What is transfer pricing and why is it an issue?
While companies under common control (referred to in this article as multinational enterprises or MNEs) may conduct business with each other in the same manner as they do with third parties, they can also transact with each other at prices that they would not or could not with third parties. The prices at which intercompany transactions take place are called transfer pricing. Transfer pricing in and of itself is not an issue. The issue arises when MNEs use transfer pricing to accomplish group objectives, instead of setting transfer prices in the same manner as they would third party prices. For instance, they could use these intercompany transactions to increase profits in low tax jurisdictions (and correspondingly decrease profits in high tax jurisdictions), use intercompany pricing to prop up fledgling or failing companies or to accomplish other group organizational objectives. This type of manipulation of prices could result in profits or losses that may not be commensurate with the economic reality of the transactions undertaken.
The potential for jurisdictional misalignment of economic results is of concern because, even though these intercompany transactions may eliminate in consolidation for purposes of the MNE’s financial statements, both U.S. and foreign countries’ tax accounting guidance and tax law generally require a jurisdiction-by-jurisdiction tax analysis. Since tax jurisdictions rarely align such that an adjustment in one jurisdiction is offset by a corresponding adjustment in another jurisdiction, transfer pricing adjustments could result in double taxation, additional tax and penalties.
Tax authorities are focused on protecting the tax base from which their tax revenues are derived. In 2019, the IRS Commissioner, Charles Rettig, signaled his approval of the IRS “pushing the field with things like transfer pricing”. The IRS’ victory in the recent transfer pricing case against The Coca-Cola Company is expected to encourage the IRS to continue to vigorously pursue perceived transfer pricing abuses.
The Coca-Cola Case:
The Coca-Cola case highlights the importance of having profits reflect the economic underpinnings of an MNE’s transactions. In particular, this case reflects the importance of determining which entity owns intangibles, and the value that is expected to be generated by those intangibles.
The Tax Court agreed with the IRS’ determination that the transfer pricing methodology used by The Coca-Cola Company (“Coke”) did not reflect arm’s-length pricing because Coke’s mostly wholly owned contract manufacturers (“supply points”) were overcompensated (and therefore Coke was correspondingly undercompensated) by more than $9 billion for 2007 – 2009. This over-compensation was determined by comparing the profits earned by the supply points to the functions they performed, the risks they assumed and the assets they utilized in their business, using the Comparable Profits Method.
The Coke case delved into many technical issues, some specific only to Coke. However, the Tax Court’s discussion and holding regarding intangibles are of particular interest as the global economy continues to generate more value from non-physical i.e., intangible assets.
A particular point of contention between Coke and the IRS was the ownership of marketing intangibles. Despite Coke’s attempt to assign marketing intangibles to the supply points by having them pay marketing costs, the Tax Court found that the supply points had no real functions or responsibilities with respect to marketing, other than to pay the costs that Coke directed them to pay. The Tax Court agreed with the IRS that, based on what they did, the supply points were contract manufacturers. As such, transfer pricing theory would suggest that the supply points would have earned a small but positive operating margin, commensurate with their functions, risks and assets utilized. Instead, the supply points earned profits significantly in excess of the comparable companies selected (Coke bottlers, segregated into geographic regions). The additional profit was explained by Coke as compensation for the marketing intangibles allegedly belonging to the supply points. However, Coke’s agreements with its supply points identified Coke as the owner of the “assets generated by …marketing efforts”, and the court found that the economic substance resulting from the marketing activities did not support a different conclusion. Without ownership of the marketing intangibles, the supply points were essentially contract manufacturers. Thus, the IRS concluded that Coke was shifting profits to its foreign supply points.
The Tax Court agreed with the IRS. Coke plans to appeal.
While most companies won’t be dealing with the magnitude of adjustments as in the Coke case, it is important to note that economic returns for an entity (e.g., operating margin, return on assets) need to be commensurate with what that entity does, the risks that it bears and the assets that it owns and utilizes. Specifically, where intangibles are an important driver of profits, companies should clarify and document which entities create, own, and utilize the intangible asset.
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The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.