Complying with global transfer pricing rules.

The intercompany transfer pricing guidelines provided in regulations under Internal Revenue Code section 482 allow corporations with cross-border transactions increased flexibility when determining intercompany pricing methodologies. In July 1994, the Internal Revenue Service amended the temporary and proposed regulations under IRC sections 6662(e) and 6662(h), which apply accuracy-related penalties to transfer pricing provisions. Under these provisions, sizable penalties apply to adjustments to taxable income resulting from transfer pricing valuation misstatements. A penalty of 20% of the additional tax would apply if the adjustment increases income by the lesser of $5 million or 10% of gross receipts. A penalty of 40% applies to adjustments of $20 million or 20% of gross receipts.

These penalties may be avoided if

* The taxpayer selects and applies a transfer pricing method using the "reasonable application standard."

* The taxpayer maintains sufficient contemporaneous documentation to prove the selected method, as well as its application, provided the most accurate measure of an arm's length result under the principles of IRC section 482's best method rule.

Taxpayer strategies

Although most taxpayers agree that the penalty regulations present a tremendous burden, they have adopted various strategies to deal with them as painlessly as possible. Some hope for changes in the penalty provisions or harmonization between the United States and the Organization for Economic Cooperation and Development on the basic transfer pricing rules. Trade organizations frustrated with the administrative chore of the reasonable application standard and the contemporaneous documentation requirement--including the International Electronics Manufacturers and Consumers of America, the International Chamber of Commerce, the Japan Tax Association and the Tax Executives Institute--have lobbied the IRS for modifications in the penalty regulations. Richard Hammer, partner of Price Waterhouse in New York and member of the U.S. Council for International Business, said the most current data requirement and the need to disprove other methods "represent a financial burden far in excess of any reliability that could be obtained" from the penalty provisions' implementation. Most taxpayers share Hammer's sentiments regarding compliance to avoid the section 6662(e) penalty. However, faced with the possibility of substantial penalties, they generally choose one of the following practical alternatives to tackle the reasonable application and contemporaneous documentation requirements.

The APA alternative

Some taxpayers believe advanced pricing agreements (APAs) are the best way to cope with the penalty regulations. APAs give taxpayers the opprotunity to obtain prior approval of their transfer pricing methodology from the IRS and foreign tax authorities. This is particularly helpful if the taxpayer implements a method not specified in the 482 regulations or has unusual facts and circumstances that affect the profitability of an intercompany transaction. However, APAs are complex, lengthy and costly. They can involve onerous documentation and administration and require professional expertise. The success and attractiveness of APAs to companies will depend on cost--benefit analyses by individual businesses. Although APAs may be an ideal solution for some taxpayers, most would be advised to rely on an experienced transfer pricing professional to resolve their intercompany pricing issues.

Relying on a professional

The section 6662 penalty regulations specifically state that reliance on a qualified professional is a key determinant when the IRS evaluates the "reasonableness" of a taxpayer's application of section 482 transfer pricing rules. An objective and thorough study by an in-house expert is satisfactory.

Saving money

Many midsized companies want to adopt a pragmatic and less burdensome compliance approach to satisfy the tax examiner and avert an audit controversy. The first step is a preliminary in-house review of existing intercompany transactions, contracts and pricing methods and strategies. The second involves comparing the taxpayer's financial ratios to comparable industry financials. Such a preliminary review may determine whether the taxpayer's profitability resulting from its existing transfer prices is reasonable relative to similar uncontrolled companies. This analysis also can help to estimate the level of risk of a tax audit. The taxpayer can then consult a tax professional to mitigate risk.

Using a PC

Many cost-conscious multinationals that want the comprehensive benefits of a transfer pricing and contemporaneous documentation study performed by a professional services firm without the hourly fees are turning to a "virtual specialist" in the form of transfer pricing documentation software. Guiding taxpayers through the data collection and pricing analysis processes, these Windows-based applications gather, organize and store information on functions, risks and comparables that will document the taxpayer's transfer pricing decisions. The software is useful for ongoing tax planning and periodic review of transfer pricing practices. Nonetheless, the judgment of an experienced transfer pricing specialist is still necessary for critical tasks such as selecting the best method and evaluating whether existing documentation is sufficient.

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