Mike Costello: IRS Compliant Transfer Pricing Valuation

Controlled Group Transactions Must Reflect Arm’s-Length Prices

Friday, July 6, 2007 - by Mike Costello
Mike Costello
Mike Costello

To stay competitive, many businesses are developing reciprocal relationships or merging with companies abroad, or alternatively, are starting up divisions and subsidiaries in other countries. If your business is considering such a step, you need to find out the ramifications of transferring products or services.

The globalization of the marketplace over the past few years has many implications for businesses. One result of the increasingly complex interrelationships between and within businesses, both internationally and in different tax jurisdictions, is the need for transfer pricing valuations. Transfer pricing becomes an issue when one company transfers tangible or intangible assets or services to another company, not independent from it, that is also not in the same tax jurisdiction. These types of groups of companies or organizations—owned directly or indirectly by the same interests—are called “controlled” groups for tax purposes. Several types of transfers may occur among these controlled groups, including the transfer of service-related intangible assets, intangible assets and intellectual property, and tangible assets, such as inventory.

To satisfy tax authorities, transfer prices must approximate the price that would result from arm’s-length negotiations between unrelated companies. This is because, since unrelated, or uncontrolled, companies have an incentive to negotiate the best deal they can get, the prices resulting from their negotiations are likely to reflect market forces rather than tax considerations.

The “Arm’s-Length” Issue

Some controlled businesses have attempted to fix transfer prices to alleviate tax burdens in particular tax jurisdictions. The Internal Revenue Service (IRS) is thus particularly concerned about whether transfer prices truly reflect market prices. Under Section 482, the IRS can reallocate the income, deductions, credits, allowances or any other item of controlled groups to prevent tax evasion, and can also impose severe penalties if the groups fail to set the correct transfer prices. Whether a related, or controlled, transaction meets the arm’s-length standard is one of the IRS’s primary criteria in determining if the transaction is unfairly avoiding taxation.

Valuation Consultants Analyze Transfer Pricing Methods

How can businesses know what prices would be considered arm’s-length? In developing transfer prices for a company, a valuation professional attempts to ascertain the motives and incentives of unrelated buyers and sellers in the company’s industry. He or she then relates these motives to that company’s financial status and other factors, usually using one of several pricing methods, depending on the information available and the nature of the transaction.

In determining which method to use, the valuation practitioner must assess the degree of comparability between the controlled and uncontrolled transactions as well as the quality and extent of the data. Because the IRS may require extensive documentation to prove that the transfer price is correct, obtaining the services of an experienced valuation professional who knows how to assemble and interpret the data is imperative.

Seasoned Expertise is Essential

To avoid IRS interference and penalties, it’s best to become familiar with transfer pricing issues and get reliable, expert advice from a trustworthy professional consultant. Please call us with any questions you might have about transfer pricing. We would be glad to provide the benefit of our expertise to ensure your transfer prices withstand IRS scrutiny.

Local Case Study

We recently performed a transfer pricing study for a publicly traded manufacturing company with subsidiaries located in six countries. The study included the analysis of numerous tangible property and services transactions between the U.S. parent and foreign subsidiaries and their compliance with Internal Revenue Code Section 482 including the newly enacted Services Cost Method. In addition, Decosimo analyzed similar transactions between the foreign subsidiaries from the perspective of the corresponding foreign jurisdiction’s tax laws, including China Germany, Switzerland and the United Kingdom.

(Mike Costello, CPA/ABV, CFE is a Certified Public Accountant, Certified Fraud Examiner, business appraiser and consultant with more than 20 years of training and experience in business valuations and appraisals, business acquisitions and divestitures, and forensic accounting.

He has written several articles for the Tennessee CPA and the AICPA’s Management Consultant newsletter.

He was the Managing Director and President of Costello, Strain & Company, PC, a CPA firm he established in May 1984. The firm was merged with Joseph Decosimo and Company, LLP, CPA’s in September 2003. Joseph Decosimo and Company, LLP was founded in 1972 and today is one of the top 100 CPA firms in the nation.)


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