What is Transfer Pricing?
Transfer pricing is the setting of the price for goods and services sold between controlled (or related) legal entities within an enterprise. For example, if a subsidiary company sells goods to a parent company, the cost of those goods paid by the parent to the subsidiary is the transfer price.
How transfer pricing playing role in tax planning?
Transfer pricing is in the cross hairs of tax policy as it relates to the competing objectives of three parties: the revenue-maximizing objective of the domestic tax authority, the revenue-maximizing objective of the foreign tax authority, and the tax-minimizing objective of the taxpayer. Because of the inherent differences in judgment and interpretation of facts when analyzing a company’s transfer pricing, together with the clashing revenue objectives of multiple tax authorities and taxpayers, the risk of adjustments to taxable income, double taxation, and potential for penalties is nontrivial, even for multinationals that make good-faith efforts to comply with Sec. 482.
Disputes between tax authorities and taxpayers may arise in many areas, including:
- Tax authorities may question the choice of the economic method.
- Tax authorities may disagree with the taxpayer’s characterization of the value chain within the group.
Example – As an example of the last type of dispute, in 2006 the IRS and GlaxoSmithKline Holdings (Americas) Inc. (GSK U.S.) settled a transfer-pricing dispute covering 1989 through 2005 for $3.4 billion, the largest settlement ever obtained by the IRS. At issue was the price charged GSK U.S. by its U.K.-based parent, GlaxoSmithKline PLC, through its worldwide operating group (Glaxo Group) for cost of goods sold, royalties, and other expenses, related in part to manufacturing and distributing Zantac and other prescription drugs. The position of GSK U.S. was that the drugs were developed outside the United States, as was the marketing strategy it used to sell them. As such, GSK U.S. was performing routine distribution and was charged prices and royalties based on the “resale price method,” which determines the appropriate arm’s-length range by the markups received by comparable distributors in uncontrolled, arm’s-length transactions. Based on the same facts, however, the IRS considered the marketing functions performed by GSK U.S. to have had a substantial role in creating demand for the drugs, and therefore, GSK U.S. deserved a much higher gross profit margin. The IRS applied the residual-profit-split method, which allocated Glaxo Group profit first between “routine” functions performed by GSK U.S. and GSK Group, then split the remaining profit according to where the largest part of the value was created.
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