U.S. Transfer Pricing OverviewPresented by Will James – BKD, LLP

Agenda

US. Transfer Pricing (TP) Rules – Overview Overview of U.S. Documentation Requirements Required Documentation Penalties Tax Return Disclosure Requirements IRS TP Compliance Initiative Overview of TP Methods Best Method Analysis Final Intercompany Services Regulations Cost Sharing Regulations Advanced Pricing Agreements

U.S. Transfer Pricing Rules

Relevant Rules/RegulationsSection 482 of Internal Revenue Code and the

accompanying Treasury Regulations

U.S. Transfer Pricing Rules (cont.)

Arms length standard “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)”(Treas. Reg. §1.482-1(b)(1))

Treasury Regulations §1.482 –Overview

1.482-1: Allocation of Income and Deductions among Taxpayers

1.482-2: Determination of Taxable Income in Specific Situations

1.482-3: Methods to Determine Income…Tangible Property 1.482-4: Methods to Determine Income…Intangible Property 1.482-5: Comparable Profits Method 1.482-6: Profit Split Method 1.482-7: Sharing of Costs 1.482-8: Examples of Best Method Rule 1.482-9: Methods to Determine Income…Service Transactions

Definition of Controlled

1.482-1(i)(4) “Controlled includes any kind of control, direct or indirect,

whether legally enforceable or not, and however exercisable or exercised, including control resulting from the actions of two or more taxpayers acting in concert or with a common goal or purpose. It is the reality of the control that is decisive, not its form or the mode of its exercise. A presumption of control arises if income or deductions have been arbitrarily shifted.”

Overview of U.S. Documentation Requirements TP documentation is required under U.S. tax lawsMust be in existence when tax return is filed

There is no documentation safe harbor for small taxpayers

Penalties will be assessed in cases of taxpayers without adequate TP documentation

TP documentation is requested as part of all general tax audits

U.S. does not follow OECD Guidelines Relevant law is Internal Revenue Code §482

Documentation prepared for other countries is not acceptable to the Internal Revenue Service (IRS)

Required Documentation

1. Overview of taxpayer’s business including economic and legal factors which affect pricing

2. Description of organizational structure covering all related party transactions

3. Any specific documents required by §482 regulations (e.g., cost-sharing agreements or market penetration)

4. Description of selected method and explanation of rationale for selecting method

5. Description of unselected methods considered and explanation of why they were not selected

Required Documentation (cont.)

6. Description of the controlled transactions, including terms of sale, and any internal data used to analyze those transactions

7. Description of comparables used, how comparability was evaluated and adjustments made

8. Explanation of economic analysis and projections used in developing method

9. Summary of relevant documents collected between the end of the tax year and the date the return was filed

10. General index of principal and background documents and recordkeeping of those documents

U.S. Transfer Pricing Penalties –Summary

Penalty Transactional Net Adjustment

Substantial Valuation (20% penalty)

Price or value is 200% or more (50% or less) than the correct amount

Net adjustment exceeds the lesser of $5 million or 10% of gross receipts

Gross Valuation (40% penalty)

Price or value is 400% or more (25% or less) than the correct amount

Net adjustment exceeds the lesser of $20 million or 20% of gross receipts

U.S. Transfer Pricing Penalties –Review of IRC §6662 Internal Revenue Code §6662 imposes an accuracy-related

penalty for an underpayment of tax attributable to improper transfer pricing (“valuation misstatement”) 20% penalty for substantial valuation misstatements: Claimed transfer price is more than 200% or less than 50% of the

arm’s length amount or Net §482 adjustment exceeds the lesser of $5 million or 10% of

gross receipts

40% penalty for gross valuation misstatements: Claimed transfer price is more than 400% or less than 25% of the

arm’s length amount or Net §482 adjustment exceeds the lesser of $20 million or 20% of

gross receipts

U.S. Transfer Pricing Penalties –Review of IRC §6662 (cont.) Taxpayers may avoid an accuracy-related penalty

by showing: The taxpayer determined its transfer price in accordance

with a specific method set forth in the regulations prescribed under §482 and the use of such method was reasonable

