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Transfer Pricing: A Primer
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Transfer pricing in the news 

Excerpt from Bloomberg BusinessWeek (October 21, 2010):
To reduce its overseas tax bill, Google uses a complicated legal structure that has saved it $3.1 billion since 2007 and boosted last year's overall earnings by 26 percent. While many multinationals use similar structures, Google has managed to lower its overseas tax rate more than its peers in the technology sector. Its rate since 2007 has been 2.4 percent . According to company disclosures, Apple (AAPL), Oracle (ORCL), Microsoft (MSFT), and IBM (IBM) ² which together with Google make up the top five technology companies by market capitalization ² reported tax rates between 4.5 percent and 25.8 percent on their overseas earning from 2007 to 2009. All of these arrangements are legal. Google's practices are very similar to those at countless other global companies operating across a wide range of industries, says Jane Penner, a company spokeswoman who declined to address the particulars of Google's tax strategies.

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Media reaction to Google story
The tactics of Google « depend on transfer pricing, paper transactions among corporate subsidiaries that allow for allocating income to tax havens while attributing expenses to higher-tax countries. Such income shifting costs the U.S. government as much as $60 billion in annual revenue, according to Kimberly A. Clausing, an economics professor at Reed College in Portland, Oregon.
- Bloomberg News, October 21, 2010

It s called transfer pricing how s it mesh with that whole

and technically it s legal. But don t be evil thing?

- Kai Ryssdal, American Public Radio, October 21

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Scope of this presentation 

An Overview of Transfer Pricing 
 

Terms of Art Best Method Rule Comparability 

  

Types of Controlled Transactions Examples Recordkeeping Requirements Advance Pricing Agreements

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Overview of transfer pricing

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What is transfer pricing? 
Transfer

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pricing is a set of rules that looks at whether the pricing on a transaction between related parties is the same as the arm·s length price that would occur in a comparable transaction between unrelated parties. 
Designed

to prevent tax avoidance among related

entities 
Concern

about tax avoidance likely to occur only when ´controlledµ parties are subject to different tax regimes

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Terms of art 

Taxpayers 


For purposes of 482, a taxpayer is any person, organization, trade or business, whether or not subject to US taxation. Treas. Reg. § 1.482-1(i)(3). Foreign persons are therefore taxpayers for purposes of these rules. Any control, direct or indirect, whether legally enforceable or not, and however exercisable or exercised, including control resulting from the actions of two or more taxpayers acting in concert or with a common goal or purpose. Treas. Reg. § 1.482-1(i)(4). It is the reality of control that is decisive, not its form or the mode of its exercise. A presumption of control arises if income or deductions have been arbitrarily shifted. A controlled taxpayer means any one of two or more taxpayers that are controlled directly or indirectly by the same interests and includes a taxpayer that owns or controls other taxpayers. Treas. Reg. § 1.482-1(i)(5). 

Controlled  

 

Controlled taxpayers 

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Terms of art (cont.) 

Controlled group 

The taxpayers owned or controlled directly or indirectly by the same interests. Treas. Reg. §`.482-1(i)(6). 

Transaction 

Any sale, assignment, lease, license, loan, advance, contribution, or any other transfer or interest in or a right to use any property or money, however such transaction is effected, and whether or not the terms of such transaction are formally documented. Treas. Reg. §1.482-1(i)(7). 

Controlled transaction 

Any transaction between two or more members of the same group of controlled taxpayers. Treas. Reg. § 1.482-1(i)(8). 

Uncontrolled transaction 

An uncontrolled transaction is any transaction between two or more taxpayers that are not members of the same group of controlled taxpayers. Id.

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Key concept: arm·s length price 
The

price at which two unrelated and nondesperate parties would agree to a transaction.

