Transfer Pricing

Transfer pricing is the pricing of transactions between commonly controlled entities: a US parent selling components to its Irish manufacturing subsidiary, a Singapore affiliate providing back-office services to the group, an intercompany loan, a royalty for the use of a US-developed trademark. Because both sides of the transaction sit under common control, the price is not set by a market. It is set by the group. And because the price determines which jurisdiction reports the income, every tax authority with a claim on either side has an interest in the number.

Section 482 gives the IRS authority to reallocate gross income, deductions, credits, and allowances between controlled taxpayers where necessary to prevent evasion of taxes or to clearly reflect income. The operative standard is the arm's length standard: a controlled result is arm's length if it is consistent with what uncontrolled taxpayers would have realized in the same transaction under the same circumstances. Two structural points get missed at scoping. Section 482 is the government's tool, not the taxpayer's, so a taxpayer generally cannot invoke it to adjust its own reported result on an original return. And "control" is broader than ownership: the regulations reach any kind of control, direct or indirect, however exercisable and whether or not legally enforceable.

There is no priority ordering of methods in the US regulations. The best method rule asks which method, on the facts, provides the most reliable measure of an arm's length result, and the answer turns on the degree of comparability and on the quality of the data and assumptions. For tangible property the candidates are the comparable uncontrolled price method, resale price, cost plus, the comparable profits method, and profit split, with parallel sets for services and intangibles. The comparable profits method is the workhorse, which pushes the hard work onto functional comparability and onto the tested party's segmented financials, and the general ledger has almost never been segmented that way.

No US filing threshold triggers a study. Documentation is elective in form and effectively mandatory in consequence, because it is what protects against the Section 6662(e) penalty. That penalty is 20% of the underpayment attributable to a substantial valuation misstatement, triggered either by a reported price at 200% or more, or 50% or less, of the correct amount, or by a net Section 482 adjustment exceeding the lesser of $5 million or 10% of gross receipts. Section 6662(h) escalates it to 40%. Because the threshold is the lesser of the two figures, a group with $30 million of gross receipts is exposed at a $3 million adjustment: smaller clients cross the line on smaller adjustments, not larger ones. Protection requires that the study exist when the return is filed and be produced within 30 days of a request.

The US did not adopt the OECD master file and local file requirements, so US documentation means the ten principal documents under the Section 6662(e) regulations rather than a local file prepared to another country's template. The US did implement country-by-country reporting, on Form 8975 and Schedule A, for a US ultimate parent with revenue of $850 million or more in the preceding reporting period. Separately, a 25% foreign-owned US corporation reports its related-party transactions on Form 5472, where the penalty is $25,000 per failure per year.

Related terms: Form 5471, GILTI, Subpart F Income, Foreign Tax Credit, Book-Tax Differences

Go deeper: Transfer Pricing Documentation: A Practitioner's Guide to Scoping and Defending It

Most of the hours in a transfer pricing study go to evidence assembly, not economics: extracting intercompany balances across entities, building a segmented tested-party P&L that ties to statutory financials, and carrying prior-year positions forward. Adopt's agents do that assembly inside the systems you already use, so the review starts from a tied-out workpaper. Sign up free.