When it comes to transfer pricing, scrutiny extends to all taxpayers, both those operating in the black and those in the red. 

By Lindsay Haskell and Dan DeLau

Transfer pricing regulations are stringent with regards to income tax reporting, as Treasury Department Regulations under Section 482 mandate contemporaneous documentation to validate the arm’s length nature of intercompany transactions. Despite misconceptions that these requirements only concern profitable entities, the risks of non-compliance extend to all taxpayers, including those reporting losses.

Contemporaneous transfer pricing documentation refers to records and information that are prepared at the time of a transaction, providing a real-time reflection of a company’s pricing policies. These documentation requirements are a crucial component of compliance with transfer pricing regulations and are required by tax authorities (both U.S. and foreign jurisdictions) to substantiate that transactions between related entities are conducted at arm’s length—that is, under conditions that would apply to transactions between unrelated parties. 

Specific Requirements

The specific requirements for contemporaneous documentation may vary but generally include the following key elements.

  • Description of controlled transactions – A detailed description of the nature, terms, and conditions of each controlled transaction should be provided. This involves explaining the type of goods, services, or intangibles involved, as well as the contractual terms.
  • Analysis of functional and risk profiles – A comprehensive analysis of the functions performed, assets employed, and risks assumed by each of the related parties involved in the transaction is necessary, to establish the roles and contributions of each entity in the transaction.
  • Selection and application of transfer pricing method – identification and justification of the transfer pricing method chosen for each controlled transaction, e.g. comparable uncontrolled price (CUP), resale price method (RPM), cost-plus method (CPM).
  • Comparable data – Availability and analysis of comparable data to support the chosen transfer pricing method, which may involve benchmarking the transaction against similar transactions between unrelated parties.
  • Economic analysis and assumptions – A thorough economic analysis, including financial projections, assumptions, and financial models that support the arm’s length nature of the pricing.
  • Documentation timeliness – The documentation must be prepared and maintained contemporaneously, meaning it should be in existence at the time each year’s tax return is filed.
  • Review and approval – Documentation should be reviewed and approved by qualified personnel within the organization to ensure accuracy and compliance with transfer pricing regulations.

Risks of Non-Compliance

  • Penalties and adjustments – The Internal Revenue Service (IRS) has the authority to impose penalties (under Section 6662, for example) for failure to maintain contemporaneous documentation. Penalties may range from a percentage of the adjustment to complete disallowance of specific deductions or credits, including disallowing the use of net operating losses in the current year for losses generated in a prior year when the contemporaneous documentation requirements weren’t met.
  • Increased IRS scrutiny – The IRS is actively focusing on transfer pricing issues. A 2018 directive highlights the agency’s commitment to evaluating transfer pricing matters with an emphasis on exerting penalties, including if documentation is inadequate or is not contemporaneous (e.g. updated annually). Lack of contemporaneous documentation may trigger a more in-depth examination, potentially resulting in adjustments that could have been avoided with proper documentation.
  • Defensive shield against losses – Companies reporting losses are not exempt from transfer pricing scrutiny. In fact, tax authorities may be particularly interested in understanding the pricing strategies of loss-making entities to ensure that intercompany transactions are conducted at arm’s length (i.e. the loss was not the result of the use of an inappropriate method). Contemporaneous documentation serves as a defensive shield by providing a transparent and justifiable rationale for pricing decisions.
  • Future profitability – Companies experiencing losses today may rebound and generate taxable income in the future. Contemporaneous documentation serves as a foundation for establishing arm’s length pricing when profitability is restored, along with the utilization of prior year losses that were calculated based on the pricing methodologies in place during the year the loss was generated.
  • Demonstrating diligence – Even in the face of losses, maintaining contemporaneous documentation demonstrates a commitment to due diligence and compliance. It positions the taxpayer as proactive and transparent, potentially facilitating a more efficient audit process.

Justifying Compliance

Maintaining contemporaneous documentation is essential not only for demonstrating compliance but also for managing transfer pricing risks proactively. The risks associated with not maintaining contemporaneous transfer pricing documentation are substantial for all taxpayers, regardless of their current financial position, making adhering to regulatory requirements both a legal obligation and a strategic necessity.

By prioritizing the preparation and upkeep of contemporaneous transfer pricing documentation, taxpayers can safeguard themselves against penalties, adjustments, and heightened IRS scrutiny while ensuring transparency and compliance with evolving regulatory standards. Companies are therefore encouraged to work closely with tax professionals to ensure their documentation meets the specific requirements of the jurisdictions in which they operate. 

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