There are many things foreign company leadership should consider upon deciding to expand operations into the US marketplace. Some include choosing the right type of legal entity, setting up bank connections, and navigating compensation issues. However, one item that often gets overlooked, particularly in the initial years of operation, is transfer pricing. Broadly defined, transfer pricing refers to how companies price transactions between related parties. Although the concept has been present in some form or another since the 1930s, it wasn't until the early 90s that detailed guidelines were published. In most cases, the transfer pricing rules adopted by various jurisdictions are based on the arms-length principle. This means that the transaction price between related parties should be similar to a price they would agree upon if they had dealt with each other as unrelated parties.
The Internal Revenue Service (“IRS”) is responsible for administering the transfer pricing regulations in the US. The agency requires that taxpayers have transfer pricingadjustments reflected on their tax returns and supporting documentation available upon request. So, while the supporting documentation does not have to be submitted with the tax return, the taxpayer must disclose intercompany transactions on the tax forms, which serve as a roadmap for the IRS. It is important to note that once the tax return is filed, taxpayers cannot retroactively adjust their transfer pricing unless the adjustment results in additional US tax. Therefore, companies should consider and establish reasonable transfer pricing policies early in the US expansion process. This also helps to avoid the risk of non-compliance penalties and allows companies to potentially take advantage of planning opportunities. Adjustments to the company’s functions, assets and risks can change the transfer pricing results, potentially resulting in less tax if planned properly.
Initially, the activities between the US and a foreign parent might be straightforward; however, it is not uncommon for that relationship to grow and mature over time. As a result of that growth, the transfer pricing policies governing those activities may also need to change.
Let's take an example of a tech company based in the UK (UKCo) looking to enter the US market through its newly formed US subsidiary (USCo).
In the first example, the USCo may have some sales staff providing sales support to US customers who purchase the products/services directly from the parent entity. As a result, there could be commissions paid to the US on the sales generated for the UK, resulting in taxable income for the USCo. So even in this simple case, intercompany transactions exist between the two related parties, and transfer pricing applies. Many companies tend to think of this as a “cost center” which should not necessarily be profitable, but the view of the IRS is that an unrelated company in the US providing sales services would be profitable, or they would not be in business. So, they typically expect the costs plus a reasonable markup to be paid by UKCo for those services.
Over time, USCo may want to hold the contracts with the US customers and may have a large enough workforce to operate independently from the UKCo, providing not only the salesforce, but the core products/services and all necessary customer support.
It may appear, since the USCo is now operating more independently, that there are no intercompany transactions subject to transfer pricing regulations; however, that is not the case. Although the USCo is transacting directly with the US customers, is relying on its workforce for services and customer support, and seemingly has no interaction with the parent, it still has to pay a royalty to the UKCo for the right to use its intellectual property. Therefore, the intercompany transaction changed from a service transaction to an intangible property transaction, and different rules apply.
At each stage of the US subsidiary's growth, the functions, risks, and assets will govern which transfer pricing policy best suits the intercompany dealings. An appropriate approach for one type of transaction is unlikely to be suitable for a different transaction. Taxpayers should evaluate their transfer pricing as their company operations change and expand to ensure that their policies are compliant with the transfer pricing rules of each applicable jurisdiction and take advantage of possible planning opportunities to optimize tax efficiency.
Goran Vukicevic is a tax manager in Hughes Pittman & Gupton, LLP's corporate tax and international practices and co-leads the global expansion tax services team. He has experience working with both public and non-public companies with his primary focus in the corporate tax practice. He has worked with clients in a variety of industries including biomedical, pharmaceutical, software and technology development, as well as manufacturing and distribution. Goran's experience in these industries includes corporate tax compliance, accounting for income taxes pursuant to ASC 740, and inbound/ outbound compliance and consulting for multinational companies.