Did you know the most frequently audited item for multinational tax returns is transfer pricing? This article explores the transfer pricing needs of US-based Multinational Companies (MNCs).
Penalty-Protection Through Documentation
An IRS audit of a MNC will typically include an examination of transfer pricing. If a transfer pricing adjustment is made that results in a tax assessment over a specific threshold, the IRS may assert penalties. To avoid those penalties, taxpayers can provide transfer pricing documentation that they prepared simultaneously with their tax return filings.
Robust transfer pricing documentation helps demonstrate that the taxpayer had reasonable cause for their pricing of intercompany transactions and acted in good faith. Taxpayers rely on their transfer pricing documentation defensively during the audit process to demonstrate that they complied with the arm’s length standard under Internal Revenue Code (IRC) 482. The documentation provides the basis for the reasonable cause and good faith exception to the penalty if the requirements are met.
IRS Penalties
There are different types of penalties that may be imposed by the IRS concerning transfer pricing documentation compliance. The primary penalty is a 20% addition to the tax penalty on the portion of the underpayment of tax that is attributable to accuracy-related misconduct (e.g., negligence or disregard of rules or regulations, any substantial understatement of income tax or any substantial valuation misstatement). The penalty rate may be as high as 40% under certain circumstances, including gross valuation misstatements. Additionally, a net adjustment penalty applies when the net transfer pricing adjustment exceeds the relevant dollar thresholds.
Objectives of Transfer Pricing Documentation
The Organisation for Economic Co-operation and Development (OECD) Base Erosion and Profit Shifting (BEPS) Action 13 Report identifies three main objectives of transfer pricing documentation:
- To ensure that taxpayers consider transfer pricing requirements when establishing prices and other conditions for transactions between associated enterprises and in reporting the income derived from those transactions in their tax returns.
- To provide tax administrations with the information necessary to conduct an informed transfer pricing risk assessment and select cases for audit.
- To provide tax administrations with information necessary to conduct an audit of the transfer pricing of entities subject to tax in their jurisdictions. Taxpayers may also be incentivized to focus attention on their transfer pricing arrangements and their compliance with transfer pricing rules.
By preparing transfer pricing documentation, taxpayers can place themselves in a better position to defend their transfer pricing policies in the event of an audit by the tax authorities. For tax administrations, the transfer pricing documentation will help to ensure the integrity of the taxpayer’s position.
Benefits for Taxpayers Who Invest in Robust Transfer Pricing Documentation
Robust transfer pricing documentation facilitates efficient transfer pricing risk assessments and examinations for both taxpayers and examiners. High-quality transfer pricing documentation allows the examining agent to rely on the taxpayer’s analysis of functions, risks, intangibles and value drivers, saving both the taxpayer and the IRS time in examining low-risk transfer pricing issues.
Frazier & Deeter’s Approach to Transfer Pricing Documentation
We believe that transfer pricing compliance documentation should follow a comprehensive and practical approach. Only the mandatory information required by the tax regulations should be maintained, with minimal administrative and cost impact for the business. To achieve this objective, FD’s team of experts has developed a transfer pricing documentation compliance toolkit with the following features:
- Time-efficient, functional analysis documentation checklist – This standardized information checklist addresses the mandatory sections of the transfer pricing documentation.
- Option to choose standard large sample industry benchmark reports or customized benchmark analysis – We adopt a pragmatic approach by focusing on functional comparability and producing cost-effective benchmarking analyses using a team of offshore specialists.
- Executive management styled transfer pricing documentation reports – The transfer pricing documentation toolkit will cover the mandatory sections’ required regulations, along with the additional sections required under the OECD guidelines on master file and local file (largely adopted by most non-US jurisdictions).
- Transfer pricing agreements – The IRS recommends maintaining intercompany agreements, which clarify how the assignment of rights and responsibilities between the parties is established and how risks are allocated. FD can provide transfer pricing intercompany agreement templates in relation to meeting the standards for transfer pricing documentation compliance requirements in the US and other jurisdictions.
If your business extends across borders and you do not currently have a strong transfer pricing documentation approach, reach out to our transfer pricing team. FD has experienced advisors who can help your business understand the importance of robust transfer pricing documentation for MNCs.