What Multinational Groups Need to Know About Transfer Pricing When Closing Their 2024 Books
By Ralf Ruedenburg, Partner
Year-end is fast approaching and multinational groups are preparing to close their 2024 books. Finance and accounting teams are reviewing and updating their to-do lists and establishing priorities. If transfer pricing considerations are not on the list, the recent IRS focus on transfer pricing means they should be added. Even if a company is considering transfer pricing now, it is still an important time to make it a priority. Read on for an update on current IRS audits on transfer pricing, which can lead to significant tax adjustments.
Transfer Pricing and Tax Compliance Requirements
In essence, U.S. transfer pricing rules (Internal Revenue Code §482 and regulations thereunder), allow the IRS to make adjustments to the income, deductions, credits or allowances if transactions between related parties (controlled transactions) do not meet the arm’s length standard. Generally, the arm’s length standard is met 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). The purpose of potential adjustments is to clearly reflect the taxable income and prevent the evasion of tax in the U.S. Penalties can be up to 40% of the unpaid tax under certain circumstances.
The IRS has used Inflation Reduction Act funding to expand transfer pricing enforcement efforts on U.S. subsidiaries of foreign companies. Back in October 2023, a foreign-owned corporation transfer pricing initiative was launched and notices were sent to U.S. taxpayers asking them to confirm whether they comply with U.S. transfer pricing rules and regulations. Taxpayers that did not respond to the notice were recommended for an IRS examination.
We expect the IRS to increase their efforts to identify U.S taxpayers that are a member of a multinational group and that do not comply with U.S. transfer pricing rules and regulations.
Multinational Groups Should Be Ready for a Prospective IRS Exam
This is what taxpayers should do to be prepared for a potential IRS examination:
- Review related-party transactions within the group and update transfer pricing policies and agreements, if needed. If intellectual property (IP) is part of this analysis, taxpayers should make sure the IP owner is compensated from users of the IP in the group in a manner that meets the arm’s length standard. The IRS and other tax authorities are increasingly challenging the ownership of IP and its use in a multinational structure. Key considerations are whether IP has been transferred from one country to another after a merger or acquisition or whether the owner of IP is receiving reasonable compensation for its use by other companies in the group. This can be achieved by a license fee, royalty or service fee supportable by comparable transaction analysis.
- Review and update transfer pricing documentation and benchmarking studies and make sure that they comply with U.S. transfer pricing rules and regulations. In many cases, non-U.S. based multinational companies have transfer pricing documentation in place, but it is prepared using non-U.S. transfer pricing guidelines or transfer pricing guidelines issued by the Organization for Economic Cooperation and Development (OECD). Multinational groups need to keep in mind that the U.S. transfer pricing documentation requirements are different from the ones used by other countries or the OECD. For instance, there is no master or local file. Although there is a lot of information included in a non-U.S. study, the devil is in the details. We have seen instances where the IRS accepted a non-U.S./OECD transfer pricing study, but also many scenarios in which the documentation is rejected. The following is a list of reasons why this may happen:
- Selection of the tested party: The tested party is a party of the controlled transaction, for which the key performance indicator (for instance, gross margin or operating margin) is being tested against a group of comparable entities. A transfer pricing documentation may correctly analyze related-party transactions between a U.S. company and a non-U.S. company within the group. However, if the non-U.S. company is selected as the tested party, the IRS may reject the documentation because an analysis of the U.S. company in terms of the key performance indicators is expected.
- Selection of third-party comparables: Generally, a group of entities that is comparable to the tested party in terms of business activities has to be selected and the key performance indicator elected has to be analyzed for this group to determine whether the tested party results are within a range of results of this group. The IRS is likely to reject documentation where the group of comparables is selected from non-U.S. companies.
- Selection of the tested party: The tested party is a party of the controlled transaction, for which the key performance indicator (for instance, gross margin or operating margin) is being tested against a group of comparable entities. A transfer pricing documentation may correctly analyze related-party transactions between a U.S. company and a non-U.S. company within the group. However, if the non-U.S. company is selected as the tested party, the IRS may reject the documentation because an analysis of the U.S. company in terms of the key performance indicators is expected.
- Make sure that the transfer pricing documentation meets IRS expectations:
- Industry and company analysis sections of the report should be clear and provide context for related-party transactions.
- Functional analysis narratives should be robust and link facts to analysis.
- Risk analysis should be consistent with intercompany agreements.
- Support for best method selection must be provided, as well as the reason for rejecting specified methods.
- Complete comparability analysis should be provided.
- The impact of differences in risks or functions between the tested party and the comparable companies should be provided.
- Detailed well-reasoned support for proposed adjustments to the application of a specified method should be provided.
- Industry and company analysis sections of the report should be clear and provide context for related-party transactions.
It should be noted that any transfer pricing-related adjustments to the financial statements do not have to be finalized by year-end. They are generally part of the closing process.
PKF O’Connor Davies Guidance
U.S. companies that are a member of a multinational group should review related-party transactions and make sure that documentation is in place to defend the positions taken against the IRS in case of an examination. Transfer pricing documentations prepared under non-U.S. transfer pricing rules and regulations may not serve that purpose and there is a risk that the IRS will reject such documentation. As groups expand and related-party transactions increase in size, the risk of an IRS transfer pricing adjustment can be significant.
Contact Us
If you need any assistance, please reach out to your PKF O’Connor Davies client service team or:
Ralf Ruedenburg, CPA
International Tax Partner
rruedenburg@pkfod.com