How to minimize risks of an IRS transfer pricing review For years, transfer pricing was a relatively low-profile topic

among international tax and finance professionals. Now an aggressive Internal Revenue Service push to enforce documentation and compliance offers a glimpse of the staggering penalties that can result from inadequate transfer pricing planning. In a recent case, Symantec Corp.found itself in a $1 billion transfer pricing dispute after it acquired software maker Veritas in 2005. According to the IRS, licensing fees Veritas received from an Irish subsidiary were too low, and the company?s accounting records credited the U.S. operations with too much of the cost of creating certain technologies. Bottom line: That approach increased income at the Irish subsidiary, which operated in a lower-tax environment and allowed the company to lower its U.S. tax bite. Put simply, transfer pricing is a strategy by which related companies in different taxing jurisdictions exchange products and services tax-efficiently. Effective transfer pricing can enhance a company?s overall profitability and eliminate double taxation, which often results from cross-border transactions. Experts say the Symantec case illustrates the delicate balance between smart business and smart government as businesses seek to minimize tax payments and countries seek to maximize tax revenue. "Not that long ago, a lot of midsized businesses that didn?t have transfer pricing documentation in place would just roll the dice, because the IRS gave them 30 days to come up with information," says Mark Kral, a managing director with RSM McGladrey?s international tax practice. "But then the IRS started asking for documentation to prove the study had been done for the year under examination. That makes it a lot harder to ignore." IRS Commissioner Mark Everson noted the transfer pricing crackdown when he testified earlier this year before the U.S. Senate Finance Committee.He expressed concern about the growing gap between "book income" that public companies report to shareholders and taxable income the IRS records. That difference stood at $266 billion in 2003, and Everson said that his agency?s Large and Midsized Business Division has responded by stepping up compliance checks and audits. "The growing tension created by the desire of corporations on one hand to maximize book earnings, and on the other hand to minimize taxable earnings and increase cash flow, presents incentives that could drive noncompliant behavior," Everson testified. "Those [businesses] who comply with the letter and spirit of the law should know that we are aggressively identifying and pursuing those who do not." A basic tenet of transfer pricing requires that transactions within a company take place at "arm?s length." That means charging a price for products or services at or near those on the open market. However, the tax liability generated by that arm?s-length relationship can vary dramatically ? particularly if the tax burden in one country is significantly less than another. Consider the following example:

Assume a subsidiary located in country A purchases $100 worth of goods. It then repackages, exports and sells those goods to the parent company,located in country B, for $200. The parent company sells the goods for $300. Both entities profit $100. If the tax rate in country A is 20 percent, and the tax rate in country B is 60 percent, the after-tax profit for the company is $120. Now, consider a transfer pricing approach in which the subsidiary sells the goods to the parent firm for$280, and the parent sells them for $300. In this case, the company?s profit actually increases. Why? Because the subsidiary now posts an after-tax profit of $144, based on the 20 percent tax rate. Since the parent company earns just $20 on the transaction, it pays just $12 in tax (based on the 60 percent tax rate in country B). In this scenario,the company?s overall aftertax profit rises to $152 from $120. State and local implications of transfer pricing In addition to the international tax implications, domestic transfer pricing has increasingly become an important component of a company?s effective overall state tax rate. In recent years, states have more aggressively audited and attacked company state tax planning structures, including an increase in the discretionary use of IRS Section 482. This tax regulation allows the IRS to allocate a company?s gross income, deductions, credits or allowances between business units in order to more clearly reflect total income. Local tax authorities are also becoming more assertive about requiring companies to file combined returns to avoid "distortion" for transactions between affiliated domestic corporations. "Whether a company is defending an audit, implementing a new structure or migrating from an existing structure, a domestic transfer pricing study is essential to ensure that their related party transactions are at arm?s length," says Craig Ridenour, a managing director with RSM McGladrey?s state and local tax practice. "In today?s environment, domestic and international transfer pricing considerations are equally important in supporting and managing a company?s worldwide effective tax rate." Developing an effective transfer pricing approach Clearly,effective transfer pricing can be a powerful tool to improve profitability. On the other hand, an ill-considered approach can result in sizable penalties ? as much as 40 percent of the underpayment an IRS review determines. If your company has cross-border operations, is planning to expand internationally or has substantial transactions between affiliated domestic corporations, are you confident in the quality of your company?s approach to transfer pricing? If not, consider some of the following steps: Establish a game plan. Most experts agree that the best transfer pricing strategies are part of regular business planning. Prior to the start of each fiscal year,set aside time for your company?s tax and finance staff to meet with a qualified professional services firm with deep experience in both international and domestic tax. This meeting should lay the groundwork to define key roles and responsibilities.