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Key concept: best method rule 

Every controlled transaction must be judged under the pricing method that provides the most reliable measure of an arms length result. All methods rely on the assumptions the taxpayer uses. The key to supporting the best method is the soundness of those underlying assumptions. There is no hierarchy of methods. Primary factors to determine best method: 
   



Degree of comparability between the controlled transaction and any uncontrolled transactions; The quality of the data and assumptions used in the analysis; and A higher degree of comparability results in a smaller chance that differences could render the analysis inaccurate.

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Key concept: comparability 

Taxpayers can determine the most reliable price by comparing to transactions that occur between unrelated parties. Comparability of transactions depends on: 
    

Functions performed by parties; Risks undertaken; Contractual terms; Economic conditions; and Nature of goods and services. 



Relevancy of factors Adjustments must be made to account for any differences in comparability.

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Types of controlled transactions

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Types of controlled transactions 
    

Loans or advances Performance of services Use of tangible property Sales of goods and other transfers of tangible property Use of intangible property Global dealing operations

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Loans and advances 

The IRS can make a § 482 allocation if one member of a controlled group makes a loan or advance to another member of that group but does not charge an arm·s-length rate. Treas. Reg. . § 1.482-(2)(a)(1)(i). 


The IRS may determine that the rate is too high or too low. The IRS may impute interest on accounts receivable if they are not promptly paid. 

Debt terms between controlled taxpayers is at arm·s length only if it bears interest at a rate that would be charged in independent transactions with or between unrelated parties under similar circumstances. Treas. Reg. § 1.482-2(a)(2)(i).

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Loans and advances (cont.)  

Exceptions to general rule:
Safe harbor (Treas. Reg. § 1.482-2(a)(2)(iii)) 


Available if the creditor is not engaged in the business of making loans. Stated interest is deemed to be arm·s length if it is not lower than the applicable federal rate (´AFRµ) or higher than 130% of the AFR. If there is no stated interest, the AFR may be used. If the stated interest is higher than 130% of the AFR, 130% of the AFR may be used. 

 

If a taxpayer borrows money from an unrelated party and relends to a controlled party, the stated interest on the unrelated debt should be used for the controlled transaction. Treas. Reg. § 1.482-2(1)(2)(ii).

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Performance of services 

If a member of a controlled group performs marketing, managerial, administrative, technical or other services for another member, the parties must establish an arm·s-length price as compensation for those services. Treas. Reg. § 1.482-2(b)(1).  

An arm·s-length service fee must be charged whether the services are performed for the benefit of one particular member or to benefit the entire group. Treas. Reg. § 1. 482-2(b)(2)(i). The arm·s-length fee must be based on the benefits expected when the services are performed, rather than the benefits actually realized. Id. 

No charge required in the following situations (Treas. Reg. § 1.4822(b)(ii)): 


Parent company performs services in its capacity as shareholder of subsidiaries; and A member performs services that are duplicative of activities performed by another member on its own behalf.

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Performance of services (cont.)
f

A member of a controlled group that provides intercompany services to another member must charge an amount equal to the amount that it would charge if the two parties were unrelated and dealing at arm·slength. Treas. Reg. . § 1.482-2(b)(3). Preferred methods for calculating arm·s-length rate
f f

f

Comparable uncontrolled price (´CUPµ) method; and Cost plus method.

f

If services performed are not integral to either the performer of the services or the recipient, the arm·s-length charge is equal to the cost of providing the services. Id.
f

For example, head office costs incurred by a parent company may be allocated to subsidiaries that benefit from those services but are typically not marked up because those administrative services are not integral to the parent·s business.

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Performance of services (cont.) 

Services are treated as an integral part of the business activity (Treas. Reg. § 1.482-2(b)(7) if any of the following apply: 

Services are considered integral to the business of a service provider or recipient if either party is engaged in the trade or business of rendering similar services to unrelated persons; or Services are considered integral to the business of the service provider if the performance of such services for related persons is one of its principal business activities.  

