Much of the professional transfer-pricing literature focuses on determining arm’s-length transfer prices for various intercompany transactions. This focus is perfectly understandable. Many countries require that taxpayers document annually that their intercompany transfer prices are at arm’s length. The logical first step in preparing a transfer-pricing analysis is thus to determine what constitutes an arm’s-length transfer price.
Less in the spotlight, however, is what happens when a transfer price is not at arm’s length and must be adjusted. In the current economic environment, many countries in the world have budget deficits. Focusing on transfer prices between related parties seems to be a sure way for many countries to increase tax revenues (or at least protect their tax base). As a result of their focus on transfer pricing, more and more tax authorities are uncovering non-arm’s-length transfer prices during tax audits. To comply with the arm’s-length standard throughout the world, satisfy local country transfer-pricing documentation requirements, and avoid imposition of transfer-pricing penalties, many taxpayers are using transfer pricing offensively by initiating transfer-pricing adjustments on their own.
A counterparty is involved in any intercompany transaction—a transfer-pricing adjustment to one party causes secondary financial consequences in the multinational group. For U.S. taxpayers, in addition to the tax impact of the initial transfer-pricing adjustment, these secondary financial consequences trigger their own secondary tax consequences. Given the historical focus on determining arm’s-length transfer prices, many U.S. taxpayers are unaware of the secondary U.S. tax consequences that result from a transfer-pricing adjustment.
The purpose of this article is first to explain to readers how a transfer-pricing adjustment triggers secondary financial consequences in the multinational group. The article then explains how the U.S. transfer-pricing rules 1 address and classify the secondary tax consequences for U.S. taxpayers that result from these secondary financial consequences. The article details the relief the IRS provides to qualified, electing taxpayers to avoid the secondary U.S. tax consequences that arise from transfer-pricing adjustments. Finally, the article explains why taxpayers need to perfect their transfer prices on timely filed U.S. tax returns or risk losing U.S. tax deductions for overlooked deductions related to transfer prices.
Two Types of Transfer-Pricing Adjustments
This article first describes the two broad types of transfer-pricing adjustments: (1) primary adjustments and (2) secondary, or compensating, adjustments. A primary adjustment is an initial transfer-price adjustment, whereas a secondary adjustment is a collateral adjustment that the counterparty involved in the transaction must make.
Once a transfer price is found to be not at arm’s length, then an adjustment (the primary adjustment) has to be made to either increase or decrease the transfer price. Depending upon the direction of the primary adjustment, the consequences to the taxpayer are fairly obvious: The taxpayer’s tax liability will be either increased or decreased; the taxpayer might owe interest on a tax underpayment, or it might be owed interest on a tax overpayment. In the case of a transfer-price adjustment that results in a U.S. tax underpayment, the taxpayer may also owe a penalty. 2
IRS-initiated primary adjustment: Most tax practitioners are aware that Sec. 482 establishes the internationally accepted arm’s-length standard. Many tax practitioners outside of the international arena are surprised, however, that the actual language of Sec. 482 says nothing about the arm’s-length standard, and that it does not even refer to the taxpayer. Instead, Sec. 482 is addressed exclusively to the secretary of the Treasury and allows him or her to allocate income and deductions among two or more controlled trades or businesses “to prevent evasion of taxes or clearly to reflect the income” of the trades or businesses. 3
Given the terseness of Sec. 482, its substance is contained in a detailed set of regulations 4 issued over the past 45 years. Regs. Sec. 1.482-1(a)(2) describes the IRS’s authority to make allocations (i.e., to adjust transfer prices):
The [IRS] may make allocations between or among the members of a controlled group if a controlled taxpayer has not reported its true taxable income. In such case, the [IRS] may allocate income, deductions, credits, allowances, basis, or any other item or element affecting taxable income. . . . The appropriate allocation may take the form of an increase or decrease in any relevant amount.
Two examples of IRS-initiated transfer-pricing adjustments follow.
