Articles
9 February 2012

At Arm’s Length

IRS Requires Careful Cross-border Transactions

by Alan Summers and Peyton Robinson

09 February 2012—

 Before you consider conducting business with a foreign affiliate, it’s vital to understand the tax laws and consequences that may await you. 

The Internal Revenue Service (IRS) is empowered to adjust income, deductions, credits or allowances between commonly controlled businesses “to prevent evasion of taxes or clearly to reflect income.” Although the consequences of these possible adjustments are most often considered in international tax planning, foreign transactions are not necessary for the statute to apply.

U.S. regulations require that related entities deal with each other in a way that is at arm’s length. That general principle, as elucidated in the regulations, and as incorporated in the country’s income tax treaties, means that when a Utah business conducts business with a foreign affiliate (which could be any commonly controlled organization), one of them must charge or pay for services, a royalty for intangible property, or otherwise treat any transaction (including loans, and the use or sale of property) as if the affiliate were unrelated. If the U.S. entity fails to do so, the IRS may seek to adjust the pricing of such transactions and propose accuracy-related penalties. Then the related party may face the foreign tax authority raising questions of its own—and there is no assurance that both tax authorities will agree on how the income from the transaction should be divided. This potential for double tax on the same income makes this area of the tax law called “transfer pricing,” not merely a trap, but a minefield for the unwary. 

A sobering example is the 2006 settlement between GlaxoSmithKline Holdings (Americas) and the IRS. In lieu of litigation over the reasonableness of the U.S. company’s transfer pricing practices, the IRS and GlaxoSmithKline Holding reached a settlement in which the U.S. affiliate agreed to pay $3.4 billion in additional taxes. This was the largest single taxpayer settlement ever realized by the IRS.

 

Avoiding Double Tax Trouble

So what does your business need to know before conducting business with a foreign affiliate? 

The following example illustrates how easily this double tax problem can arise, the problems it can create, and what steps businesses can and should consider at the front end to head off problems with the tax authorities. The details are fictional, but are based on common scenarios seen in practice.

A Utah business, SnowFun (fictional name) believes that it can boost sales of its popular ski equipment by expanding into the British Columbia, Canada ski resort market. Canada is just one country in the company’s five-year plan, but as a neighboring country, SnowFun’s executive team believes it will be a good test market. While SnowFun could use unrelated companies to provide distribution of the ski equipment into Canada, management felt it would be more efficient to bring those operations in-house. 

At first, SnowFun used a sales branch to market its products near the British Columbia ski resorts, but Canadian sales grew rapidly and SnowFun eventually decided to incorporate its sales branch in Canada using the name CanadaSnow. SnowFun provided all sales support services to CanadaSnow in the start-up phase, including marketing materials, IT and administrative support, as well as products to stock its warehouse. 

The sales growth and cross-border activity of SnowFun resulted in an IRS audit for taxable years 2006 and 2007. Furthermore, the international examiner told SnowFun that the transactions it had with its Canadian subsidiary were under review. 

The transactions that may be subject to IRS scrutiny could be:

 

• The sale of tangible goods from SnowFun to CanadaSnow 

• Services provided by SnowFun to CanadaSnow for IT and other needs

• CanadaSnow’s use of SnowFun’s intellectual property in Canada

 

Advance Planning is Key

SnowFun has two primary objectives: 1) Make the IRS audit end as quickly as possible with no adjustment or penalties, and 2) enable the company to go forward with its business in a way that mitigates future audit risk from the Canada Revenue Agency and the IRS. 

Achieving these objectives requires careful advance planning. Justifications created after the fact to support the intercompany pricing are inevitably viewed with skepticism by tax authorities and rarely succeed. The lack of contemporaneous documentation of the analysis that supported the pricing of the transactions and the transfers of the tangible and intangible property exacerbates SnowFun’s and CanadaSnow’s exposure to a transfer pricing adjustment and accuracy-related penalties. Ideally, SnowFun should model the possible structure and functions of CanadaSnow as early as possible with a clear understanding of the contemplated intercompany transactions. 

 

Next Best Alternatives

Without advance planning or related documentation, SnowFun would be left to explain its intercompany pricing after the fact. Although a post hoc explanation may be viewed by the IRS as self-serving, SnowFun could prepare a study presenting information that was requested in the information document request for 2006 and 2007, but with a view to explaining and defending, rather than documenting the transactions. The point of the response to the IRS is to show that all of the transactions with CanadaSnow have been at arm’s length. Where the facts are supportive, this type of non-contemporaneous documentation has been successful on some occasions. 

If the IRS exam team is not persuaded by the explanations provided by SnowFun, then the typical IRS process would lead to a 30-day letter, allowing for the IRS appeals process, followed by a 90-day letter (a statutory notice of deficiency). There are numerous alternative dispute resolution processes available to SnowFun, including advance-pricing agreements. But whatever the company chooses, after the audit leads to a proposed adjustment, no company would choose it as an initial method to prepare for resolution of the issues.

 

The Bottom Line

As Utah companies move into international markets, they should think ahead regarding internal pricing—advance planning is crucial to avoiding transfer-pricing problems. While these internal transactions rarely drive business decisions for foreign investments, poor planning for internal transactions can cause significant business problems, including large tax adjustments and penalties.   

 

Attorneys Peyton Robinson and Alan Summers are in the Ernst & Young LLP National Tax Department. The authors may be contacted at: peyton.robinson@ey.com or alan.summers@ey.com. The views expressed in this article are those of the authors and do not represent the views of Ernst & Young LLP

 


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