Affiliated Transactions: Accounting and Tax Considerations

An affiliated transaction is a business deal between two parties with a pre-existing relationship, allowing related companies or individuals to exchange goods, services, or financing. These transactions attract attention from accountants and tax authorities because the relationship could influence the deal’s terms, potentially distorting financial results or shifting tax liabilities. A framework of rules exists to ensure these transactions are properly identified, valued, and reported.

Identifying Affiliated Parties

Determining if a party is affiliated is the first step in applying the correct accounting and tax treatment. The definition of a related party is broad, based on the ability of one party to control or exert significant influence over another. These relationships, which require careful judgment to identify, fall into several categories.

Control-Based Relationships

The most straightforward affiliated relationship is between a parent company and its subsidiaries. Control is presumed when one entity owns more than 50% of another’s voting stock, giving it power over management and policies. Transactions between a parent and its subsidiaries, such as intercompany loans or sales of inventory, are examples of affiliated transactions.

Common Control

Affiliation also exists between companies under the common control of a single individual, family, or entity, which are referred to as “sister companies.” For instance, if an individual owns two separate businesses, those businesses are considered affiliated parties. Because of their shared ownership, transactions between them are not considered arm’s length and are subject to related party rules.

Key Management Personnel

Transactions with a company’s leadership are also considered affiliated. This includes executive officers, board members, and others with authority over the entity’s activities. The definition extends to the immediate family members of these individuals. Immediate family is defined as spouses, children, and other dependents who could influence or be influenced by the executive.

Significant Influence

A relationship does not require outright control to be affiliated. If one entity can exert significant influence over another’s operating and financial policies, they are deemed related parties. Significant influence is presumed to exist if an investor holds between 20% and 50% of a company’s voting stock. An ownership stake of this size has a substantial impact on decisions, warranting the application of affiliated party rules.

The Arm’s Length Principle

The arm’s length principle governs the treatment of affiliated transactions. This standard requires that deals between related parties use terms equivalent to those between independent parties. The objective is to prevent the relationship from influencing the price, which could be used to artificially shift profits or manipulate financial statements, ensuring fairness in financial and tax reporting.

Applying this principle means a company must determine a fair market price for items exchanged with an affiliate. For example, if a parent company loans money to its subsidiary, the interest rate must be comparable to what an independent bank would charge. If one affiliate sells goods to another, the price should reflect what an unrelated distributor would pay for the same products.

To establish an arm’s length price, companies use comparability analysis, which involves finding similar transactions between unrelated parties to use as a benchmark. One method is the comparable uncontrolled price (CUP) method, which directly compares the price of property or services in a controlled transaction to an uncontrolled one. The goal is to ensure the reported results are consistent with what would have occurred if the parties were independent.

Financial Reporting and Disclosure Requirements

For financial reporting under U.S. Generally Accepted Accounting Principles (GAAP), the objective is transparency. ASC 850, Related Party Disclosures, mandates that companies disclose material transactions with affiliates in their financial statement footnotes. These disclosures help investors and creditors understand the impact of these relationships on the company’s financial position. The rules apply even if no money changes hands, such as a parent providing free management services to a subsidiary.

The required disclosures are specific. A company must describe the nature of the relationship with the affiliated party, such as a parent-subsidiary or common control relationship. It must also provide a description of the transactions that occurred during the reporting period, including the dollar amounts involved, for example, disclosing total sales to an affiliate.

The disclosure must include any amounts due to or from related parties as of the balance sheet date, including outstanding loan balances or accounts payable. The terms and manner of settlement for these balances should also be described. Companies should not represent that transactions were made on arm’s length terms unless they can substantiate that claim.

Tax Treatment Considerations

The Internal Revenue Service (IRS) is concerned with ensuring affiliated transactions do not improperly reduce a company’s U.S. taxable income. The authority for the IRS in this area is Section 482 of the Internal Revenue Code. This section grants the IRS power to allocate income, deductions, or credits between controlled entities to prevent tax evasion or to clearly reflect the income of each entity.

This concept is important in international business, where it is known as “transfer pricing.” A transfer price is the price charged when one affiliate sells goods, services, or property to another affiliate in a different country. The IRS scrutinizes these prices to prevent companies from shifting profits from the U.S. to a lower-tax jurisdiction, for example, by charging an artificially low price for goods sold to the foreign affiliate.

To defend their transfer pricing practices, companies should maintain extensive documentation. A transfer pricing study justifying the arm’s length nature of the transactions is a best practice that can help avoid significant penalties under Section 6662 if the IRS adjusts the prices. The documentation should detail the method used to determine the prices.