General Features of U.S. Transfer Pricing Rules

The U.S. transfer pricing rules are detailed and extensive. They generally incorporate the basic principles of transfer pricing, including the Arm’s-Length Principle, comparability analysis, and selection of an appropriate transfer pricing method.

An important feature of the U.S. system is the use of the Comparable Profits Method (CPM) instead of the Transactional Net Margin Method (TNMM) commonly referred to under the OECD transfer pricing framework.

Under U.S. rules, the taxpayer’s intention to avoid or evade tax is not necessary for the Internal Revenue Service (IRS) to make a transfer pricing adjustment. Therefore, the IRS may adjust a related-party transaction even when the taxpayer had no intention of reducing or avoiding tax.

U.S. transfer pricing rules do not give automatic priority to any particular method of testing transfer prices. Instead, an explicit analysis must be carried out to identify the Best Method, meaning the method that provides the most reliable arm’s-length result.

The U.S. comparability rules allow only limited adjustments for business strategies. Such adjustments are mainly restricted to clearly defined market share strategies. The rules also permit limited consideration of location savings while evaluating comparability.

Comparable Profits Method (CPM)

The Comparable Profits Method (CPM) was introduced in the proposed U.S. regulations of 1992 and has become an important method in the transfer pricing practices of the IRS.

Under CPM, the focus is on the overall financial results of the tested party rather than individual transactions. The overall results of the tested party are compared with the overall results of similarly situated independent enterprises for which reliable financial information is available.

The comparison is made using a Profit Level Indicator (PLI) that most reliably measures profitability for the particular type of business.

For example, the profitability of a sales company may be measured using Return on Sales. Return on Sales may be calculated by expressing pre-tax profit as a percentage of sales.

Return on Sales = Pre-Tax Profit ÷ Sales × 100

CPM generally requires a lower level of comparability regarding the exact nature of goods or services. This means that the goods or services of the tested party and comparable enterprises do not always need to be identical.

Another practical advantage of CPM is that financial information about comparable enterprises can often be obtained from public filings in the United States and many other countries.

However, adjustments may be required to improve comparability between the tested party and comparable enterprises. Such adjustments may include interest adjustments relating to customer financing or debt levels and adjustments for differences in inventory.

Cost-Plus and Resale Price Methods under U.S. Rules

Under U.S. transfer pricing rules, the Cost-Plus Method and Resale Price Method are applied to goods strictly on a transactional basis.

This means that comparable transactions must be identified for the transactions being tested. Industry averages or general statistical measures cannot be used as substitutes for comparable transactions.

For example, if a manufacturing company provides contract manufacturing services to both related and unrelated parties, it may have internal information about comparable transactions. Such information may provide reliable data for applying the Cost-Plus Method.

However, where internal comparable transactions are not available, obtaining reliable external information for applying the Cost-Plus Method may be difficult.

Services Cost Method

The U.S. transfer pricing rules provide additional provisions for services to address difficulties in obtaining comparable transactional information.

Where services provided to a related party are not part of the primary business of either the tested party or the related-party group, the price may be presumed to satisfy the arm’s-length requirement if the services are charged at cost plus zero. This approach is known as the Services Cost Method.

Under this method, the service provider recovers the cost of providing the service without earning a profit or mark-up.

The method may apply to non-integral support services such as accounting, data processing, product testing, and other back-office activities, where the group is not engaged in providing such services to customers as its main business.

The Services Cost Method is not permitted for manufacturing, reselling, and certain other services that are considered integral to the business.

Shared Services Agreements

U.S. transfer pricing rules specifically permit Shared Services Agreements. Under such agreements, different members of a related group may provide services that benefit more than one group member.

The prices charged for shared services may be considered arm’s length when the related costs are allocated consistently among group members according to their reasonably anticipated benefits.

For example, shared service costs may be allocated among group members using a formula based on expected sales, actual sales, or a combination of relevant factors.

