Transfer Pricing and Related Valuation Issues

When one person sells something to another person, it is usually assumed that the seller tried to get a fair price. Typically, that price is set by the laws of supply and demand in a market economy. However, when the people involved in the transaction are related in some way, the game changes. For this reason, often transactions between related parties aren’t really reflective of the actual worth. This is why, in home appraisals for example, only arm’s length transactions are considered.

This same principle applies in the business world. Unfortunately, when a price is not reflective of value, it creates a multitude of problems in terms of taxing the transaction. Transfer pricing is used to solve those problems and attorneys who represent business clients must advise those clients of transfer pricing and how it applies in transactions between different branches of multi-entity companies.

When a multi-entity company has different branches, one branch may provide products, goods or services to another. Because of the relationship between the parties in the transaction, the pricing will not necessarily be fair market value.

This creates a number of problems, including a low profit margin for subsidiaries. The biggest issue, however, arises in the taxation of profits. The country/area where the subsidiary is located, for instance, would not get its fair share of the profit on the sale of the goods because of the below-market sale. Double taxation could also occur if two different countries taxed multiple branches of a company for the same profits on the same product.

Transfer pricing is used to ensure that each country that is home to a branch of the business gets its fair share of taxes. Transfer pricing rules are set by treaties between different countries. Failure to comply with transfer pricing requirements can result in penalties, depending on the current laws in the relevant jurisdiction. Attorneys, therefore should strongly encourage clients operating multi-entity organizations to seek assistance in transfer pricing from qualified professionals.

To avoid taxation and trade problems, guidelines are set for transfer pricing. The Organization of Economic Cooperation and Development (OECD) is one source of guidelines on transfer pricing, although countries also establish their own income tax treaties that create transfer price guidelines that must be followed.

While there are multiple sets of guidelines, most use the same standard: the “Arm’s Length” standard. Today, fifty of the United States’ income tax treaties require mutual application of the Arm’s Length standard when resolving disputes on transfer pricing.

While transfer pricing methodology is complicated, the basic rule is simple: the Arm’s Length standard means that the transfer price assessed should be the same price that would have been charged if the two branches of the multi-entity company had not been related. The United States has clarified further their transfer pricing rules (Internal Revenue Code §482), also requiring that the transfer of any intangible property must be reported as yielding income commensurate with the amount of income that can be attributed to the intangible.

Applying the Arm’s Length Standard is difficult, despite clear guidelines for pricing, because it requires that a transaction be evaluated by finding comparable independent transactions. When a transaction occurs between a parent company and its subsidiary, the companies are considered “commonly controlled” taxpayers. When a transaction occurs between two unrelated parties, on the other hand, it is considered an uncontrolled transaction. The level of risk, the assets involved, and the purpose of the transfer in the controlled transaction are compared to the same elements in an uncontrolled transaction to determine the appropriate transfer price. Unfortunately, finding comparables can be difficult, especially in developing countries where they might be only one provider of a specific product.

As such, the transfer pricing regulations recognize that the comparability between the controlled and uncontrolled companies cannot be exact. However, the uncontrolled transaction either must be similar enough to the controlled transaction or it must be adjusted so it becomes similar enough to provide a reasonable means of determining what would have occurred in an arm’s length transaction. When adjustments to achieve a reasonable degree of similarity are not possible, an uncontrolled transaction must still be used to determine transfer pricing, but the reliability of the comparison is reduced.

To ensure that transfer pricing is as reliable as possible, a Best Method Rule is often built into the transfer pricing regulations for most jurisdictions. It is, however, important to note that if any method is shown to produce the most reliable measure that method will prevail.

The IRS outlines specific methods for different categories of item. For instance, for the transfer of intangible property, there are five specified methods for determining transfer price:

  • The comparable uncontrolled price method (CUP): The price of the property in the controlled transaction is assessed in comparison to the price in a comparable uncontrolled transaction,
  • The resale price method: The gross profit margin in the controlled transaction is compared to the gross profit margin in uncontrolled transactions,
  • The Cost plus method: The gross profit markup in controlled and uncontrolled transactions is compared,
  • The comparable profits method: The operating profits in controlled and uncontrolled transactions are compared, and
  • The split profits method: Either the combined profit/loss in the controlled transaction is compared to the same allocation in uncontrolled transactions or a two-step residual profit split method is used.

It is important to note that the above methods apply only to tangible property and that separate guidelines exist for a variety of different types for transactions. For example, among others, the IRS has also established methods for transfer pricing associated with the exchange of:

  • Intangible property (the comparable transaction method; the profit split method; the comparable profits method and unspecified methods); and
  • Controlled services (the services cost method, the comparable uncontrolled services price method, the gross services margin method, the cost of services plus method, the comparable profits method, the profit split method and unspecified methods).

When selecting the best method, one primary consideration is how comparable the controlled transaction is to the uncontrolled transaction. Another primary factor is an assessment of the level of quality of the data and the assumptions made in the analysis of the transactions.

As long as the transfer price is within a reasonable arm’s length range as determined by the application of the best method, the IRS won’t allocate taxable income. Further, while 20% to 40% penalties are imposed by the IRS for misstatements in valuation, no penalties are assessed when the companies determined their pricing in accordance with methods established in §482 — as long as the company’s choice of method was reasonable and they have documentation supporting their determination of price.

Transfer pricing is a very complex area of law, and one in which clients must follow the specific guidelines relevant to their transaction based on jurisdiction and type of transaction. Clients should be advised to consult with business valuation professionals to avoid potential penalties for incorrect pricing and profit allocation.

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