Transfer pricing is a term to describe methods of pricing transactions between related entities located in different countries. Transfer pricing is one of the focused campaigns at the IRS Large Business and International (“LB&I”) Division.
Intercompany pricing affects the tax liability in each country when a company operates in multiple countries. The tax authorities in all countries want to determine whether the transfer pricing was reasonable and consistent with an arms-length transaction between unrelated parties. In the context of foreign investment in US real estate, the IRS focal point is the financing terms between the foreign parent and the US subsidiary.
Transfer pricing between commonly controlled entities in located different countries
Foreign investors in United States commercial real estate typically invest utilizing the blocker structure. This entails setting up one or more foreign corporations in a nontax jurisdiction such as the Cayman Islands with a US C corporation subsidiary, which invests in US real estate through an LLC. The C corporation is known as blocker corporation, since it blocks the foreign investor from filing tax returns and paying tax. The U S C Corporation pays the U.S. taxes on its taxable income from rental operations and gain on the sale of the property.
Foreign parent corporations often capitalize their US subsidiaries with both equity and debt. The funds are then used by the blocker corporation to finance the acquisition of the real estate. The use of the intercompany debt will allow a deduction of interest which reduces the taxable income of the blocker. The interest income usually avoids the 30% withholding on fixed and periodic (FDAP) income either under the portfolio debt exception or a treaty.
IRS audit issues
The IRS has two ways to challenge the amount of interest expense that the blocker corporation is deducting. First it can try to reclassify the debt and equity and disallow the interest in its entirety on the part that it successfully recharacterizes, and second it can challenge the interest rate being charged on the debt.
Classification of transfer as equity or debt
The blocker corporation has an incentive to treat the transfer from the foreign parent as a loan rather than equity because interest payments from the blocker reduce the blockers taxable income. From the IRS perspective the interest expense serves to erode the blocker its US tax base. The IRS will first evaluate whether the loan is more appropriately characterized as an equity contribution to capital, rather than bona-fide debt. If the IRS successfully challenges the characterization of debt and is able to characterize the debt as equity, the payment of interest and principal would be recast as dividends to the extent there is current or accumulated earnings and profits (E&P) and would be subject to 30% FDAP withholding.
To determine if a loan is bona fide debt, all the facts and circumstances are considered and evaluated in the context of IRC section §385 and debt/equity case law. Factors considered include:
- whether there is a written loan agreement
- name given by the parties
- presence or absence of maturity date
- principal repayment
- source of payments
- thin capitalization
- interest payments
- repeated loan extensions
- An independent creditor test
- the financial status and credit history of earnings of the blocker
- whether the blocker has a strong history of earnings and ability to service the debt
- Whether the debt to equity ratio is less than 1.5 to 1
Transfer pricing rules under section 482
If the facts and circumstances developed indicate that the loan was a bona fide debt than the IRS will determine if the interest rate will be upheld under the transfer pricing rules. An arm’s length interest rate is a rate which would have been charged at the time the indebtedness arose, in independent transactions between unrelated parties under similar circumstances. All relevant factors shall be considered, including the principal amount and duration of the loan, the security involved, the credit standing of the borrower, and the interest rate the lender would charge for comparable loans between related parties. The blocker corporation has the burden of proving that the interest rate on the loan from its foreign parent is arm’s length. The regulations under §482 provide for three ways to do so.
- The blocker corporation may choose to apply a rate that falls within the safe haven range. An interest rate falls within the safe haven range if it is not less than 100%, or is no greater than 130% of the applicable Federal rate.
- Under the situs rules, if the foreign parent uses proceeds of a loan that the foreign parent borrowed in the United States to finance the loan to the blocker, the arm’s length rate will be the rate of interest the foreign parent paid to borrow the funds, increased by other costs or deductions incurred by the foreign parent.
- If the blocker uses neither of these methods, then the blocker must substantiate that the interest rate is arm’s length under the best methods rule by providing, for example, a valid transfer pricing study. The best methods rule will provide the most accurate result. It will use comparable uncontrolled transactions and measure them against the taxpayers’ transaction. It will look at the completeness and accuracy of the underlying data and reliability of assumptions made, and the adjustments needed to make them comparable. The taxpayer’s transfer pricing study will be upheld if the results are within the arm’s length range of two or more comparable uncontrolled transactions.