Example 1. IRS-initiated primary adjustment: In year 1, U.S. Parent allows its wholly owned foreign subsidiary, ForSub, to use certain equipment at no charge. Upon IRS examination of year 1, which occurs in year 3, the IRS determines that the year 1 arm’s-length charge for the use of the property is $50,000.
For year 1 the IRS allocates $50,000 of income from ForSub to U.S. Parent (the primary adjustment) to reflect an arm’s-length charge for the use of the property. Accordingly, the IRS’s primary adjustment increases U.S. Parent’s year 1 taxable income by $50,000.
Tax impact of primary allocation: In this example, unless it has other tax attributes that would shelter the increased U.S. income from tax, the primary adjustment causes the U.S. Parent to owe U.S. income tax. Since the primary adjustment was made in year 3, the U.S. Parent would also likely owe interest, and possibly an underpayment penalty, on the underpaid year 1 tax. Given the size of the primary adjustment, the U.S. Parent might also owe a Sec. 6662 transfer-pricing penalty 5 on the year 1 tax underpayment.
The primary adjustment has reduced U.S. Parent’s foreign-source income from year 1. This reduction likely impacts the foreign tax credit computations the U.S. Parent made when it originally prepared its year 1 U.S. income tax return.
Example 2. IRS-initiated primary adjustment: In year 1, USSub sells tangible property to Foreign Parent for $75,000. Upon IRS examination of year 1, which also occurs in year 3, the IRS determines that the year 1 arm’s-length charge for the property is $100,000. 6 The IRS thus allocates $25,000 of income from Foreign Parent to USSub for year 1 (the primary adjustment) to reflect an arm’s-length charge for the property. Accordingly, the IRS’s primary adjustment increases USSub’s year 1 taxable income by $25,000.
Tax impact of primary allocation: As with Example 1, in this Example 2, unless USSub has other tax attributes that would shelter the increased U.S. income from tax, the primary adjustment causes the USSub to owe U.S. income tax. Again, since the primary adjustment was made in year 3, USSub would also likely owe interest, and possibly an underpayment penalty, on the underpaid year 1 tax. Given the size of the primary adjustment, the USSub might also owe a Sec. 6662 transfer-pricing penalty 7 on the year 1 tax underpayment.
Taxpayer-initiated transfer-pricing adjustments: Not all transfer-pricing adjustments are made by the IRS. 8 As noted, the language of Sec. 482 does not speak to the taxpayer at all, but allows only the IRS to make a transfer-pricing adjustment (i.e., allocations) to a U.S. taxpayer’s income. Even though Sec. 482 does not explicitly allow it, Regs. Sec. 1.482-1(a)(3) provides that a U.S. taxpayer may actually make transfer-pricing adjustments on its own:
If necessary to reflect an arm’s length result, a controlled taxpayer may report on a timely filed U.S. income tax return (including extensions) the results of its controlled transactions based upon prices different from those actually charged.
Even though it might be at odds with the clear language of Sec. 482, because of the enactment of the onerous transfer-pricing penalty, 9 the regulations give taxpayers the ability to self-correct their transfer prices to avoid this penalty. Equally importantly, many U.S. taxpayers close their accounting books and records well before they file their U.S. tax returns, so U.S. taxpayers must be able to use the self-adjustment mechanism even after their accounting books and records have been closed.
Regs. Sec. 1.482-1(a)(3) further provides:
Except as provided in this paragraph, section 482 grants no other right to a controlled taxpayer to apply the provisions of section 482 at will or to compel the [IRS] to apply such provisions. Therefore, no untimely or amended returns will be permitted to decrease taxable income based on allocations or other adjustments with respect to controlled transactions.
