Why SMB CFOs Should Care About Transfer Pricing

Small and mid-tier manufacturers incorrectly assume that because they’re small, their transfer-pricing policy won’t be audited. They're wrong.
Cristina MoreraOctober 25, 2016

In an era of globalization and continued growth of international trade, intracompany pricing has become an everyday necessity for many businesses. But why has transfer pricing become such a hot tax issue?

Cristina Morera

Cristina Morera

Transfer prices (prices charged between related parties) directly affect the allocation of group-wide taxable income (and therefore taxes) across national tax jurisdictions. From a multinational company’s perspective, transfer pricing can help an organization to identify opportunities for business optimization.

It can influence cash-flow streams, as, for example, when less corporate tax is imposed by the tax authorities, which can increase the resources at hand. It can affect investment decisions,such as when a jurisdiction with frequent changes of transfer pricing rules may create uncertainty, leading to a decision to exit a country. And transfer pricing can have an impact on key performance indicators, as when less corporate tax increases the profitability of a company.

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Opinion_Bug7Transfer pricing is, however, viewed as a threat by tax authorities worldwide. No country — poor, emerging, or wealthy — wants its tax base to suffer because of transfer pricing.

In the United States, Section 482 of the Internal Revenue Code gives the Internal Revenue Service the authority to adjust taxable income between two related parties to more accurately reflect the income earned by each party. Ever since the IRS settled the landmark transfer-pricing case in 2006 in which GlaxoSmithKline Holdings agreed to pay $3.4 billion to resolve the largest tax dispute in IRS history at that time, the IRS has continuously increased its enforcement efforts.

In September 2015, the IRS’s Large Business & International (“LB&I”) division was reorganized to include the Treaty and Transfer Pricing Operations Practice Area to address transfer-pricing issues. The IRS has recently hired economists to expand its enforcement team. Amazon, AOL, Adobe, Hewlett-Packard, Microsoft, and, most recently, Facebook, have made headlines because of transfer-pricing disputes with income adjustments ranging from tens of millions to upward of a billion dollars.

But the regulatory tentacles of transfer pricing are not designed exclusively to reach large multinational companies. Small and mid-tier manufacturers across verticals incorrectly assume that because they’re small, their transfer-pricing policy won’t be audited. This isn’t the case.

Although it has not been officially announced, the IRS has shared informally that even small taxpayers with less than $25 million in revenue might be targets, because agents are finding easy adjustments with utterly unprepared companies.

In fact, the IRS is now expanding its scope to include mid-sized and smaller companies. Late last year, David Varley, the acting director of the IRS’s transfer pricing group, noted that this initiative includes middle-market foreign-owned businesses, foreign parent companies that operate limited-risk distributors in the United States, and entities based in the United States with assets that range between $10 million and $250 million.

Unfortunately, this topic is barely on small and mid-sized company leadership’s radar. According to the results of a 2014 transfer-pricing survey focusing on small and mid-tier manufacturers, only 11.8% of CFOs and 8% of CEOs steering small and mid-sized manufacturers agree that transfer pricing is one of the top five business issues they worry about.

Further, a 2013 food manufacturers’ transfer pricing survey revealed that only 12.6% of food manufacturing respondents considered transfer pricing an issue on which their company spent a significant amount of time. On this same survey, 62.5% of respondents indicated that transfer pricing is not one of the top five business issues their company worries about.

The Organisation for Economic Co-operation and Development (“OECD”), a key player in the area of international taxation, notes that transfer pricing is not an exact science. This represents a window of opportunity for tax authorities to impose transfer-pricing adjustments and recalculation of taxes to be paid. This, together with fiscal shortfalls, has encouraged governments to identify transfer pricing as a soft target with the potential to produce large tax revenues.

When it comes to transfer pricing, ignorance is not bliss. Failure to act could cost a company hundreds of thousands of dollars in legal fees. Even what may appear to be a harmless intracompany management fee may attract the attention of the tax authorities who could challenge the amount of the fee or even its deductibility if it’s not adequately priced and/or documented,. The significant penalties and interest on overdue tax that follow, potentially in addition to double taxation (where income has already been taxed elsewhere), make transfer pricing a risk worth managing.

For most global companies, the question is not if they will get audited, but when. As such, financial executives should focus their attention on mitigating transfer- pricing-related risks where and when possible. But what can you do?

In this arena, proactivity is key. The most popular and cost-efficient way a multinational company can alleviate transfer-pricing risks is to obtain a transfer- pricing study reviewed by each jurisdiction it’s designed to cover.

A transfer pricing study is an in-depth review of the company’s pricing policies and related documentation. It can produce the following benefits:

  • Reduce taxes and penalties by ensuring that the company’s transfer-pricing policies comply with all requirements in the local jurisdiction, including meeting local documentation rules.
  • Provide support for recording no tax liabilities for tax exposures in the company’s financial statements pursuant to FIN 48.
  • Help identify opportunities to reduce the company’s global effective tax rate by restructuring multinational operations.
  • Help find ways to increase global supply-chain efficiency by relocating operations or reorganizing legal entities.

Transfer pricing is certainly subject to challenge by tax authorities. But if it’s properly approached and documented, results can generally stand up to audit.

Cristina Morera is a senior manager in the international taxation group in the Boston office of accounting and consulting firm Baker Newman Noyes.