The taxpayer has documentation (that was in existence as of the time of filing the return) which sets forth its transfer pricing method and which establishes that the use of such method was reasonableand

The taxpayer provides such documentation to the IRS within 30 days of a request for such documentation

U.S. Tax Return Disclosures

Disclosures Covered in Tax Returns? Short Answer – Yes

Disclosure Forms:Form 5471 – U.S. Entity Owns Foreign Subsidiary Schedule M details the transactions between foreign

entities Form 5472 – Foreign Entity Owns U.S. Subsidiary

Form should be filed with income tax return of the affected shareholder

$10,000 penalty for failure to file per instance IRS has recently started to vigorously assess

penalties for improper filings

IRS to Aggressively Review Transfer Pricing Issues Given the economic crisis, the IRS will vigorously

investigate U.S. multinational enterprises, which are seen as “shopping for best tax deals” –according to Commissioner Douglas ShulmanWill need tax revenues to fund bailouts and other

stimulus spendingThere will be “increased public pressure of corporate

taxpayers to adhere to not only the letter of the law, but the spirit of the law in their home country law”

IRS Transfer Pricing Compliance Initiative – Overview January 2003 IRS LMSB* Commissioner issued

directive launching new transfer pricing compliance initiative

Directive instructs agents to Request transfer pricing documentation at opening

conference of all audits Enforce 30-day deadline for providing documentation Provide documentation to IRS International Examiner or

IRS economist Penalties cannot be waived unless documentation was

prepared & submitted timely and approved by Penalty Review Board

* Large and Mid Size Business Division (now called Large Business & International Division) –Companies with assets over $10 million

IRS Transfer Pricing Compliance Initiative - Results IRS continuing to audit more small & mid-size

companies as part of mandate IDRs now requests “transfer pricing studies” as

opposed to listing TP documentation requirements under Section 6662

IRS enforcing the requirement that TP documentation be contemporaneous

IRS interviewing individuals who prepared the documentation and taxpayer personnel

Challenging taxpayer’s documentation

IRS Transfer Pricing Compliance Initiative – Results (cont.) Imposition of penalties Reviewing Form 5471/5472s for data consistency IRS will audit a taxpayer for subsequent tax year if

they find an adjustment Can no longer ignore U.S. TP documentation

requirementsDocumentation should be kept current

IRS will add 2,000 staff to its international group over the next few years to expand audit coverage Will include transfer pricing economists

IRS Transfer Pricing Compliance Initiative – Areas of Focus Inbound companies with low profitability All companies with cost sharing arrangements Companies with amended tax returns Services transactions Transfers of intangible property for nil or

insufficient compensation

Overview of Transfer Pricing Methods Tangible PropertyComparable Uncontrolled Price MethodResale Price MethodCost Plus MethodComparable Profits MethodProfit Split MethodOther Unspecified Methods

Overview of Transfer Pricing Methods (cont.) Intangible PropertyComparable Uncontrolled TransactionComparable Profits MethodProfit Split MethodOther Unspecified Methods

Overview of Transfer Pricing Methods (cont.) Services Methods

Comparable Uncontrolled Services Price Gross Services Margin Cost of Services Plus Comparable Profits Method Profit Split Method Unspecified Methods

Best Method Analysis

“The arm’s length result of a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable measure of an arm’s length result.” (Treas. Reg. §1.482-1(c)(1)).

No hierarchy of methods Need to document why the method chosen is the

“best method” and why other methods were not applicable

Best Method Analysis (cont.)