Consider an advance pricing agreement (APA). An APA between your company and the IRS serves to reduce your risk of an audit. The agreement between the taxpayer and the IRS comprises the parameters of prospective intercompany transactions and the transfer pricing methodology that is appropriate in determining the pricing of such transactions. After reaching the agreement ? and meeting its terms? the taxpayer is protected from transfer pricing adjustments during the term of the agreement. On behalf of your company, a tax professional can contact the IRS to head off any unnecessary red flags by outlining facts and details anonymously before proceeding with an APA. Conduct a transfer pricing study. If your business does not have the internal resources to handle some of these steps, consider a transfer pricing study. This review, which an independent third party conducts, may be the best method to ensure your company minimizes tax liabilities while complying with revenue requirements in each jurisdiction. It will identify all related parties and transactions,select the best transfer pricing method, determine arm?s-length pricing ranges by reviewing comparable companies, and create documentation to substantiate the overall strategy. By taking these steps, youcan ensure your business is maximizing its profit potential ininternational markets while reducing exposure to a potentially crippling IRS review.

The "arm's-length principle" of transfer pricing states that the amount charged by one related party to another for a given product must be the same as if the parties were not related. An arm's-length price for a transaction is therefore what the price of that transaction would be on the open market. For commodities, determining the arm'slength price can sometimes be as simple a matter as looking up comparable pricing from non-related party transactions, but when dealing with proprietary goods and services or intangibles, arriving at an arm's length price can be a much more complicated matter. US transfer pricing law requires that the best method rule be used to determine which transfer pricing methodology is most appropriate for determining the arm's-length price of a given transaction. The official definition of the arm's length standard as it applies in the United States can be found in Section 482-1 (b) of the transfer pricing regulations: (b) Arm's length standard--(1) In general. In determining the true taxable income of a controlled taxpayer, the standard to be applied in every case is that of a taxpayer dealing at arm's length with an uncontrolled taxpayer. A controlled transaction meets the arm's length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had

engaged in the same transaction under the same circumstances (arm's length result). However, because identical transactions can rarely be located, whether a transaction produces an arm's length result generally will be determined by reference to the results of comparable transactions under comparable circumstances. See Sec. 1.482-1(d)(2) (Standard of comparability). Evaluation of whether a controlled transaction produces an arm's length result is made pursuant to a method selected under the best method rule described in Sec. 1.482-1(c). (2) Arm's length methods--(i) Methods. Sections 1.482-2 through 1.482-6 provide specific methods to be used to evaluate whether transactions between or among members of the controlled group satisfy the arm's length standard, and if they do not, to determine the arm's length result. (ii) Selection of category of method applicable to transaction. The methods listed in Sec. 1.482-2 apply to different types of transactions, such as transfers of property, services, loans or advances, and rentals. Accordingly, the method or methods most appropriate to the calculation of arm's length results for controlled transactions must be selected, and different methods may be applied to interrelated transactions if such transactions are most reliably evaluated on a separate basis. For example, if services are provided in connection with the transfer of property, it may be appropriate to separately apply the methods applicable to services and property in order to determine an arm's length result.

Transfer Pricing Methods

Best Method Rule of Transfer Pricing

The best method rule is intended to avoid the rigidity of the priority of methods that formerly had been required. The rule guides taxpayers and the IRS as to which method is most appropriate in a particular case. The temporary regulations no longer provided for an ordering rule to select the method that provides for an arms-length result. Rather, in choosing a method, the arms-length result must be determined under the method which provides the most accurate measure of an arms-length result. The best method rule appears to be somewhat subjective and, because of its technical nature, may require special expertise. Certainly, the rule does not appear to eliminate

the potential for controversy between the IRS and taxpayers. The rule will likely require taxpayers to expend more energy developing intercompany transfer prices and reviewing data. The best method rule had three limitations: 1. Tangible property rules normally do not adequately consider the effect of nonroutine intangibles in determining which method is the best method. In these cases, adjustments may be required under the intangible property rules.7 2. Tangible property comparable methods may be superseded, especially as they effect significant nonroutine intangibles that are not defined. 3. A taxpayer can request an advance pricing agreement to determine its best method. Multiple Methods of Transfer Pricing The temporary regulations encouraged the taxpayer to use more than one transfer pricing method. When two or more methods produce inconsistent results, the best method rule should be applied to determine which method produces the most accurate measure. Presumably, if the results are consistent, it may not be necessary to invoke the best method rule. If the best method rule does not clearly indicate the most accurate method, consistency between results should be considered as an additional factor. Using this approach, the taxpayer should ascertain whether any of the methods, or separate applications of a method, yields a result consistent with any other method. Comparable Uncontrolled Price Method The CUP method provides the best evidence of an arm's length price. A CUP may arise where:
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the taxpayer or another member of the group sells the particular product, in similar quantities and under similar terms to arm's length parties in similar markets (an internal comparable); an arm's length party sells the particular product, in similar quantities and under similar terms to another arm's length party in similar markets (an external comparable); the taxpayer or another member of the group buys the particular product, in similar quantities and under similar terms from arm's length parties in similar markets (an internal comparable); or an arm's length party buys the particular product, in similar quantities and under similar terms from another arm's length party in similar markets (an external comparable).

