What Are Transfer Pricing Adjustments?

When companies with related entities, such as a parent company and its subsidiary, conduct business, they must establish a price for the goods or services exchanged. This internal pricing is known as transfer pricing. The purpose is to ensure these transactions are priced as if they were conducted between unrelated parties.

A transfer pricing adjustment is a change made to these internal prices to align them with market values. This is necessary when a transaction price does not reflect what independent companies would have agreed upon. The goal is to prevent profit shifting, where a company might artificially lower profits in a high-tax country and inflate them in a low-tax one. By correcting these prices, tax authorities ensure each entity pays the appropriate tax in its jurisdiction.

Types of Transfer Pricing Adjustments

Transfer pricing adjustments are categorized based on who initiates them. The most common type is initiated by a tax authority during an audit, which ensures that the profits reported in a specific country are accurate and reflect the economic activity that occurred there.

A primary adjustment is the initial change a tax authority in one country makes to a company’s taxable income. This happens when the authority determines that the price charged between related entities was not at arm’s length. For example, if a U.S. parent company sells goods to its foreign subsidiary at a price lower than the market rate, the IRS might increase the parent’s taxable income to reflect the price that would have been charged to an independent buyer.

Following a primary adjustment, a tax authority may assert a secondary adjustment to reflect the economic reality of the initial change. For instance, if a primary adjustment increases a U.S. parent’s income because its foreign subsidiary was undercharged, the excess cash held by the subsidiary is considered moved from the parent. Tax authorities may treat this excess cash as a deemed dividend subject to withholding taxes or as a deemed loan requiring the subsidiary to pay interest.

To alleviate the double taxation that a primary adjustment creates, the tax authority in the second country can make a correlative adjustment. This is a corresponding change that aligns with the primary adjustment. For example, if the IRS increases a U.S. parent’s income, the subsidiary’s country can decrease the subsidiary’s taxable income by the same amount, preventing the same profit from being taxed twice.

Companies can also make their own taxpayer-initiated adjustments before filing a tax return. This proactive approach helps companies align with their transfer pricing policies and avoid disputes with tax authorities. A company might do this if it realizes its actual profits from intercompany transactions deviated from initial projections.

The Arm’s Length Principle and Adjustment Methods

The international standard for determining transfer prices is the arm’s length principle. This principle, outlined in U.S. Treasury regulations under Section 482 and OECD Guidelines, mandates that transactions between related parties must be priced as if they were between independent entities. When a price deviates from this standard, an adjustment is calculated using one of several recognized methods.

• The Comparable Uncontrolled Price (CUP) method compares the price and conditions of a transaction between related parties to those of a transaction between unrelated parties. For this method to be reliable, the transactions must be highly comparable in terms of the product, contract terms, and market conditions.
• The Resale Price Method (RPM) is often used for distributing finished goods. It starts with the price at which a product purchased from a related party is resold to an independent customer. This price is then reduced by a gross margin that covers the reseller’s expenses and profit, with the remainder being the arm’s length price.
• The Cost Plus (C+) Method is applied to manufacturing and begins with the costs incurred by the supplier. An appropriate markup, determined by comparing markups in similar transactions between unrelated parties, is then added to these costs to arrive at the arm’s length price.
• The Transactional Net Margin Method (TNMM) examines the net profit margin a company earns from a transaction with a related party. This margin is then compared to the net profit margins earned by independent companies in similar transactions. The TNMM is widely used because it is less sensitive to transactional differences and can be applied when comparable data for prices is unavailable.
• The Profit Split Method is used for highly integrated transactions that are difficult to evaluate separately. This method identifies the combined profit from the transaction and divides it between the related parties based on their relative contributions, reflecting how independent companies would have distributed the profit.

Tax Implications and Double Taxation

Transfer pricing adjustments carry tax consequences, with the most prominent risk being double taxation. This issue arises when two different countries tax the same income, placing a financial burden on multinational corporations.

Economic double taxation occurs when a primary adjustment is made by one country without a corresponding correlative adjustment in the other. For example, if a U.S. parent provides services to a German subsidiary for $1 million and the IRS determines the price should have been $1.5 million, it will increase the parent’s taxable income by $500,000. If Germany does not allow the subsidiary to deduct this additional $500,000, that same profit is taxed in both countries.

Secondary adjustments also have tax implications. If a tax authority deems that an adjustment resulted in a shift of value, it may recharacterize the transaction. For instance, if the $500,000 adjustment is treated as a deemed dividend from the German subsidiary to the U.S. parent, it could trigger a withholding tax levied by the subsidiary’s country.

Beyond the immediate tax payments, companies may also face interest charges on the underpaid tax. Penalties for non-compliance can also be applied, often calculated as a percentage of the tax underpayment.

Resolving Adjustments and Mitigating Double Taxation

When a company faces a transfer pricing adjustment and the resulting double taxation, there are established procedures to seek relief. These mechanisms are designed to facilitate agreement between the tax authorities of the countries involved to ensure income is taxed only once.

The primary mechanism for resolving these disputes is the Mutual Agreement Procedure (MAP). MAP is a formal process under most bilateral tax treaties that allows the competent authorities of the two countries to negotiate a resolution. The competent authority is the body within a country’s tax administration responsible for applying the tax treaty. A taxpayer facing double taxation can request MAP assistance from their home country’s competent authority.

The purpose of MAP is to have the competent authorities agree on an adjustment that leads to a correlative adjustment in the other country, thereby eliminating double taxation. The process begins with the taxpayer submitting a detailed request with all relevant documentation. The competent authorities then engage in discussions to arrive at a mutually acceptable outcome, though the process can take several years.

To proactively prevent transfer pricing disputes, companies can seek an Advance Pricing Agreement (APA). An APA is a binding agreement between a taxpayer and tax authorities that establishes the transfer pricing methodology for future intercompany transactions. By agreeing on the methodology in advance, companies can achieve certainty and avoid future adjustments and penalties. APAs can be unilateral (with one tax authority), bilateral (with two), or multilateral (with more than two).