58560384 transfer pricing overview 2011

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Transfer Pricing:A Primer

Fernwood GlobalKalbian Hagerty LLP


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+Transfer pricing in the news Excerpt from Bloomberg BusinessWeek (October 21, 2010):

To reduce its overseas tax bill, Google uses a complicated legal structurethat has saved it $3.1 billion since 2007 and boosted last year's overallearnings by 26 percent. While many multinationals use similar structures,Google has managed to lower its overseas tax rate more than its peers inthe technology sector. Its rate since 2007 has been 2.4 percent .

According to company disclosures, Apple (AAPL), Oracle (ORCL),

Microsoft (MSFT), and IBM (IBM)

which together with Google make upthe top five technology companies by market capitalization reported taxrates between 4.5 percent and 25.8 percent on their overseas earningfrom 2007 to 2009.

All of these arrangements are legal.Google's practices are very similarto those at countless other global companies operating across a wide

range of industries,

says Jane Penner, a company spokeswoman whodeclined to address the particulars of Google's tax strategies.

Fernwood GlobalKalbian Hagerty LLP

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+Media reaction to Google story

The tactics of Google depend on transfer pricing,paper transactions among corporate subsidiaries thatallow for allocating income to tax havens while attributingexpenses to higher-tax countries. Such income shiftingcosts the U.S. government as much as $60 billion inannual revenue, according to Kimberly A. Clausing, aneconomics professor at Reed College in Portland,Oregon.

- Bloomberg News, October 21, 2010

Its calledtransfer pricing and technically itslegal. But hows it mesh with that wholedont beevil thing?

- Kai Ryssdal, American Public Radio, October 21

Fernwood Global LLCKalbian Hagerty LLP

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+Scope of this presentation

An Overview of Transfer Pricing

Terms of Art

Best Method Rule

Comparability

Types of Controlled Transactions

Examples

Recordkeeping Requirements

Advance Pricing Agreements


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+Overview of transfer pricing


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+ What is transfer pricing?

Transfer pricing is a set of rules that looks atwhether the pricing on a transaction betweenrelated parties is the same as the arms lengthprice that would occur in a comparable transaction

between unrelated parties.

Designed to prevent tax avoidance amongrelated entities

Concern about tax avoidance likely to occur onlywhen controlled parties are subject to differenttax regimes


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+Terms of art Taxpayers

For purposes of 482, a taxpayer is any person, organization, trade orbusiness, whether or not subject to US taxation. Treas. Reg. 1.482-1(i)(3).

Foreign persons are therefore taxpayers for purposes of these rules.

Controlled Any control, direct or indirect, whether legally enforceable or not, and

however exercisable or exercised, including control resulting from theactions of two or more taxpayers acting in concert or with a common goalor purpose. Treas. Reg. 1.482-1(i)(4).

It is the reality of control that is decisive, not its form or the mode of itsexercise.

A presumption of control arises if income or deductions have beenarbitrarily shifted.

Controlled taxpayers A controlled taxpayer means any one of two or more taxpayers that are

controlled directly or indirectly by the same interests and includes ataxpayer that owns or controls other taxpayers. Treas. Reg. 1.482-1(i)(5).


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+Terms of art (cont.)

Controlled group The taxpayers owned or controlled directly or indirectly by the same

interests. Treas. Reg.`.482-1(i)(6).

Transaction

Any sale, assignment, lease, license, loan, advance, contribution, or any

other transfer or interest in or a right to use any property or money,however such transaction is effected, and whether or not the terms ofsuch transaction are formally documented. Treas. Reg.1.482-1(i)(7).

Controlled transaction

Any transaction between two or more members of the same group of

controlled taxpayers. Treas. Reg. 1.482-1(i)(8).

Uncontrolled transaction

An uncontrolled transaction is any transaction between two or moretaxpayers that are not members of the same group of controlledtaxpayers. Id.


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+Key concept: arms length price

The price at which two unrelated and non-desperate parties would agree to a

transaction.