If the safe haven rule and the situs rule are not applicable and the stated rate of interest is determined not to be arm’s length, then the IRS will decrease the interest rate to reflect what it determines to be an arm’s length rate. The IRS will look at any other debt of the blocker and compare the terms of that debt to the foreign parent debt to help determine what an arm’s length interest rate is. The taxpayer will need to justify their rate based on such factors as examining and quantifying the credit risk of the borrower and identifying similar third party terms and rates. Mezzanine debt terms on commercial real estate transactions would provide comparable data points.
The regulations impose a 20% nondeductible transactional penalty on a tax underpayment attributable to a transfer price that is 200% or more, or 50% or less than the arm’s length price. The penalty is increased to 40% if the reported transfer price is 400% or more, or 25% or less than the arm’s length price. A 20% net adjustment penalty on the tax underpayment could also apply if the net adjustment exceeds the lesser of $5 million or 10% of the taxpayer’s gross receipts. This is increased to 40% if the net transfer pricing adjustments exceed $20 million or 20% of gross receipts. For a blocker, presumably gross receipts, would be its share of the rental income and gross proceeds from property sales of the underlying LLCs that it invests in.
The IRS would assess the taxpayer the higher of the transactional penalty or net adjustment penalty, not both penalties. To challenge a penalty assessment, the taxpayer should have documentation to establish that the pricing was at arm’s length terms. The IRS is not required to, but may request that the taxpayer provide the following documentation:
- A description of the selected method and why it was selected
- A description of the alternative methods that were considered, and why they were not selected
- A description of comparable unrelated party transactions, and how comparability was used.
Having a transfer pricing study or documentation is not enough to avoid penalties. The documentation must be assessed for adequacy and reasonableness. In determining whether to assess a penalty, the IRS may consider whether there are other sources of relevant data the taxpayer had access to or should have reasonably have identified and considered. Section 6662(e) penalty protection is available if the taxpayer’s position is reasonable based on the data, facts and circumstances, and is adequately documented, and based on the best methods rule. A penalty will not be imposed if the taxpayer can demonstrate that based on available data it had a reasonable basis for concluding that its analysis of the arm’s length character of its transfer pricing was most reliable and it satisfied the documentation requirements. It must be contemporaneous with the transaction or at least existed when the tax return was filed.
IRS administrative guidance to IRS examiners on transfer pricing cases
In January 2018, the IRS issued new interim directives on how IRS examiners should approach a transfer pricing audit, which are effective until the Internal Revenue Manual is updated. In general, the new directive does not require that the taxpayer provide contemporaneous transfer pricing documentation at the beginning of an audit of a cross border transaction. However, the IRS agent may request it during the audit.
The following are two instances where an information document request (“IDR”) is required:
- Exams under an LB&I campaign where there is specific guidance for the mandatory transfer pricing IDR provided in the campaign: and
- Exams with an initial indication of transfer pricing compliance risk where transfer pricing practice area employees are assigned to the case.
Before this directive was issued, the IRS agent had to issue a mandatory IDR requesting the taxpayer to provide contemporaneous transfer pricing documentation at the beginning of the audit.
LB&I is managing its limited resources to effectively manage the transfer pricing audits. This allows them to focus on issue identification and risk analysis at the beginning of an audit. The directive states that due to practical tax administration and limited resources, examiners should not start with the best method analysis from scratch or ignore the analysis provided by the taxpayer. The examiner should give full consideration to the taxpayer’s selection and application of the best method. A best methods selection and application are critical to justify the transfer pricing report or documentation.
Previously, the IRS agent could disregard the taxpayer’s transfer pricing analysis if they concluded that it was not accurate. Under the new directive, they may not do so. If the IRS agent wants to challenge the best method selection, they must go though an approval process to the IRS Transfer Pricing Review Panel and provide why the taxpayer’s method is unreliable, address potential adjustments to improve reliability and support exam’s recommended alternate best method.
Transfer pricing is a high priority for the IRS LB&I division. Blocker corporation financing transactions are being scrutinized if they fall outside the safe harbor rules. Transfer pricing terms must meet the criteria of the best method rules and be properly documented to avoid an IRS audit adjustment, and perhaps penalties.
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