Most of transfer pricing regulations are found in Section 482 of the Internal Revenue Code (“IRC 482”). The purpose of IRC 482 is to ensure taxpayers clearly reflect income attributable to controlled transactions and to prevent avoidance of taxes regarding such transactions. IRC 482 places a controlled taxpayer on a tax parity with an uncontrolled taxpayer by determining true taxable income. Followings are an overview of IRC 482.
Transfer pricing refers to the pricing of transactions between controlled entities. For example, when a US parent (USP) sells a product to its controlled foreign corporation (CFC), IRC 482 requires USP 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 the “arm’s length standard”, which means that the price of the product that USP 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, the IRS has the authority under IRC 482 to make adjustments by reallocating items of gross income, deductions, credits, or allowances in order to properly reflect income between the entities.
When reviewing the transfer pricing for controlled transactions, it is important to determine how USP selected a transfer pricing method to document that the prices charged to CFC were arm’s length. There are various pricing methods available to the USP which are discussed in the regulations promulgated under IRC 482. These include:
– Comparable Uncontrolled Price (CUP)
– Resale Price Method
– Cost Plus Method
– Comparable Profits Method (CPM), and
– Various Profit Split Methods.
There is no hierarchy for these methods. However, 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.” In addition, the taxpayer must be able to support the pricing method it selected. One way to determine whether the USP selected the best method is to review its Transfer Pricing Policy, if the taxpayer prepared one. The Transfer Pricing Policy is the documentation that a taxpayer prepares to show that its transfer pricing was conducted at arm’s length.
It should be noted that transfer pricing regulations apply to all types of transactions between controlled entities, including sales of tangible property, royalties for the use of intangible property, cost sharing arrangements, loans and advances and related interest, services, use of tangible property, etc.
For more detailed guidelines in IRC 482, taxpayers may go to IRS website and search “IRC section 482” using its search tools.
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