Transfer Pricing and Cross-Border Transactions

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Transfer pricing is a mechanism for determining arm’s length pricing in related-party transactions, often in the context of cross-border transactions.

Transfer pricing audits are increasing in number, complexity, and expense all around the world as tax authorities look for additional revenue. Transfer pricing continues to be a top audit issue in international tax planning for U.S. corporations. In this environment, tax departments need to implement proactive corporate tax planning strategies to efficiently manage transfer pricing disputes in a way that minimizes exposure to potential penalties and double taxation.

Transfer pricing rules

The U.S. transfer pricing regulations under §482 seek to ensure that appropriate amounts of income of a multinational enterprise are subject to U.S. taxation. The Organization for Economic Cooperation and Development (OECD) also maintains its own transfer pricing guidelines. Collectively these regulations aim to prevent profit shifting to lower tax jurisdictions and avoid international double taxation.

U.S. transfer pricing regulations

The IRS employs the arm’s length standard in administering transfer pricing. The transfer pricing regulations try to determine the price that the related parties would have agreed to if they had dealt with each other at arm’s length as unrelated parties.

According to the IRS:

“A controlled transaction meets the arm’s length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (arm’s length result). However, because identical transactions can rarely be located, whether a transaction produces an arm’s length result generally will be determined by reference to the results of comparable transactions under comparable circumstances.”

The IRS can make transfer pricing adjustments to transactions between “two or more organizations, trades, or businesses” that are owned or controlled by the same interests.

OECD transfer pricing guidelines

The OECD first published its Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations in 1995. The OECD has since continuously revised and supplemented the guidelines, reflecting an ongoing focus on international tax challenges, including transfer pricing issues.

The most recent edition went into effect in 2018, following a substantial revision and expansion as part of the OECD’s Base Erosion and Profit Shifting (BEPS) initiative.

Like the IRS, the OECD employs the arm’s length principle because it “provides broad parity of tax treatment for members of [multinational enterprise] groups and independent enterprises,” avoiding the creation of “tax advantages or disadvantages that would otherwise distort the relative competitive positions of either type of entity.” The guidelines state that the arm’s length principle “has also been found to work effectively in the vast majority of cases.”

Transfer pricing methods and documentation requirements to avoid adjustment penalties

Taxpayers can generally avoid incurring a penalty with respect to a transfer pricing adjustment if:

• The taxpayer established that the transfer price was determined in accordance with a specified method under the §482 regulations and the taxpayer’s use of the method is reasonable
• The taxpayer has documentation that sets out the determination of the transfer price in accordance with such method and that its use of the method was reasonable
• The documentation is contemporaneous to the time that the return was filed and is provided to the IRS within 30 days of its request
• The taxpayer determined its transfer price using either:
  • A specified method under the regulations (the use of which was reasonable)
  • An unspecified method when none of the specified methods was likely to result in a price that clearly reflected income and the method used was likely to result in a price that clearly reflected income
• The taxpayer has documentation (in existence when its return was filed) establishing its use of the particular transfer pricing method and that the use of that method was reasonable
• The documentation is provided to the IRS within 30 days of request

[Download our Transfer Pricing Forum comparative study of the typical transfer pricing issues by country panelists in major and emerging industrial countries.]

Examples of transfer pricing risks and disputes

Recent high-profile disputes between major multinational companies and the IRS made headlines: Coca-Cola, Altera, Medtronic, and Facebook.

Coca-Cola

A U.S. tax court ruled in 2020 that Coca-Cola Co. must pay most of a $3.4 billion additional tab ordered by the IRS for attributing too much profit to foreign affiliates.

The tax court’s decision upheld the IRS’s method for reallocating profits between Coca-Cola and affiliates that made and sold ingredients for the company’s soft drinks. The ruling pertained to the company’s taxable income between 2007 and 2009.

Altera

In 2020 the U.S. Supreme Court announced that it wouldn’t review the Ninth Circuit’s 2019 decision in the semiconductor manufacturer Altera Corp. case. That decision required the cost of employee stock-based compensation (SBC) to be included in the pool of intangible development costs (IDC) under cost sharing arrangements (CSA). This decision has had important implications for companies whose SBC costs were excluded from IDC under a CSA.

Medtronic

The Medtronic case centered on the company’s allocation of profits for tax purposes among its U.S. parent company, U.S. distributor, and Puerto Rican device manufacturer. While the IRS argued that the company owed nearly $1.4 billion in taxes, a tax court found in a 2016 opinion that it had underpaid by just about $14 million. In 2018, though, the U.S. Court of Appeals for the Eighth Circuit sent the case back, ordering the tax court to make numerous additional findings.

Facebook

The tech giant is challenging a $1.73 million tax bill for 2010 that hinges on the value of intangible assets, such as trademarks and copyrights, that it transferred to an Irish subsidiary. The IRS claims that these assets are worth $13.8 billion – more than twice Facebook’s $6.5 billion valuation. The company has said that as much as $9 billion plus interest and penalties could be on the line because the IRS’s position could apply to its subsequent tax years.