In determining the best method, need to consider the following:Degree of comparability between controlled and

uncontrolled transactionsQuality and completeness of the underlying data and

assumptions used in the analysis

Final Intercompany Services Regulations

On July 31, 2009, IRS issued final regulations governing intercompany services transactions

Largely consistent with temporary intercompany services regulations issued in 2006

Effective for tax years beginning after July 31, 2009 Services must convey a direct benefit to the

recipient of the serviceServices serve to enhance recipient’s commercial

position orRecipient would be willing to pay for the same

activity or perform the activity itself

Final Intercompany Services Regulations (cont.) SCM (cost safe harbor election) – cost can be charged

for routine (low level) administrative services Specified Covered Services – services listed in Revenue

Procedure or Low-margin Covered Services – median mark-up of

comparables is 7% or less To qualify for the SCM, the following must also be met: Services must also not contribute to the key competitive

advantages, core capabilities or fundamental success of the group (‘business judgment test’)

Service must not be a specifically excluded service Taxpayer must maintain required documentation

Final Intercompany Services Regulations (cont.) Specifically excluded services, which do not qualify for

the SCM include:Manufacturing Production extraction, exploration or processing of

natural resources Construction Reselling, distribution, acting as a sales or purchasing

agent or acting under a commission or similar arrangement

Research, development or experimentation Engineering or scientific Financial transactions – including guarantees Insurance or reinsurance

Final Intercompany Services Regulations (cont.) Services which are not beneficial should not be

allocatedProvides an indirect or remote benefitDuplicative ShareholderPassive association

Final Intercompany Services Regulations (cont.) Implications Need to ensure compliance with the final intercompany

services regulations Review against current practices for intercompany services

The charge-out of stock options could potentially be unacceptable in other jurisdictions

More documentation is now required for intercompany services arrangements (e.g., intercompany agreements and compliance with SCM)

In recent audits, the IRS has focused on cost base of the services fee, how the costs were allocated and how they tie into the general ledger

Temporary Cost Sharing Regulations

On December 31, 2008, the IRS and U.S. Treasury released temporary cost sharing regulationsHad an effective date of January 5, 2009 and can be

applied retroactively for all open tax yearsTemporary regulations have same weight as final

regulations Will likely be finalized without any significant

changes Replaces the 1995 cost sharing regulations

Temporary Cost Sharing Regulations (cont.) Cost sharing arrangement (CSA) is an arrangement in

which controlled participants share the costs and risks of developing cost shared intangibles in proportion to their reasonably anticipated benefit shares

In order to qualify as a CSA, the following must be met: Cost Sharing Transactions Administrative requirements fulfilled Platform Contribution Transaction (PCT) (buy-in payment)

is determined Divisional Interests for the intangibles must be reliable,

non-overlapping, perpetual and exclusive

Temporary Cost Sharing Regulations (cont.) Investor Model is the fundamental concept for

determining results that would have been realized under an arm’s-length CSA and for addressing the relationships and contributions of each CSA participant

PCT valuation methodologies Income Method Residual Profit Split Method Comparable Uncontrolled Transaction Market Capitalization Acquisition Price Method Unspecified Methods

Temporary Cost Sharing Regulations (cont.) Periodic adjustmentsApplies to all transfer pricing methods used to

determine PCT Allows IRS to make an adjustment to the PCT if the

PCT was not correct due to the forecasts used at the time Taxpayer cannot make adjustment PCT will likely be analyzed by IRS since cost sharing is a

Tier 1 issue IRS has the benefit of hindsight

Temporary Cost Sharing Regulations (cont.) ImplicationsCSAs are no longer as attractive as in the pastThe investor model and periodic adjustment will

likely mean that more of the returns accrue to the participant making the PCT contribution

Historical CSAs (those before January 5, 2009) needed to be documented by July 6, 2009 to qualify for treatment under the 1995 CSA regulations

Advanced Pricing Agreements

Agreement Types (Rev. Proc 2006-9) Unilateral BilateralMultilateral

Filing Fees Large Taxpayers - $50,000 Small Taxpayers - $22,500 Gross Worldwide Income < $200M annually Small Transactions < $50M annually Intangible Transactions < $10M annually

$35,000 for Renewals

Questions?