Capitalize on Global Tax Rate Differences

Companies face an increasingly integrated international economy, an economy comprised of varying national corporate income tax rates.

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Transfer pricing enables companies to capitalize on those tax rate differences. By selling products, services and intangible items among controlled entities operating in various countries, companies may transfer some profits to nations offering the most favorable income tax treatment.

Capitalizing upon transfer pricing requires being aware of related U.S. tax provisions, as well as the regulations offered by various other countries. In the United States, transfer pricing requirements are documented in U.S. Treasury Regulations, 1.482. Those U.S. regulations allow corporations to adjust transaction transfer prices up to a tax filing deadline and any valid extensions. Other countries, including many European nations, require that transfer prices be set before a transaction.

Pricing equivalencies

Companies utilizing transfer pricing must also adhere to an arm’s length standard, a standard that requires that prices be equivalent to what a company would face on the open market for a product, service or intangible asset.

Complying with that arm’s length standard and setting appropriate prices requires industry knowledge and analyzing what items would cost if purchased from an uncontrolled source. For companies willing to make the effort, transfer pricing regulations offer opportunities to realize considerable savings.

A U.S. corporation, for example, established a manufacturing facility in China to produce electronic devices. The intangible assets, including the necessary manufacturing expertise, reside with the Chinese company. By determining what those electronic devices would cost if purchased from a domestic distributor, the U.S. corporation sets an appropriate transfer price to pay the Chinese company.

The U.S. corporate income tax rate is 35 percent, while the Chinese company must pay a 25 percent tax rate in China. Purchasing those electronic devices from the Chinese company essentially enables the American corporation to transfer profits to that entity by increasing the purchase price to an acceptable level. Those profits are then taxed at the 25 percent tax rate in China.

While many countries such as China offer lower tax rates than the United States, there are instances in which companies benefit by transferring costs to a U.S. entity. An American corporation has a related entity operating in Canada that is comprised only of a sales force; all back-office functions, such as payroll administration, human resources and data processing, are performed by the U.S. corporation.

The sum of provincial and federal corporate income taxes in Canada makes it worthwhile to transfer those service costs to an American corporation in some cases, especially when an American company carries a large net operating loss that can absorb the added income without tax significance.

Transfer pricing methods may also be applied toward intangible items, such as the use of logos, trademarks and trade names. A British corporation with operations throughout Europe, for example, decided to establish a related company in the United States.

Rather than registering the logo, trademark and trade name as property of the U.S. entity, the British corporation retained ownership of those items, with the American entity paying annual royalties for use of those intangible assets. The corporate income tax rate in the United Kingdom is 28 percent, while the U.S. rate is 35 percent.  The company realizes an overall effective tax savings of 7 percent by paying these royalty fees to the British corporation.

Attaining such savings requires understanding applicable domestic and international tax regulations. It requires conducting and documenting detailed price analyses, too. Amidst difficult economic conditions and intense global competition, though, the potential tax savings can make meeting transfer pricing requirements worthwhile for American manufacturers with operations abroad.

Mary Thomas, CPA, JD, MKThomas@weaverandtidwell.com, is the Director of International Tax Services at Weaver and Tidwell.

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