Transfer Pricing - Research Paper Example

? Transfer Pricing Insttitution Transfer Pricing Introduction Transfer pricing represents an intricate yet interesting challenge to MNCs, who ought to establish suitable prices at which goods, services, intellectual property, and financial instruments are transferred among the affiliated entities. Most companies review global taxable income levels and cash requirements prior to establishing inter-company pricing and arrangements. The most dominant methods employed to establish arm’s length pricing entail: comparable uncontrolled price, resale price approach, and cost-plus approach. The U.S. has an aggressive transfer pricing policy environment as administrators and legislators pursue to lure foreign investment. Transfer prices entail changes made between controlled (or related) entities such as branches and companies that can be either wholly or majority owned by a parent company. The paper explores diverse scenarios of transfer pricing that an entity can pursue to minimize the tax burden. Discussion Based on their earnings and transactions, it may be rewarding for U.S. corporations operating offshore to launch separate foreign entities to conduct business abroad. In the event that a U.S. corporation operates abroad as a foreign corporation and reinvests its foreign earnings offshore, then the U.S. income tax can be deferred until the income may be repatriated in the form of dividend. Similarly, a U.S. corporation (with the exclusion of a Subchapter S corporation) can claim a credit for foreign income taxes paid, which can avert the situation of income getting taxed twice (by both the U.S and the foreign jurisdiction). Another approach in which companies can alleviate the tax burden centers on seeking ways to generate wealth within countries with lower tax rates (Collins, Chamberlin, & Hirsch, 2012). For instance, a multination labeled as USAco, based in the U.S., manufactures and sells cars within the U.S. plus other two foreign countries (in this case Mexico and Ireland). The foreign sales for the company are made via CARco, which represents a wholly owned foreign corporation. Irrespective of the transfer price employed for sales by USAco to CARco, the foreign sale income amounts to $300 per car [the final sales price minus $1000 manufacturing cost minus the $200selling expense]; nevertheless, transfer prices so the impact on the allocation of the combined profit between the two entities (USAco and CARco). A transfer price of $1000 would allocate the amalgamated profit of $300 wholly to CARco, while, in the other extreme, a transfer price of $1300 would allocate the amalgamated profit of $300 entirely to USAco. In the event that the tax rate differs between that of the U.S and that of foreign countries (U.S (35%) and the applicable foreign tax rate for Mexico/Ireland (25%), the USAco group can minimize its global taxes by employing higher transfer prices for its controlled sale. In the example, is the transfer price of $1000 is employed for sale by USAco to CARco the $300 gross profit is mainly allocated wholly to CARco, and the total tax on that profit translates to foreign tax of $135 [$300 income multiplied by 25% foreign tax rate]. A multinational company (MNC) might utilize transfer pricing strategies for two core purposes: income tax liability reduction or funds repositioning. In the event that the tax rate within the country of the selling affiliate is lower than the tax rate within the buying affiliate country, a high, markup policy on sales is likely to leave minimal taxable income within the buying affiliate country to be taxed at an increased rate (Urquidi, 2008). Even if, the tax rate within the purchasing affiliate is not higher than that of the selling affiliate country, a higher markup policy will leave reduced funds to be removed from the purchasing affiliate country. In the event that a transfer price is enhanced, the selling firm’s revenue and profits rise, and the receiving firm’s profits dip. Selling brand new cars for $1000 to a related firm within a tax haven, which then resells the car unit for $12,000, would minimize or eliminate U.S. tax profits; however, legitimate transfer pricing does not tolerate transfers done at unreasonable prices (Wittendorff, 2010). The ideal allocation allows each country to tax a suitable portion of the taxpayer’s overall profit while circumventing the taxation of the same company. The mechanism employed for allocation a multinational’s global profits between its U.S. and the foreign affiliate’s shapes the transfer price employed for intercompany transactions. The foreign tax limitation safeguards U.S. entities operating within high-tax foreign jurisdictions from claiming credits for the excess foreign taxes. The non-creditable foreign taxes enhance the global tax rate on foreign earnings. As such, a domestic corporation has the option of avoiding these higher foreign taxes by changing its transfer prices so as to move the incomes from the high-tax jurisdictions (Urquidi, 2008). IRS Audit The activities that draw IRS essentially center on non-compliance with U.S. immigration and tax laws, double taxation of business profits and the U.S., appraisal of penalties, and failure to allocate and budget costs. Keeping sufficient records details one of the most prominent things that a tax payer can undertake to circumvent a possible IRS audit or examination, and guarantee that an IRS audit or examination does not yield in an assessment of additional tax, interest, and penalties. A tax payer ought to maintain sufficient records and books to substantiate income, losses, deductions, and credits reported on the tax return. Most frequently, the IRS decides to audit a return owing to common tax audit red flags including discrepancies within the reporting or owing to suspicion of underrepresentation. The right transfer strategy can be central in saving a company millions of dollars in taxes; an incorrect strategy can trigger penalties that are higher than the initial tax. To guarantee compliance with the dynamic transfer pricing landscape, companies are increasingly implementing best practices that yield to complete end-to-end transfer pricing