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Transfer Pricing – FAQs

What does a taxpayer need to do to meet its transfer pricing obligations to the IRS?

Self-compliance requires a taxpayer to carry out the following four steps in connection with the filing of its annual tax return:

  1. Undertake an analysis that is reasonably designed to determine whether its income from related party transactions reflects the most accurate application of the arm’s length standard of IRC Section 482;
  2. Report the income resulting from its analysis on its tax return, even if that is in excess of the income actually earned;
  3. Have or prepare documentation, including information specified in the Regulations, describing its analysis and justifying the results and, with two exceptions, that documentation must be in existence when the tax return is filed; and
  4. Furnish the documentation to the IRS within 30 days of a request.

What risks and penalties does my company face if we don’t get our transfer pricing right?

Understating a company’s income will result in additional tax on that income, interest on the underpayment of tax, and penalties. Two categories of transfer pricing penalties exist. First, transactional penalties are 20% of the underpayment of tax, if the price or charge that was reflected in the tax return is 200% or more (or 50% or less) than the price or charge that is determined to be “arm’s length” by the IRS, and 40% of the underpayment of tax, if the price or charge that was reflected in the tax return is 400% or more (or 25% or less) than the price or charge that is determined to be “arm’s length” by the IRS. Second, net adjustment penalties are 20% of the underpayment of tax, if the transfer pricing adjustment to income exceeds $5 million or 10% of the gross receipts of the company, and 40% of the underpayment of tax, if the transfer pricing adjustment to income exceeds $20 million or 20% of the gross receipts of the company. These penalties apply when, for a taxable year, the amount of underpayment of tax is greater than $10,000 (or greater than $5,000) if the taxpayer is not a corporation or is an S corporation or a personal holding company).

Full understanding of this penalty regime, its exceptions and details, and its application to the specific facts and circumstances of a particular taxpayer requires detailed analysis by a competent attorney.

What is an Advance Pricing Agreement (“APA”) and what are its benefits?

An APA is a contract, usually for five or more years, between a taxpayer and the IRS (and potentially other tax authorities) specifying the transfer pricing method that the taxpayer will apply to its related-company transactions. An APA is designed to help taxpayers voluntarily resolve actual or potential transfer pricing disputes with the IRS in a proactive, cooperative manner. An APA serves as an alternative to the traditional examination process.

Often APAs do not only look to “future” years, but may involve the resolution of transfer pricing issues pending from prior years (“rollback” years), thereby providing a potential means for resolving existing transfer pricing audits or adjustments.

An APA provides a company greater certainty on the transfer pricing method adopted, mitigating the possibility of disputes and facilitating the financial reporting of potential tax liabilities. An APA also reduces the incidence of double taxation, and the costs associated with both audit defense and documentation preparation.

Are Advance Pricing Agreements (“APAs”) only for very large multinational companies?

While it is true that most very large multinational companies (both U.S. or foreign-headquartered ones) operating in the U.S. are part of the APA program, the program is open to all companies that think they can benefit from having either unilateral APA (only with the IRS) or a bilateral APA (with the IRS and the tax authority of a country with a tax treaty with the United States). The APA process can be expensive, but it should result in reduced transfer pricing compliance costs and create certainty and audit protect for the company’s transfer pricing policy. Contact the Law Office of Johan Deprez to explore if an APA is appropriate for your company.

The adjustments that the IRS and the tax authority of a foreign country made to two related parties resulted in the same piece of worldwide income being taxed twice. Am I stuck paying tax to both authorities on the same income?

Double taxation occurs when the same income is taxed by two different taxing jurisdictions. Tax treaties generally set forth a “Competent Authority Procedure” by which to resolve the competing income claims of the different international taxing jurisdictions. A taxpayer may apply to the IRS’ Advance Pricing and Mutual Agreement (“APMA”) Program for negotiation with the other treaty tax authority and possible resolution of its double taxation problem. Please contact the Law Office of Johan Deprez to see if a Competent Authority Procedure is appropriate for your situation.