As governments worldwide struggle with record deficits and declining tax revenues, the pressure to generate more taxes is leading to increased scrutiny of multinational firms’ transfer-pricing methods by the Internal Revenue Service and foreign tax authorities.The crackdown on transfer pricing—the pricing of goods or services one unit of a company provides to another unit—comes with hefty penalties, says Horacio Peña, senior economist at PricewaterhouseCoopers. Penalties can hit 40% in the United States and go as high as 100% in Mexico and the U.K., Peña says. Developing nations are also getting into the act, including China, India and Brazil.
Steven Fortier, a principal at KPMG, says transfer pricing has become a “hot-button issue,” with corporate tax experts trying to reduce the risk of double taxation. A big focus in both the U.S. and Canada is outbound royalties, according to KPMG.
Peña says another key area in the U.S. is transfer pricing of intellectual property, particularly in the pharmaceutical, chemical and software industries.
The IRS has added 1,600 economists, lawyers and accountants to this effort over the past two years, doubling its resources. It has been expanding and rewriting the rules, too.
“I’ve been in transfer pricing for 22 years,” says Peña, “and I’ve never seen so many changes in rules as over the last three.”
There are steps finance executives can take to minimize the risk of audits and penalties. Avoiding penalties is critical, Peña says, because they can “snowball” as tax authorities target companies nailed for transfer pricing by another country.
The first step for a global firm should be doing an inventory of intra-company transactions, especially those involving affiliates in low-tax jurisdictions, Peña says.
Second, companies need good documentation for all transfer-pricing transactions. Otherwise, tax authorities are apt to review all of a company’s open tax years, so “you’re likely to get hit with a major adjustment,” Peña warns. A recent survey by Ernst & Young shows 74% of respondents say such documentation has become “more important than it was two years ago.”
Finally, Peña suggests companies go to the tax authorities to work out “advance pricing agreements,” effectively green-lighting transfer-pricing practices. The E&Y survey found 23% of companies were using such agreements in 2010.
If a company is embroiled in a dispute with IRS auditors, experts suggest taking the dispute to the IRS national office. “If your relationship with the IRS audit team becomes negative, it can be advantageous to shift the venue,” Peña says.