2.USAco, a domestic corporation, wholly owns a foreign subsidiary in Hong Kong c
ID: 2421761 • Letter: 2
Question
2.USAco, a domestic corporation, wholly owns a foreign subsidiary in Hong Kong called HKco. USAco sells HKco the seven components necessary to make sunglasses. Following one page of directions written in Chinese, HKco employees put the components together to make the sunglasses for HKco’s sale throughout Europe. In order to determine whether USAco has any foreign base company sales income under Subpart F, the IRS needs to analyze whether HKco’s activities constitute manufacturing. What procedures can the IRS employ to gather the information needed to make this determination?
Explanation / Answer
Transfer pricing is the practice of charging one business for goods or services supplied by another business in the same group.
An intercompany transaction is recognized in the financial records of both units of the entity as if it were an arms-length transaction with an unrelated party.
The adjustments to cost allocations for intercompany asset transactions are necessary because the historical cost to the seller is the relevant basis for allocations on the consolidated income statement, not the historical cost to the buyer (buyers cost includes sellers profit margin). The restatement of the asset to the sellers historical cost occurs because, from the consolidated perspective, an arms-length transaction with an unrelated party has not occurred
The price should conform to the arms length principle: looking at any transaction between related parties, would two unconnected third parties have entered the agreement under the same terms and conditions
A service must confer an economic or commercial advantage to the recipient. Put another way, would an independent company be willing to pay for such a service? Examples of typical services include: administration, accountancy, marketing, recruitment, and training.
Followinga are some of intercompany transaction that USAco must price at arm's lenght in order to avoide penalty:
Appropriate charge for providing the staff to CANco to collect receivable.
Appropriate interest should be charged if USAco is proving loans.
Rent should be charged if USAco is providing space to CAnco for conducting business
Appropriate price should be set for all the transactions taking place between the two companies. A price is considered appropriate if it is within a range of prices that would be charged by independent parties dealing at arm's length. This is generally defined as a price that an independent buyer would pay an independent seller for an identical item under identical terms and conditions, where neither is under any compulsion to act.
Compliance techniques that USAco employ to minimize the risk of a transfer pricing penalty:
companies have multiple Enterprise Resource Planning (ERP) systems operating around the world due to historical factors. Multiple ERP systems with different data structures can lead to ineffi ciencies, increase the potential for inconsistent implementation of transfer pricing
conduct a comprehensive assessment of the intercompany environment. USAco may consider an evaluation that addresses all aspects of the intercompany lifecycle, including transfer pricing policy design, budgeting and forecasting, transaction execution, monitoring and adjustments, month-end accounting close, and tax compliance reporting.
USA co. must select one of the pricing methods specified in the regulations to test the arms-length character of its transfer prices. Under the Best Method Rule, given the facts and circumstances of the transactions under review, the pricing method selected should provide the most reliable measure of an arms-length result relative to the reliability of the other potentially applicable methods. In other words, while there may be more than one method which can be applied to a given set of facts and circumstances, the method that yields the most accurate, or best, result should be selected
Taxpayers with intercompany transactions must disclose detailed information on controlled transactions with foreign entities via forms 5471 and 5472 which are submitted along with their tax returns.
Acceptable TP methods for tangible and intangible property transfers include Comparable Uncontrolled Price (CUP)/Comparable Uncontrolled Transaction (CUT), resale price, cost plus, comparable profit, profit split and unspecified methods that comply with the arms length principle.
For tangible goods, the IRS accepts the CUP, Resale Price, Cost Plus, CPM, Profit Split, and unspecified methods. For intangible goods, the IRS accepts the CUT, CPM, Profit Split, and unspecified methods. For services, the IRS accepts the Services Cost, Comparable Uncontrolled Services Price, Gross Services Margin, Cost of Services Plus, CPM, Profit Split, and unspecified methods. For CSAs buy-ins, the IRS accepts the CUT, Income, Acquisition Price, Market Capitalization, Residual Profit Split and unspecified methods.
The principal documents required by the regulations are: An overview of the taxpayers business and an analysis of the legal and economic factors affecting pricing A description of the organizational structure Any documents explicitly required by regulations (e.g., CSA documents) A description of the pricing method and reasons why the method was selected (a best method analysis) A description of alternative methods and why they were not selected A description of controlled transactions and any internal data used to analyze them A description of comparables used, how comparability was evaluated and any adjustments that were made An explanation of any economic analysis and any projections used to develop the pricing method Any material data discovered after the close of the tax year but before filing the tax return A general index of the principal and background documents and a description of the recordkeeping system A general index of the principal and background documents and a description of the recordkeeping system
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