For example, a controlled member whose sole purpose is to provide marketing services in a target market and provides such services to members of the controlled group will be subject to transfer pricing rules.

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Use of tangible property 

A member of a controlled group that uses or occupies tangible property that is owned or leased by another member of the controlled group must pay an arm slength rental charge. Treas. Reg. i 1.482-2(c)(1). Relevant factors to be considered: 
    

Period and location of use; The owner s investment in the property or the rent paid; Expenses of maintaining the property; The type of property involved; and The condition of the property.

Treas. Reg. § 1.482-2(c)(2)(i). 

If one controlled subleases the property to another member, the arm s-length price of the sublease is deemed to be the lease amount that the lessee pays to the unrelated party plus any other expenses associated with the property, such as maintenance, repair, utility, and management costs. Treas. Reg. i 1.482-2(c)(iii).

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Sales of goods 

If a member of a controlled group transfers tangible property to another member, the parties must establish an arm s length sales price An arm s length price for the sales of goods between two members of a controlled group must be tested using one of five methods: 
     

Comparable uncontrolled price method ( CUP Resale price method; Cost plus method; Comparable profits method; Profit split method; or

);

Any other method if the taxpayer can demonstrate that such method is the most reliable measure of arm·s length results.

Treas. Reg. § 1.482-3(a).
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Sales of goods (cont.) 

CUP Method 


The arm s-length price is calculated as the price that the seller obtains in a comparable uncontrolled transaction. Treas. Reg. i 1.482-3(b)(1). The CUP method will usually be the best method if there are no differences between the controlled and uncontrolled transactions that would affect the price or there are only minor differences for which appropriate adjustments to price can be calculated. Treas. Reg. § 1.482-3(b)(2)(ii)(A).  The most important comparability factor for purposes of this calculation is similarity of product. Treas. Reg. i 1.4823(b)(2)(ii)(A).  Contractual terms are also key here, such as scope of warranties, sales volume, credit terms, and transport terms. Treas. Reg. § 1.4823(b)(2)(ii)(B)(2).

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Sales of goods (cont.) 

Resale Price Method 

The arm·s-length price for a sale between controlled taxpayers is the price at which the goods are resold by the buyer to an unrelated person, less a gross profit comparable to that earned by a comparable uncontrolled distributor in comparable circumstances. Treas. Reg. § 1.482-3(c)(2)(i). This method is appropriate for entities that buy and resell goods without adding substantial value by physically altering them. Treas. Reg. § 1.4823(c)(1). This method is inappropriate for a controlled buyer that owns intangible property that adds substantial value. Id.  

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Sales of goods (cont.) 

Cost Plus Method 

The arm·s-length price for a controlled sale under this method is the sum of the seller·s cost of goods sold and an appropriate gross profit markup determined from comparable uncontrolled transactions. Treas. Reg. § 1.482-3(d)(1). The appropriate gross profit is the product of the controlled seller·s production costs and the gross profit markup expressed as a percentage of cost, that is earned in comparable uncontrolled transactions. Treas. Reg. § 1.482-3(d)(2)(ii). Controlled and uncontrolled transactions are comparable only if the manufacturing functions, capital investments, risks, and contract terms do not differ materially or reliable adjustments can be made for material differences. Treas. Reg. § 1.482-3(d)(3)(ii)(A).  

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Transfers of intangible property 

For licenses and other transfers of intangible properties, the primary method authorized by the 482 regulations to determine the appropriate arm¶s length price is the comparable uncontrolled transaction (³CUT´) method. Treas. Reg. § 1.482-4(a). 

The other permissible methods are: 


Comparable profits method; and Profit split method.

Id.

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Intangible defined 

An ´intangibleµ is all property that has ´substantial value independent of the services of any individual and is within one of six classes: 
   

Patents, inventions, formulae, processes, designs, patterns, or know how; Copyrights and literary, musical or artistic compositions; Trademarks, trade names, or brand names; Franchises, licenses, or contracts; Methods, programs, systems, procedures, campaigns, surveys, customer lists, or technical data; or Other similar items where the value derived comes not from its physical attributes but from its intellectual content or other intangible properties. 

