Transfer pricing documentation vs. benchmarking: Pick the right method to reduce audit risk
By: Wipfli Editorial Team
Transfer pricing documentation rules vary by jurisdiction, making it unclear how regulations apply in an audit situation. And it’s important to get it right.
Transfer pricing audits by the IRS and tax authorities are expensive, both in terms of time and company resources. To defend against the risk of audits and penalties, many multinationals prepare transfer pricing documentation annually. Others use transfer pricing benchmarking instead.
Which method is best? It depends on your company’s revenue, the volume of intercompany transactions and perceived risk. To choose the right transfer pricing strategy for your firm, you also need to understand the differences between transfer pricing documentation and benchmarking.
What is transfer pricing?
Transfer pricing rules apply to goods, services and royalties — effectively any internal company transaction that crosses borders in a multinational corporation. Tax authority adjustments to transfer prices can result in additional tax owed, late payment interest, nondeductible penalties and possibly double tax.
Transfer pricing is among the most contentious tax issues for multinationals because two or more tax authorities can audit the same intercompany transaction.
An overview of transfer pricing documentation
Companies prepare transfer pricing documentation to explain why transfer prices are reasonable and consistent with the “arms-length standard” (i.e., what unrelated companies would charge each other).
Typically, documentation is the first and best way to defend against a tax adjustment during an audit. In fact, some countries require transfer pricing documentation as part of every audit.
In the U.S., the IRS can assess additional tax and transfer pricing penalties if:
- The taxable income adjustment is a “substantial” or “gross” valuation adjustment and
- The company has not prepared “contemporaneous” transfer pricing documentation by the time the tax return is filed.
The documentation report is not submitted until requested during an audit — and then it has a 30-day deadline.
If there are no U.S. transfer pricing adjustments, no penalties or additional taxes are due. Therefore, a taxpayer who argues successfully against an IRS audit adjustment would not owe additional tax or be assessed penalties.
Key items to include in transfer pricing documentation
The U.S. transfer pricing documentation rules specify 10 items that need to be included in a report to mitigate penalty risk. However, these four are the most important. Companies need to:
- Explain the business in detail, including corporate structure (functional analysis).
- Explain how recent industry developments affect the business (industry analysis).
- Analyze financial information and intercompany transactions (financial/economic analysis).
- Select the “best method” or the “most appropriate method” for benchmarking transactions and demonstrate how the profitability or pricing is arms-length (financial/economic analysis).
Depending on the facts, the economic analysis often benchmarks the profitability margins of the subsidiary against similar companies. You could also assess the pricing of third-party transactions or profit splits.
Most transfer pricing documentation reports require interviews with key management to collect facts and analyze the industry. These reports can become large documents and they must be updated annually to be considered “contemporaneous” penalty protection. Advisor fees for transfer pricing documentation reports are higher due to the extensive interviewing process.
An overview of transfer pricing benchmarking
For companies with a limited volume of intercompany transactions or lower risk, a benchmarking study can be a practical alternative. Under this option, companies establish a range of profit margins at similar companies. Companies often use this benchmark to adjust their prices for subsidiaries.
While similar to transfer pricing documentation, there are a couple of key differences with benchmarking:
- Benchmarking is not considered penalty protection in the event of a large adjustment ($5 million or a 50% change in intercompany prices).
- Benchmarking requires limited fact gathering and no assessment of the company's profitability.
- Benchmarking can be adapted into a full report once a company becomes larger or when the risk of an adjustment increases.
- A full study can be prepared if the IRS decides to do a transfer pricing audit. However, the company could be at risk of penalties if there is a “substantial” adjustment.
If your company is not at risk for a substantial tax adjustment, a benchmarking analysis may be the most cost-effective approach.
Transfer pricing benchmarking vs. transfer pricing documentation
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Documentation |
Benchmarking |
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Overview |
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Objective |
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Deliverables |
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Audit protection |
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Cost |
Time required for interviews and comprehensive economic analyses |
Time incurred on benchmarking and report writing |
How Wipfli can help
Need help weighing the options? Use our side-by-side comparison document as a reference. Or contact us today to team up. The international tax specialists at Wipfli can help you analyze your tax liability and risk — and make sure your transfer pricing method is audit ready. We understand the tax implications of working across borders — and we look ahead at how you plan to grow.
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