5 transfer pricing reminders for 2021 returns

Here are five things to keep in mind from a transfer pricing perspective:

1. Adequate support for arm’s-length nature of related-party transactions

Depending upon the perceived level of risk associated with the pricing of intercompany transactions, taxpayers should have an appropriate level of documentation to justify their intercompany pricing. In some cases, transfer pricing policy documents, market references, budgets, and intercompany agreements might be enough to support the validity of a related-party transaction and intercompany pricing. In other cases, however, a full transfer pricing study, including a benchmarking analysis and analysis of certain similar transactions that the taxpayer enters into with third parties, might be required.

Taxpayers that are unsure about whether their transfer pricing documentation is sufficient should work with their transfer pricing adviser to determine whether additional work is required.

2. Importance of intercompany agreements

Contractual terms in related-party and third-party agreements are a key area of focus for tax authorities, including the IRS, in transfer pricing examinations. Several recent tax cases, including Medtronic, Inc. v. Commissioner decided by the U.S. Tax Court on Aug. 18, 2022, provide a detailed review of related- and third-party agreements to determine whether the terms of the contracts substantiated comparability.

It also can be important for intercompany agreements to provide details on the risks that the parties to the transaction face. These details can support the risk analysis included in the transfer pricing documentation of intercompany pricing.

3. Financial data of comparable companies

The profitability of potentially comparable companies used in a transfer pricing analysis has, in general, increased this year. There appear to be two main reasons for this:

• Many companies that were struggling prior to the COVID-19 pandemic, or as a result of the COVID-19 pandemic, have been acquired and no longer are in the pool of comparable companies. Thus, there is a selection bias in the sense that only stable, profitable companies have remained and are included in the analysis of comparable companies.
• Although revenues generally have declined as a result of the COVID-19 pandemic, companies have managed to stay profitable because certain costs, such as travel and entertainment-related expenses, have decreased.

These anomalies causing increased profitability for companies have resulted in the interquartile range of a comparability analysis being much higher than it historically has been. Because intercompany pricing generally is based on historical data, including financial data of comparable companies, a taxpayer’s 2021 fiscal or financial year results might not be consistent with the arm’s-length standard. Thus, when preparing a transfer pricing analysis, it is necessary to carefully review the financial data of comparable companies to understand why the profitability of the companies manifests in this manner and to include an explanation of the deviation as part of the transfer pricing documentation.

4. Transfer pricing policy versus arm’s-length results

It is possible that the manner in which taxpayers set their transfer prices might differ from the manner in which the transfer prices are tested. For example, to price related-party transactions, a taxpayer might use the market minus approach (determining purchase price based on a resale margin applied on the sale price to the end customer). However, to prepare transfer pricing documentation, the same taxpayer might use the operating margin approach (determining purchase price by looking at the operating margin of the comparable companies and working back to the purchase price) due to data limitations. Transfer pricing documentation should explain discrepancies that might arise between the taxpayer’s transfer pricing policy and the methodology used for transfer pricing documentation purposes.

Year-end adjustments and adjustments to the Schedule M (Form 5471), “Transactions Between Controlled Foreign Corporation and Shareholders or Other Related Persons,” also might be required for consistency with the arm’s-length standard.

5. Transfer pricing documentation to mitigate tax risk

Taxpayers that have contemporaneous transfer pricing documentation prepared in compliance with relevant IRC provisions and regulations generally are protected from federal tax accuracy-related penalties. Contemporaneous documentation meeting these standards also can reduce transfer pricing uncertainty and potentially reduce transfer pricing audit adjustments, especially in the current environment in which tax authorities are paying more attention to taxpayers’ transfer pricing reports and compliance work.

Taxpayers also should be aware of changing documentation requirements in light of the global approach highlighted by the Organization for Economic Cooperation and Development’s Pillar 1 and Pillar 2 initiatives. Prior transfer pricing analyses and documentation might no longer be compliant with new requirements. Therefore, taxpayers should work with their transfer pricing adviser to determine whether updates or changes to transfer pricing analyses and documentation are necessary.