If your manufacturing company operates through two or more
entities and is expanding into multiple states or even overseas, you need to
become familiar with transfer pricing. While the term is typically associated
with large, multinational corporations, manufacturers of various sizes may
encounter transfer pricing issues.
Defining transfer pricing
Transfer pricing refers to pricing arrangements for transfers of
goods or services between related companies in different jurisdictions.
Examples of related companies include a parent and its subsidiary, or
brother-sister companies with common ownership. Transfer pricing arrangements
also include cross-border, related-party transactions involving intellectual
property, such as patent or trademark licenses.
These arrangements may invite scrutiny because they're easily
manipulated to reduce a company's tax liability by shifting income to
jurisdictions with lower tax rates. For example, let's say that Parentcorp, a
manufacturing company in a high-tax jurisdiction, has a wholly owned
subsidiary, Subcorp, in a low-tax jurisdiction.
Subcorp manufactures component parts and sells them to
Parentcorp, which, in turn, assembles them into finished products. Subcorp
sells the components to Parentcorp at inflated prices, increasing Subcorp's
taxable income and reducing Parentcorp's taxable income. In this example, the
transfer pricing arrangement essentially shifts income to Subcorp's low-tax
jurisdiction, reducing the enterprise's overall tax liability.
Understanding IRS regs
Transfer pricing regulations are complex. Generally, the IRS
aims to prevent manipulation by requiring transactions between related
companies to be roughly comparable to arm's-length transactions between
unrelated companies.
Specifically, Internal Revenue Code Section 482 allows the IRS
to distribute, apportion or allocate gross income, deductions, credits or
allowances between or among related parties to prevent evasion of taxes or to
clearly reflect the income of any parties. State tax rules vary and may mirror
IRS rules.
Depending on the jurisdictions involved and the circumstances,
there are a few methods for setting appropriate transfer prices. Two common
methods are:
- Comparable
profits.
This analyzes the profitability of comparable transactions involving
similar companies.
- Cost-plus. This applies
a market-based markup to the "suppliers'" costs to arrive at a suitable
profit.
In addition, many jurisdictions require companies to present
documentation to support their transfer prices. Even if it's not required,
maintaining documentation to back up an enterprise's transfer pricing is a best
practice.
The penalties for noncompliance with transfer pricing
regulations can be substantial. For example, in the United States, they can be
up to 40% of the amount by which federal taxes are underpaid.
Protecting your manufacturing company
If transfer pricing becomes an issue for your manufacturing
company, an audit by the IRS or other tax authorities can result in substantial
assessments of back taxes, interest and penalties. So, it's a good idea to take
steps to protect your company.
The first step is to conduct a risk assessment. Next, ensure you
have appropriate transfer pricing policies and procedures in place based on
your company's risk profile, corporate structure and activities. These policies
and procedures should incorporate appropriate methods for determining
arm's-length prices.
Finally, document your methodology to help support your position
in case your transfer pricing arrangements are challenged. Even if not
required, this documentation can smooth the audit process and help avoid or
reduce penalties by establishing a good faith effort to comply with transfer
pricing regulations.
Avoiding compliance issues
If your manufacturing company does business with related companies in other states or countries, stay on top of transfer pricing. Establishing reasonable transfer policies and practices will help your business avoid potential compliance problems. It also may reveal opportunities to reduce your enterprise's tax bills by adjusting transfer prices within acceptable limits.