Transfer pricing regulations in the US are one of the oldest in the world, with them being first introduced over a century ago. The main section that governs those regulations is section 1.482 of the Inertial Revenue Code (IRC).
Arm’s length principle
The arm’s length principle is defined in section 1.482-1(b)(1) of the IRC, stating that a controlled transaction (i.e. a transaction between related parties) meets the arm’s length standard if the pricing set is the same if the same transaction were to occur between uncontrolled taxpayers.
Related party definition
Related parties are defined in 1.482-1(i)(5) of IRC as one of two or more taxpayers that are, directly or indirectly, owned or controlled by the same interest.
As opposed to a lot of other countries, the US regulations don’t have a set definition of control, meaning the regulations don’t specify a certain percentage of the voting power needed or something similar. Control can be direct or indirect and doesn’t have to be legally enforceable. The decision on whether the parties are related is based on the case circumstances.
Transfer pricing methods
The methods that can be used to determine the arm’s length price are defined in section 1.482-9(a) as follows:
- Services cost method
- Comparable uncontrolled price method
- Gross services margin method
- Cost of services plus method
- Comparable profits method
- Profit split method
- Other unspecified methods
The services cost method
evaluates the arm’s length price by looking at the total services costs with no markup. The cases in which the method can and can’t be applied are outlined in section 1.482-9(b). For instance, the method can’t be applied to manufacturing, production, and financial transactions.
The gross services margin method examines the amount charged in a controlled service transaction by comparing the gross profit margin of the transaction to that of a comparable uncontrolled transaction.
The cost of services method assesses the arm’s length amount that should be charged in a controlled transaction by comparing the gross services profit markup. This method is usually used when the taxpayer provides similar services to related and unrelated parties.
The other methods have similar definitions to those in the OECD guidelines.
There is no hierarchy of methods, and the choice between the methods should be made according to the “best method rule”. This means the method that will be chosen is the one that will, under the details of the case in question, provide the most accurate estimation of the arm’s length result.
When deciding which method will provide the most accurate estimation, there are two main things to keep in mind:
- The comparability between the controlled transaction and any uncontrolled transactions.
- The quality of the available data and the assumptions made.
Comparability analysis
An important part of the transfer pricing compliance is the comparability analysis. Below is a summary of the main points regarding comparability analysis in the US:
- The comparables should be from the geographic market where the related taxpayer operates. If this kind of information isn’t available, then information from other markets should be used with the appropriate adjustments.
- The comparability factors include functions, risks, contractual terms, economic conditions, and property or services.
Documentation requirements
Taxpayers are not required to submit documentation with their yearly reports, only if the Assessor requests them to. They do however need to maintain documentation regarding their transfer pricing methodology. This documentation is very similar to the local file set in the OECD guidelines and includes 10 items, e.g., the organizational structure, the method selection, the description of the comparables, and more.
In addition, for fiscal years starting June 30, 2016, multinational enterprise groups with annual revenue of 850 million USD or over, with an ultimate parent entity in the US need to submit a Country-by-Country report.
Safe Harbours
Section 1.482-2(a) outlines the safe harbour provisions for certain intercompany loans. According to the section the safe harbour rate charged for those loans should be between 100% and 130% of the applicable Federal rate.
Advance Pricing Agreements (APA) and Mutual Agreement Program (MAP)
Both APAs and MAPs are available in the US.
APAs are agreements made between the taxpayer and the tax authorities, in advance, to avoid tax disputes regarding transfer pricing methodology.
The Internal Revenue Service (IRS) offers three types of APAs:
- Unilateral APA – between the taxpayer and the IRS.
- Bilateral APA – between the taxpayer, a foreign related party, the IRS, and the foreign tax authority.
- Multilateral APA – between the taxpayer, two or more foreign related parties, the IRS, and multiple foreign tax authorities.
MAPs are agreements made after an incident of double taxation has occurred, when a taxpayer believes that the taxation they are subject to, is inconsistent with the treaty. The IRS will examine the case and will decide what the appropriate action is; whether to decline the request, provide unilateral relief, or contact the other tax authority to negotiate a bilateral solution.
Approach to transfer pricing audits
The IRS has published several publications regarding its approach to transfer pricing audits. The publications provide a deeper understanding of how the IRS handles those audits. For example, the Transfer Pricing Examination Process, Publication 5300, explains the framework of transfer pricing examination. Or the Transfer Pricing Audit Roadmap, which goes over each step of the audit process.
In general, the purpose of a transfer pricing audit is to establish a reasonable outcome under the case circumstances. The audit process includes three phases, planning, execution, and resolution. First, the IRS understands the facts of the case and then they meet with the taxpayer to discuss their findings and a possible resolution.
Penalties
When an underestimation of the value of services or property on a federal return occurs, two types of penalties can be imposed; transactional penalty and net adjustment penalty. The penalty rate depends on the difference between the arm’s length amount and the declared amount.
Transactional penalty:
- 20% penalty – If the declared amount is either 200% and more or 50% and less, than the amount that should’ve been declared according to the arm’s length principle.
- 40% penalty – If the declared amount is either 400% and more or 25% and less, than the amount that should’ve been declared according to the arm’s length principle.
Net adjustment penalty:
- 20% penalty – the net adjustments in the price of properties or services increase the taxable income by 5 million USD or 10% of the taxpayer’s gross receipts, whichever is higher.
- 40% penalty – the net adjustments in the price of properties or services increase the taxable income by 20 million USD or 20% of the taxpayer’s gross receipts, whichever is higher.
Taxation at a glance
As mentioned above The US’s tax authority is the Internal Revenue Service or the IRS. There are a few levels of taxation in the country, federal (set by the US Treasury), state (set by local state authorities), and municipal (set by local municipalities). This means that in addition to the federal law, that is applicable all through the US, the state or even the municipality the entity is located in will affect the final taxation rate. For example, corporate tax is 21% at the federal level, but additional state tax might be imposed depending on the state.
The table below provides a summary of the main taxation rates related to businesses:
Tax type | Tax rate |
Corporate tax | 21% (federal rate) |
Sales tax | 2.9% – 7.25% |
Withholding tax on dividends to non-residents | 30% |
Withholding tax on interest to non-residents | 30% |
Withholding tax on royalties to non-residents | 30% |
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