Incidental sales of a product by a taxpayer to arm's length parties may not be indicative

of an arm's length price for the same product transferred between non-arm's length parties, unless the non-arm's length sales are also incidental. Transactions may serve as comparables despite the existence of differences between those transactions and non-arm's length transactions, if:
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the differences can be measured on a reasonable basis; and appropriate adjustments can be made to eliminate the effects of those differences.

Where differences exist between controlled and uncontrolled transactions, it may be difficult to determine the adjustments necessary to eliminate the effect on transfer prices. However, the difficulties that arise in making adjustments should not routinely preclude the potential application of the CUP method. Therefore, taxpayers should make reasonable efforts to adjust for differences. The use of the CUP method precludes an additional allocation of related product development costs or overhead unless such charges are also made to arm's length parties. This prevents the double deduction of those costs-once as an element of the transfer price and once as an allocation. Resale price method of Transfer Pricing The resale price method begins with the resale price to arm's length parties (of a product purchased from an non-arm's length enterprise), reduced by a comparable gross margin. This comparable gross margin is determined by reference to either:
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the resale price margin earned by a member of the group in comparable uncontrolled transactions (internal comparable); or the resale price margin earned by an arm's length enterprise in comparable uncontrolled transactions (external comparable).

Under this method, the arm's length price of goods acquired by a taxpayer in a nonarm's length transaction is determined by reducing the price realized on the resale of the goods by the taxpayer to an arm's length party, by an appropriate gross margin. This gross margin, the resale margin, should allow the seller to:
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recover its operating costs; and earn an arm's length profit based on the functions performed, assets used, and the risks assumed.

Where the transactions are not comparable in all ways and the differences have a material effect on price, the taxpayer must make adjustments to eliminate the effect of those differences. The more comparable the functions, risks and assets, the more likely that the resale price method will produce an appropriate estimate of an arm's length

result. An exclusive right to resell goods will usually be reflected in the resale margin. The resale price method is most appropriate in a situation where the seller adds relatively little value to the goods. The greater the value-added to the goods by the functions performed by the seller, the more difficult it will be to determine an appropriate resale margin. This is especially true in a situation where the seller contributes to the creation or maintenance of an intangible property, such as a marketing intangible, in its activities. Cost plus method of Transfer Pricing The cost plus method begins with the costs incurred by a supplier of a product or service provided to an non-arm's length enterprise, and a comparable gross mark-up is then added to those costs. This comparable gross mark-up is determined in two ways, by reference to:
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the cost plus mark-up earned by a member of the group in comparable uncontrolled transactions (internal comparable); or the cost plus mark-up earned by an arm's length enterprise in comparable uncontrolled transactions (external comparable).

In either case, the returns used to determine an arm's length mark-up must be those earned by persons performing similar functions and preferably selling similar goods to arm's length parties. Where the transactions are not comparable in all ways and the differences have a material effect on price, taxpayers must make adjustments to eliminate the effect of those differences, such as differences in:
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the relative efficiency of the supplier; and any advantage that the activity creates for the group.

The more comparable the functions, risks and assets, the more likely it is that the cost plus method will produce an appropriate estimate of an arm's length result. In general, for purposes of applying a cost-based method, costs are divided into three categories: (1) direct costs such as raw materials; (2) indirect costs such as repair and maintenance which may be allocated among several products; and

