CPAs Provide Expertise for Transfer Pricing Analyses

MAY 2010

Transfer pricing, the process by which multinational companies set arm’s-length prices for cross-border transactions within a corporate group, is complex and consistently ranks as the No. 1 international tax issue facing multinational companies, according to Ernst & Young’s 2009 Global transfer pricing survey. To avoid penalties and potential interest, most tax authorities require taxpayers to prepare annual transfer pricing reports when they file tax returns.

During its infancy, transfer pricing was dominated by economists. However, as global transfer pricing regulations developed, international examiners gained experience and financial accounting standards evolved. Consequently, companies now need experienced tax accountants not only to validate the reliability of the data during tax controversies but also to guide taxpayers during implementation. There is definitely still a role for economists on project teams, but CPAs are probably more conversant with such steps as making a compensating adjustment journal entry or quantifying FIN 48 risks (FASB Interpretation no. 48, Accounting for Uncertainty in Income Taxes, now codified in FASB ASC Topic 740) for financial reporting purposes.

Stuart Rohatiner, CPA, JD

Below are examples of transfer pricing issues where expert accounting skills are important:

Financial reporting. Certain industries have unique accounting revenue and expense treatment, and to calculate the appropriate benchmark ratios for transfer pricing purposes, an accountant needs to analyze the financial statement footnotes and understand which items are characterized as operating, pass-through, etc. For example, the income statements for a professional services firm include a special line item called “reimbursements” under the revenue and cost-of-sales categories. Reimbursements are generally pass-through contractor costs and reimbursed expenses and would likely be excluded from the operating revenue and operating expense calculations for transfer pricing purposes. In addition, with the currently volatile economy and corresponding impact on profitability, companies are increasingly monitoring their taxable income in each jurisdiction and likely making year-end compensating adjustments to the books and records to get profit margins within the arm’s-length ranges.

Transfer pricing audit document requests. The IRS and other tax authorities historically requested that taxpayers provide copies of their transfer pricing reports to support their pricing during audit years. Fast-forward to the current environment, and a typical audit request specifies tying the transfer pricing data from reports to general ledgers, consolidating income statements and balance sheets.

FIN 48 analysis. Public companies and their auditors are now required to analyze the income tax calculations and determine if the company needs to quantify and include in the financial statements any tax exposures that are “more likely than not” to be sustained upon examination. Auditors have increasingly identified transfer pricing risks, especially adjustments and penalties proposed by tax authorities, and forced taxpayers to disclose the details in SEC public filings and book reserves.

Reliability of financial data. Since much of transfer pricing financial analysis involves comparing unaudited financial statements with audited ones, a tax accountant who can validate the reliability of the unaudited data is invaluable, especially in tax controversy settings.

IRS analysis of adjustments and methods. The trend toward an increased focus on the accounting details of intercompany transactions may be a result of the IRS’ hiring international examiners with accounting backgrounds. Whatever the reason, the IRS has placed a new emphasis on reviewing all accounting and functional differences between the taxpayer-tested party and the comparable companies selected in the transfer pricing report. For example, during a recent meeting of a taxpayer with the IRS, the IRS international examiner compared each accounting line item from the taxpayer’s annual report with those of the comparable companies to make sure that adjustments were considered for any differences in functions or risks. Similarly, the examiner insisted on analyzing all potential transfer pricing methods and profit level indicators available, even though the IRS had agreed to the same method and profit level indicator with the taxpayer twice previously and the facts hadn’t changed significantly.

It shouldn’t come as a surprise that with the increasing complexity of transfer pricing and diminishing taxable income of corporations, the level of scrutiny by tax authorities has risen exponentially. In fact, in 2009, the IRS announced plans to hire an additional 800 agents in fiscal 2010 to focus on international examinations, and the agency’s proposed fiscal 2011 budget contains funding for 800 more. The field of transfer pricing will continue to grow and present employment opportunities for practitioners with the desired blend of economics and tax accounting skills.

 By Steve Snyder, CPA/CFF, CVA

Cross-Border Tax Issues

 By JAMES COLLINS , JOURNAL OF ACCOUNTANCY, FEBRUARY 2010 CFOs can exercise reasonable diligence to ensure that they have procedures in place to deal with some of the more common shortcomings in cross-border tax compliance. The following are some routine tax compliance situations that U. S. companies ($500 million or less in sales) with outbound activities are most likely to encounter:

1.  Ensure that intercompany working capital accounts to the parent company and among foreign affiliates are settled every 120 days or that market interest is charged on overdue receivables. Buildups of intercompany payables to a foreign parent or affiliate, without regular and ongoing settlement, can cause the IRS to impute interest income to the creditor for U.S. tax purposes.

2. Document foreign payments at reduced or zero rates of withholding tax. The payer is liable for withholding tax that it fails to withhold and bears the burden of proof that the proper amount has been withheld. Prudent CFOs will periodically test to ensure that their accounts payable personnel are familiar with foreign withholding tax rules and are maintaining proper documentation for payments made overseas.

3. Address intercompany cross-border pricing issues. The ultimate protection against IRS tax assessments on pricing issues is an advanced pricing agreement (APA) whereby the IRS abides by intercompany pricing it has already reviewed with the taxpayer and its representatives (usually an economist, accountant or lawyer). The next level of security is a pricing study whereby a professional firm compiles and reviews a company’s intercompany pricing arrangements, analyzes them, and issues a report. Finally, a company can greatly reduce the exposure for routine transactions by finding comparable transactions with unrelated parties and ensuring that charges and costs for transactions among related companies are comparably priced.

4. Determine tax status of foreign affiliates. If a U.S. company owns shares in a foreign company, it may qualify as a passive foreign investment company if it has a high proportion of assets or income that is passive. For this purpose, cash is considered a passive asset, so newly formed companies are especially vulnerable. If a U.S. company owns 10% or more of a foreign corporation, it should evaluate whether other U.S. shareholders that each own a 10% or greater interest own in aggregate an additional 40%. If they do, the foreign affiliate likely is a controlled foreign corporation, subject to the anti-deferral regime of subpart F of the Internal Revenue Code.

5. Ensure that interest expense due to foreign affiliates is deducted on a cash basis on the U.S. tax return. For tax purposes, interest accrued to foreign affiliates is usually deductible, but only when actually paid.

6. Evaluate whether the company is obligated to file Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, and Form 8865, Schedule O, Transfer of Property to a Foreign Partnership (under section 6038B). If a U.S. company owns 10% or more of a foreign-organized affiliate or it has contributed more than $100,000 in property to a foreign partnership during any 12-month period, the company should evaluate whether it must file Form(s) 8865 and Schedule O. File forms 5471 and 8865 with the tax return for each separate controlled foreign corporation or foreign partnership.

7. Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, and Form 8865 are required for each separate legal entity, even if the companies are organized in the same country and even if a subconsolidation of financial information for two or more separate foreign entities is available. —By James Collins (jcollins@friedmanllp.com), a senior manager at Friedman LLP in New York.