Documentation and APAs

s governments pay more attention to transfer prices, they demand more documentation from taxpayers. Under the IRC Section 6662 regulations, the IRS can impose 20 percent or 40 percent penalties if companies have substantial adjustments to their transfer prices, and lack adequate contemporaneous documentation of a reasonable effort to establish arm’s length prices. Australia and New Zealand have recently implemented aggressive audit policies. Mexico and Canada also impose contemporaneous documentation requirements. These and other countries have substantially increased their staffs of transfer pricing examiners and economists.

The United Kingdom’s recent shift to self assessment of income taxes included the obligation to file tax returns in accordance with the arm’s length principle. In the UK, France, Germany, Japan, and most other countries that do not explicitly require contemporaneous documentation, taxpayers are obligated to provide the information requested during examinations, and may be punished, either explicitly or through arbitrary adjustments, if they are not able to respond with complete information.

U.S. §6662 Documentation

ECS’ documentation reports for U.S. clients are designed to meet the requirements of Section 6662, without creating difficulties if they should come to the attention of other governments. ECS’ documentation reports range from providing relatively basic documentation for simple inbound or outbound sales to complex analyses documenting royalty rates, buy-ins for cost sharing agreements, and other intangible transactions.

• ECS analyzed the royalty rates paid to a European parent company by U.S. manufacturing entities for use of the parent’s brand names, trademarks, and technology. To demonstrate the reasonableness of the rates, ECS examined the prevailing rates in the industry and compared the profitability of the U.S. operations, both before and after payment of the royalties, with the profitability of a sample of independent U.S. companies in the industry. ECS’ analysis provided the basis for the successful resolution of this issue.

• A foreign-owned U.S. distributor with a history of contentious IRS examinations used its initial transfer pricing documentation report by a senior ECS professional to establish a cooperative dialogue that led the IRS to close the examination without proposing any change in transfer prices.

• In one of the first IRS examinations of a year covered by a section 6662 report, the senior ECS professional responsible for the report persuaded the IRS field team to accept the report's definition of the scope of the controlled transactions, selection of the best method, choice of comparables, and adjustments to those comparables, leaving only a small adjustment to the client's allocation of expenses between the controlled and uncontrolled transactions.

Foreign Documentation

Reports that are intended to be given to non-U.S. governments are designed to take account of the relevant governments’ preferences in methodology and terminology. In preparing a documentation report, ECS chooses and applies the most appropriate method based on a thorough analysis of the intercompany transactions and available uncontrolled comparables, while remaining constantly mindful of the client’s budget and the likelihood that the documentation will be subject to government scrutiny.

• A multinational client wanted to implement a single approach that would be applied consistently on a worldwide basis. ECS prepared an analysis documenting the intangible property and risk-taking assumptions adopted by the client, and developed an approach to calculating resale gross margins that varied by country and product line. This analysis has provided the basis for the client’s successful responses to Customs and tax audits for more than a decade.

• ECS has provided documentation for use in Mexico, Canada, Europe and Japan, and is currently working with various clients in preparing the contemporaneous documentation reports that now are required in Canada.

• An ECS documentation report prepared for non-U.S. distribution subsidiaries of a U.S. multinational, using the OECD approved transactional net margin method ("TNMM"), was recently accepted by Japan’s National Tax Administration as the appropriate standard for testing the arm’s length nature of transfer prices paid by the company’s Japanese subsidiary.

Advance Pricing Agreements

Through an Advance Pricing Agreement (APA), companies can establish the arm’s length nature of their intercompany prices to avoid future disputes. Sometimes the APA process can also be used to resolve disputes over past years efficiently and economically. ECS’ documentation reports provide the economic analysis and demonstration that intercompany prices are consistent with arm’s length expectations that are critical in obtaining an APA.

• ECS provided the economic analysis used in reaching a bilateral APA for its client’s sales between the United States and Canada. ECS’ analysis demonstrated that the prices paid by the Canadian entity to the affiliated U.S. supplier were consistent with those paid in third party transactions.

• ECS provided the economic analysis of third party license and supply agreements that became the basis for an APA allowing foreign affiliates to use technology developed by the U.S. parent company.