New Transfer Pricing Regs, New Headaches

New transfer pricing rules require more proof that internal transactions at multinational companies are conducted at arm's length.
Helen ShawAugust 2, 2006

In a move that affects all U.S. and foreign multinational companies, the U.S. Treasury Department and the Internal Revenue Service have issued proposed and temporary regulations on how services transactions are taxed under the transfer pricing rules. The regulations could affect management, legal, human resources, accounting, treasury and technical services, among others.

The revision was prompted three years ago, amid U.S. government concern that company-owned intellectual property was being transferred abroad and disguised as services, noted David Canale, director of national transfer pricing at Ernst & Young. (For more, see CFO magazine’s “Haven or Hell?.”) While the new regulations are simpler than the 2003 proposals, “these regulations are still quite onerous and burdensome,” said Canale.

Different units of multinational companies often provide services to each other — for a charge — across national borders. But the IRS and other taxing authorities around the world have long worried that such transfer pricing is also used to raise or lower the profits of those units, depending on whether they are in a low- or high-tax country. Transfer pricing rules require that transactions between different units of the same company must be conducted at arms-length — that is, one unit must charge the other the going market-rate, thus insuring that the transfer is not simply a tax dodge. The situation is analogous to parents who rent real estate to their children: They can still claim business deductions, but only if they charge market-rate rent.

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The old regime didn’t require much documentation or support for a multinational’s position that it conducted transactions with a related company on an arm’s-length basis, noted Bob Ackerman, Ernst & Young’s Americas leader for transfer pricing services, during a conference call on the topic. That will change on January 1, 2007.

“The process has now become more complicated and from a compliance standpoint, burdensome for multinationals,” commented Ackerman. “These regulations mandate supporting documentation to prove certain services should be charged at cost or without a markup or with a markup,” he said. Many multinational firms have not conducted due diligence on this issue in the past year, added Ackerman.

The new rules (see the related Web site below) update which transfer pricing methods can be used to determine an arm’s length price for a service transaction. The simplified-cost based method for pricing low-margin services has been eliminated and replaced by the services cost method, which allows two avenues for routine back-office services to be charged at cost with no markup.

The rules were issued to reflect the significance of cross-border services and the increasingly global economy, according to a release by the U.S. Treasury. They apply equally to foreign and U.S. multinationals, added Ackerman. The regulations on related party service transactions had not been updated since they were issued in 1968.