Treas. Reg. § 1.482-4(b).

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Type of transfer of an intangible
f

A controlled transfer of an intangible may be either a sale, a license, or some other permission to use the intangible. The IRS typically respects the form of the transaction if it is consistent with the underlying economic substance. There are some exceptions to this treatment, however:
f

f

f

If a transferee pays little or no consideration and the the transferor retains a substantial interest in the property, the transaction will be analyzed as a license. Treas. Reg. § 1.482-4(f)(1). The IRS, even if it accepts the form, may consider the other alternative forms for purposes of determining the correct amount of consideration. Treas. Reg. § 1.482-1(d)(3)(iv). Sec. 482 requires that the income with respect to the transfer or license of an intangible must be commensurate wit the income attributable to the intangible. Treas. Reg. § 1.482-4(f)(2) interprets this clause to mean that such a transaction will be subject to periodic review.

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CUT method 

The arm·s length consideration for the use of any intangible under the CUT method is the amount charged in a comparable uncontrolled transaction. Treas. Reg. § 1.482-4(c)(2)(i). The CUT method is likely to be the best method when the intangible transferred in a controlled transaction was also transferred in an uncontrolled transaction. Treas. Reg. § 1.482-4(c)(2)(ii). Two intangibles are considered comparable only if they are used in connection with similar products or processes within the same industry and have similar market potential. Treas. Reg. § 1.482-4(c)(2)(iii)(B)(1). The reliability of the results under the CUT method depends on the quality and completeness of the underlying data and assumptions. Treas. Reg. § 1.482-4(c)(2)(iv.)   

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Global dealing of financial service firms 

Special methods apply to financial services firms: 
  

Gross Margin Method Comparable Uncontrolled financial transaction method Gross Markup Method Profit Split Method

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Transfer pricing example

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Transfer pricing example 

U.S. SUB is a wholly-owned subsidiary that distributes toasters on behalf of its Foreign Parent, FP, in the U.S. FP also sells toasters to unrelated Company C for U.S. distribution.  

Products sold to U.S. SUB are of higher quality than those sold to Company C. The effect on the price of the toasters cannot be accurately determined. 

U.S. SUB also purchases blenders from unrelated parties for resale in the U.S. 

Distributions functions between toasters and blenders appear to be similar. Products are sold to the same type of customer, purchased under similar terms and volumes and have similar resale values.

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Questions to ask yourself 
 

Step One: Are there controlled taxpayers? Step Two: Is there a controlled transaction? If so, what kind? Step Three: Which pricing method should be used to determine the most reliable transfer price? Step Four: Do you have data from comparable uncontrolled transactions? Step Five: What is the arm s length price after applying the most reliable pricing method chosen in Step Four?  

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Step 1: Are there controlled taxpayers? 


In our example, the parties we have are U.S. SUB and its foreign parent, FP. U.S. SUB and FP are clearly related and therefore will be treated as controlled taxpayers.

Step 2: Is there a controlled transaction?
f In our example, U.S. SUB purchases toasters from its foreign parent, FP. f This transaction is a sale of tangible property between two controlled taxpayers

and therefore constitutes a controlled transaction.

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Step 3: Determine the most reliable pricing method 

Several pricing methods potentially apply to a sale of tangible goods: 
   

Comparable Uncontrolled Price; Resale Price; Cost Plus; Comparable Profits Method; and Profit Split Method. 



