Is Your Small Business on the Hook for Transfer Pricing?

Small- and medium-sized businesses (SMBs) that perform cross-border, intercompany transactions—regardless of their size or industry—must adhere to transfer pricing rules. These companies may not understand whether transfer pricing applies to their business—let alone how to comply with the rules while meeting their business goals.

While transfer pricing is complex and the penalties can be steep, complying with the transfer pricing rules and retaining supporting documentation can offer your business significant benefits:

• Limiting the chance of revaluations and penalties
• Managing enterprise risk
• Increasing operating cash flow and liquidity
• Optimizing cross-border distributions
• Mitigating the risk of double taxation
• Improving supply-chain efficiency
• Complying with the IRS and foreign country standards

To get started, business owners, controllers, and CFOs should ask themselves three things:

1. Do we have a global structure that triggers the transfer pricing rules?
2. Have we worked with the right specialists to establish the required “arm’s length” price and supporting documentation for our intercompany transactions in order to limit the chance of penalties?
3. How do we access experienced transfer pricing specialists to ensure we are in compliance today and have a strategy for tomorrow that aligns with our business goals?

Understandably, most SMBs don’t have dedicated international tax or transfer pricing specialists on staff, so working with an external transfer pricing specialist can help a company answer these questions and determine the best path forward.

Transfer pricing determines the prices for goods and services exchanged between related parties in different countries. Related parties can include a company and its foreign subsidiary or entities with the same foreign owner.

Tax rules and regulations require that these related entities price their transactions as if they were unrelated parties using the arm’s length standard. These transactions include everything from goods and services to intangible assets such as intellectual property.

Companies that are required to file Forms 5471 and 5472 are generally responsible for performing complex transfer pricing analysis. In addition to integrating the markups into the company’s financial statements, transfer pricing impacts other areas of a company’s tax profile:

• US income and expense
• US fixed assets and depreciation
• Foreign income and expense items
• GILTI
• Subpart F
• FDII
• Foreign tax credits

Establishing an arm’s length price is not as easy as an in-house estimate of a reasonable markup—it requires a selection of specific methods prescribed by the IRS and an analysis of similar companies and transactions. This usually includes benchmarking analysis and documentation.

Failing to use the arm’s length standard can have a material impact on your company. Consider the example of a US company that manufactures goods for resale. It costs the US company $75 per unit to manufacture its goods. The US company sells these goods to an unrelated company in Germany. The US company negotiated to sell 10 units of the product to the unrelated German company for $100 per unit. The products can be resold in Europe for $110 per unit. The German company has a $1,000 COGS and $100 of profit for the 10 units.

The US manufacturer owns an entity in Ireland and an entity in the Netherlands. The US entity sells 10 units of the same product under the same conditions to the Irish entity for $80 per unit and to the Netherlands entity for $110 per unit.

Total Tax: $122

As a result, the Netherlands entity breaks even and does not pay income tax in the Netherlands. The Irish entity pays tax on profits at the lower Irish tax rate, and the US entity books less income, therefore artificially lowering the amount of tax owed in the US. This structure would likely incur penalties and a revaluation under an IRS audit.

Using the arm’s length price negotiated with the unrelated German company, the sales prices to the Ireland and Netherlands entities are both $110 per unit.

Total Tax: $143

The result of this pricing structure, which is based on the arm’s length standard, is that an uncontrolled price is used. Both the Netherlands and Irish entities book the appropriate amount of income, and each pays the correct amount of tax in their jurisdiction. The US entity also books the appropriate amount of income and pays the correct amount of tax. This pricing structure is more likely to withstand an IRS audit and not incur penalties or revaluations.

When it comes to compliance, businesses with international entities must follow transfer pricing rules, regardless of their size. Relying on in-house estimates or failing to provide the right documentation can result in IRS revaluations and penalties. In addition, these businesses may face scrutiny by and enforcement from foreign tax authorities. Working with an advisor who understands the complexities of transfer pricing helps you avoid missteps that can lead to enforcement actions.

Planning your transfer pricing strategy with an advisor also gives you an opportunity to review your business and make strategic and proactive decisions that align with your goals. You can discover ways to make your business more efficient, maximize competitive advantages, and minimize weaknesses and risks.

For example, transfer pricing planning strategies can help best position your company across a wide array of important areas, including:

• Supply chain strategy and sourcing
• Geographic location of management
• Location of intangible property
• Legal structure
• Autonomy of subsidiaries
• Cross-border cash liquidity
• Foreign currency risk mitigation

Aldrich’s international tax specialists provide services that align with your specific needs, including transfer pricing documentation and global transfer pricing structuring. We bring our network of US and foreign specialists from different fields together—tax, legal, economists, and other service providers—to deliver insights to you. If you’re ready to turn transfer pricing from a compliance requirement into a business advantage, let’s talk.