strategy. The strategy incorporates structured and automated data gathering processes, operational transfer pricing (inclusive of proactively monitoring, calculating, reporting, and rendering price adjustments throughout the year), transfer pricing risk assessments and planning, documentation and financial optimization, policy and intercompany agreement implementation. Transfer pricing audit and dispute avoidance techniques encompass: preparation of “quality” transfer pricing documentation, proper structuring of entities, risks, and functions, the preparation of appropriate intercompany agreements, and regular “course of conduct” audits (Heimert & Ceteris, 2010). MNCs ought to be proactive rather than reactive, and require the adoption of holistic approaches (rather than fragmented responses) to tax audits and controversies (Bakker & Levey, 2011). This may necessitate implementation of policies to circumvent transfer pricing audits and disputes from the launch of a project or transaction, inclusive of the proactive employment of advance pricing agreements. Defending a multinational company client in an IRS audit It is pertinent that entities adopt a proactive stance towards transfer pricing. As such, entities should implement strategic tax plan. In anticipation of tax audits, entities necessitate to have a concise and uniform approach towards transfer pricing. To get started, it is essential to determine the suitable transfer pricing method to utilize in establishing the company’s transfer prices. Furthermore, it is essential to highlight those responsible for implementation of changes and collection of relevant information that avails the best support to the prices (OECD, 2012). A transfer pricing analysis mainly incorporates four critical factors: functions, risks, contractual terms, and economic conditions. The significance of the factors and their pertinence during the IRS audit hinges on the pricing approach employed by the MNC. The quality and reliability of the company’s transfer pricing documentation should lean towards aiding in tax compliance. Inadequate analysis or incomplete policies throughout the year is likely to compromise arm’s length pricing (Talha, Alam & Sallehhuddin, 2005). The aim of the evaluation and management of transfer pricing centers on: minimizing or eradicating out-of-period adjustments; regularly appraising intercompany policy compliance with simplicity; and making timely adjustment that guarantees suitable pricing. Managing and generating a detailed audit trail at all steps during the entire transfer pricing process is central is essential in mitigating IRS audit. An audit plan for a multinational company’s transfer pricing methods There are several factors that could yield to transfer pricing audit risks, namely: absence of suitable pricing documentation; identified misalignment of profitability levels relative to industry standards; persisting losses, “low profits” or considerable variations within year-to-year effective tax rates; significant transactions undertaken with companies based in low-tax jurisdictions; significant intra-group services; financial transaction involving related parties such as interest expense and intercompany debt; and, payments of royalties, management fees, and transfers/valuations of intellectual property made to related parties based at low-tax jurisdictions (Autrey & Bova, 2012). Country basis The statutory tax rates relating to the countries in which the group operates can be scrutinized so as to establish whether there is any incentive for transferring profits around the group. The effective tax rate (ETR) in the countries in question should be computed and compared with standards rates manifest in each country. Any significant divergence from the standard rate should be probed in detail, and the highlighted variances explained. Business basis This incorporates analyzing key risk takers and asset holders of the group. Furthermore, the share price strategy of the group should be closely monitored, especially relating to whether there is an incentive to move the profits to a shareholder. The local profit margin should be analyzed based on the company’s activities within the group. The approach should be probed from jurisdiction to jurisdiction. Conclusion Transfer pricing is pertinent to U.S. companies operating within low-tax foreign jurisdictions given that, in such situations, a U.S. parent company possesses an incentive to transfer income to its low-tax foreign subsidy by employing lower transfer prices on controlled inventory sales. However, shifting income to a low-taxed foreign subsidy does not enduringly avoid the residual tax on lowly-taxed foreign earnings, but it defers the tax until the foreign subsidiary repatriates the earnings via a dividend distribution. Transfer pricing is also pertinent to foreign-owned U.S. companies, in which transfer pricing represents a repatriation approach for bringing cash back to the foreign company, devoid of paying U.S. withholding tax on dividends. References Autrey, R. L. & Bova, F. (2012). Gray Markets and Multinational Transfer Pricing. The Accounting Review, 87 ( 2), 393-421. Bakker, A. J., & Levey, M. M. (2011). Transfer pricing and dispute resolution: Aligning strategy and execution. Amsterdam: IBFD. Collins, E., Chamberlin, D. & Hirsch, G. (2012). U.S. Transfer pricing: Ups and downs on amended returns. Tax Notes International, 69 (3), 307-319. Heimert, A. M., & Ceteris. (2010). Guide to international transfer law pricing: Law, tax planning and compliance strategies. Alphen aan den Rijn: Kluwer Law International. OECD (2012). Dealing Effectively with the Challenges of Transfer Pricing. Retrieved from: http://www.oecd.org/site/ctpfta/49428070.pdf Talha, M., Alam, S. S., & Sallehhuddin, A. (2005). Transfer pricing and taxation implications disclosure in segmental reporting: Malaysian evidence. International Business & Economics Research Journal, 4 (7), 31-40. Urquidi, A. (2008). An introduction to transfer pricing. New School Economic Review, 3 (1), 27-45. Wittendorff, J. (2010). Transfer pricing and the arm's length principle in international tax law. Austin, TX.: Wolters Kluwer Law & Business. Read More