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+Key concept: best method rule

Every controlled transaction must be judged under the pricingmethod that provides the most reliable measure of an arms lengthresult.

All methods rely on the assumptions the taxpayer uses. The key tosupporting the best method is the soundness of those underlying

assumptions.

There is no hierarchy of methods.

Primary factors to determine best method: Degree of comparability between the controlled transaction and any

uncontrolled transactions;

The quality of the data and assumptions used in the analysis; and

A higher degree of comparability results in a smaller chance thatdifferences could render the analysis inaccurate.


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+Key concept: comparability

Taxpayers can determine the most reliable price by comparingto transactions that occur between unrelated parties.

Comparability of transactions depends on:

Functions performed by parties;

Risks undertaken; Contractual terms;

Economic conditions; and

Nature of goods and services.

Relevancy of factorsAdjustments must be made to account for any differences in

comparability.


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+Types of controlled transactions


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+Types of controlled transactions

Loans or advances

Performance of services

Use of tangible property

Sales of goods and other transfers of tangible property

Use of intangible property

Global dealing operations


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+Loans and advances

The IRS can make a 482 allocation if one member of acontrolled group makes a loan or advance to another memberof that group but does not charge an arms-length rate. Treas.

Reg. .

1.482-(2)(a)(1)(i). The IRS may determine that the rate is too high or too low.

The IRS may impute interest on accounts receivable if they are notpromptly paid.

Debt terms between controlled taxpayers is at arms lengthonly if it bears interest at a rate that would be charged inindependent transactions with or between unrelated partiesunder similar circumstances. Treas. Reg. 1.482-2(a)(2)(i).


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+Loans and advances (cont.)

Exceptions to general rule:

Safe harbor (Treas. Reg. 1.482-2(a)(2)(iii))

Available if the creditor is not engaged in the business of making

loans. Stated interest is deemed to be arms length if it is not lower than

the applicable federal rate (AFR) or higher than 130% of theAFR.

If there is no stated interest, the AFR may be used.

If the stated interest is higher than 130% of the AFR, 130% of theAFR may be used.

If a taxpayer borrows money from an unrelated party and relends toa controlled party, the stated interest on the unrelated debt shouldbe used for the controlled transaction. Treas. Reg. 1.482-2(1)(2)(ii).


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+Performance of services

If a member of a controlled group performs marketing,managerial, administrative, technical or other services for anothermember, the parties must establish an arms-length price ascompensation for those services. Treas. Reg. 1.482-2(b)(1). An arms-length service fee must be charged whether the services are

performed for the benefit of one particular member or to benefit theentire group. Treas. Reg. 1. 482-2(b)(2)(i).

The arms-length fee must be based on the benefits expected when theservices are performed, rather than the benefits actually realized. Id.

No charge required in the following situations (Treas. Reg.

1.482-2(b)(ii)): Parent company performs services in its capacity as shareholder of

subsidiaries; and

A member performs services that are duplicative of activities performedby another member on its own behalf.


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+Performance of services (cont.)

A member of a controlled group that provides intercompanyservices to another member must charge an amount equal to theamount that it would charge if the two parties were unrelated anddealing at arms-length. Treas. Reg. . 1.482-2(b)(3).

Preferred methods for calculating arms-length rate

Comparable uncontrolled price (CUP) method; and

Cost plus method.

If services performed are not integral to either the performer of the

services or the recipient, the arms-length charge is equal to thecost of providing the services. Id.

For example, head office costs incurred by a parent company may beallocated to subsidiaries that benefit from those services but aretypically not marked up because those administrative services are notintegral to the parents business.


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+Performance of services (cont.)

Services are treated as an integral part of the business activity(Treas. Reg. 1.482-2(b)(7) if any of the following apply:

Services are considered integral to the business of a service

provider or recipient if either party is engaged in the trade orbusiness of rendering similar services to unrelated persons; or

Services are considered integral to the business of the serviceprovider if the performance of such services for related persons isone of its principal business activities.

For example, a controlled member whose sole purpose is toprovide marketing services in a target market and providessuch services to members of the controlled group will besubject to transfer pricing rules.


