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Transfer pricing is a mechanism for determining arm’s length pricing in related-party transactions, often in the context of cross-border transactions.
Transfer pricing audits are increasing in number, complexity, and expense all around the world as tax authorities look for additional revenue. Transfer pricing continues to be a top audit issue in international tax planning for U.S. corporations. In this environment, tax departments need to implement proactive corporate tax planning strategies to efficiently manage transfer pricing disputes in a way that minimizes exposure to potential penalties and double taxation.
Transfer pricing rules
The U.S. transfer pricing regulations under §482 seek to ensure that appropriate amounts of income of a multinational enterprise are subject to U.S. taxation. The Organization for Economic Cooperation and Development (OECD) also maintains its own transfer pricing guidelines. Collectively these regulations aim to prevent profit shifting to lower tax jurisdictions and avoid international double taxation.
U.S. transfer pricing regulations
The IRS employs the arm’s length standard in administering transfer pricing. The transfer pricing regulations try to determine the price that the related parties would have agreed to if they had dealt with each other at arm’s length as unrelated parties.
According to the IRS:
“A controlled transaction meets the arm’s length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circ*mstances (arm’s length result). However, because identical transactions can rarely be located, whether a transaction produces an arm’s length result generally will be determined by reference to the results of comparable transactions under comparable circ*mstances.”
The IRS can make transfer pricing adjustments to transactions between “two or more organizations, trades, or businesses” that are owned or controlled by the same interests.
OECD transfer pricing guidelines
The OECD first published its Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations in 1995. The OECD has since continuously revised and supplemented the guidelines, reflecting an ongoing focus on international tax challenges, including transfer pricing issues.
The most recent edition went into effect in 2018, following a substantial revision and expansion as part of the OECD’s Base Erosion and Profit Shifting (BEPS) initiative.
Like the IRS, the OECD employs the arm’s length principle because it “provides broad parity of tax treatment for members of [multinational enterprise] groups and independent enterprises,” avoiding the creation of “tax advantages or disadvantages that would otherwise distort the relative competitive positions of either type of entity.” The guidelines state that the arm’s length principle “has also been found to work effectively in the vast majority of cases.”
