Understanding Transfer Pricing Rules for Foreign-Owned U.S. Entities

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When a foreign business has a U.S. entity, there are often intercompany transactions that occur between the U.S. entity and its foreign parent. These transactions may take the form of loans, interest expense payments, management or services fees, and even intercompany sales or purchases of inventory between the two entities or the U.S. entity and other related parties/businesses in the organization. As a result, the foreign business needs to consider transfer pricing rules.

Transfer pricing relates to the controlled transactions that exist between related parties, such as services provided, goods sold, or intercompany funding. The IRS applies transfer pricing rules to any U.S. business regardless of size. Since a foreign business setting up a new U.S. entity is likely to have intercompany transactions with its U.S. entity and that U.S. entity with other foreign related entities, transfer pricing rules need to be addressed. The regulations are designed to prevent tax avoidance among related entities and apply an arm’s-length standard to each transaction.

The arm’s-length standard generally is met when the results of a controlled transaction are consistent with results that would have been realized if uncontrolled taxpayers had engaged in a similar transaction under similar circumstances. Foreign businesses that do not implement arm’s-length practices may face potential tax consequences, including an adjustment to taxable profit of its U.S. entity and potential penalties for non-disclosure and underreported income.

To implement a transfer pricing plan, foreign businesses must maintain documentation demonstrating that intercompany charges are reasonable and comply with arm’s-length standards. Regulations set forth the principal documents that must be maintained by a taxpayer to satisfy the transfer pricing documentation requirement. Having this documentation does not automatically protect against penalties, but significantly reduces potential exposure if arm’s-length principles are adhered to.

To meet the documentation requirement of the penalty regulations, taxpayers must select and apply a method in a reasonable manner and document the selection process and its application. Documentation, including transfer pricing studies, should be updated annually, and full studies should be completed every third year of operation. A transfer pricing plan is generally required to be produced within 30 days when requested by a tax authority.

It is important to note that inadequate, incomplete, or untimely production of documentation makes it much more difficult and resource intensive for an IRS examination team to assess a taxpayer’s reporting position. This will increase audit time and taxpayer burden, as well as exposure to IRS-assessed penalties.

For more information on how U.S. transfer pricing rules and intercompany documentation requirements may affect your foreign business, please reach out to Kevin Brown or Gwayne Lai of Baker Tilly x Anchin or your Baker Tilly x Anchin Relationship Professional. Stay tuned for the next installment of our U.S. Expansion Playbook series, which will delve into the withholding regime.