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.