Although a taxpayer may generate a book-tax difference for transfer prices for a particular year, once the taxpayer has filed its tax return, it may only make transfer-pricing adjustments that increase its U.S. taxable income. In the case where a taxpayer has uncovered a transfer-pricing error in its favor in a prior year, it cannot file an amended U.S. return with reduced taxable income and request a refund of taxes. Regs. Sec. 1.482-1(a)(3) also clearly provides that a taxpayer cannot compel the IRS to make a transfer-pricing adjustment in the taxpayer’s favor. The regulations thus encourage taxpayers to “come clean” and correct their transfer prices, but only if the correction benefits the U.S. government.
Given the multijurisdictional focus of the global economy, and because most foreign countries also have enacted strict transfer-pricing documentation requirements, this U.S.-centric focus means that a U.S. multinational taxpayer must focus on satisfying the transfer-pricing requirements of all of the jurisdictions in which it operates in the current year. If it does not ensure allocations are properly made by the time the U.S. tax return is filed, then the U.S. taxpayer may risk losing U.S. tax deductions because the U.S. multinational taxpayer will not be able to amend prior years’ tax returns to decrease U.S. taxable income. This U.S.-centric focus on adjustments, and the confusion that results when a U.S. taxpayer computes transfer prices based upon tax results, not on transfer prices as reported in its books and records, also likely results in more, and prolonged, transfer-pricing disputes.
An example of a taxpayer-initiated transfer-pricing adjustment follows:
Example 3. Taxpayer-initiated primary adjustment: Foreign Parent charges its wholly owned U.S. subsidiary, USSub, $100,000 to use certain equipment in year 1. After its books are closed, but before its U.S. tax return is filed for year 1, USSub’s advisers determine that the arm’s-length charge for the use of the property is really only $65,000. Accordingly, USSub books a taxpayer-initiated transfer-pricing adjustment (primary adjustment) to increase its year 1 taxable income by $35,000.
U.S. tax impact of primary allocation: As a result of USSub’s transfer-pricing adjustment, USSub pays more U.S. tax on its increased income. However, USSub owes no interest or penalties on underpaid U.S. tax and would not be subject to any U.S. transfer-pricing penalty. As illustrated in Examples 1 and 2, this would not be the case if the IRS were to make the $35,000 transfer-pricing adjustment in year 3 when it examines USSub’s year 1 tax return.
Secondary, or Compensating, Adjustments
A counterparty is involved in any intercompany transaction. A primary adjustment also affects the counterparty, and causes secondary financial consequences within the taxpayer’s group of companies. As a result, secondary adjustments (referred to in the regulations as collateral adjustments), may be required so that the counterparty properly records the primary adjustment in its books and records. Regs. Sec. 1.482-1(g) addresses collateral adjustments:
The [IRS] will take into account appropriate collateral adjustments with respect to allocations under section 482. Appropriate collateral adjustments may include correlative allocations, conforming adjustments, and setoffs. 10
Correlative adjustments: Regs. Sec. 1.482-1(g)(2)(i) provides that:
When the [IRS] makes an allocation under section 482 (referred to in this paragraph (g)(2) as the primary allocation) [to the income of one member of a group of controlled taxpayers,] appropriate correlative allocations will also be made with respect to any other member of the group affected by the allocation.
Logically, a correlative adjustment has exactly the opposite effect on the counterparty’s taxable income as the primary adjustment had on the first party’s taxable income. The correlative adjustment also affects the amount of the counterparty’s earnings and profits (E&P) for U.S. tax purposes. The E&P adjustment would further impact the counterparty’s taxability for future dividends, and foreign tax credit computations, for U.S. tax purposes.
U.S. tax impact of collateral allocation in Example 1: In Example 1, the income (and accumulated E&P) of ForSub for U.S. tax purposes would be decreased by $50,000 because of the collateral adjustment.
Foreign country tax impact of collateral adjustment in Example 1: The tax laws of the country where the counterparty, ForSub, is located might not allow ForSub to decrease its taxable income after the fact. 11 If ForSub was located in a country that had an income tax treaty with the United States, since the IRS initiated the transfer-pricing adjustment, the applicable income tax treaty should allow ForSub to deduct the amount of the correlative adjustment for local country tax purposes under the treaty’s mutual agreement procedure (MAP) provision.
