Dealing with the secondary U.S. tax consequences of transfer-pricing adjustments.

• Author: Hill, James M.

Much of the professional transfer-pricing literature focuses on determining arm's-length transfer prices for various intercompany transactions. This focus is perfectly understandable. Many countries require that taxpayers document annually that their intercompany transfer prices are at arm's length. The logical first step in preparing a transfer-pricing analysis is thus to determine what constitutes an arm's-length transfer price.

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Less in the spotlight, however, is what happens when a transfer price is not at arm's length and must be adjusted. In the current economic environment, many countries in the world have budget deficits. Focusing on transfer prices between related parties seems to be a sure way for many countries to increase tax revenues (or at least protect their tax base). As a result of their focus on transfer pricing, more and more tax authorities are uncovering non-arm's-length transfer prices during tax audits. To comply with the arm's-length standard throughout the world, satisfy local country transfer-pricing documentation requirements, and avoid imposition of transfer-pricing penalties, many taxpayers are using transfer pricing offensively by initiating transfer-pricing adjustments on their own.

A counterparty is involved in any intercompany transaction--a transfer-pricing adjustment to one party causes secondary financial consequences in the multinational group. For U.S. taxpayers, in addition to the tax impact of the initial transfer-pricing adjustment, these secondary financial consequences trigger their own secondary tax consequences. Given the historical focus on determining arm's-length transfer prices, many U.S. taxpayers are unaware of the secondary U.S. tax consequences that result from a transfer-pricing adjustment.

The purpose of this article is first to explain to readers how a transfer-pricing adjustment triggers secondary financial consequences in the multinational group. The article then explains how the U.S. transfer-pricing rules (1) address and classify the secondary tax consequences for U.S. taxpayers that result from these secondary financial consequences. The article details the relief the IRS provides to qualified, electing taxpayers to avoid the secondary U.S. tax consequences that arise from transfer-pricing adjustments. Finally, the article explains why taxpayers need to perfect their transfer prices on timely filed U.S. tax returns or risk losing U.S. tax deductions for overlooked deductions related to transfer prices.

Two Types of Transfer-Pricing Adjustments

This article first describes the two broad types of transfer-pricing adjustments: (1) primary adjustments and (2) secondary, or compensating, adjustments. A primary adjustment is an initial transfer-price adjustment, whereas a secondary adjustment is a collateral adjustment that the counterparty involved in the transaction must make.

Primary Adjustments

Once a transfer price is found to be not at arm's length, then an adjustment (the primary adjustment) has to be made to either increase or decrease the transfer price. Depending upon the direction of the primary adjustment, the consequences to the taxpayer are fairly obvious: The taxpayer's tax liability will be either increased or decreased; the taxpayer might owe interest on a tax underpayment, or it might be owed interest on a tax overpayment. In the case of a transfer-price adjustment that results in a U.S. tax underpayment, the taxpayer may also owe a penalty. (2)

IRS-initiated primary adjustment: Most tax practitioners are aware that Sec. 482 establishes the internationally accepted arm's-length standard. Many tax practitioners outside of the international arena are surprised, however, that the actual language of Sec. 482 says nothing about the arm's-length standard, and that it does not even refer to the taxpayer. Instead, Sec. 482 is addressed exclusively to the secretary of the Treasury and allows him or her to allocate income and deductions among two or more controlled trades or businesses "to prevent evasion of taxes or clearly to reflect the income" of the trades or businesses. (3)

Given the terseness of Sec. 482, its substance is contained in a detailed set of regulations (4) issued over the past 45 years. Regs. Sec. 1.482-1(a)(2) describes the IRS's authority to make allocations (i.e., to adjust transfer prices):

The [IRS] may make allocations between or among the members of a controlled group if a controlled taxpayer has not reported its true taxable income. In such case, the [IRS] may allocate income, deductions, credits, allowances, basis, or any other item or element affecting taxable income. ... The appropriate allocation may take the form of an increase or decrease in any relevant amount. Two examples of IRS-initiated transfer-pricing adjustments follow.

Example 1. IRS-initiated primary adjustment: In year 1, U.S. Parent allows its wholly owned foreign subsidiary, ForSub, to use certain equipment at no charge. Upon IRS examination of year 1, which occurs in year 3, the IRS determines that the year 1 arm's-length charge for the use of the property is $50,000.

For year 1 the IRS allocates $50,000 of income from ForSub to U.S. Parent (the primary adjustment) to reflect an arm's-length charge for the use of the property. Accordingly, the IRS's primary adjustment increases U.S. Parent's year 1 taxable income by $50,000.

Tax impact of primary allocation: In this example, unless it has other tax attributes that would shelter the increased U.S. income from tax, the primary adjustment causes the U.S. Parent to owe U.S. income tax. Since the primary adjustment was made in year 3, the U.S. Parent would also likely owe interest, and possibly an underpayment penalty, on the underpaid year 1 tax. Given the size of the primary adjustment, the U.S. Parent might also owe a Sec. 6662 transfer-pricing penalty (5) on the year 1 tax underpayment.

The primary adjustment has reduced U.S. Parent's foreign-source income from year 1. This reduction likely impacts the foreign tax credit computations the U.S. Parent made when it originally prepared its year U.S...