Transfer Pricing Update
More taxpayers are focusing on making sure they have adequate support for transfer pricing policies.
Transfer pricing continues to be one of the leading topics in the tax world. Pursuant to the changes implemented to documentation requirements by the Organization for Economic Co- operation and Development (“OECD”) and the Internal Revenue Service (“IRS”) over the last two years, and to the publicity surrounding high profile audits and assessments imposed on multinational entities (“MNEs”), more taxpayers are focusing on making sure they have adequate support for transfer pricing policies.
Marcum LLP’s Transfer Pricing Services group can help taxpayers navigate the rules and regulations in this increasingly complex area of taxation.
RECENT DEVELOPMENTS: CHANGES TO DOCUMENTATION REQUIREMENTS
In 2015, the OECD published revised standards for transfer pricing documentation, including the new requirement for country by country (“CbC”) reporting. The new documentation requirements are applicable to MNEs with global revenues in excess of €750 million and are effective for years beginning January 1, 2016. The new reporting requirements were designed to increase global transparency. A three-tier approach to the documentation requires a master file, a local file, and a CbC report. All of the CbC information is filed in the MNE’s primary country of residence and is automatically exchanged with countries meeting certain conditions, in particular confidentiality and the proper use of the information.
In 2016, the U.S. Treasury Department followed suit and issued final regulations that align U.S. transfer pricing reporting requirements with those recommended
by the OECD, including the CbC reporting and automatic sharing of information with other tax jurisdictions. Similar to the OECD guidelines, this new
documentation is required for MNEs with global revenues in excess of $850 million. The regulations are effective for U.S. MNE groups that begin on
or after the first day of a tax year of the ultimate parent entity that begins on or after June 30, 2016. (Although this date did not correspond with
the OECD’s effective date, various solutions were offered including “parent surrogate filing” for MNEs subject to the OECD guidelines or early elections
by U.S. parents of MNEs).
Many MNEs are not subject to the new reporting requirements given the revenue thresholds. Those MNEs may continue to follow the existing documentation requirements. However, before the new standards became effective in most jurisdictions, many high profile audits, assessments, and cases brought the perils of a transfer pricing audit to the forefront for MNE taxpayers. Many of these cases involve transfer pricing issues for intellectual property and the allocation of services.
In the U.S. and other taxing jurisdictions, whether subject to the new regulations or the old regulations for documentation of transfer pricing, there can be severe penalties for failure to provide documentation to support MNE transfer pricing. In the U.S., there are two types of penalty thresholds: the valuation (transactional) threshold and the net §482 (as defined in the Internal Revenue Code) adjustment threshold. These penalties are computed at either 20% or 40% of the underpayment of tax as a result of a transfer pricing adjustment.
In the U.S., if a MNE is audited, the IRS typically asks for transfer pricing documentation at the beginning of the audit. The taxpayer has 30 days to produce the documentation report in order to obtain protection from the potentially onerous penalties.
Amazon.com v Commissioner
The IRS began its audit of Amazon’s cost sharing arrangement (“CSA”) beginning in 2008. In 2011, the IRS asserted a transfer pricing adjustment increasing Amazon’s income by approximately $3.4 billion.
The Tax Court held that Amazon’s use of the comparable uncontrolled transaction (“CUT”) method was the best method in performing the analysis of Amazon’s intangible property. The IRS applied a discounted-cash-flow (“DCF”) method to the expected cash flows from the European business to determine that the value of the intangible property should have been $3.6 billion. Amazon successfully argued that the IRS inflated the value of the intangible property by improperly including in it the value of subsequently developed intangible property, in violation of the regulations.
Coca Cola v Commissioner
The beverage company received an IRS notice in September of 2015 based upon an audit of the years 2007-2009. The IRS claimed that the company underreported income during the three-year period by leaving out substantial sums related to licensing fees paid by foreign producers and distributors. The IRS asserted that Coca-Cola undercharged seven foreign affiliates for intellectual property, primarily trademarks and formulas, used in the production and sale of concentrates abroad.
The proposed adjustment would increase Coca-Cola’s income by $9.4 billion. Although the petition is still pending, this case shows the IRS’s willingness to ignore past agreements. The IRS had accepted Coca-Cola’s transfer pricing model for 20 years.
Medtronic, Inc. v Commissioner
The issue in Medtronic was whether the income related to certain intercompany licenses for intangible property should be reallocated from Medtronic U.S. to its Puerto Rican subsidiary. While Medtronic applied the CUT method to determine the arm’s- length royalty rate, the IRS asserted that the comparable profits method (“CPM”) was the best method to determine the arm’s-length royalty rate on the intercompany sales. The IRS’ position was largely based on the assertion that the Puerto Rican subsidiary performed only the assembly of finished products, with Medtronic U.S. performing all other economically significant functions.
Ultimately, the Tax Court found the Puerto Rican subsidiary performed much more than merely the assembly of finished products and that the IRS’ almost $1.4 billion transfer pricing adjustment was arbitrary, capricious, or unreasonable. As of July 2017, the IRS has petitioned the Eighth Circuit for another chance to prove Medtronic Inc. owes hundreds of millions of dollars in taxes.
UPDATE OF RECENT TAX CASES INVOLVING TRANSFER PRICING
Even when documented in a timely fashion, transfer pricing analyses included in contemporaneous documentation reports don’t always provide a black and white result.This is especially evident in instances involving intangible property. A look back at some high profile transfer pricing cases illustrates the potential for varying economic analyses resulting in different transfer pricing results.
The past two years involved an increased focus on the preparation of contemporaneous documentation to avoid penalties from transfer pricing adjustments. The IRS also has raised the stakes with respect to the provision of intercompany services in an attempt to limit outbound migration of intangible property. These events make clear that some areas of transfer pricing can leave taxpayers with substantial uncertainty in a transfer pricing examination. MNEs can better prepare for the increased transfer pricing scrutiny by ensuring that their transfer pricing analysis and the contemporaneous documentation has taken into account all the relevant facts and circumstances surrounding the transaction and that the economic analysis demonstrates that the results are consistent with the arm’s-length standard. Taxpayers with thorough, complete, and independently reviewed transfer pricing documentation have a greater chance of success with the IRS and other taxing authorities.
HOW CAN MARCUM HELP?
Marcum provides transfer pricing services to clients in multiple industries and jurisdictions. The services provided are in accordance with existing laws and regulations and currently include:
- Planning – assistance in developing economically supportable transfer pricing policies and executing sustainable tax planning;
- Documentation and compliance;
- Implementation – providing advice on developing and implementing policies, procedures, and systems for setting, monitoring, and documenting intercompany transactions; and
- Dispute resolution.
For international organizations engaged in transfer pricing, the best defense is to perform adequate research and build a strategy early to anticipate and manage both old and new regulations. Marcum can provide insight into the changing requirements and support for taxpayer transfer pricing policies.