If the taxpayer is not allowed a deduction and thus is subject to double taxation, the taxpayer can request relief through competent authority assistance, in which the designated tax authorities (the competent authorities) of the two countries consult to determine the proper tax treatment. If no competent authority relief were available (i.e., there was no income tax treaty with a mutual agreement procedure (MAP)), then international double taxation would result.
U.S. tax impact of collateral allocation in Example 2: In Example 2, the collateral adjustment is made to Foreign Parent, who is presumably subject to U.S. tax only through the operations of USSub. The major impact of the collateral adjustment is that USSub’s earnings and profits (E&P) are increased, which increases the chance that USSub’s distributions to Foreign Parent are categorized as dividends for U.S. tax purposes.
Foreign country tax impact of collateral adjustment in Example 2: As in Example 1, the tax laws of the country where the counterparty, Foreign Parent, is located might not allow Foreign Parent to decrease its taxable income after the fact. 12 Competent Authority relief might be available for Foreign Parent under the applicable income tax treaty. If there were no income tax treaty, then international double taxation would result.
U.S. tax impact of collateral adjustment in Example 3: In Example 3, the taxpayer, USSub, included the taxpayer-initiated primary adjustment in its timely filed U.S. tax return, so there is no collateral adjustment that must be made from the U.S. perspective.
Foreign country tax impact of taxpayer-initiated adjustment in Example 3: Presumably, Foreign Parent would also include the taxpayer-initiated primary adjustment in its local country tax return and would be entitled to decrease its local country income accordingly.
In Example 3, because the IRS did not make the adjustment, no tax authority action has taken place that would trigger the MAP under the applicable income tax treaty. If Foreign Parent could not record the corresponding decrease to its taxable income caused by the taxpayer-initiated primary adjustment (because the accounting books had already been closed, for example), then international double taxation would result.
The primary and correlative adjustments only shift taxable income, and thus income tax liability, from one party to the other party. After the primary and correlative adjustments have been recorded, however, the non-arm’s-length piece of the intercompany payment (i.e., the related cash) belongs, for tax purposes, to a different entity from the one that originally recorded the transaction.
The taxpayer’s tax accounts and cash accounts are thus not in balance. A final adjustment (the conforming adjustment) is required so that the cash accounts and the tax accounts of the parties can be equalized.
Regs. Sec. 1.482-1(g)(3)(i) describes conforming adjustments:
Appropriate adjustments must be made to conform a taxpayer’s accounts to reflect allocations made under section 482. Such adjustments may include the treatment of an allocated amount as a dividend or a capital contribution (as appropriate), or, in appropriate cases, pursuant to such applicable revenue procedures as may be provided by the Commissioner . . . , repayment of the allocated amount without further income tax consequences.
Under Regs. Sec. 1.482-1(g)(3)(i) above, the non-arm’s-length piece of the intercompany payment (i.e., the excess cash) would be treated as a dividend or a capital contribution for U.S. tax purposes. This is consistent with established U.S. tax principles that provide that a transfer of property by a subsidiary to its parent shareholder for less than fair market value is treated as a dividend by the parent shareholder. Conversely, a transfer of property by a parent shareholder to its subsidiary for more than fair market value is treated as a contribution to capital by the subsidiary.
Conforming adjustment in Example 1: In Example 1, as a result of the underpayment of rent expense, ForSub has $50,000 more cash than it is entitled to. This excess cash held by ForSub (the conforming adjustment) would be deemed to be a capital contribution by U.S. Parent to ForSub for U.S. tax purposes.
Conforming adjustment in Example 2: In Example 2, as a result of its underpayment for the tangible property, Foreign Parent has $25,000 more cash than it is entitled to. This excess cash held by Foreign Parent (the conforming adjustment) would be deemed to be a dividend payment from USSub to Foreign Parent for U.S. tax purposes. This deemed dividend payment would decrease USSub’s E&P. The dividend payment could be subject to U.S. withholding tax 13 when paid to Foreign Parent.