(3) operating expenses such as selling, general, and administrative expenses. The cost plus method uses margins calculated after direct and indirect costs of production. In comparison, net margin methods-such as the transactional net margin method (TNMM) discussed in Section B of this Part-use margins calculated after direct, indirect, and operating expenses. For purposes of calculating the cost base for the net margin methods, operating expenses usually exclude interest expense and taxes. Properly determining cost under the cost plus method is important. Cost is usually calculated in accordance with accounting principles that are generally accepted for that particular industry in the country where the goods are produced. However, it is most important that the cost base of the transaction of the tested party to which a mark-up is to be applied be calculated in the same manner as-and reflects similar functions, risks, and assets as-the cost base of the comparable transactions. Where cost is not accurately determined in the same manner, both the mark-up (which is a percentage of cost) and the transfer price (which is the total of the cost and the mark-up) will be misstated. For example, if the comparable party includes a particular item as an operating expense, while the tested party includes the item in its cost of goods sold, the cost base of the comparable must be adjusted to include the item. Transactional Profit Methods of Transfer Pricing Traditional transaction methods are the most reliable means of establishing arm's length prices or allocations. However, the complexity of modern business situations may make it difficult to apply these methods. Where the information available on comparable transactions is not detailed enough to allow for adjustments necessary to achieve comparability in the application of a traditional transaction method, taxpayers may have to consider transactional profit methods. However, the transactional profit methods should not be applied simply because of the difficulties in obtaining or adjusting information on comparable transactions, for purposes of applying the traditional transaction methods. The same factors that led to the conclusion that it is not possible to apply a traditional transaction method must be considered when evaluating the reliability of a transactional profit method. The OECD Guidelines endorse the use of two transactional profit methods:
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the profit split method; and transactional net margin method (TNMM).

The key difference between the profit split method and the TNMM is that the profit split method is applied to all members involved in the controlled transaction, whereas

the TNMM is applied to only one member. The more uncertainty associated with the comparability analysis, the more likely it is that a one-sided analysis, such as the TNMM, will produce an inappropriate result. As with the cost plus and resale price methods, the TNMM is less likely to produce reliable results where the tested party contributes to valuable or unique intangible assets. Where uncertainty exists with comparability, it may be appropriate to use a profit split method to confirm the results obtained. Profit split method of Transfer Pricing Under the profit split method:
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The first step is to determine the total profit earned by the parties from a controlled transaction. The profit split method allocates the total integrated profits related to a controlled transaction, not the total profits of the group as a whole. The profit to be split is generally the operating profit, before the deduction of interest and taxes. In some cases, it may be appropriate to split the gross profit. The second step is to split the profit between the parties based on the relative value of their contributions to the non-arm's length transactions, considering the functions performed, the assets used, and the risks assumed by each non-arm's length party, in relation to what arm's length parties would have received.

The profit split method may be applied where:

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the operations of two or more non-arm's length parties are highly integrated, making it difficult to evaluate their transactions on an individual basis; and the existence of valuable and unique intangibles makes it impossible to establish the proper level of comparability with uncontrolled transactions to apply a onesided method.

Due to the complexity of multinational operations, one member of the multinational group is seldom entitled to the total return attributable to the valuable or unique assets, such as intangibles. Also, arm's length parties would not usually incur additional costs and risks to obtain the rights to use intangible properties unless they expected to share in the potential profits. When intangibles are present and no quality comparable data are available to apply the one-sided methods (i.e., cost plus method, resale price method, the TNMM), taxpayers should consider the use of a profit split method. The second step of the profit split method can be applied in numerous ways, including:
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splitting profits based on a residual analysis; and

relying entirely on a contribution analysis.

Following the determination of the total profit to be split in the first step of the profit split, a residual profit split is performed in two stages. The stages can be applied in numerous ways, for example:
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Stage 1: The allocation of a return to each party for the readily identifiable functions (e.g., manufacturing or distribution) is based on routine returns established from comparable data. The returns to these functions will, generally, not account for the return attributable to valuable or unique intangible property used or developed by the parties. The calculation of these routine returns is usually calculated by applying the traditional transaction methods, although it may also involve the application of the TNMM. Stage 2: The return attributable to the intangible property is established by allocating the residual profit (or loss) between the parties based on the relative contributions of the parties, giving consideration to any information available that indicates how arm's length parties would divide the profit or loss in similar circumstances.

Transactional net margin method (TNMM) of Transfer Pricing The TNMM:

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compares the net profit margin of a taxpayer arising from a non-arm's length transaction with the net profit margins realized by arm's length parties from similar transactions; and examines the net profit margin relative to an appropriate base such as costs, sales or assets.

This differs from the cost plus and resale price methods that compare gross profit margins. However, the TNMM requires a level of comparability similar to that required for the application of the cost plus and resale price methods. Where the relevant information exists at the gross margin level, taxpayers should apply the cost plus or resale price method. Because the TNMM is a one-sided method, it is usually applied to the least complex party that does not contribute to valuable or unique intangible assets. Since TNMM measures the relationship between net profit and an appropriate base such as sales, costs, or assets employed, it is important to choose the appropriate base taking into account the nature of the business activity. The appropriate base that profits should be measured against will depend on the facts and circumstances of each case.