Is Transfer Pricing Illegal? The Risks of Non-Compliance

Transfer pricing is an internal accounting practice where multinational corporations set prices for goods, services, and assets exchanged between their related entities in different countries. While the practice is legal, its execution is strictly regulated. The primary issue is adherence to tax regulations designed to prevent companies from manipulating internal prices to shift profits to low-tax countries and lower their overall tax liability.

Tax authorities like the Internal Revenue Service (IRS) scrutinize these transactions to ensure prices are fair and reflect market realities. Failing to follow these regulations can transform a standard business practice into a major compliance issue with significant financial risks.

The Arm’s Length Principle

The governing standard for transfer pricing is the arm’s length principle. This international consensus, embedded in U.S. tax law under Internal Revenue Code (IRC) Section 482, requires that related business entities price their transactions as if they were unrelated. The goal is to prevent a parent company from providing goods to a subsidiary at an artificially low price or a subsidiary paying inflated fees for services to a parent in a lower-tax jurisdiction.

For example, the price for a used car sold to a stranger would be its fair market value, while the price for the same car sold to a family member might be discounted. The arm’s length principle requires a corporation to use the “stranger” price in its internal dealings. This standard ensures that profits are taxed in the jurisdictions where the economic activity that generates them occurs.

Tax authorities evaluate transactions by analyzing the functions performed, assets used, and risks assumed by each entity. For instance, a manufacturing division that invests in research and equipment should be compensated fairly for those contributions when it sells goods to a related distribution division. Determining an arm’s length price involves finding comparable transactions under comparable circumstances, requiring a detailed examination of market conditions.

Common Transfer Pricing Methods

To apply the arm’s length principle, companies use several established methods accepted by the Organisation for Economic Co-operation and Development (OECD) and the IRS. The most appropriate method is the one that provides the most reliable measure of an arm’s length result based on the specific facts and circumstances. The selection of a method must be justified in the company’s tax documentation.

• The Comparable Uncontrolled Price (CUP) method is the most direct approach, comparing the price in a controlled transaction to the price in a comparable transaction between unrelated parties, such as when a company sells the same product to both a subsidiary and an independent company.
• The Resale Price Method is used for distribution activities and starts with the price at which a product is resold to an independent customer, which is then reduced by a gross margin to find the arm’s length price for the original transfer.
• The Cost Plus Method is applied to manufacturing or services and begins with the supplier’s costs, to which a profit markup is added that is comparable to what a third-party manufacturer would earn.
• The Transactional Net Margin Method (TNMM) is used when comparable transaction data is limited and examines the net profit margin relative to a base like costs or sales, comparing it to the net margins of independent companies.

Required Documentation and Reporting

Proving compliance with the arm’s length principle requires detailed documentation justifying the chosen transfer pricing methods. The OECD established a standardized three-tiered approach to documentation that many countries have adopted to get a comprehensive view of a company’s global operations.

The Master File provides a high-level overview of the multinational enterprise’s (MNE) global business. Its purpose is to give tax authorities a clear understanding of the economic, legal, and financial context of the MNE’s transfer pricing practices. It contains standardized information on the MNE’s organizational structure, business descriptions, and overall transfer pricing policies.

The Local File provides detailed information specific to the taxpayer in each country. This report focuses on the material transactions between the local entity and its related foreign entities. It must identify the relevant controlled transactions and provide a detailed analysis to justify the transfer pricing method selected and how it was applied.

The Country-by-Country (CbC) Report is required for MNE groups with consolidated annual revenue exceeding a high threshold, such as €750 million. This data allows tax authorities to perform high-level risk assessments of potential profit shifting. The report provides an aggregate, jurisdiction-wide summary of key financial data, including revenue, profit, taxes paid, employees, and assets for each jurisdiction.

Consequences of Non-Compliance

Non-compliance with transfer pricing regulations results in civil penalties and financial consequences rather than criminal charges. When a tax authority like the IRS determines that prices do not adhere to the arm’s length principle, it can propose a tax adjustment. This reallocates income between related entities to reflect a correct price, leading to a higher tax liability and substantial interest charges on the underpaid amount.

Monetary penalties for valuation misstatements are also imposed under tax laws. Under IRC Section 6662, a 20% penalty for a “substantial valuation misstatement” applies when the net transfer pricing adjustment exceeds the lesser of $5 million or 10% of the company’s gross receipts. The penalty increases to 40% for a “gross valuation misstatement” if the adjustment surpasses the lesser of $20 million or 20% of gross receipts.

Another consequence is the risk of double taxation. This occurs when one country adjusts a company’s taxable income upwards, but the corresponding country does not allow a downward adjustment. The result is that the same profit gets taxed twice, and while tax treaties provide a mechanism to resolve such disputes, the process can be lengthy, costly, and is not always successful.

The IRS is increasing scrutiny in this area and asserting penalties more frequently, even in cases where documentation exists but is deemed insufficient. Simply having a transfer pricing report is not enough; the analysis must be robust and well-reasoned. The financial stakes for non-compliance are high, making proactive and thorough transfer pricing management a necessity for any multinational business.