IRS Keeps Up Pressure on Transfer Pricing

By Geri Westphal

The IRS is taking an aggressive approach in examining transfer pricing policies of companies in their jurisdictions. Here are a few things to do about it.

Some believe the IRS’s renewed emphasis on Transfer Pricing policies comes as a result of the decline in corporate tax revenues that is a by-product of our depressed economy. Others feel the renewed interest is a result of the booming growth in foreign income as reported by US-based multinationals.

Although the global economy has weakened and times are tough, many US-based multinationals are moving forward with their respective globalization efforts. The IRS has long been concerned that US-based multinationals are potentially ”stripping away” profits from the United States and moving them to ”less expensive” jurisdictions across the globe.

As a consequence of these trends, the IRS has determined that it’s time for renewed emphasis on transfer pricing enforcement. Many believe the IRS will take an aggressive approach in examining the transfer pricing policies of companies in their jurisdictions.

NEW transfer Pricing focus

In late 2009, the IRS created a new “Transfer Pricing Practice” within its existing Large and Mid-Size Business Division (LMSB). This new group was formed for the sole purpose of handling important transfer pricing issues. Its focus is on identifying emerging issues and trends, and providing technical expertise throughout the IRS organization as needed. It also mandated to develop examination best practices to ensure optimal resource allocation. (See related story, “IRS Bringing in New Expertise to Challenge MNCs on Transfer Pricing” at iTreasurer.com).

The LMSB has also created a new Transfer Pricing Center that brings together a central knowledge base and resource center for examiners to have appropriate information at their fingertips. Much effort is being spent on making sure this new group has the resources they need to be
effective.

There has been a dramatic increase in the IRS’s budget for transfer pricing enforcement. They have increased the number of economists on staff by approximately 50 percent. This increase gives the IRS its largest staffing level of economists in the history of their economist program. As global enforcement pressures increase, there is increased cooperation among tax treaty countries and a greater willingness to share information under the applicable tax treaties. Indications are that information exchange under tax treaties is being used more frequently by the IRS to obtain transfer-pricing information. The process has been significantly streamlined, making obtaining shared information much easier.

Making TP a top priority

The combination of changes in global interest rates and the ramp up of IRS staff, leads one to believe that US-based multinationals would be well served to make transfer pricing a top priority in 2011 and beyond.

Section 1.482-2(a) of the US transfer pricing regulations allows a US entity engaged in intercompany loan activity to provide evidence that the rate used meets the arm’s-length standard, which means it is consistent with the market rate for a comparable loan. This section also allows for a safe haven if the loan is USD-denominated and if the rate is not less than the Applicable Federal Rate (AFR) and not greater than 1.3x the AFR. AFR rates are posted on the IRS Web site and are updated monthly.

Many US multinationals have historically used a simple method for calculating intercompany interest rates, whereby a benchmark rate (i.e. applicable market rate) is used to match the term of the loan. Spreads may be added for implied credit risk based on the financial strength of the subsidiary. But this is not always the case.

To illustrate an example of a hypothetical transfer pricing policy to calculate a short-term rate, treasury might use 1YR LIBOR plus an added credit spread of 100 basis points for Baa credit. Treasury may have determined the hypothetical creditworthiness of its internal subsidiary to be Baa, and have assigned the 100 basis point spread to this credit risk. The result would be a transfer price of 1.76 percent. In this example, the hypothetical transfer price falls outside the safe harbor range of 0.41 percent to 0.53 percent.

Determining Arm’s Length

If treasury used this same hypothetical transfer pricing policy for calculating a long-term rate, it could use a 10-year bond rate for the same Baa credit as was used in the previous example. The 10-year bond rate of 2.54 percent with an added credit spread of 100 basis points would result in an arm’s-length rate for a long-term loan of 3.54 percent. In this example, the hypothetical transfer price would fall within the safe harbor range of 3.32 percent to 4.32 percent.

Another common method for setting transfer-pricing rates is to use a comparable market rate with a similar maturity. Following this type of policy, treasury might use the prime rate for a comparable one-year rate and a current Baa corporate bond rate for our 10-year example. Both of these rates fall outside the IRS safe harbor range. However, since both of these rates fall outside the IRS safe harbor range, they are likely to draw scrutiny; therefore, companies should have solid documentation.

Know your at-risk transactions

The purpose of these examples is to highlight the diversity of methods used in setting transfer-pricing rates. A company’s transfer pricing rates can fall within the IRS safe harbor range with no issue. It becomes more difficult if one relies on a rate that falls outside of this range.

In order to manage transfer pricing risk that may exist with respect to an IRS inquiry, a US-based multinational would need to ensure that they can defend their choice of intercompany interest rates against a claim that the arm’s length rate is too high. For transactions where there may be deemed ‘significant risk’ from a transfer pricing perspective, US-based multinationals should consider preparing thorough documentation that can be provided to the IRS within a reasonably short period of time after receiving the transfer pricing information document request. This documentation process should occur each time rates are changed.

Will you be ready?

So what documentation should the company have? Remember the saying, the best defense is a good offense? It applies here. If there is an audit of the company’s transfer pricing policy, the company will typically have 30 days to respond to the IRS requests and to provide the right documentation.

Incomplete or inaccurate documentation can result in significant penalties. Consult the company’s tax experts for formal guidance on the contents of transfer pricing documentation programs, but in general, a good documentation program should contain the following:

Principal Documents

• A summary of business structure, including a breakdown of the economic and legal factors that affect the pricing of its property or services. If the company sells services between subsidiaries, describe those activities and the associated pricing attached to each service. The same applies to selling products. Describe the activity thoroughly.
• A summary of the company’s legal structure including organizational chart covering all subsidiaries and other related parties involved in the transfer-pricing program.
• The most current transfer pricing policy.
• A description of the different methods that were considered and an explanation of why they were not selected.
• A description of the comparables that were used for determining arm’s length, how the comparability was determined and what adjustments may have been made.
• An explanation of the economic analysis used for developing the specific rates.

Secondary Documents

• This includes any work papers that support assumptions or conclusions made as part of the transfer policy. Background documents do not have to be provided to the IRS in response to the request for principal documents. The IRS can make an additional request to review supporting documents, at which time a company has 30 days to provide information to the IRS. Failure to provide complete data may result in penalties.

keep up with the changes

With the increase in M&A activity, one can imagine that a company’s international organizational structure could change significantly during the course of any one year. It is important to keep the company’s transfer-pricing program in step with its growth and global expansion.

If the company’s legal structure changes, change the transfer pricing documentation to reflect the change. It is recommended that the policy and associated documentation program be reviewed on an annual basis. But again, consult the company’s tax experts for formal guidance.