Transfer pricing is a key tax consideration, because it can result in the permanent reduction of an organization’s tax liability. The permanent reduction is caused by the recognition of income in different taxing jurisdictions that may have different tax rates.
The basic concept behind the use of transfer pricing to reduce one’s overall taxes is that a company transfers its products to a division in another country at the lowest possible price if the income tax rate is lower in the other country; or at the highest possible price if the tax rate is higher.
By selling to the division at a low price, the company will report a very high profit on the final sale of products in the other country, which is where that income will be taxed at a presumably lower income tax rate.
A company with a location in Countries Alpha and Beta has the choice of selling goods either in Alpha or transferring them to Beta and selling them there. The company is faced with a corporate income tax rate of 40% in Country Alpha. To permanently avoid some of this income tax, the company sells its products to another subsidiary in Country Beta, where the corporate income tax rate is only 25%. By doing so, the company still earns a profit ($60,000) in Country Alpha, but the bulk of the profit ($125,000) now appears in Country Beta. The net result is a consolidated income tax rate of just 28%!
The IRS is well aware of this [transfer pricing] tax avoidance strategy, and has developed tax rules that do not eliminate it, but that will reduce the leeway that an accountant has in altering reportable income.
Use “Market Rate” As Its Basis
Under Section 482 of the IRS code, the IRS’s preferred approach for developing transfer prices is to use the market rate as its basis. However, very few products can be reliably and consistently compared to the market rate, with the exception of commodities, because there are costing differences between them. Also, in many cases, products are so specialized (especially components that are custom-designed to fit into a larger product) that there is no market rate against which they can be compared.
Even if there is some basis of comparison between a product and the average market prices for similar products, the accountant still has some leeway in which to alter transfer prices, because the IRS will allow one to add special charges that are based on:
The cost of transferring the products, or extra fees, such as royalty or licensing fees that are imposed for the subsidiary’s use of the parent company’s patents or trademarks; or
For administrative charges related to the preparation of any documentation required to move products between countries.
It is also possible to slightly alter the interest rates charged to subsidiaries (though not too far from market rates) for the use of funds sent to them from the parent organization.
Calculate the Price Based Upon “Back Work” Method
If there is no basis upon which to create prices based on market rates, then the IRS’s next most favored approach is to calculate the prices based upon the work back method. Under this approach, one begins at the end of the sales cycle by determining the price at which a product is sold to an outside customer, and then subtract the subsidiary’s standard markup percentage and its added cost of materials, labor, and overhead, which results in the theoretical transfer price.
The work back method can result in a wide array of transfer prices, since a number of different costs can be subtracted from the final sale price, such as standard costs, actual costs, overhead costs based on different allocation measures, and overhead costs based on cost pools that contain different types of costs.
Use “Cost Plus” Method
If those two approaches do not work, then the IRS’s third most favored approach is the cost plus method. As the name implies, this approach begins at the other end of the production process and compiles costs from a product’s initiation point. After all costs are added before the point of transfer, one then adds a profit margin to the product, thereby arriving at a transfer cost that is acceptable by the IRS. However, once again, the costs that are included in a product are subject to the same points of variation that were noted for the work back method. In addition, the profit margin added should be the standard margin added for any other company customer, but can be quite difficult to determine if there are a multitude of volume discounts, seasonal discounts, and so on. Consequently, the profit margin added to a product’s initial costs can be subject to a great deal of negotiation.
Overriding Issues You Should Ware Of
Issues#1: An overriding issue to consider, no matter what approach is used to derive transfer prices, is that taxing authorities can become highly irritated if a company continually pushes the outer limits of acceptable transfer pricing rules in order to maximize its tax savings. When this happens, a company can expect continual audits and penalties on disputed items, as well as less favorable judgments related to any taxation issues.
Approach#1: Consequently, it makes a great deal of sense to consistently adopt pricing policies that result in reasonable tax savings, are fully justifiable to the taxing authorities of all involved countries, and do not push the boundaries of acceptable pricing behavior.
Issue#2: Another transfer pricing issue that can modify a company’s pricing strategy is the presence of any restrictions on cash flows out of a country in which it has a subsidiary.
Approach#2: In these instances, it may be necessary to report the minimum possible amount of taxable income at the subsidiary, irrespective of the local tax rate. The reason is that the only way or a company to retrieve funds from the country is through the medium of an account receivable, which must be maximized by billing the subsidiary the highest possible amount for transferred goods. In this case, tax planning takes a back seat to cash flow planning.
Issue#3: Yet another issue that may drive a company to set pricing levels that do not result in reduced income taxes is that a subsidiary may have to report high levels of income in order to qualify for a loan from a local credit institution. This is especially important if the country in which the subsidiary is located has restrictions on the movement of cash, so that the parent company would be unable to withdraw loans that it makes to the subsidiary.
Approach#3: As was the case for the last item, cash flow planning is likely to be more important than income tax reduction.
Issue#4: A final transfer pricing issue to be aware of is that the method for calculating taxable income may vary in other countries. This may falsely lead one to believe that another country has a lower tax rate.
Approach#4: A closer examination of how taxable income is calculated might reveal that some expenses are restricted or not allowed at all, resulting in an actual tax rate that is much higher than originally expected. Consultation with a tax expert for the country in question prior to setting up any transfer pricing arrangements is the best way to avoid this problem.