Taxpayers Should Now Review Their Transfer Pricing Documentation

Globalization and the economic downturn is forcing the IRS to take a very close look at transfer pricing, joining taxing authorities around the world. According the Gregory Ossi and Mike Shepherd of PricewaterhouseCoopers, writing for ThomsonReuters, U.S.-based corporations more than tripled their foreign profits between 1994 and 2004, and most of that profit is being earned in so-called “tax haven” countries. 

During the Tax Executives Institute’s Midyear Conference last year, the IRS announced that it was creating a new position, director for transfer pricing, and that the new hire would initiate a new emphasis on transfer pricing, centralizing the operations, and bringing keen regulatory focus to what must seem like a great revenue generating (protecting) opportunity.

Earlier this month, the IRS announced the appointment of Samuel M. Maruca (an attorney, late of Covington & Burling) as Transfer Pricing Director in the Large Business and International Division (LB&I).

It can be expected the IRS will look closely at both inbound and outbound transactions, involving foreign-controlled domestic operations and U.S. control of foreign operations.

Ossi and Shepherd conclude:

Taxpayers should review their transfer pricing policies and documentation to ensure that they will withstand expected increased scrutiny by the taxing authorities.

An article in CFO World highlights an example of how transfer pricing works in a practical setting. James Haddad is CFO of Cadence Design Systems, provider of software, hardware and services used to design semiconductors and other devices. Typically, Cadence will license certain technology to its international subsidiaries for an “arms-length” fee, generally comparable to a price to which two unrelated parties would agree in a deal. To allocate corresponding costs between the entities within Cadence, Haddad and his finance team identify the best method for valuing the technology, and arriving at an arms-length price. They may review comparable uncontrolled transactions and evaluate future income or cash flow streams. “It’s a very difficult, challenging discipline,” Haddad says. “You want to make sure these (transactions) are fair, arm’s length and will withstand third-party review.”

Over the past three years, the “challenging discipline” has been made much easier with the introduction of ktMine, the license and royalty rate database offered by BVR.  Because each case “is very fact-specific,” the more specific the comparable arm’s length agreements are, the better chance a transaction has of passing muster.

Comparability is discussed at length in IRS regulations. A key and oft-misunderstood distinction is this:

In order to be considered comparable to a controlled transaction, an uncontrolled transaction need not be identical to the controlled transaction, but must be sufficiently similar that it provides a reliable measure of an arm's length result.

In other words, the regulations contemplate use of uncontrolled transactions that are comparable, rather than identical, to the controlled transaction.  In that light, emphasis is on accuracy and completeness of the data used to determine comparables.

ktMine’s database of nearly 10,000 unredacted license agreements, fully searchable by key word, industry, SIC, effective date, royalty rates, agreement types and licensor/licensee has brought a new confidence level to comparables research for the taxing authorities, CFO’s and their advisors.