Understanding Transfer Pricing Part I
Posted September 20, 2011
Understanding Transfer Pricing – Part I
Transfer pricing is the number one global tax issue facing taxpayers operating across international and state borders. It involves all aspects of intercompany pricing arrangements between related business entities, including transfers of tangible goods, the provision of services, transfers of intellectual property, and loans and other financing transactions.
Because it is highly scrutinized by the Internal Revenue Service and foreign tax authorities, transfer pricing requires careful attention as you plan your international tax strategy. The practice can have a significant impact on tax planning and financial statements.
The Arm's Length Standard
The foundation of transfer pricing in the United States is the "arm's length standard," which states that "a controlled transaction meets the arm's length standard if the results of the transaction are consistent with the results that would be realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances." (Treas. Reg. §1.482-1(b)(1)).
However, as a practical matter, it is rare that identical transactions between unrelated third parties can be located. This is particularly true with manufactured products. Therefore, Treas. Reg. §1.482 provides five specific methods for U.S. taxpayers to determine whether or not their transactions with a related or controlled party meet the arm's length standard. For transactions involving tangible goods the methods are:
Transaction Based Methods
- Comparable Uncontrolled Price Method (CUP)
- Resale Price Method (RPM)
- Cost Plus Method (CP Method)
Results Based Methods
- Profit Split Method (PSM)
- Comparable Profits Method (CPM)
Choosing the Best Method
From these methods an evaluation must be made to select the "best method" based on the facts and circumstances applicable to the type of transaction. Due consideration is given to the availability of comparable uncontrolled transactions (Treas. Reg. §1.482-1(c)(1)).
In the United States there is no strict priority of methods, and the determination of the best method is based on an evaluation of the available methods to determine which produces the most reliable measure of an arm's length result. The two primary factors to take into account in the determination of the best method are:
- The degree of comparability between the controlled transaction (or taxpayer) and any uncontrolled comparables
- The quality of the data and assumptions used in the analysis (Treas. Reg. §1.482-1(c)(2))
In general, comparability of transactions and circumstances must be evaluated considering all factors that could affect prices or profits in arm's length dealings. Factors include:
- Functions
- Contractual terms
- Risks
- Economic conditions
- Property or services
In order to be considered comparable to a controlled transaction, an uncontrolled transaction need not be identical to the controlled transaction, but must be sufficiently similar that it provides a reliable measure of an arm's length result. If there are material differences between the controlled and uncontrolled transactions, adjustments must be made if the effect of such differences on prices or profits can be determined with sufficient accuracy to improve the reliability of the results.
Part II of this series will focus on factors affecting comparability and adjustments to improve comparability. Contact us to learn more about transfer pricing and other international tax issues.
