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The Simple Approach to Transfer Pricing

October 11, 2017

Occam’s razor, a problem-solving principle attributed to philosopher William of Ockham, holds that “Entities are not to be multiplied without necessity.” The popular interpretation of Occam’s razor rule is that the simplest answer, application or explanation is preferred over the more complex solution. This also applies to tax planning benefits related to transfer pricing for international related party transactions.

The Case
A construction company headquartered in Minneapolis, Minn., wanted to expand into Canada. In order to meet Canadian requirements, the company created a Canadian legal entity (CanCo). CanCo would be responsible for sales and marketing, construction services, purchasing building materials, and hiring sub-contractors to complete construction projects within Canada. 

The Wants and Needs
The CFO of the U.S. headquartered parent of CanCo wanted to ensure that the U.S. parent company was being properly paid for providing sales, design, and construction development and oversight out of the U.S., so cash would flow efficiently back into the U.S. parent company. 

The U.S. parent company contacted the Eide Bailly NTO International Tax service team for assistance in creating an arms-length system of payment of charges incurred by the U.S. parent company.

The CFO asked Eide Bailly to analyze the arms-length cost related to the service the U.S. parent company performed for CanCo, particularly connected with:

  • Research and development
  • Construction process design
  • Purchasing
  • Quality control
  • Sales and marketing
  • Strategic planning
  • General administrative

The request that was made by the CFO is quite common for companies expanding internationally. But, the request suggests a question based on Occam’s razor rule: Why analyze the more complex side of an intercompany transaction?

In most intercompany transactions, there is a clear distinction between which entity performs the less-complex functions. Therefore, once that information is known, the focus should move to simplicity.  In the construction company example above, the U.S. parent company provides the more complex functions. The CanCo entity then performs sales and marketing activities at the direction of the U.S. parent, and arranges for labor and sub-contracting to complete the construction projects.

Our Approach
Eide Bailly’s recommended approach in a transfer pricing analysis is to benchmark the profitability of the entity with the less complex functions and those with fewer risks—in this example, CanCo. This has the benefit of:

  1. Being more efficient
  2. Being technically correct according to transfer pricing rules
  3. Focusing on what tax authorities are primarily concerned with regarding transfer pricing, i.e., an arms-length attribution of taxable income 

Rather than “multiplying entities without necessity,” Eide Bailly used the comparable profits method (CPM) to benchmark CanCo arms-length profit based upon its functions, risks and assets. We searched for companies with publicly-available financial statements domiciled in North America that perform functions similar to those of CanCo. Once we identified a set of comparable companies, we looked at what they earned as a markup on their total costs, or net cost plus markup. Then we calculated the interquartile range of those markups to determine the arms-length range of profitability that CanCo should earn.

Finally, we assisted the U.S. parent company and CFO with implementing their intercompany pricing plan. The U.S. parent collects all revenue. CanCo, on a monthly basis, calculates its total operating costs for providing services to the U.S. parent company and invoices those costs plus the arms-length markup determined under the transfer pricing plan. For example, if the arms-length markup is 5 percent of cost and CanCo’s costs are $100, the entity would invoice the U.S. parent for $105, creating $5 of taxable income in Canada. It should be noted the same “seek the less complex” approach can be taken with a foreign distributor where we benchmark functionally-similar distributors’ net operating margin, rather than functionality.

The Benefit
A focus on simplicity in transfer pricing is much easier, more accurate and supportable than the alternative. If companies take the more complex route, they will be performing more work than necessary and will still need to ensure their entities earn an arms-length profit for their activities, creating more administrative cost to get an answer. This would probably make William of Ockham simply ask “Why?” 

Please contact your Eide Bailly professional or a member of our International Tax Team to learn more about transfer pricing planning.