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Oct 1994

Transfer prices in the real world - 10 steps companies should take before it's too late. (International Taxation)

by Davis, H. Thomas, Jr.

    Abstract- Steps that accountants at multinational companies can follow to prepare themselves for an IRS audit on their transfer-pricing methodology are presented. These include consulting with external advisors to map out a game plan; examining how third-party deals differ from related party deals; developing a financial model for testing transfer-pricing methodology in use; and educating senior management about the implications of the IRS's current drive against poor transfer-pricing practices. Other steps that should follow are collating internal and external documentation; making spot checks within the company; monitoring the company's position in the industry cycle; and ensuring that tax returns present transfer-pricing policies consistently.

* If individual transfer prices or the whole transfer-pricing structure are not defensible, there is no time to correct them. Disputes are won on facts, and it is impossible to change bad facts once an audit has started.

* Reconstructing the company's position years from now will be difficult or impossible. Necessary documents will have been lost. Reasons for an embarrassing result will have been forgotten. Worst of all, critical persons will have left the company, and it will be impossible to fill the gaps. Gathering the necessary documents in advance can preclude enormous trouble in the future.

* The January 1993 proposed and temporary regulations under IRC Sec. 482 require contemporaneous planning and documentation as a means of justifying transfer prices to the IRS. The process itself has become significant. According to IRS Associate Chief Counsel (International) Robert J. Culbertson, documentation provides the substance for the comparability principle and serves as support for taxpayers that want to take advantage of flexibility. Documentation is what makes the arm's- length standard work.

George N. Carlson of Arthur Andersen stated the following in Deja Vu All Over Again: The New Section 482 Regulations:

Concurrent with the setting of any transfer price, it will be essential for a taxpayer to 1) identify the intercompany transaction; 2) analyze the functions and the risks of the entities participating in the transaction; 3) develop support for a transfer price, normally including evidence on comparable transactions between unrelated parties; 4) select the appropriate (best) method; and 5) set the transfer price. If one were inclined to view the regulations as a "compact" between government and business, flexibility is what is being offered to businesses, but documentation is what is required.

* The taxpayer can avoid the 20% and 40% penalties under IRC Sec. 6662 if it makes a "reasonable effort" to determine its proper tax liability accurately, and if it can show it had a "reasonable belief" its transfer-pricing methodology produced an arm's-length result. It is now clear these tests can be satisfied, and large penalties avoided, by proper documentation and by reliance on professional tax advisors at the time prices are set.

Here are 10 steps to take before the next audit.

STEP 1: Before the beginning of a business cycle, meet with your outside advisors and agree on a game plan. Preparing for a transfer price audit is no different from preparing for any other adventure: the adventurers get together and agree on where they are going, how they will get there, and what they take.

Before the beginning of a business cycle (annual, seasonal or other), the company's senior tax executive and any other managers responsible for transfer pricIng should meet with the company's outside tax counsel and tax accountants. The purpose of the meeting is to discuss 1) what method to use to set the company's transfer prices, 2) what financial results this method is likely to produce, 3) what information will be needed to provide the best support for these prices, and 4) who will be responsible for implementing any changes and gathering necessary information. If economists should be engaged to develop competitive data or an industry study, arrangements should be made at this time.

This is also the time to consider whether to seek an Advance Pricing Agreement (APA) with the IRS. The company's outside tax attorneys and accountants should advise how long they believe the process will take, how much it might cost, and whether a favorable agreement is likely. Some practitioners are wary of APAs, and at this writing fewer than 50 APAs have been entered. However, an APA is less expensive than litigation and provides a measure of certainty that some taxpayers require.

Company employees in other affected areas should be consulted, either at or after the all-hands meeting. Depending on the company's business, this group may include customs, shipping, and production personnel.

STEP 2: Consider how any third-party transactions compare with related party transactions. Even though the company may purchase or sell virtually all of its products with related parties, there may still be some transactions with third parties. These transactions provide a base of comparison for the terms of related-party sales. Ideally, the terms and circumstances of sales will be similar, so the third-party sales will support the planned transfer prices. If the terms are different, any reasons for the differences should be documented; if there is no logical reason for any differences, it may be necessary to change the prices in the related party sales or the third-party sales.

STEP 3: Prepare a financial model to test the method agreed on Sometimes good concepts don't work. Before implementing the planned pricing methods, test them in a financial model. This could be the company's budget, the company's tax planning model, or a special model prepared by the finance or tax department. If the results are not what was expected, go back to STEP 1.

The model should also project the financial results if the business produces differences in volume of production or sales, timing, and other possible variables. Try to determine when during the business cycle it will be necessary to change transfer prices to account for these changes in the business.

