As 2022 comes to a close, multinationals should consider assessing and potentially adjusting their transfer pricing before year-end to avoid potential book-tax differences and other administrative burdens.
Throughout the year, transfer pricing compliance typically involves setting provisional transfer prices based on benchmarked results. If necessary to reflect an arm’s length result, a taxpayer may report prices on a tax return that differs from the prices actually charged.1 If the taxpayer makes these “true-up” adjustments after closing financial statements for the year, the adjustment will create a book-tax difference that requires additional compliance efforts. Therefore, it is a best practice in transfer pricing compliance to consider transfer pricing adjustments during the year and true-ups before year-end to avoid unnecessary administrative efforts.
Transfer pricing compliance process
The global standard by which transfer pricing is evaluated is the “arm’s length principle.” The U.S. regulations under Section 482 of the Internal Revenue Code explain the arm’s length principle as follows: “In determining the true taxable income of the controlled taxpayer, the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer.”2 Thus, the arm’s length principle involves comparing the transactions of one of the controlled parties (the “tested party”) to the transactions of uncontrolled parties (the “comparables”) to determine whether the controlled transactions are arm’s length.
Nearly all transfer pricing analysis is done by way of a “lookback test.”3 Taxpayers use a provisional transfer price throughout the year to generate intercompany invoices and project that the tested party results fall within the arm’s length range of results developed using comparables information.
However, estimates can be wrong, and taxpayers are required to make adjustments, as needed, to report an arm’s length transfer price in transfer pricing documentation contemporaneous with the filing of a tax return. A brief example demonstrates the variables relied upon to set the transfer price and the potential need for a true-up.
In this example, “USCo” is defined as a wholly-owned subsidiary that distributes electronics in the United States for its parent company, “ForCo.” USCo is the tested party and has applied the comparable profits method (CPM) with an operating margin (OM) profit level indicator (PLI).
USCo sets the transfer price intending to achieve an operating margin similar to the previous year’s results of 3%. The operating margin is calculated using the ratio of operating profit to sales, (sales price times sales volume) minus the cost of goods sold (COGS) and minus sales, general and administrative (SG&A) expenses -- all divided by sales. Thus, the OM is affected by any variance from sales price, sales volume and SG&A expense. Further, the OM percentage for the comparables results is not available until May or June of the following year. Thus, substantial risk exists that the provisional transfer price may need to be adjusted.
If a taxpayer decides that a true-up is needed, the taxpayer can make that true-up either before year-end or after year-end. Before year-end, the taxpayer should be in possession of most of the information about sales price and volume and SG&A, although the comparables information would not yet be available for the year in question. The comparables information would be available before the extended due date of the tax return, but any adjustment after the financial books have closed would be subject to additional administrative complications.
Additional complications for post-year-end adjustments
Any transfer pricing adjustment made after the closing of the financial statements will be considered a self-initiated adjustment and will create a book-tax difference that must be listed on Schedule M of the tax return. Further, Treas. Regs. Sec. 1.482-1(g)(3) requires an adjustment to conform the taxpayer’s accounts to reflect the allocations made under Section 482.4 These conforming adjustments may include the treatment of an allocated amount as a dividend or as a capital contribution (as appropriate), or, in appropriate cases, as a repayment of the allocated amount without additional income tax consequences.5 Rev. Proc. 99-32 allows taxpayers to elect deemed indebtedness and repatriation to avoid or mitigate these collateral tax consequences.
Suggested action items for a successful year-end
- Perform inventory of I/C transactions. Pay particular attention to material transaction amounts. Determine whether there are any new intercompany transactions for which a provisional policy was applied.
- Evaluate year-to-date (YTD) results. It is a best practice to periodically evaluate transfer pricing results, preferably well before year-end, such as on a monthly or quarterly basis. Performing evaluations proactively instead of waiting until year-end allows for pricing adjustments to be made and impact profitability during the same fiscal year. This process does require time and resources, particularly for organizations with a complex web of intercompany transactions. Segmentations and other data processing may be required in order to perform reliable analyses.
- Assess potential adjustments. If it appears that transfer pricing adjustments are needed, assess the drivers for the YTD results: Are they company-specific, country-specific, and are there significant variances or misapplications of transfer pricing policy? At that point, it would be helpful to review the forecast for the remainder of the year and determine whether further adjustments will be needed before the books are closed.
- Evaluate implications of TP adjustments. While conceptually a transfer pricing adjustment is relatively easy to assess and explain, in practice it can be more complicated. If the true-ups are done at the end of the year, consideration should be given to whether retroactive pricing changes are allowed in both jurisdictions involved. Does the revision of prices require new invoices to be issued and old invoices to be cancelled? That can create a significant administrative burden, particularly in jurisdictions where invoices are filed with local authorities. Finally, what are the customs and duties implications with a change in prices?
- Liaise with accounting and tax departments to book entries for current year. It is important for the transfer pricing manager to liaise with the accounting and tax departments to book the entries correctly and on a timely basis.
- Liaise with FP&A to determine if projections/forecasts need to be revised for next year. An evaluation of transfer pricing prior to year-end is helpful not only in addressing current year issues but also in avoiding challenges in the next year. Budgeting and price setting in most companies is typically done in summer/fall for next calendar year. Hence, insight from current year’s review can inform budgeting and price setting for next year.
- Liaise with legal department to update intercompany agreements need to be updated. To the extent that policies need to be updated, it is recommended that intercompany agreements are also revised or updated to reflect the new policies.
The conclusion is unmistakable – a proactive approach to monitoring transfer pricing and making changes before year-end is the preferred approach. This approach reduces tax and transfer pricing compliance issues and reduces risk exposure. It is particularly helpful during periods of notable instability, such as COVID-triggered business interruptions, supply chain issues, higher than normal inflation, and other macro-shocks.
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