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From “A Primer on Transfer Pricing” by Robert J. Misey, Jr., updated by Kimberlee S. Phelan

 

A transfer price is the price charged for intercompany transactions.  The principles of I.R.C. section 482 require that intercompany transactions be priced at arm’s length.  Although ostensibly a simple concept, the arm’s length standard has spawned hundreds of pages of regulations.

 

Transfer pricing continues to be a hot issue for multi-national companies.  Mr. Misey has learned informally from his former colleagues at the I.R.S. that companies with sales in excess of $15 million in sales can expect to have an I.R.S. economist review their intercompany transactions.  Because intercompany transactions across international borders continue to expand and because the I.R.S. continues to rigorously review intercompany transactions, transfer pricing is more than just the international tax issue of today, it is the tax issue for this millennium.

 

Political awareness of the amount of taxes paid by foreign-owned companies, may have led many U.S.-based companies to not worry about transfer pricing.  However, the transfer pricing regulations can trap U.S.-owned companies with modest operations abroad just as easily as foreign-owned companies.

 

For example, suppose NJCo manufactures and sells widgets in the U.S.  Due to increased widget orders from Canadian customers, NJCo decides to form a Canadian distribution subsidiary (“CanSub”).  Although CanSub does not have any manufacturing functions, CanSub employs its own administrative and sales staff while using NJCo’s unique distribution software to ensure that there are not any distribution problems.  In an effort to make sure that CanSub is financially solvent, CanSub has payment terms to NJCo of six months and, if CanSub’s customers do not pay, CanSub enjoys the use of NJCo’s collection staff, which is comprised of former defensive linemen from Rutgers.

 

The Best Method Rule

The best method rule in the section 482 regulations states that the arm’s length result of a controlled transaction must be determined under the method that, given the facts and circumstances, provides the most reliable measure of an arm’s length result.  The application of the best method rule establishes an arm’s length range of prices or financial returns with which to test the controlled transactions.  The tested party must fall within the middle fifty percent of that range, known as the interquartile range.

 

In determining the most reliable measure of an arm’s length result, NJCo should consider the degree of comparability between controlled and uncontrolled transactions by analyzing the functions, contractual terms, risks, economic conditions, and the nature of goods and services supplied.  If this analysis requires numerous or sizable adjustments to meet comparability, the comparable may not be reliable.

 

Future blogs will review how the U.S. transfer pricing regulations affect the intercompany transactions between NJCo and CanSub.

 

 

 

For additional information, please contact Kimberlee Phelan or Robert Misey

 

Robert J. Misey, Jr.

Reinhart Boerner Van Deuren s.c.

Admitted in California, Wisconsin, and the District of Columbia

Milwaukee Office: 414-298-8135 

Cell: 414-550-3270

Chicago Office:  312-207-5456

rmisey@reinhartlaw.com

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