Transfer Pricing Is Not Just a Tax Issue
From a business operations perspective, getting transfer pricing right helps the company determine the profitability of its various operations. As a result, management can make better decisions about resource allocation and the appropriate award of financial incentives to key employees. By identifying current and potential competitors inside and outside the industry, and benchmarking the company’s financial performance relative to its peers, management can better assess its strategic and tactical business plans.
The Public Accounting Reform and Investor Protection Act of 2002 (more commonly referred to as Sarbanes-Oxley) created a new environment regarding corporate governance and Securities Exchange Act compliance.
Entities affected by Sarbanes-Oxley include those companies whose stocks trade publicly and all registered foreign companies. In addition, all non-public companies whose debt securities are publicly traded, whose equity or debt securities are registered under the Securities Exchange Act, who are required to file reports under the act or who have filed a statement for a public offering under the act must comply with Sarbanes-Oxley.
Coverage under Sarbanes-Oxley also extends to any officer, employee, contractor, subcontractor or agent of a covered entity. As a result, non-public companies who are contractors or subcontractors of a public company are subject to obligations and proceedings under Sarbanes-Oxley.
Section 404 of Sarbanes-Oxley does not specifically address transfer pricing issues. However, it requires companies to identify financial reporting risks, ascertain related controls, assess their effectiveness, remediate any control deficiencies, and then retest and re-document those controls.
There can be situations where missing or ineffective internal controls over transfer pricing may have a material effect on a company’s financial statements:
- If there is more than a remote likelihood that the IRS or foreign tax authorities will make a transfer pricing adjustment that would lead to additional tax expense that would be material to the company’s financial statements; and
- If there is more than a remote likelihood that the IRS or foreign taxing authorities would impose, as a result of transfer pricing adjustments, penalties that would be material to the company’s financial statements.
More recently, FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, has created another nontax reason for companies to review their transfer pricing. FIN 48 requires companies to evaluate their tax positions in a two-step process:
- No tax benefit may be recognized in a financial statement unless it is more likely than not the tax position will be sustained on examination by the taxing authorities.
- The amount of the recognized benefit is limited to the largest amount of the benefit that is more than 50 percent likely to be realized on ultimate settlement with the taxing authority.
FIN 48 necessitates a reevaluation of all transfer pricing determinations, with a focus on the sustainability of each.
Transfer Pricing Studies Save Taxes & Reduce Risk
Many companies opt to conduct a review of their transfer pricing policies. Transfer pricing studies are typically conducted by experienced accountants and economists with a strong background in multistate and multinational tax matters. The objective of the study is to determine a pricing structure that will withstand challenge from the relevant taxing authorities and best serve the company’s business needs.
A well-documented transfer pricing study allows the company to minimize risk, institute tax planning strategies and maximize worldwide income. Companies may be able to increase net income by:
- Locating business operations and earning profits in favorable tax jurisdictions; and/or
- Locating business operations in areas that offer a lower cost of labor or other resources.
What to Take Away from this Discussion
All governments — federal, state and local, and non-U.S. — are looking for ways to expand the tax base without raising nominal tax rates. Businesses operating in multiple jurisdictions should expect to be pressured by taxing authorities to justify the allocation of revenue and expenses among jurisdictions. The result is uncertainty about transfer pricing positions, which creates significant financial reporting and tax disclosure issues.
Transfer pricing is an issue that no CEO, CFO, tax director, controller, board member or business owner can ignore. There are imminent reporting and compliance obligations. There is significant exposure to additional taxes and penalties. There is a very real possibility that the same profits could be subjected to tax in two or more jurisdictions.
A transfer pricing study is a tool that can minimize these risks. Combined with sound multistate and international tax planning, the company may be able to lower its overall tax obligation, reduce the effective tax rate reported in its financial statements, fully comply with its reporting obligations, and manage the profitability of its business operations at every location throughout the U.S. and around the world.
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