Transfer pricing affects more businesses that anyone probably realizes. Depending on your business, transfer pricing may be an issue that you have dealt with, are currently dealing with, or may deal with in the future as it affects more businesses than most would think. Setting accurate transfer prices for your company is not something that most people think about, but the IRS does and that is why it is better to stay ahead of them with a preemptive transfer pricing evaluation for your company.
Transfer pricing is the practice by which the price or fee for use of an asset, real or intangible, is established for transfer from one affiliated company to another. Put another way, it is the price at which different divisions within the same company transact with one another, and the IRS has several methodologies to govern those calculations.
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- IRS Transfer Pricing Methodologies
Arm’s-length consideration for intellectual property transfers must be commensurate with the income attributable to the intangible, as required by the 1986 Tax Reform Act and its subsequent revisions. Under IRS Section 482, assets that are transferred between related or controlled parties, including all forms of intellectual property, must be priced on an arm’s-length (i.e. fair market value) basis. IRS Section 482 generally considers three methods for intangible asset transfer pricing: Transaction-based, Cost-based, and Profit-based.
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- Transaction Based Methods
Dictate that inter-company fees are determined by reference to terms between uncontrolled entities. The key to successful utilization of this method is the ability to satisfy the criteria for what is a “comparable” transaction. Transaction-based methods include:
- Comparable Uncontrolled Transaction (CUT) Method
- Comparable Uncontrolled Price (CUP) Method
In the CUT method, royalty rates in similar licensing situations are a reasonable foundation for determining a royalty rate to be used as the basis for a transfer price. Based on an investigation of the industry, a review of the intellectual property being valued and on market transactions, a royalty rate appropriate for the intangible assets is estimated.
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- Profit-Based Methods
Look to a taxpayer’s relative contribution of profit by its intangibles to the combined entity, and provide that inter-company fees or royalty rates may be allocated based on this relative profitability. Profit-based methods include:
- Comparable Profits Method (CPM)
- Profit Split Method (PS)
- Taxable Net Margin Method (TNMM)
- Relative Profit Method (RP)
- Resale Method (RSM)
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- Cost-Based Methods
A company may demonstrate the arm’s-length nature of inter-company charges by the execution of a cost sharing agreement with subsidiaries and their controlled entities. A cost sharing arrangement is defined as an agreement to share the costs of development of one or more intangibles in proportion to the share of anticipated benefits from the parties’ use. IRS rules generally require that a participant in a qualified cost sharing arrangement must reasonably anticipate benefits from the use of intangibles. In addition, to qualify for a cost sharing arrangement, certain formal requirements related to accounting, documentation, and reporting must be satisfied. Separate consideration (the buy-in payment) is required for pre-existing intangible property made available to the arrangement.
CONSOR has been assisting clients with their intellectual property valuation, licensing, and other monetization needs for over 25 years. Whether for transactional or litigation purposes, CONSOR has had a successful track record in valuing and defending our clients’ intellectual property. Simply let us know how we can best serve you. To discuss your IP valuation and monetization needs, contact CONSOR at info@consor.com or (858) 454-9091.