STEP 4: At the time transfer prices are set, make sure senior management understands the transfer pricing audit process, issues, and exposure. If senior management does not understand the practicalities of a transfer price audit, the company's transfer pricing strategy, or any audit risks taken, it is likely they will frustrate the efforts of tax managers to do a good job and will not recognize the managers' contribution to a good result. The norm in this area is a long audit, numerous and seemingly aimless audit inquiries, a sudden proposal by the IRS agent of a ridiculously large adjustment unsupported by any logical business realities, and a period of negotiation with the agent or at a conference that leads to a reduced adjustment, but on a basis that frequently makes no sense. The cost of a defense, measured in management time and outside professional fees, can be high. All of these elements are frustrating, time-consuming and anxiety-provoking for senior management. Painstaking planning and documentation in advance may reduce these problems later.

STEP 5: Prepare with internal documentation. Make sure the right internal documentation exists and that it says only what it should. In dealings with unrelated parties, business people expect board of directors' minutes, purchase contracts, and individual purchase orders. The same documentation should be prepared for dealings with related parties. The new Proposed and Temporary Treasury Regulations make clear that the form of a transaction will receive some respect. If transactions with affiliates are documented differently, it must be clear why that is so.

It is just as necessary that documentation not contain any embarrassing admissions or loose statements that can lead to misinterpretation and misunderstanding later on. Everyone who has anything to do with transfer pricing must understand that the letters, memoranda, faxes, etc. they create can be discovered in an IRS audit. They should assume the IRS will discover anything they write, and should act accordingly.

STEP 6: Prepare with external documentation. The strongest defense in a transfer-price audit is with comparables. Marketing and sales people should (through legally acceptable means) gather information about competitors' prices, costs, and profits. This information can come from trade groups, published accounts, customers, ex-employees, electronic data bases in the public domain like Compustat, etc. When the IRS agent tries to claim the usual profit in your industry is a multiple of the best year the company ever had, there is no response more persuasive than a list of examples demonstrating the company's results were at or above the industry average for the audit period. This is the show- stopper the company should be aiming for.

Of course, the data could suggest the company's results were below industry standards. Be prepared either to explain why the company's transfer-pricing structure was reasonable under the circumstances, or to change transfer prices if the explanation is not persuasive.

It is difficult or impossible for most taxpayers to document comparables in a rigorous way. On the other hand, something is better than nothing, and in most cases the taxpayer is in a much better position than the IRS agent to develop this information. If the stakes are high enough, an economic study may be cost-justified. It will be easier and less expensive if this study is prepared now, and not later on when key information and individuals may no longer be available.

STEP 7: Spot check within the company. It should not be assumed the company's documentation and prices are being adjusted according to the plan. Internal communications problems, changes in personnel, and business problems can prevent needed changes from being implemented. Sometimes new products, processes, or facilities are launched during the year without incorporating the company's transfer price plan. A spot check during the year can reduce or eliminate these problems. If the company has an internal auditing department, they may be enlisted to help spot check as a part of their audit routine.

STEP 8: Consider a transfer pricing audit by outside advisors. It may be that the company's transfer prices have been set for some time, the internal and external documentation seems settled, and the financial results are acceptable. Outside professional advisors can review a client's books and records to determine what problems will arise on an audit and suggest how to change them while there is still time. Outside advisors bring a fresh perspective that can uncover problems of which the tax manager was unaware.

STEP 9: Evaluate your position at the end of the business cycle or at year-end, whichever comes first At the end of the cycle, the results of the transfer pricing structure should be reviewed. Did the profit margins and profit splits work out as intended? If not, the reasons should be identified and documented. This will permit changes in structure before the next year begins.

STEP 10: The tax return should strongly and consistently present the company's transfer pricing position. The company's tax return is the first document concerning the company's transfer prices the IRS will see. It is the company's first and best opportunity to make its case.

Unfortunately, the return is often put together in a rush at the last minute. A poorly written, inconsistent or illogical description will jeopardize months of planning and thought. To prevent this, all explanatory notes and statements should be prepared well in advance. They should strongly and consistently present the company's transfer pricing position.

The Proposed and Temporary Treasury Regulations provide limited safe harbors if a taxpayer makes various elections in its tax return. The safe-harbor election must be evidenced by a written election attached to the return; a condition to using an "other" method under either the tangible or intangible rules is that the taxpayer attach a statement to the return describing the method. These statements should be drafted well in advance of the due date.

Editor's Note--Final regulations under IRC Sec. 482 have now been issued. While this article was written based on proposed and temporary regulations, the editors feel the guidance contained in the article is still appropriate.

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