Last September, GlaxoSmithKline settled a 17-year-old dispute with the Internal Revenue Service over transfer pricing. The pharmaceutical giant agreed to pay the government $3.4 billion, the largest tax settlement in IRS history. The payment, which amounts to about 40 percent of the company's operating cash flow, is a reminder of the risks multinational corporations face as intercompany transactions come under increasing regulatory scrutiny.
Transfer pricing, which is supposed to value the sale of goods and services between corporate units at an arm's-length price, allocates corporate profit and tax among different jurisdictions, based on where economic value was created. Those allocations arouse regulators' suspicions when large differences in tax rates are involved. Testifying before the Senate Finance Committee in June 2006, IRS commissioner Mark Everson charged that companies "often manipulate the price" of activities between units so that one unit's income is "ostensibly earned in low tax jurisdictions, or in no jurisdiction, rather than the U.S."
Given the agency's concern over the "tax gap," the shortfall between taxes owed and taxes paid, it's not surprising that the IRS has made transfer pricing a top enforcement priority. Four years ago, it instructed its field examiners to make sure that companies had documentation on their transfer-pricing policies, including their choice of methods to calculate the arm's-length price and the economic and business reasons for each corporate unit. Since then, the IRS has intensified its scrutiny. The agency has created a multifunctional team headed by an executive who coordinates transfer-pricing investigations among lawyers and other experts at the IRS.
The effort is paying off. In fiscal 2005, the IRS Penalty Screening Committee reviewed 27 tax years and approved transfer-pricing penalties for each, according to Frank Ng, deputy commissioner, large and midsize business, international. In fiscal 2006, the committee reviewed 55 tax years. In all cases but one the penalty was approved and companies were forced to cough up cash.
The IRS isn't the only tax authority assembling economists, lawyers, and accountants to improve its oversight of transfer pricing. "Tax authorities around the world are increasing their focus on transfer pricing and sharing taxpayer information more readily with other [transfer pricing] treaty parties," cautions David Canale, director of national transfer-pricing services at Ernst & Young.
Put It in Writing
As the GlaxoSmithKline case shows, the stakes in transfer-pricing disputes can be enormous. In addition to the tax owed, penalties can range from 20 percent of the tax deficiency to 40 percent, according to Solomon Packer, an accounting professor at Baruch College Graduate School. An even bigger risk is the potential for double taxation when different tax jurisdictions claim the same slices of a firm's revenue. Such a scenario could lead to costly legal disputes and a high effective tax rate if the company isn't successful in its defense.
One way to mitigate those risks is to conduct a transfer-pricing study. Such documentation, which is not required by law, shows how a company arrived at an arm's-length price for intercompany transactions. A transfer-pricing study protects a business from a stiff penalty in the event of a tax adjustment by the IRS, notes Steven Musher, IRS associate chief counsel, international.
(Acknowledging the shift in the U.S. economy from manufacturing to services, the IRS issued temporary regulations in July 2006 for calculating an arm's-length price for services. Effective for taxable years beginning after December 31, 2006, the regulations list six methods for determining the price. The new regulations have "an extreme emphasis" on U.S. companies charging costs to foreign affiliates, says Steven Felgran, a principal at KPMG.)
A company can prevent transfer-pricing disputes altogether by entering into an advance pricing agreement (APA) on its pricing methods and tax allocation to jurisdictions. Such an agreement can involve one government or more. The APA program at the IRS began formally in 1991 and sparked a worldwide trend. At least 15 countries, including Canada, Japan, Korea, and China, have launched APA programs, many of which are modeled after the U.S. program. "More countries find this program to be an efficient, useful way of providing both a compliance tool and a taxpayer service," says Matthew Frank, director of the APA program at the IRS.
A number of multinationals have entered into APAs to achieve certainty in their taxes. One, AstraZeneca, first signed an APA between the United States and Britain in 1996 and is now in the process of renewing it, says Ian Brimicombe, AstraZeneca's director of group tax. While reaching an agreement is time-consuming and costly, Brimicombe remains a proponent of APAs. "If you're successful," he says, "there's a degree of certainty in your tax position — and, of course, what every CFO craves is certainty."
The elimination of uncertainty provided by an APA is "a nice benefit," agrees Barret Johnson, chief tax counsel at Pitney Bowes. But Johnson cautions that the benefit "does come at the cost of disclosing to tax authorities an awful lot of information about how you look at your business." To complicate matters, a company's business model, which is the basis for the transfer-pricing study and any agreements, could change quickly; for example, one business unit could be the main driver of the firm one year but not the next.
Last January, the first multilateral APA involving the United States and China was obtained by Wal-Mart, which operates in about a dozen countries and already has several APAs. An unusual aspect of this deal is the fact that it was made public; many companies consider the very existence of an APA to be confidential. (Johnson, for one, declines to say whether Pitney Bowes is a party to an APA.) But some companies have no qualms about touting their APAs and their benefits. For example, Google announced in January that it had entered into an APA with the IRS in December 2006, resulting in lower tax reserves and the recognition of an income-tax benefit of $90 million in fourth-quarter 2006.
As countries ratchet up their regulatory oversight, experts say companies should treat transfer pricing as a distinct category of risk. If managed well, it could result in a lower effective tax rate and prove to be a competitive advantage, says Horacio Peña, partner and senior economist at PricewaterhouseCoopers. Currently, many companies lack sufficient staff and resources to handle this risk.
David Canale's advice: Think globally, act locally. A multinational should have an overall transfer-pricing policy that is consistent with the arm's-length principle, customized according to each country's specific requirements. It should also have legally binding contracts for intercompany transactions. Those contracts should treat the deals as if the related businesses were unrelated, third parties. "Historically, a lot of companies haven't done this," says Canale.
Helen Shaw is staff writer for CFO.com.