Are You at Risk for Transfer Pricing Audits?

The IRS is on the hunt for transfer pricing abuse, and the most common audit triggers often take finance executives by surprise.
Helen ShawSeptember 21, 2006

Following GlaxoSmithKline’s record $3.4 billion settlement with the Internal Revenue Service resolving a transfer pricing tax dispute last week, the top enforcement priority of the IRS has garnered the attention of multinational companies that want to know which transactions trigger an audit.

Transfer pricing rules mandate that related parties, usually units in the same company but in different countries and tax jurisdictions, charge each other for services they perform for one another at the market rate, also known as an arms’ length price. The rules are intended to prevent companies from using intra-company chargebacks to evade taxes by inflating or deflating the profits of a particular unit. In July 2006, the U.S. Treasury Department and the IRS issued new regulations on how services transactions are taxed under the transfer pricing, rules, which affect every company with operations abroad.

“From the CFO perspective, this is a global risk management issue,” says Steven Felgran, a principal in KPMG’s economic and valuations services practice. Finance chiefs should consider where the bulk of the company’s related party transactions occur, which authorities are the strictest, and which of the companies operations around the world are most likely to be audited by tax authorities, he advises.

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In fact, says Felgran, finance chiefs are often taken by surprise by transfer pricing audits. Among the unexpected triggers: a loss-making affiliate, profit volatility, the existence of a foreign unit in a similar tax environment, and management fees, observes Felgran.

“The mere fact of having losses is the number one audit trigger in most countries,” explains Felgran. “It’s a red flag because the IRS assumes that losses may well be a function of transfer pricing abuse.” Therefore, when a company has legitimate losses, it must document them and break the connection between their losses and transfer pricing. For example, a company could report why their transfer prices are at the required arms’ length and explain why there are losses, he said.

Another circumstance that could prompt an audit is volatility in profits from year to year. “Chief financial officers and tax directors think, ‘of course it’s volatile, it’s normal, given the markets, etc.’, but that is not how the tax authority views it,” said Felgran.

Companies also mistakenly believe that if a parent company or subsidiaries are in foreign tax jurisdictions with a similar tax rate, then tax authorities would not suspect them of violating transfer pricing rules. “That is faulty reasoning because transfer pricing can be used to shift income on the books free of tax,” said Felgran. Simply having other units abroad opens opportunities to shift money pre-tax to another jurisdiction.

Management fees are another red flag for the taxman. Each corporate subsidiary pays management fees for services such as marketing, strategic planning, and advertising, but the allocation of those fees is subjective. “Companies think it is a non-issue,” notes Felgran, “but they do not understand how subjective the allocation of costs is and what the mark-up should be.”

In addition to not realizing the risks of an audit trigger in the above situations, companies often fall short with regard to transfer pricing documentation, says Felgran. For instance, a tax authority will be more likely to accept a firm’s transfer pricing practices when the company uses inter-company contracts and specifies everything is writing. “A contract signals to the tax authority that a company understands different pieces of its company are providing value to other pieces,” he said.

Now that transfer pricing is a top IRS priority, these triggers are especially important to note. The most recent IRS focus on transfer pricing began in January 2003, when the agency instructed its examiners to request taxpayers’ transfer pricing documentation and to assess penalties, noted IRS Commissioner Mark Everson at a Senate Committee on Finance hearing in June 2006. Efforts were stepped up in March 2005 when the Commissioner of the Large and Mid-Size Business Division of the IRS issued a memo detailing that examiners must consistently request such documentation at the beginning of an examination.

Various factors have contributed to the IRS focus on transfer pricing, notes Felgran. Macroeconomic reasons rank first, he says. “The country is running huge deficits and the government doesn’t want to raise taxes for political reasons,” observes Felgran, “it is a relatively easy way to get revenue into the Treasury.”