Preparing for IRS transfer pricing scrutiny: a multistep approach for working capital adjustments.

AuthorFreeman, Barry T.

Recent pronouncements by the IRS have suggested upcoming changes to its approach to transfer pricing audits. Under these changes, a company's transfer pricing methods are likely to face a higher level of scrutiny as the IRS performs more audits over a broader range of industries. Taxing authorities also are likely to more strenuously challenge the analytical approach taken by a taxpayer to determine appropriate transfer prices.

While several methods are used to evaluate transfer pricing, this article focuses on the comparable profits method (CPM). This commonly used method evaluates whether a transaction between two related parties could be considered to be "arm's length," as required by IRS regulations. To do this, the CPM compares the profitability of unrelated entities (or comparable companies) with the profitability earned by one of the related parties (the tested party). As a part of this comparison, IRS regulations say the CPM should adjust for differences in the carrying cost of working capital between the comparable companies and the tested party. This adjustment is needed in order to increase the reliability of profitability measures used to evaluate the tested party's results.

Practitioners use several different methods to make these working capital adjustments, but the various methods might not always produce consistent evaluation results. We propose a two-stage method that we call the multistep-adjustment procedure (MAP), which produces more accurate adjustments for purposes of comparing results. Application of the MAP could work to the taxpayer's advantage in some cases, but in others it could work to the taxpayer's disadvantage. So taxpayers--especially those under audit --should be sure their tax consultant is considering the MAP and comparing it to the IRS's transfer pricing approach.

Using the MAP could affect transfer pricing outcomes in three important ways:

* Compliance--Working capital adjustments performed with the MAP can place an intercompany transaction within an interquartile range (IQR), a metric used to determine if a transaction can be justified as "arms length." Other common adjustment methods might not achieve the same result in some circumstances.

* Tax Planning--Applying the MAP could shift the IQR, which would affect certain tax planning strategies pursued by the taxpayer.

* Audit Defense--The availability of a two-stage method such as the MAP, which produces a transformed IQR, could give the taxpayer support in arguing against proposed IRS transfer pricing adjustments that are based on a specific IQR. In particular, since the IRS typically makes transfer pricing adjustments to the median of the IQR, any shifts in the median would have an impact on the proposed adjustment amount.

The Need for a Multistep Approach

The CPM uses comparable uncontrolled companies to determine a range of appropriate profit levels for comparison with the profit level of the tested party in a related-party transaction. U.S. transfer pricing regulations recommend that working capital adjustments be made whenever there would be "material differences" between the profitability of the tested party and the comparable companies if these adjustments were not made.

In using the CPM, practitioners generate financial ratios called profit level indicators (PLIs) for both the tested party and the comparable companies. These ratios generally are computed as a function of a firm's operating income. Commonly used PLIs include operating margin and mark-up on cost.

Working capital adjustments are made to reduce the effect that differences in working capital (primarily accounts receivable, accounts payable, and inventories) would have on operating income. These adjustments modify certain components of the income statement...

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