For purposes of example, we will compare two methods: CUP and Resale Price Comparability factors: 
 

Functions performed, contractual terms, risks, economic conditions and property being sold or services performed CUP most important factors are similarity of product, contractual terms and economic conditions Resale Price most important factors: similarity of functions, risks borne and contractual terms

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Step 4: Using data from comparable uncontrolled transactions 

From the facts in our example, we know that the toasters sold in the controlled transaction differ significantly from the toasters sold in the uncontrolled transaction and that the effect on price cannot be accurately determined. Further, the facts show that the distribution functions for the sale of toasters and the sale of blenders by the controlled reseller are similar. The products are sold to the same customers, purchased RU7 under similar contractual terms and have similar resale values. Analyzing the comparability factors, we can conclude that the resale price method will be the most reliable.  

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Slide 34 RU7 In the example, the products are not of similar quality. In the CUP method ,similarity of products is an important factor, so this method loses reliability here. Further, the facts show that the reseller is the same in the controlled and uncontrolled transactions and the functions are similar, important factors in the resale price method. Therefore, the resale price method will provide a higher level of reliability than the CUP method in determining the best arm s length price.
Registered User, 1/21/2011

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Step 5: Apply pricing method to transaction
U.S. SUB Revenues from Resales of Blenders of Toasters Cost of Goods Sold COGS-Blenders (unrelated) COGS-Toasters (related) Gross Profit Blenders Toasters Gross Profit Margin-Uncontrolled Blender transaction 250 200 25% 750 800 1000 1000

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Step 5: apply pricing method to transaction (cont.)
f f f

Applying uncontrolled gross profit margin of 25% to the tested transaction .U.S. Sub s gross profit for toasters should be $250 (25% x $1000)

Using $250 as the arm s-length gross profit, we can determine what price U.S. Sub should pay FP for the product:

Revenues Less: arm¶s-length profit Total COGS for toasters

1,000 (250) 750

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Recordkeeping requirements

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Overview of Recordkeeping Requirements 

There are two key costs associated with a taxpayer s failure to keep adequate transfer pricing records: 


Tax penalties; and Increased audit costs. 

NB: Remember that a controlled transaction subject to the transfer pricing rules will have to deal with a minimum of two separate taxing jurisdictions. Therefore, the taxpayer will have to factor in potential audit costs and penalties in not only the U.S. but in each jurisdiction in which it has a controlled transaction.

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Transfer pricing penalties 

If the IRS determines that there is a substantial underpayment of tax as a result of a incorrect transfer pricing, the taxpayer will be subject to a penalty equal to 20% of such underpayment. This rule only applies if the IRS determines the transfer price is 200% or more (or 50% or less) of the transfer price the taxpayer used. IRC § 6662(e)(1)(B). If the IRS determines the transfer price is 400% or more (or 25% or less) of the transfer price that the taxpayer used, the underpayment will be treated as a gross valuation misstatement and will be subject to a penalty of 40% of the underpayment. IRC § 6662(h)(1). Exception: Neither of these penalties apply if the taxpayer can show that, given the available data and the applicable pricing methods, the method (and its application of that method) provided the most reliable measure of an arm's length result, and can establish that it had specific and adequate documentation of the transaction at the time it filed the return. Treas. Reg. § 1.6662-6(d)(iii).  

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IRS audits 

IRS auditors now request as a matter of course at the beginning of any examination that the taxpayer provide copies of all detailed transfer pricing documentation. Taxpayers therefore cannot start thinking about their transfer prices only when the IRS issues the first Information Document Request. If the taxpayer fails to maintain documentation and timely provide it to the IRS, the threat of a penalty may impact the entire examination, not only the transfer pricing issues. Well-prepared taxpayers will plan their transfer prices during the taxable year, prepare thorough documentation when the tax return is filed, and organize supporting documents to be provided to the IRS. The stronger the documentation, the greater the likelihood that its disclosure will discourage further IRS inquiry into the taxpayer's transfer pricing practices. It is therefore critical that the taxpayer maintain the specific and adequate documentation required by the IRS.  

