Transfer pricing is often defined as the allocation of income, through intercompany transactions, between two or more tax jurisdictions. Simple, elegant, but incomplete.
“Allocation” may suggest a neatly sliced pie. In practice, though, two tax authorities can reach different arm’s-length conclusions and claim tax on overlapping portions of the same economic income—effectively slicing the pie so the pieces add up to more than the original pastry.
These different interpretations of an arm's-length transfer pricing result in two or more tax authorities claiming the right to tax the same income, and the taxpayer is left on the hook for an outsized tax liability.
A simple example: USMfg sells a $100 product at a 20% full cost markup to its British affiliate UKDist (yielding a $20 profit), who then sells the product to a customer for $150, earning $30 of profit after considering its $120 intercompany cost. The UK tax administration, HMRC, audits the transaction and decides the arm's-length markup by USMfg should have been 10%, and thus UKDist's profit should have been $40 ($150 sales price minus $110 intercompany costs). All said, USMfg pays tax on $20 of income and UKDist pays tax on $40 of income, which in total is $10 more than the $50 of profit that actually exists in the system, post intercompany eliminations.
It may seem that there is an easy solution: USMfg should simply make a corresponding adjustment and amend its tax return showing $10 less in taxable income. But the U.S. does not automatically accept another jurisdiction’s transfer pricing adjustment. The IRS must agree that the foreign adjustment reflects an arm’s-length result before corresponding relief is appropriate. Hence our first double tax double take: corresponding tax relief is not automatic.
Fortunately for the group in our example, there exists a double tax treaty between the U.S. and UK, providing a mutual agreement procedure (MAP) mechanism for the IRS and HMRC to try to resolve their differences and settle on a non-overlapping tax base. Handy, but easier said than done--the tax administrations don't just volunteer to identify and resolve double tax issues. Invoking treaty relief typically involves a formal, taxpayer-initiated competent-authority process governed by the applicable treaty and each jurisdiction’s procedures.
The MAP process often takes 2-3 years of information gathering, negotiation, settlement, and implementation. Note: double tax treaties generally prescribe a good faith effort at resolution, but do not require ultimate relief.
All this may seem like grim news for those uninitiated to the riveting world of international tax law, but the practical takeaway is simpler: double taxation is easier to prepare for than to unwind. And the best way to prepare is by knowing where treaty relief is available across your jurisdictional footprint, understanding where transfer pricing controversy is most likely, and making sure your policies are both well documented and actually implemented. Those steps can reduce the likelihood of an assessment and put you in a much better position if one occurs. And if the pie still somehow ends larger after the slicing than before it, trusted tax advisors (such as Eide Bailly, to name one at random) can help navigate the MAP process and work toward right-sizing it.
For help navigating global taxation, contact Eide Bailly Transfer Pricing Services.
