IRS officials recently announced an expected increase in the total number of penalties assessed against multi-entity corporations involved in transfer pricing. Historically, these penalties have been nominal and rarely enforced. However, with $80 billion in funding over the next decade, the IRS is looking to crack down on attempts to shift profits to low-tax jurisdictions.
Multi-entity corporations that determine earnings and profit at the entity level rather than the corporate level often attempt to shift profits out of high tax jurisdictions. This is a process known as transfer pricing. Corporations with foreign subsidiaries are required to engage in “arm’s length” transactions when shifting costs between entities. This requires each entity, regardless of if it is a subsidiary, to engage in transactions as if the parties were not related.
When done correctly, this can be a great way for larger entities to decrease taxes by shifting costs out of high tax jurisdictions and into low tax jurisdictions to reduce the total amount of taxable income. When done incorrectly, the corporation may face two types of penalties: transactional and net adjustment. The transaction penalty is assessed when the property or services claimed differ significantly from the transaction’s correct price. The net adjustment penalty is assessed when the net adjustments made from the transfer exceed certain thresholds of the total gross receipts for the year. In many cases, these penalties can be costly to corporations and may result in additional tax owed. In some cases, the penalties can exceed the taxes which would have otherwise been owed.
Despite an expected increase in penalty assessments, there is hope for corporations not in compliance. While the IRS hopes to increase the number of penalties asserted, the Service is hoping to bring about an early resolution for most cases. For multi-national corporations, ensuring your entities are in compliance is a must if you are hoping to avoid costly penalties and litigation.
In order to best ensure compliance when it comes to transfer pricing, it is encouraged that the business have a transfer pricing study. This study is a review by the entity which compares interrelated transactions with similar deals made with unrelated parties. The goal of such studies is to ensure that entities are engaging in arm’s length transactions and not cutting favorable deals in an effort to shift profits to low tax jurisdictions. For businesses without a transfer pricing study, a careful review of transactions to determine that goods or services are sold at or near their fair market value can be the difference between compliance and costly penalties. This can be a beneficial alternative to a full-blown transfer pricing study in order to determine each entity’s level of compliance.
If you believe your entity is non-compliant, or if you are uncertain if your practices are in compliance, a transfer pricing study and review from a tax professional is highly encouraged. Ensuring compliance now is the most effective and least costly way to avoid problems in the future.