to avoid tax penalties?
Transfer pricing is not only an IRS enforcement priority, but transfer pricing valuation penalties can also be double the standard penalty for understating income in some situations. Fortunately, federal law permits an escape from these penalties if the taxpayer documents the methodology used to set the prices in the transaction. To satisfy federal requirements, this documentation needs to include the rationale for the pricing method adopted and should be completed at the time the tax returns are due; preparing appropriate documentation after the fact is generally insufficient.