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+Use of tangible property

A member of a controlled group that uses or occupies tangible property thatis owned or leased by another member of the controlled group must pay anarms-length rental charge. Treas. Reg. 1.482-2(c)(1).

Relevant factors to be considered: Period and location of use; The owners investment in the property or the rent paid; Expenses of maintaining the property; The type of property involved; and The condition of the property.

Treas. Reg. 1.482-2(c)(2)(i).

If one controlled subleases the property to another member, the arms-length price of the sublease is deemed to be the lease amount that thelessee pays to the unrelated party plus any other expenses associated withthe property, such as maintenance, repair, utility, and management costs.Treas. Reg. 1.482-2(c)(iii).


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+Sales of goods

If a member of a controlled group transfers tangible property toanother member, the parties must establish an arms lengthsales price

An arms length price for the sales of goods between twomembers of a controlled group must be tested using one of fivemethods:

Comparable uncontrolled price method (CUP);

Resale price method;

Cost plus method;

Comparable profits method;

Profit split method; or

Any other method if the taxpayer can demonstrate that such method isthe most reliable measure of arms length results.

Treas. Reg. 1.482-3(a).Fernwood Global LLCKalbian Hagerty LLP

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+Sales of goods (cont.)

CUP Method

The arms-length price is calculated as the price that the seller obtainsin a comparable uncontrolled transaction. Treas. Reg. 1.482-3(b)(1).

The CUP method will usually be the best method if there are no

differences between the controlled and uncontrolled transactions thatwould affect the price or there are only minor differences for whichappropriate adjustments to price can be calculated. Treas. Reg.1.482-3(b)(2)(ii)(A).

The most important comparability factor for purposes of thiscalculation issimilarity of product. Treas. Reg. 1.482-3(b)(2)(ii)(A).

Contractual terms are also key here, such as scope of warranties,sales volume, credit terms, and transport terms. Treas. Reg.1.482-3(b)(2)(ii)(B)(2).


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Resale Price Method

The arms-length price for a sale between controlled taxpayers isthe price at which the goods are resold by the buyer to an unrelatedperson, less a gross profit comparable to that earned by acomparable uncontrolled distributor in comparable circumstances.Treas. Reg. 1.482-3(c)(2)(i).

This method is appropriate for entities that buy and resell goodswithout adding substantial value by physically altering them. Treas.Reg. 1.482-3(c)(1).

This method is inappropriate for a controlled buyer that ownsintangible property that adds substantial value. Id.


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Cost Plus Method

The arms-length price for a controlled sale under this method is thesum of the sellers cost of goods sold and an appropriate grossprofit markup determined from comparable uncontrolledtransactions. Treas. Reg. 1.482-3(d)(1).

The appropriate gross profit is the product of the controlled sellersproduction costs and the gross profit markup expressed as apercentage of cost, that is earned in comparable uncontrolledtransactions. Treas. Reg. 1.482-3(d)(2)(ii).

Controlled and uncontrolled transactions are comparable only if themanufacturing functions, capital investments, risks, and contractterms do not differ materially or reliable adjustments can be madefor material differences. Treas. Reg. 1.482-3(d)(3)(ii)(A).


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+Transfers of intangible property

For licenses and other transfers of intangible properties, the primarymethod authorized by the 482 regulations to determine the appropriatearms length price is the comparable uncontrolled transaction (CUT)method. Treas. Reg. 1.482-4(a).

The other permissible methods are: Comparable profits method; and

Profit split method.

Id.


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+Intangible defined

An intangible is all property that has substantial valueindependent of the services of any individual and is within oneof six classes:

Patents, inventions, formulae, processes, designs, patterns, or knowhow;

Copyrights and literary, musical or artistic compositions;

Trademarks, trade names, or brand names;

Franchises, licenses, or contracts;

Methods, programs, systems, procedures, campaigns, surveys,customer lists, or technical data; or

Other similar items where the value derived comes not from itsphysical attributes but from its intellectual content or other intangibleproperties.

