Transfer pricing, an accounting practice widely used by multinationals with multiple divisions in different countries, can lower costs and taxes when goods or services are transferred between different divisions of the same company.
Because of the potential for abuse, however, it is carefully scrutinized by the Internal Revenue Service.
Just last month, the IRS demanded $28.9 billion, plus penalties and interest, in back taxes from Microsoft. The issue was a transfer pricing cost-sharing arrangement, which is not uncommon, according to Mimi Song, chief economist at Exactera.
“Many tech companies send intellectual property to entities in low-tax countries to be legally owned, developed, maintained, and exploited. Then, they share ongoing costs associated with the IP, which effectively allows them to book revenue and retain profits locally, thus reducing hefty tax bills in higher-tax countries.”
In the case of Microsoft, from 2004 to 2013 the tech giant licensed marketing and technology intangibles to entities in Puerto Rico, Ireland, and Singapore, all under a global cost-sharing arrangement.
“Due to the transfer pricing arrangement, Microsoft’s foreign income dwarfed that of the U.S., even though Microsoft’s IP was originally developed in the U.S.,” she said. “It raised the question about Microsoft’s business need for such a cost-sharing arrangement. After an initial investigation involving the Puerto Rico manufacturer, the IRS determined that the arrangement was ‘illusory in nature, serving no material economic purpose except to shift income to Puerto Rico.'”
It may take some time before the controversy is concluded.
“Microsoft plans to contest the case through the IRS’s administrative appeals office and, if necessary, the courts, which will take several years,” said Song. “In the meantime, though, taxpayers can learn from this case and be proactive about transfer pricing arrangements involving intangible assets.”
Song cited three lessons to be learned from the case:
- Tax cannot be the sole reason for a business decision. “Microsoft openly stated that some of its arrangements were constructed for tax purposes rather than business purposes,” she said. “But you can’t let the desire for lower tax bills lead business decisions. Of course, you can be smart and strategic, but shifting IP to low-tax jurisdictions for the sake of saving tax dollars is visible to tax authorities and not great for your company’s reputation with consumers, either. Tax authorities won’t hesitate to act on it. Business structure should always be based on what is best for the business.”
- The IRS is becoming an extremely tough adversary. “Historically, the IRS hasn’t had the best track record when cracking down on transfer pricing,” Song said. “Most taxpayers worried more about their pricing in other countries. However, lately the stars are aligning for the U.S. tax authority. In 2020, the IRS won a $3.3 billion payout from Coca-Cola over the transfer pricing of intangibles. Already, the IRS has made some unusually aggressive moves with Microsoft, including hiring a corporate law firm to represent the agency. Now with the $80 billion injection courtesy of the Inflation Reduction Act — a large portion of which is slated for transfer pricing compliance — the IRS will have the resources to go after other companies as well.”
- Substance over form. “Transfer pricing isn’t just a numbers game. Even with bona fide cost-sharing arrangements, tax authorities are likely to challenge the substance of the transaction and the buy-in payment,” said Song. “Profits stemming from intangible assets that land in tax havens or shell companies won’t go unnoticed. Even worse, such arrangements will be viewed as tax avoidance or evasion, and transfer pricing adjustments will be coupled with harsher penalties. When pricing intangibles, thoroughly evaluate the development, enhancement, maintenance, protection, and exploitation (or ‘DEMPE’) functions, which are considered to be the primary functions that determine economic ownership of intangibles. Craft the narrative to focus on economic and business substance, not merely legal ownership.”
Documentation is critical, Song emphasized.
“Transfer pricing documentation may be a compliance requirement, bu it’s also a chance to proactively explain business decisions,” she said. “Documenting transactions contemporaneously gives you the advantage of explaining the rationale behind transactions in real time, as opposed to trying to piece together explanations after the fact. Narratives matter.”
“Tax authorities may not understand your industry, so it’s important to explain the business and any red flags — for example, business that takes place in tax havens — and make sure documentation is consistent and aligns with reality,” she continued. “Being proactive about compliance, and mindful of these points, could just spare you the hassle and headaches that — win or lose — Microsoft is sure to face.”
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