In a changing global tax environment in which greater attention is being paid to whether transfer pricing practices are really tax avoidance schemes, multinational companies are under greater pressure to justify the prices at which products are traded between related legal entities.
In the U.S., the Internal Revenue Service has become more sophisticated in recent years at devising transfer pricing methods to determine if transactions are occurring at arm’s length as they would between unrelated parties, experts say. The agency has also become more willing to litigate transfer pricing disputes as evidenced in ongoing high-profile battles with Amazon.com Inc., Altera Corp. and Microsoft Corp., which have billions of dollars at stake.

“Ultimately, you’re going to have to withstand an examination, and the question will be a simple one: Was the amount that was paid at arm’s length?” Thomas Humphreys at Morrison & Foerster LLP said. “That’s the basis upon which the agreement may start to fall if the transaction is examined.”

Here, experts share five tips to consider while drafting transfer pricing agreements so that these agreements can withstand the inevitable scrutiny from the IRS.

Have Robust and Current Documentation

Any transfer pricing agreement must be accompanied by contemporaneous and factually thorough documentation that is put together by experts who truly understand the company’s business and what exactly is being transferred, Humphreys says.

“[Avoid] form contracts that aren’t tailored to the specific client facts,” he said. “It has to be adapted to the specific business and context.”

The documentation must include things such as descriptions of the parties and activities related to the transaction, the parties’ functions, risks and assets, a description of the approach used to select comparable transactions in the industry, prices, royalty rates, license terms and interest rates, experts say.

Timothy Larson of Citrin Cooperman said that while it may seem like a no-brainer to include such details, businesses may sometimes lack the information needed or take shortcuts, especially if they are preparing the reports internally instead of retaining a third-party service provider such as an accounting firm. Documentation must also be current and up-to-date, he said.

“A lot of times, companies will let transfer pricing studies go stale,” Larson said. “The best-case scenario is that a company would refresh a transfer pricing report every year… or every other year if there’s been no significant change in the business such as acquisitions or dispositions.”

Know the Requirements Overseas

Since transfer pricing arrangements typically cross international borders, Larson says that businesses must be prepared to have separate documentation prepared for tax authorities in other jurisdictions where the transaction takes place.

“You cannot rely on a U.S. transfer pricing study and give that to another country’s authority,” Larson said. “They would absolutely refuse it.”

Separate reports for each country may be able to borrow data and information used in the U.S. study, but each country will have different requirements for what it is looking for, Larson says.

Tax authorities in each country may challenge the economics of a transaction if the documentation provided does not support the purported facts, Jeffrey Korenblatt at Reed Smith LLP says.

“If you have a document, for example, a license, and it lacks basic elements of what you would expect third parties to draft, you will increasingly see the service or other tax authority coming in to challenge it and say these provisions were not addressed [such as the transfer of] valuable ownership of items,” Korenblatt said, adding that detailed documentation can protect a company from penalties if the IRS has to make adjustments after an audit.

Choose an Appropriate Pricing Method

Joseph B. Darby III of Sullivan & Worcester said that there are a number of different methods for allocating income and profits between a U.S. company and its foreign affiliates, and there are some that the IRS prefers over the others.

The comparable profits method, for example, is a classic go-to method for the revenue agency for determining the arm’s-length standard even though it can be difficult to implement, and it looks at profits earned by uncontrolled taxpayers in a similar industry under similar circumstances, Darby says.

“CPM is a challenging method to apply because you basically have to hire an accountant to do a massive data search,” Darby said. “It requires quite a bit of broad market research, but it’s one that the IRS seems to be particularly enamored of at the moment.”

If the transaction involves a lot of intangibles, one would have to use what’s called a “profit split method” that involves weighing the nature and value of the intangibles in different jurisdictions, Darby says.

Joseph Tobin, a senior manager in Deloitte’s transfer pricing group, says that while it can be very difficult to find real world benchmarks for intangibles, the IRS has typically favored a method of making projections for income attributable to the products in question.

“A lot of intangibles are self-created by the company in question and they will get a patent for it or some other kind of intellectual property protection and by its very nature, it’s unique,” Tobin said. “The question is: What’s the fair, arm’s-length price for that? There’s not stuff that you can find out in the marketplace if it’s something the company is creating and it has not even yet finished creating.”

Consider an Advance Pricing Agreement

U.S.-based multinationals can predetermine the tax treatment of intercompany transactions with their foreign affiliates by negotiating an advance pricing agreement with the IRS. However, the process can be very expensive and time-consuming and is typically not advisable for small- and medium-sized businesses, Darby says.

“For big companies, it makes a lot of difference to avoid conflict up front,” he said. “The IRS is not likely later to challenge your pricing method as long as you comply with the APA.”

Negotiating an APA can take about 12 to 18 months, and two to five years for bilateral APAs that involve negotiating with the IRS as well as another tax jurisdiction, according to Tobin, and it can mean that the taxpayer may end up paying more based on terms dictated by the IRS.

“You’re starting at a position that is more favorable to the IRS and you’re arguing from there to get the best deal that you can,” he said.

Collaborate While Negotiating

For companies that decide to get the IRS’s stamp of approval on an APA, Korenblatt said that it is important to establish a good working relationship with agency officials during negotiations and do one’s homework ahead of time.

“Make it a collaborative process instead of being dictatorial and adversarial,” he said. “In situations where you can come to the table and do some of the heavy lifting, it is going to facilitate the whole process … The reason you spend that additional time and effort [to get an APA] is it does give you a level of certainty that you just can’t get in the absence of it.”

Tobin said that while the IRS may have the upper hand during these negotiations, a company can still leverage its own position and minimize costs by looking at past court cases in similar transfer pricing situations where the agency’s arguments were ruled against.

“You want to be able to remind the IRS diplomatically about positions that they’ve lost in court and that they know they have vulnerabilities on, and additionally, you want to have it be clear just exactly what the issues are that are agreed upon,” he said.