Treas. Reg.

1.482-4(b).Fernwood Global LLCKalbian Hagerty LLP

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+Type of transfer of an intangible

A controlled transfer of an intangible may be either a sale, alicense, or some other permission to use the intangible. The IRStypically respects the form of the transaction if it is consistent withthe underlying economic substance. There are some exceptionsto this treatment, however: If a transferee pays little or no consideration and the the transferor

retains a substantial interest in the property, the transaction will beanalyzed as a license. Treas. Reg. 1.482-4(f)(1).

The IRS, even if it accepts the form, may consider the other alternativeforms for purposes of determining the correct amount of consideration.Treas. Reg. 1.482-1(d)(3)(iv).

Sec. 482 requires that the income with respect to the transfer or licenseof an intangible must be commensurate wit the income attributable tothe intangible. Treas. Reg. 1.482-4(f)(2) interprets this clause tomean that such a transaction will be subject to periodic review.


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+CUT method

The arms length consideration for the use of any intangible underthe CUT method is the amount charged in a comparableuncontrolled transaction. Treas. Reg. 1.482-4(c)(2)(i).

The CUT method is likely to be the best method when theintangible transferred in a controlled transaction was alsotransferred in an uncontrolled transaction. Treas. Reg. 1.482-4(c)(2)(ii).

Two intangibles are considered comparable only if they are used

in connection with similar products or processes within the sameindustry and have similar market potential. Treas. Reg. 1.482-4(c)(2)(iii)(B)(1).

The reliability of the results under the CUT method depends on thequality and completeness of the underlying data and assumptions.Treas. Reg. 1.482-4(c)(2)(iv.)


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+Global dealing of financial servicefirms

Special methods apply to financial services firms:

Gross Margin Method

Comparable Uncontrolled financial transaction method

Gross Markup Method

Profit Split Method


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+Transfer pricing example


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+Transfer pricing example

U.S. SUB is a wholly-owned subsidiary that distributes toasterson behalf of its Foreign Parent, FP, in the U.S.

FP also sells toasters to unrelated Company C for U.S.

distribution. Products sold to U.S. SUB are of higher quality than those sold to

Company C. The effect on the price of the toasters cannot beaccurately determined.

U.S. SUB also purchases blenders from unrelated parties for

resale in the U.S. Distributions functions between toasters and blenders appear to be

similar. Products are sold to the same type of customer, purchasedunder similar terms and volumes and have similar resale values.


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+Questions to ask yourself

Step One: Are there controlled taxpayers?

Step Two: Is there a controlled transaction? If so, what kind?

Step Three: Which pricing method should be used to determinethe most reliable transfer price?

Step Four: Do you have data from comparable uncontrolledtransactions?

Step Five: What is the arms length price after applying themost reliable pricing method chosen in Step Four?


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+Step 1: Are there controlled taxpayers?

In our example, the parties we have are U.S. SUB and its foreignparent, FP.

U.S. SUB and FP are clearly related and therefore will be treated ascontrolled taxpayers.


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Step 2: Is there a controlledtransaction?

In our example, U.S. SUB purchases toasters from its foreign parent, FP.

This transaction is a sale of tangible property between two controlledtaxpayers and therefore constitutes a controlled transaction.


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+Step 3: Determine the most reliable

pricing method Several pricing methods potentially apply to a sale of tangible goods:

Comparable Uncontrolled Price; Resale Price; Cost Plus; Comparable Profits Method; and

Profit Split Method.

For purposes of example, we will compare two methods: CUP and ResalePrice

Comparability factors: Functions performed, contractual terms, risks, economic conditions and property

being sold or services performed

CUP most important factors are similarity of product, contractual terms andeconomic conditions Resale Price most important factors: similarity of functions, risks borne and

contractual terms


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+Step 4: Using data fromcomparable uncontrolledtransactions

From the facts in our example, we know that the toasters soldin the controlled transaction differ significantly from the toasters

sold in the uncontrolled transaction and that the effect on pricecannot be accurately determined.

