USA
Fernando Lopez and Derek Morgan
by Fernando Lopez and Derek Morgan
Section 482 of the Internal Revenue Code (IRC) authorises the US Internal Revenue Service (IRS) to adjust the income, deductions, credits, or allowances of commonly controlled taxpayers to prevent evasion of taxes or to clearly reflect their income. The regulations under section 482 generally provide that the price charged by one affiliate to another, in an intercompany transaction involving the transfer of goods, services, or intangibles, yields results that are consistent with the results that would have been realised if uncontrolled taxpayers had engaged in the same transaction under the same circumstances.
a) Transfer pricing rules
United States TP rules are based on the arm’s length principle and their purpose is to ensure that taxpayers clearly reflect income from “controlled transactions”, and do not evade taxation by artificially shifting income between different tax jurisdictions. A transaction is a controlled transaction for IRC 482 purposes if the transaction is between two or more organisations, trades, or businesses that are either: 1) owned; or 2) controlled by the same interests.
b) Transfer pricing methods
US TP methods generally follow and are consistent with the TP methods outlined in the OECD guidelines. For transactions involving tangible goods, commonly accepted methods are the CUP, resale price, cost plus, CPM, profit-split, and unspecified methods. For intangible goods, acceptable methods include the comparable uncontrolled transaction (CUT), CPM, profit-split, and unspecified methods. For services, acceptable methods include the services cost, comparable uncontrolled services price, gross services margin, cost of services plus, CPM, profit-split, and unspecified methods. For cost sharing agreements involving buy-ins of existing intangibles, acceptable methods are the CUT, income, acquisition price, market capitalisation, residual profit split, and unspecified methods.
Under the Best Method Rule, given the facts and circumstances of the transactions under review, the pricing method selected should provide the most reliable measure of an arm’s length result relative to the reliability of the other potentially applicable methods.
c) OECD guidance
US TP regulations are consistent with the OECD Transfer Pricing Guidelines (TPG). This includes US rules related to cost sharing arrangements (CSAs) that are consistent with the guidance on cost contribution arrangements in chapter 8 of the OECD TPG. In general, the US has agreed to the broad parameters of the OECD’s proposals on country-by-country reporting (CbCR), and master file and local rules under OECD Action 13. The IRS plans to implement CbCR at this time, however, only once basic data has been released for groups with revenues in excess of USD 850 million.
d) Reporting requirements
Taxpayer preparation of TP documentation is not mandatory. However, taxpayers who do not have documentation on hand when audited by the IRS are subject to a net adjustment penalty that is to be assessed in every case where the penalty thresholds are met.
a) Preparation of transfer pricing documentation
Taxpayers must maintain two categories of documentation – principal documents and background documents.
The principal documents include:
A general overview of the business, including economic and legal factors affecting pricing;
A description of the organisational structure;
Any documentation related to a qualified cost sharing arrangement;
A description of the method selected and reasons for the selection;
A description of controlled transactions and method used to analyse the transactions;
An explanation of economic analysis and projections relied upon in developing the method;
A description of any data obtained after the tax year and before filing a tax return; and
A general index of the principal and background documents, including the record system used for cataloguing these documents.
Background documents support the assumptions, conclusions, and positions in the principal documents, and demonstrate how the taxpayer’s method was selected and applied to provide the most reliable measure of an arm’s length result. Background documents need not be provided to the IRS unless they are specifically requested.
b) Compliance with OECD master and local file documentation in the US
The US has not adopted the OECD’s master file and local file concept. However, for larger taxpayer groups (over EUR 750 million), the US has implemented Country-by-Country Reporting.
c) Penalties
IRC sections 6662(e) and (h) set forth penalties when IRS TP adjustments lead to increased taxes. A 20% penalty is assessed as a substantial valuation penalty and is applied if the price or value is 200% or more (or 50% less) than the correct amount, or the net adjustment exceeds the lesser of USD 5 million or 10% of gross receipts. A 40% penalty is a gross valuation penalty, and is based on price or value change of 400% or more (or 25% or less) than the correct amount, or a net adjustment that exceeds the lesser of USD 20 million or 20% of gross receipts.
Adjustments are excluded from the penalty calculation if the taxpayer applies a specified or unspecified method under the best method rule, and if the taxpayer has created TP documentation by the time the taxpayer files their return for each specific year. If a taxpayer is audited, the IRS can request TP documentation and will give the taxpayer 30 days to respond with such documentation before penalties can be assessed.
As previously stated, a taxpayer in the US may select any particular method that is reasonable and determinable from all facts and circumstances. The ultimate economic method selected for controlled transactions should be based on the following criteria:
The experience and knowledge of the taxpayer;
The extent to which the taxpayer obtained accurate data and analysed it in a reasonable manner;
The extent to which the taxpayer used the most current reliable data for the tax year in question;
The extent to which the taxpayer reasonably followed the relevant requirements in the section 482 regulations;
The extent to which the taxpayer reasonably relied on a study or other analysis prepared by a professional;
The extent to which the taxpayer used more than one uncontrolled or arbitrarily selected comparable, providing a result that did not represent the overall business of the taxpayer;
The extent which the taxpayer relied upon TP methods developed and applied under an advanced pricing agreement for a prior year (assuming facts and circumstances have had no material changes); and
The size of the net TP adjustment in relation to the size of the controlled transaction which gave rise to the adjustment.
All of these factors must be considered in preparing the principal documents on which the taxpayer intends to rely.
In situations where there is uncertainty about what constitutes an arm’s length price, taxpayers have the option of entering into an advanced pricing agreement (APA) with the IRS. APAs typically cover a term of five years but can be adjusted to cover previous and prospective years as appropriate. The IRS typically prefers bilateral APAs, and charges a substantial fee to cover the administrative costs of reviewing an APA.
Mowery & Schoenfeld is an accounting, advisory, and IT firm in Chicago with offices in Miami and Manilia, Philippines. With 20 partners and 160 employees, we are dedicated to values of People, Clients, Growth, & Adaptability. Our growing international practice is focused on LATAM and multinational advisory.
GGI member firm Mowery & Schoenfeld, LLCLincolnshire, Illinois, USAT: +1 847 247 8959
Auditing & Accounting, Tax
Practicing in accounting and international tax since 1998, Mowery & Schoenfeld’s International Tax Partner Fernando Lopez specialises in providing international tax services, including cross-border tax planning and structuring, and has helped many of his clients expand in both US and foreign markets.Contact Fernando.
As a Senior Tax Manager for Mowery & Schoenfeld’s International team with over 17 years of experience, Derek Morgan specialises in identifying and managing the foreign tax compliance process for corporations and partnerships, helping them to navigate the ever-changing global tax landscape.Contact Derek.
