The concept of “transfer pricing” relates to the pricing of transactions between controlled entities. For example, when a US parent (Parent) sells a product to its controlled foreign corporation (CFC), I.R.C. section 482 requires Parent to sell that product at an arm’s length price to its CFC. Under IRC 482, controlled entities should price transactions in the same way that uncontrolled entities would under similar circumstances. This is, in essence, the “arm’s length standard,”—the price of the product that Parent charges its CFC should be the same as it would charge to an unrelated party for the same product under similar circumstances.
If the transfer price is not arm’s length, section 482 provides the IRS with authority to make adjustments by reallocating items of gross income, deductions, credits, or allowances in order to properly reflect income between the entities.
When Does Section 482’s Arm’s Length Standard Apply?
Section 482 allows the IRS to make adjustments and allocations in order to ensure that transactions clearly reflect income attributable to controlled transactions and to prevent the evasion of taxes.
The statutory language of section 482 envisions three basic requirements before it applies:
1) Two or more organizations, trades or businesses;
2) common ownership or control, either directly or indirectly; and
3) An IRS determination that an allocation is necessary either to prevent evasion of taxes, or to clearly reflect the income of the entities.
Section 482 encompasses the so-called arm’s-length standard. The arm’s-length standard applies to outbound and inbound transactions.
What Is “Control” For Section 482 Purposes?
Treas. Reg. section 1.482-1(i)(4) provides a broad definition of what constitutes control. That definition provides that any kind of control, direct or indirect, may give rise to “control” within the meaning of section 482, whether the control is legally enforceable or not. In addition, where two or more taxpayers act in concern or with a common goal or purpose, it may be sufficient to constitution “control” within the meaning of section 482. The reality—not the form—of the control is decisive
The regulations further provide that, “A presumption of control arises if income or deductions have been arbitrarily shifted.”
Reallocation to Clearly Reflect Income
Section 482 may apply where an allocation is necessary to:
- prevent evasion of taxes, or
- clearly reflect income
Allocations affecting taxable income can be made to income, deductions, credits and other allowances. Generally, allocations have been upheld by the courts unless the taxpayer can demonstrate that the IRS determination was arbitrary and capricious.
What is The Best Method Rule?
There are various pricing methods available in the regulations under IRC 482. These include the Comparable Uncontrolled Price (CUP), Resale Price Method, Cost Plus Method, Comparable Profits Method (CPM) and various Profit Split Methods. There is no per se hierarchy among these methods. The taxpayer must select the method that provides the most reliable measure of an arm’s length result taking into consideration all the data available. This is known as the “best method rule.”
Parties in a controlled transaction are required to use the best method to determine the arm’s length price of goods sold between entities. There are transactional-based and profit-based methods. Determining the best method depends on many factors including, but not limited to, the existence of comparable transactions and the degree of similarity of these comparables. Comparables are determined based on the degree of similarity in the functions performed and other factors including risks assumed, contractual terms, economic conditions, and property or services included in the transaction.
The taxpayer is required to be able to support the pricing method selected. One manner to determine and document that the taxpayer selected the best method is to obtain a Transfer Pricing Study. A Transfer Pricing Study is the documentation that a taxpayer prepares to show that its transfer pricing was conducted at arm’s length. Freeman Law can assist with transfer Pricing Studies.
If the IRS pursues a valuation adjustment, the adjustment may give rise to double taxation. In such case, the taxpayer may have access to double tax relief under Article 25 of the US Model Tax Treaty and the Mutual Agreement Process. Taxpayers may need to invoke competent authority procedures under such circumstances.