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Required documentation 

Documentation must be in existence when the return is filed. The IRS may excuse a minor or inadvertent failure to provide required documents, but only if the taxpayer has made a good faith effort to comply, and the taxpayer promptly remedies the failure when it becomes known. 

The required documentation is divided into two categories, principal documents and background documents.The taxpayer must keep a general index of the principal and background documents and a description of the recordkeeping system used for cataloging and accessing those documents.

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Principal documents 

The principal documents should accurately and completely describe the basic transfer pricing analysis the taxpayer has conducted.The documentation must include the following: 
 

 

An overview of the taxpayer's business, including an analysis of the economic and legal factors that affect the pricing of its property or services; A description of the taxpayer's organizational structure (including an organization chart) covering all related parties engaged in transactions potentially relevant under section 482, including foreign affiliates whose transactions directly or indirectly affect the pricing of property or services in the United States; Any documentation explicitly required by the regulations under section 482; A description of the method selected and an explanation of why that method was selected, including an evaluation of whether the regulatory conditions and requirements for application of that method, if any, were met; A description of the alternative methods that were considered and an explanation of why they were not selected;

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Principal documents (cont.) 

More required principal documents: 
  

A description of the controlled transactions (including the terms of sale) and any internal data used to analyze those transactions. A description of the comparables that were used, how comparability was evaluated, and what (if any) adjustments were made; An explanation of the economic analysis and projections relied upon in developing the method. for example, if a profit split method is applied, the taxpayer must provide an explanation of the analysis undertaken to determine how the profits would be split; and A description or summary of any relevant data that the taxpayer obtains after the end of the tax year and before filing a tax return, which would help determine if a taxpayer selected and applied a specified method in a reasonable manner.

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Background documents 

The assumptions, conclusions, and positions contained in principal documents ordinarily will be based on, and supported by, additional background documents. Documents that support the principal documentation may include: 
         

Books and transaction records of original entry; Applicable profit and loss statements; Documents relating to transactions involving the same or similar products or services; Shipping and export documents; Commission agreements; Third-party and intercompany purchase and sales invoices; Manuals and specifications; Documents describing or setting out the functions, responsibilities, and risks of the various related and unrelated parties; Documents relating to the transactions that the taxpayer or a related entity filed with foreign countries; Records of loans, guarantees, and hedging or other risk-shifting agreements; and Records of research and development sharing agreements and agreements for the provision of management services. 

The taxpayer need not provide background documents to the IRS in response to a request for principal documents. If the IRS subsequently requests background documents, a taxpayer must provide that documentation to the IRS within 30 days of the request. However, the IRS may, in its discretion, extend the period for producing the background documentation.

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Advance pricing agreements ( APA ) 

Taxpayers can choose to negotiate the best transfer pricing method for their controlled transaction with the IRS through an APA. Google famously entered into an APA with respect to its controlled transactions. 
 



Taxpayer must file a request for an APA before filing its tax return Types of APA  Unilateral APA ² Between the taxpayer and the IRS  Bilateral or multilateral APA ² Among the taxpayer, the IRS, and the taxing authorities of one or more foreign jurisdictions Term: Usually a minimum of five years Benefits:  The taxpayer does most of the work to establish the best transfer pricing method and therefore has a chance to establish the most favorable transfer pricing method.  The taxpayer will have a certain tax position that allows it to decide whether to enter into the transaction in the first place.  Minimizes compliance and audit costs.

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Cost sharing agreements 


Most common proactive tax planning tool (e.g., Google) Allows companies to treat intellectual property as owned offshore for tax purposes Requires a sophisticated set of calculations High scrutiny by tax authorities 



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Almost every country has transfer pricing rules. Therefore, your client will have to calculate the correct transfer price in compliance with the laws of every country in which the transaction takes place. Document, document document. Taxpayers must proactively manage their potential transfer pricing exposure. There are potentially significant financial risks associated with failure to manage transfer pricing exposure Operating in multiple jurisdictions presents your client with tax planning opportunities.   

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