Why you should offer (and automate) transfer pricing services for your clients
Historically, only large accounting firms with an in-house practice or boutique specialists have offered transfer pricing services. As more businesses expand internationally, and grow earlier in their life cycle, client demand for transfer pricing services among midsize and smaller accounting practices is also increasing. Fortunately, new advances in automation are helping to eliminate the need to outsource or create an in-house practice, enabling accountants with globally expanding clients to offer transfer pricing services of their own.
What is transfer pricing?
Transfer pricing is the price an entity charges a related affiliate, subsidiary, or commonly controlled company for goods, services, licenses, or loans. For compliance purposes, the price of these intercompany transactions must be based on the arm’s length principle, which essentially suggests pricing be comparable to the price a company would charge an unrelated party under similar circumstances.
Transfer pricing is a common tax planning tool. By allocating more profits to lower tax jurisdictions (both countries and states), or to entities with carryforward losses, intercompany transaction prices can lead to tax savings for a multinational group as a whole.
How to determine the best transfer price
To help ensure global profits aren’t artificially shifted from one jurisdiction to another, multinational corporations and tax authorities have adopted the Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines. These include the documentation taxpayers need to support the pricing of their intercompany transactions.
There are five main methods for a taxpayer or its accounting partner to establish a transfer price:
- Comparable uncontrolled price method
- Cost-plus method
- Resale price method
- Comparable profit method
- Profit-split method
1. Comparable uncontrolled price method
The comparable uncontrolled price method compares the price of an intercompany product or service to the price of a similar transaction between the taxpayer and an unrelated party, or a similar transaction between unrelated parties. While this method is the prefered method, it’s rarely used because of its many required similarity factors (e.g., the product/service, the contractual terms, and the geographic market must all be substantially similar).
2. Cost-plus method
The cost-plus method compares the gross profit margin markup and is typically used when the taxpayer is engaged in manufacturing activity. A relatively high degree of similarity is required when using this method.
This is different from the cost-plus model, described below.
3. Resale price method
The resale price method (RPM) is used to determine the price of tangible personal property only, not services. With this method, the gross margin on a transaction between related parties must be the same as the gross margin on a similar transaction between unrelated parties.
If similar transaction data isn’t available or there isn’t enough reliable information to apply a transactional-based method, a profit-based method is usually used.
4. Comparable profit method
The comparable profit method is the most commonly used. It compares the profitability ratios of one party (e.g., the service provider or reseller) to the profitability ratios of comparable companies, typically using the operating profit. The similarity requirements for the product/service are lower under this method, but there must be greater similarity among the functions, risks, and assets.
There are two commonly used models applied under this method: The low-risk distributor model and the cost-plus model.
Low-risk distributor model
The low-risk distributor model is generally used when one party resells another party’s products, including software and SaaS solutions. In this model, the reseller’s operating profit margin (a percentage of sales) is compared to the operating profit margins of comparable companies. See a use case for the low-risk distributor model.
The cost-plus model is generally used when one party provides services to another party and the service provider is considered low risk (i.e., it doesn’t bear significant risks or use significant intangible assets in providing the service). It’s typically used when:
A foreign subsidiary acts as a contract manufacturer on behalf of its parent company
A subsidiary provides research and development (R&D) services to another company in the group
A parent company provides management services to a subsidiary
The markup itself is typically based on profitability. See a use case for the cost-plus model.
5. Profit-split method
The profit-split method is used for more complex transactions in which two parties share intellectual properties in an intercompany transaction. For example: Company A has technology for running shoes, Company B has the brand name, and together they develop a new shoe and split the profits according to each party’s contribution to the overall profit.
All five methods described above should fulfill the OECD’s arm’s length principle.
The Internal Revenue Service (IRS) has the authority to adjust the income, deductions, credits, or allowances of commonly controlled taxpayers to clearly reflect their income and prevent tax evasion. The agency looks to ensure prices charged by one affiliate to another “yield results that are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances.”
Because of the inherent complexity and higher audit risk associated with transfer pricing, multinational companies generally rely on accounting firms to ensure they maintain compliance with requirements in the countries where they operate.
Because of that same complexity and risk, midsize and small accounting practices typically take one of the following routes when a client develops transfer pricing needs:
Try to manage transfer pricing manually (with mixed results)
Contract the business out to a larger firm with an in-house practice
Turn the clients away
Transfer pricing is complicated, but there’s a simpler option available to most firms: automation.
Automating transfer pricing services
Automation allows accounting firms and consulting firms to supplement existing or offer new transfer pricing services, thereby meeting the growing needs of multinational or multistate clients.
Avalara Transfer Pricing Reports for Accountants simplifies and automates the transfer pricing documentation process, so even nonexperts can do it. It supplies necessary control and visibility while enabling firms with or without transfer pricing capabilities to prepare transfer pricing reports for their clients in three simple steps: data collection, documentation review, and report generation.
Templated reports combine predetermined, fixed benchmarks with a self-guided questionnaire that simplifies and streamlines the workflow. This allows accounting practices to offer growing international clients, including ecommerce sellers, a value-added service that improves client satisfaction and enhances their role as a trusted advisor.
Learn more about Avalara Transfer Pricing Reports for Accountants.
It’s here — Read Avalara Tax Changes 2023
Review tax updates and trends, plus get a forecast of what’s to come
Stay up to date
Sign up for our free newsletter and stay up to date with the latest tax news.