Further, the facts show that the distribution functions for thesale of toasters and the sale of blenders by the controlledreseller are similar. The products are sold to the samecustomers, purchased under similar contractual terms andhave similar resale values.

Analyzing the comparability factors, we can conclude that theresale price method will be the most reliable.


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+Step 5: Apply pricing method to

transaction

U.S. SUB

Revenues from Resales

of Blenders 1000

of Toasters 1000

Cost of Goods Sold

COGS-Blenders (unrelated) 750

COGS-Toasters (related) 800

Gross Profit

Blenders 250

Toasters 200

Gross Profit Margin-Uncontrolled Blender transaction 25%


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+Step 5: apply pricing method to

transaction (cont.)

Revenues 1,000

Less: arms-length profit (250)

Total COGS for toasters 750


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Applying uncontrolled gross profit margin of 25% to the testedtransaction

.U.S. Subs gross profit for toasters should be $250 (25% x $1000)

Using $250 as the arms-length gross profit, we can determine whatprice U.S. Sub should pay FP for the product:


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+Recordkeeping requirements


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+Overview of RecordkeepingRequirements

There are two key costs associated with a taxpayers failureto keep adequate transfer pricing records: Tax penalties; and

Increased audit costs.

NB: Remember that a controlled transaction subject to thetransfer pricing rules will have to deal with a minimum of twoseparate taxing jurisdictions. Therefore, the taxpayer will haveto factor in potential audit costs and penalties in not only theU.S. but in each jurisdiction in which it has a controlledtransaction.


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+Transfer pricing penalties

If the IRS determines that there is a substantial underpaymentof tax as a result of a incorrect transfer pricing, the taxpayer willbe subject to a penalty equal to 20% of such underpayment.This rule only applies if the IRS determines the transfer price is200% or more (or 50% or less) of the transfer price the

taxpayer used. IRC

6662(e)(1)(B). If the IRS determines the transfer price is 400% or more (or

25% or less) of the transfer price that the taxpayer used, theunderpayment will be treated as a gross valuationmisstatement and will be subject to a penalty of 40% of theunderpayment. IRC 6662(h)(1).

Exception: Neither of these penalties apply if the taxpayer canshow that, given the available data and the applicable pricingmethods, the method (and its application of that method)provided the most reliable measure of an arm's length result,and can establish that it had specific and adequatedocumentation of the transaction at the time it filed the return.Treas. Reg. 1.6662-6(d)(iii).


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+IRS audits

IRS auditors now request as a matter of course at thebeginning of any examination that the taxpayer provide copiesof all detailed transfer pricing documentation. Taxpayerstherefore cannot start thinking about their transfer prices onlywhen the IRS issues the first Information Document Request.

If the taxpayer fails to maintain documentation and timelyprovide it to the IRS, the threat of a penalty may impact theentire examination, not only the transfer pricing issues. Well-prepared taxpayers will plan their transfer prices during thetaxable year, prepare thorough documentation when the taxreturn is filed, and organize supporting documents to beprovided to the IRS.

The stronger the documentation, the greater the likelihood thatits disclosure will discourage further IRS inquiry into thetaxpayer's transfer pricing practices. It is therefore critical thatthe taxpayer maintain the specific and adequate documentationrequired by the IRS.


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+Required documentation

Documentation must be in existence when the return is filed.The IRS may excuse a minor or inadvertent failure to providerequired documents, but only if the taxpayer has made a goodfaith effort to comply, and the taxpayer promptly remedies thefailure when it becomes known.

The required documentation is divided into two categories,principal documents and background documents. The taxpayermust keep a general index of the principal and background

documents and a description of the recordkeeping system usedfor cataloging and accessing those documents.


