By Ted Howard
It might not be getting as much press as the rest of the administration’s revenue plans. But it is a big part of the agenda nonetheless.
The Obama administration just gave corporate America 1.6 trillion reasons to worry about tax hikes. That’s the projected—and record—deficit offered in the $3.8 trillion FY 2011 budget unveiled on February 1. To help narrow the gap, the administration proposes to slam shut a series of loopholes regarding overseas activities by MNCs. One area is conspicuously absent from the president’s revenue proposals: transfer pricing. But treasurers shouldn’t take heart—in terms of stricter enforcement, this is among the items at the top of the administration’s agenda.
New legislation regarding transfer pricing isn’t really necessary, since it is more of an audit and administrative issue. “How much one related party should charge another related party for goods or services is very fact-specific and it’s difficult to see how new legislation would help answer that basic question,” notes William Cavanagh, partner and tax attorney at Chadbourne & Park in New York.
Nonetheless, the raft of revenue measures proposed in 2009 and those in the White House budget “definitely heighten the incentive to use transfer pricing as a way of avoiding taxes,” says Barry Seldon, a professor of economics at the University of Texas at Dallas. By tweaking the costs that subsidiaries charge one another and the parent for goods and services, MNCs can position themselves to report more of their income in low-tax jurisdictions and more of their expenses in high-tax ones. “I’m not saying they’re doing it, but it’s one feasible way” to offset other tax hits, Mr. Seldon says.
BUYER AND SELLER BEWARE
That could turn out to be a big mistake. The Internal Revenue Service takes a dim view of corporates that use unduly advantageous transfer prices, according to Mr. Cavanagh. The IRS is adding many more economists and IRS international agents–“literally hundreds”–to audit taxpayers’ pricing claims. Mr. Cavanagh says the IRS also is churning out hundreds of pages of transfer pricing regulations to better analyze and pursue transfer pricing overreach.
The topic is a priority for IRS boss Douglas Shulman. In a December 2009 address at an international tax conference, Mr. Shulman sounded more like a beleaguered city police commissioner outgunned by criminal gangs than a tax wonk discussing a technical issue. “While we have a phenomenal cadre of experts in this area, we need more people with industry-specific and transfer-pricing expertise to match up with corporate taxpayers and to fully develop the issues, discuss them with taxpayers and their representatives, and ultimately resolve the issues,” he said.
To this end Mr. Shulman said the IRS would establish a transfer-pricing practice so it can better crack down on cheaters—although he put it more diplomatically: “The idea here is to create a group of experts in the transfer-pricing area that we can use to coordinate our handling of the most important issues to taxpayers and to us.”
THE BEST DEFENSE
Despite the greater scrutiny, there are things that companies can do to minimize the risk of challenges from the IRS. First and foremost is to review transfer pricing policies. According to Mr. Cavanagh, many companies hire an economist or other expert to study their transfer pricing and create the policy. However, often times this policy is never revisited and left to gather dust despite changes in markets or other circumstances. It is imperative to keep this policy up-to-date.
“You need to have a policy in place for all the places you do business,” Mr. Cavanagh says. The underlying arguments should be consistent across all countries. “You can’t whipsaw both authorities,” he says. Some companies make the mistake of arguing one thing to one tax authority and something else to another authority. These contradictions often come out. Short of doing a joint audit, foreign countries will request a company’s home transfer policy, which often exposes conflicts.
Companies should seek to get prices out in the open by giving the IRS a heads-up on their pricing intentions. Some file advance pricing agreements (APAs) with the IRS to head off problems. Companies submit the transfer prices they plan to charge along with their rationales. The APA program is coordinated with US tax treaty partners so it can help companies reduce problems like double taxation.
Mr. Seldon believes that APAs are in for more scrutiny. However, he says this is just a continuation of the perennial cat-and-mouse game between multinationals and the IRS. “Everyone knows what’s going on.” While only a handful of companies file APAs, the list will probably grow going forward as transfer pricing becomes more of an issue and the IRS starts challenging more companies.
And it’s not just the US that is ramping up transfer-pricing scrutiny. The number of countries that have transfer pricing taxes has nearly quadrupled in the past decade. In many cases, the US has agreements with these countries on issues such as double taxation.
Many of these countries view transfer pricing as a big-dollar tax issue and accordingly are making it a high priority, Mr. Cavanagh says. He adds that, aside from the various tax treaties, authorities tend to run their audits independently, but this is likely going to change as more countries start working together on joint audits. “It will be interesting to see whether the tax authorities of two or three countries that agree on very little can reach consensus on how to conduct a joint tax audit,” he says. But companies shouldn’t expect these logistical issues to keep the tax wolves from their doors for long—greater international pricing scrutiny appears to be firmly in the cards.