Thus, the allocation method should reasonably reflect the benefits expected to be received by each participating group member.

Actual Conduct and Contractual Terms

Under U.S. transfer pricing rules, the actual conduct of the parties is more important than the contractual terms of the transaction.

If the actual behaviour of the related parties differs from the terms written in the contract, the IRS may determine the terms of the transaction according to the parties’ actual conduct.

Therefore, contractual documents alone do not determine the transfer pricing treatment. The manner in which the parties actually perform the transaction is an important consideration.

Transfer Pricing Adjustments by the IRS

The IRS cannot adjust a transfer price when the price falls within the Arm’s-Length Range.

However, if the price charged in a related-party transaction falls outside the arm’s-length range, the IRS may make a unilateral adjustment. The price may be adjusted to the midpoint of the arm’s-length range.

Generally, the taxpayer has the burden of proving that the transfer pricing adjustment made by the IRS is incorrect. However, this position may differ where the IRS adjustment is shown to be arbitrary and capricious.

Where the taxpayer and the IRS do not reach an agreement, courts generally require both parties to support and demonstrate the facts relating to the transfer pricing dispute.

Transfer Pricing Documentation and Penalties

U.S. transfer pricing rules impose penalties where significant transfer pricing adjustments are made by the IRS.

If the IRS adjusts transfer prices by more than US$5 million or 10% of the taxpayer’s gross receipts, penalties may apply.

The basic penalty is 20% of the amount of the tax adjustment. At a higher threshold, the penalty may increase to 40%.

A taxpayer may avoid these penalties only by maintaining proper contemporaneous transfer pricing documentation that satisfies the requirements of U.S. regulations.

The taxpayer must provide the required documentation to the IRS within 30 days of a request by the IRS.

If the taxpayer does not provide documentation, the IRS may make transfer pricing adjustments on the basis of any information available to it.

For transfer pricing purposes, contemporaneous documentation means that the documentation existed within 30 days of filing the taxpayer’s tax return.

The documentation requirements are detailed and generally require a Best Method Analysis and proper support for the transfer pricing method and prices used by the taxpayer.

The documentation must reasonably support the prices used in calculating the taxpayer’s tax liability.

Commensurate with Income Standard

U.S. tax law applies the Commensurate with Income Standard to transactions involving intangible property.

Intangible property may include patents, processes, trademarks, and know-how.

Under this standard, a foreign transferee or user of intangible property may be considered to pay a royalty to the controlling transferor or developer. The royalty should be commensurate with the income earned from the use of the intangible property.

This rule may apply even when the royalty is not actually paid. Therefore, a deemed royalty payment may be recognized for tax purposes.

Such deemed payments for the use of intangible property in the United States may result in withholding tax.

Key Exam Points

U.S. transfer pricing rules generally use the Comparable Profits Method (CPM) instead of TNMM. The taxpayer’s intention to avoid or evade tax is not necessary for an IRS transfer pricing adjustment.

The U.S. follows the Best Method Rule and does not automatically give priority to any single transfer pricing method.

Under CPM, the overall results of the tested party are compared with the overall results of comparable independent enterprises using an appropriate Profit Level Indicator.

The Cost-Plus and Resale Price Methods are applied to goods on a transactional basis, and industry averages cannot replace comparable transactions.

The Services Cost Method allows eligible non-integral services to be charged at cost plus zero.

Under U.S. rules, the actual conduct of the parties is more important than contractual terms.

The IRS cannot adjust a price within the Arm’s-Length Range. A price outside the range may be adjusted to the midpoint of the range.

Transfer pricing penalties may apply where adjustments exceed US$5 million or 10% of gross receipts. The penalty is generally 20% and may increase to 40% at a higher threshold.

Contemporaneous documentation must be provided to the IRS within 30 days of request.

The Commensurate with Income Standard requires royalties relating to intangible property to correspond with the income derived from the use of the intangible, even where the royalty is treated as a deemed payment.