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+Principal documents

The principal documents should accurately and completely describethe basic transfer pricing analysis the taxpayer has conducted. Thedocumentation must include the following: An overview of the taxpayer's business, including an analysis of the

economic and legal factors that affect the pricing of its property or services;

A description of the taxpayer's organizational structure (including anorganization chart) covering all related parties engaged in transactionspotentially relevant under section 482, including foreign affiliates whosetransactions directly or indirectly affect the pricing of property or services inthe United States;

Any documentation explicitly required by the regulations under section482;

A description of the method selected and an explanation of why thatmethod was selected, including an evaluation of whether the regulatoryconditions and requirements for application of that method, if any, weremet;

A description of the alternative methods that were considered and anexplanation of why they were not selected;


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http://taxandaccounting.bna.com/btac/display/link_res.adp?fedfid=4415887&fname=usc_26_482&vname=tm26cfrhttp://taxandaccounting.bna.com/btac/display/link_res.adp?fedfid=4415887&fname=usc_26_482&vname=tm26cfrhttp://taxandaccounting.bna.com/btac/display/link_res.adp?fedfid=4415887&fname=usc_26_482&vname=tm26cfrhttp://taxandaccounting.bna.com/btac/display/link_res.adp?fedfid=4415887&fname=usc_26_482&vname=tm26cfr


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+Principal documents (cont.)

More required principal documents:

A description of the controlled transactions (including the terms ofsale) and any internal data used to analyze those transactions.

A description of the comparables that were used, how comparabilitywas evaluated, and what (if any) adjustments were made;

An explanation of the economic analysis and projections relied uponin developing the method. for example, if a profit split method isapplied, the taxpayer must provide an explanation of the analysisundertaken to determine how the profits would be split; and

A description or summary of any relevant data that the taxpayerobtains after the end of the tax year and before filing a tax return,

which would help determine if a taxpayer selected and applied aspecified method in a reasonable manner.


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+Background documents

The assumptions, conclusions, and positions contained in principal documents ordinarily willbe based on, and supported by, additional background documents. Documents that supportthe principal documentation may include: Books and transaction records of original entry;

Applicable profit and loss statements;

Documents relating to transactions involving the same or similar products or services;

Shipping and export documents;

Commission agreements;

Third-party and intercompany purchase and sales invoices;

Manuals and specifications; Documents describing or setting out the functions, responsibilities, and risks of the various related and

unrelated parties;

Documents relating to the transactions that the taxpayer or a related entity filed with foreign countries;

Records of loans, guarantees, and hedging or other risk-shifting agreements; and

Records of research and development sharing agreements and agreements for the provision ofmanagement services.

The taxpayer need not provide background documents to the IRS in response to a request forprincipal documents. If the IRS subsequently requests background documents, a taxpayermust provide that documentation to the IRS within 30 days of the request. However, the IRSmay, in its discretion, extend the period for producing the background documentation.


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+Advance pricing agreements(APA)

Taxpayers can choose to negotiate the best transfer pricing method fortheir controlled transaction with the IRS through an APA. Google famouslyentered into an APA with respect to its controlled transactions.

Taxpayer must file a request for an APA before filing its tax return

Types of APA

Unilateral APA Between the taxpayer and the IRS

Bilateral or multilateral APA Among the taxpayer, the IRS, and the taxingauthorities of one or more foreign jurisdictions

Term: Usually a minimum of five years

Benefits:

The taxpayer does most of the work to establish the best transfer pricingmethod and therefore has a chance to establish the most favorable transferpricing method.

The taxpayer will have a certain tax position that allows it to decide whether toenter into the transaction in the first place.

Minimizes compliance and audit costs.

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+Cost sharing agreements

Most common proactive tax planning tool (e.g., Google)

Allows companies to treat intellectual property as ownedoffshore for tax purposes

Requires a sophisticated set of calculations

High scrutiny by tax authorities


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+ Conclusions

Almost every country has transfer pricing rules. Therefore, yourclient will have to calculate the correct transfer price incompliance with the laws of every country in which thetransaction takes place.

Document, document document. Taxpayers must proactively

manage their potential transfer pricing exposure.

There are potentially significant financial risks associated withfailure to manage transfer pricing exposure

Operating in multiple jurisdictions presents your client with tax

planning opportunities.