Conforming adjustment in Example 3: In Example 3, as a result of the overpayment of equipment rent, Foreign Parent has $35,000 more cash than it is entitled to. This excess cash held by Foreign Parent (the conforming adjustment) would also be deemed to be a dividend payment from USSub to Foreign Parent for U.S. tax purposes. As in Example 2, this deemed dividend payment would decrease USSub’s E&P and could be subject to U.S. withholding tax 14 when paid to Foreign Parent.
IRS Relief From Conforming Adjustments
As illustrated above, under the regulations, primary adjustments trigger collateral U.S. tax consequences. In Example 1, U.S. Parent’s foreign tax credit computations originally made in year 1 were also likely affected by the decrease in foreign-source income. In Examples 2 and 3, the U.S. taxpayer may incur additional U.S. withholding taxes 15 from the deemed dividends paid to Foreign Parent.
Taking these circumstances into account, under the authority of Regs. Sec. 1.482-1(g)(3)(i), the IRS issued Rev. Proc. 99-32 16 to provide a means by which U.S. taxpayers can avoid or mitigate such potential detrimental collateral tax consequences. If a taxpayer elects under the revenue procedure, the taxpayer will be allowed to repatriate cash corresponding to the amount allocated in a primary adjustment by establishing an interest-bearing account receivable from, or payable to, the related party, thereby avoiding the federal income tax consequences of the collateral adjustments that might otherwise result. In Examples 2 and 3, rather than dealing with the withholding obligation that might result from the recharacterization of the excess profits of a foreign parent as a dividend, the taxpayer could transform the excess profit into a loan and repay it without further income tax consequences. 17
The election is not automatically available to all taxpayers. An IRS-initiated adjustment of a U.S. taxpayer will be eligible for treatment under Rev. Proc. 99-32 provided that no transfer-pricing penalty 18 exists with regard to the transfer-pricing adjustment and no portion of the adjustment is due to taxpayer fraud. 19 An adjustment initiated by a U.S. taxpayer will be eligible for treatment under Rev. Proc. 99-32 provided that the taxpayer is bound by the treatment provided by the revenue procedure. 20
Information to Be Submitted
Provided a taxpayer is eligible, the taxpayer must submit a number of documents to avail itself of the benefits of the Rev. Proc. 99-32 election.
IRS-initiated transfer-pricing adjustments: To elect treatment under Rev. Proc. 99-32, a taxpayer whose taxable income has been adjusted by the IRS must file a request in writing with the IRS before closing action is taken on the primary adjustment. 21 For these purposes, “closing action” means any of the following:
- Taxpayer’s execution and acceptance of a Form 870-AD, Offer to Waive Restrictions on Assessment and Collection of Tax Deficiency and to Accept Overassessment;
- Taxpayer’s execution of a closing agreement;
- Stipulation to the Sec. 482 allocation in Tax Court;
- Expiration of the statute of limitation on assessments; or
- Final determination of tax liability for the year to which the allocation relates by offer-in-compromise, execution of a closing agreement, or court action.
The taxpayer’s request, which must be signed by a person having the authority to sign the taxpayer’s federal income tax returns, must include:
A statement that the taxpayer desires the treatment provided by Section 4 of Rev. Proc. 99-32;
Designation of the years for which such treatment is requested;
Description of the arrangements or transactions that gave rise to the primary adjustment; and
An offer to enter into a closing agreement with the IRS that will memorialize the treatment afforded under Rev. Proc. 99-32.
Upon the IRS’s determination that Rev. Proc. 99-32 applies and an agreement on the amount of the primary adjustment, the IRS will enter into a closing agreement with the taxpayer.
