The IRS recently issued an international practice unit (IPU) showing its examiners how to search for potential income shifting when auditing outbound sales of tangible goods by U.S. units of multinationals.
Specifically the guidance targets sales to foreign affiliates where the price of tangible goods fails to reflect U.S.-owned intangible property, marketing and other services included in the transaction. In general, IPUs identify strategic areas of importance to the IRS and can provide insights to businesses about how examiners may audit a particular transaction.
Under the U.S. tax code, pricing should fall within the arm’s-length results for similar sales between unrelated parties. In those transactions, the price generally is determined by market conditions and is assumed to be at arm’s length. However, in a transaction between controlled (or related) parties, the price of goods may be manipulated in order to shift income to minimize taxes.
According to the IRS, U.S. multinational enterprises (MNEs) may try to maximize after-tax profits by shifting income from a high-tax affiliate to a lower-tax affiliate in transactions that don’t reflect arm’s-length pricing. MNEs may shift income through the sale of tangible goods, the provision of services, loans, and leases and the license or transfer of intangibles.
The U.S. tax code lays out transfer pricing methods for these transactions. Companies must perform a comparability analysis to determine which method is the best. To determine whether a U.S. unit of an MNE undercharged a foreign affiliate, the IRS seeks answers to the following general questions:
- Is any valuable U.S.-owned intangible property embedded in the tangible goods or otherwise passed to the affiliate other than the right to resell the tangible property?
- If so, is the U.S. unit charging an arm’s-length price reflecting the values of the tangible and intangible property?
- Does the U.S. unit provide any valuable services in connection with the sale?
- If services are involved, is the U.S. unit charging an arm’s-length price?
IRS examiners are told to consider the following elements in order to determine whether any intangible value should have been priced separately:
- Which transfer pricing method was used?
- Was it the best method?
- Was the value of the intangible property taken into account in the transfer pricing study?
- Is the tangible property compensated at an arm’s-length price, given the presence of the intangible property?
If these elements support the use of another transfer pricing method, the examiner must gather evidence to show that. Otherwise, the examiner should evaluate the comparables used to support the pricing of the tangible goods under the best method.
To determine whether valuable services were conveyed in the sale, examiners are told to consider nearly 40 factual elements, including:
- Whether the transfer pricing study identifies any marketing services the U.S. unit provided to the foreign affiliate,
- Whether the foreign affiliate performed its own marketing activities,
- Whether the foreign affiliate ever outsources marketing services to third parties or provides similar services to third parties,
- Whether the U.S. unit ever provides marketing services to the affiliate as part of a sales agreement regarding tangible goods,
- What the contract termination and modification rights are, and
- Whether the form of the transaction (including written contract terms) follows the substance of the transaction.
Note: In the best case, a U.S. multinational enterprise may have clearly defined the form of these transactions in written legal contracts. In such cases the company may expect the contracts alone to serve as the basis for tax positions it takes on its U.S. income tax return. However, the actual transaction could be inconsistent with the terms of the contracts and warrant a transfer pricing challenge. In fact, the IRS instructs its examiners to “trace the actual conduct” in the intercompany accounts that are reflected in the financial books and ledgers.
According to the IRS, the factual elements should help examiners determine whether a service should be priced separately from tangible goods.
Because standard transfer pricing documentation may not address many of the factual elements, it would be wise for companies to consider additional resources that may be necessary to respond to IRS information requests and to consult with their advisors.
The full IPU text is available at http://www.irs.gov/pub/irs-utl/ISO9411_02_04.pdf.