Taxpayer-initiated transfer-pricing adjustments: To elect treatment under Rev. Proc. 99-32, a taxpayer making a self-initiated adjustment must file a statement with the tax return reporting the primary adjustment. 22 The statement must include:
- A statement that the taxpayer desires the treatment provided by Section 4 of Rev. Proc. 99-32 for the years indicated and acknowledges that it will be bound by its election of this treatment;
- Description of the arrangements or transactions that gave rise to the primary adjustment and the amount of the primary adjustments;
- Description of any correlative adjustments;
- Amount and currency of any indebtedness created by Rev. Proc. 99-32;
- Obligee(s) and obligor(s) with respect to such indebtedness;
- Amount (and timing) of any interest includible or deductible with respect to such indebtedness;
- Amount of any foreign tax credit claimed with respect to payment(s) on the indebtedness; and
- Manner and payment of the indebtedness.
In Example 1, Rev. Proc. 99-32 would allow U.S. Parent to offset its deemed capital contribution against any valid debt U.S. Parent owes to ForSub. 23 Otherwise, U.S. Parent’s deemed capital contribution to ForSub would not trigger any adverse tax consequences to either U.S. Parent or ForSub.
In Examples 2 and 3, instead of being classified as a deemed dividend, under the provisions of Rev. Proc. 99-32, USSub would establish the interest-bearing account receivable from Foreign Parent for the excess cash Foreign Parent holds as a result of the primary adjustment. 24
This article shows that while the focus on determining what is an arm’s-length transfer price is important, U.S. taxpayers must be aware of the collateral U.S. tax consequences that result when a transfer price is not found to be at arm’s length. Whether the primary adjustment is initiated by the IRS, by a foreign tax authority, or by the taxpayer itself, U.S. taxpayers should determine whether they can use the relief the IRS provides in Rev. Proc. 99-32. If the U.S. taxpayer does not qualify, or chooses not to use the relief provided by Rev. Proc. 99-32, then the U.S. taxpayer must be aware of the collateral U.S. tax consequences resulting from collateral and conforming adjustments.
The regulations have adopted a U.S.-centric focus to adjusting transfer prices, so U.S. taxpayers need to ensure transfer prices have been properly recorded by the time they file their U.S. tax return. If transfer prices are not recorded on timely filed U.S. tax returns, the U.S. taxpayer will not be able to amend prior years’ tax returns to decrease U.S. income for overlooked deductions.
1 Sec. 482 and the Treasury regulations promulgated thereunder.
2 Secs. 6662(e) and (h) establish transfer-pricing penalties of 20% or 40%, respectively, on the increase in tax resulting from transfer-pricing adjustments.
3 Sec. 482, first sentence.
4 Regs. Secs. 1.482-1 et seq. A complete discussion of the Sec. 482 regulations is beyond the scope of this article.
5 See footnote 2.
6 Increasing the transfer price of the tangible property might also raise customs issues for Foreign Parent in this case. A discussion of these customs issues is outside of the scope of this article, however.
7 See footnote 2.
8 A foreign tax authority could also initiate a transfer-pricing adjustment.
9 See footnote 2.
10 Regs. Sec. 1.482-1(g)(1). Setoffs, which occur when there is more than one non-arm’s-length transaction between the same controlled taxpayers that require an allocation, are not discussed in this article. See Regs. Sec. 1.482-1(g)(4).
11 Recall that the IRS adjustment for year 1 was made in year 3.
12 Recall that the IRS adjustment for year 1 was made in year 3.
13 Sec. 881.
16 Rev. Proc. 99-32, 1999-2 C.B. 296.
17 Rev. Proc. 99-32, §1.
18 Rev. Proc. 99-32, §3.01.
19 Rev. Proc. 99-32, §3.03.
20 Rev. Proc. 99-32, §3.02.
21 Rev. Proc. 99-32, §5.01.
22 Rev. Proc. 99-32, §5.02.
23 Rev. Proc. 99-32, §4.02.
24 Rev. Proc. 99-32, §4.01.
James Hill is a director in the Grant Thornton LLP Transfer Pricing Practice in Los Angeles. For more information about this article, please contact Mr. Hill at email@example.com.