GLOBAL
Transfer Pricing: Rules, Regulations and Compliance

The global economy has created an abundance of new business opportunities, but companies that choose to pursue them may also face tax issues they have not encountered before. One potential problem area is transfer pricing.

As multi-nationalism has become a more common trait among a growing number of companies, many countries, the U.S. included, have enacted transfer pricing rules to prevent tax revenues from being improperly transferred out of their jurisdictions. Last year, the IRS launched a new compliance initiative, which Larry R. Langdon, commissioner of the large and mid-size business division of the IRS, called “a key component of a high-priority joint IRS/Treasury effort in the transfer pricing area.”

IRC Section 482
Section 482 of the Internal Revenue Code authorizes the IRS to allocate gross income, deductions and credits between related parties to whatever extent necessary to prevent evasion of taxes or misrepresentation of the income of the related parties. The regulations apply an “arm’s-length” standard for transactions between related parties, such as a U.S.-based company and its offshore subsidiary. In order to avoid the substantial penalties spelled out in Section 6662(e) and (h) for violations of Section 482, companies must provide substantive documentation for their transfer pricing. Penalties are computed at either 20% or 40% of the underpayment of tax resulting from a transfer pricing adjustment. The IRS has directed its auditors to complete the International Territory Manager Concurrence Form in order to detail why a taxpayer’s documentation is sufficient to avoid Section 6662(e) and (h) penalties when Section 482 allocations exceed statutory thresholds.

The 20% transfer pricing misstatement penalty applies under two circumstances: first, if the price for property or services reported by a U.S. taxpayer in connection with an intercompany transaction is 200% or more (or 50% or less) of the arm’s-length price reported by the U.S. taxpayer in connection with an intercompany transaction; second, if the income reallocation resulting under Section 482 is greater than $5 million or 10% (whichever is less) of the U.S. taxpayer’s gross receipts. The 40% penalty is assessed when the difference between the reported and arm’s-length prices is more extreme (400% or more/25% or less), or the resulting income reallocation exceeds the lesser of $20 million or 20% of gross receipts.

Note that companies with current net operating losses (e.g., start-up entities) would still fall under the transfer pricing rules. The IRS could reallocate the companies’ income, resulting in U.S. taxable income. If the companies do not have enough losses to offset the potential income, the aforementioned penalties could become applicable.

Avoiding Transfer Pricing Penalties
The best way for a company to avoid the imposition of transfer pricing penalties is by maintaining contemporaneous (in existence at the time the return is filed) documentation supporting its good faith and reasonable attempt to comply with the arm’s-length standard (referred to as the “transfer pricing report”). The regulations set forth standards designed to ensure that the documentation evidences use of the transfer pricing method that provides the most reliable measure of an arm’s-length result based upon the facts and circumstances involved. The type of documentation that must be produced within 30 days of receiving an Information Document Request is spelled out in Reg. Section 1.6662-6 and is extensive.

The taxpayer may also enter into an Advance Pricing Agreement (APA) with the IRS. Pursuant to the APA, the taxpayer and the IRS determine the appropriate transfer pricing methodology to be used in apportioning income and deductions between the taxpayer and related parties in other taxing jurisdictions. Such an agreement precludes the possibility of an IRS challenge of the company’s transfer pricing determination for a period of three to five years, but standard APA procedures can be costly and time-consuming.

In sum, any multi-national company—no matter what its size—is well advised to maintain contemporaneous factual, legal and economic documentation for significant intercompany transfers. While the transfer pricing report is not a guarantee against a transfer pricing audit by the IRS, it can forestall the imposition of penalties if it is properly prepared.

Most foreign jurisdictions have separate rules and penalties relating to transfer pricing. However, the documentation requirements are typically the same for all the countries. An effective contemporaneous transfer pricing report should satisfy the documentation requirements of both the U.S. and foreign jurisdiction(s) in which the taxpayer files tax returns.

For more information, please contact Chris Judd at cjudd@gellerco.com.

FEDERAL
Independent Contractor or Employee: An Important Distinction to Make

Is someone who provides services to your company, or performs services on behalf of it, an employee or an independent contractor? That’s an important question for both tax-liability and legal reasons, but it’s one that is not always easy to answer.

Both the federal and state governments have strong incentives to see service providers classified as employees rather than independent contractors because of the considerable revenue streams involved. Under the Internal Revenue Code, employers are responsible for withholding payroll taxes from their employees’ paychecks, something they are not required to do for independent contractors. As a result, government agencies are able to collect tax revenue more quickly and maintain tighter control of the process when workers are classified as employees.

The best interest of the business owner often lies in the opposite direction. Many are happy to sidestep the mandatory role of government bookkeeper and avoid the other obligations (such as unemployment insurance and the requirement to provide certain benefits in some cases) by relying more on independent contractors than employees. This battle between the federal and state governments and employers has been going on for a long time and has spawned numerous court decisions.

Key Factors Used to Determine Status
Some of the key factors the judiciary has designated as being important considerations in determining whether a person is an employee or an independent contractor include:

• The amount of control exercised by the employer over the services provided.
• Whether it is the business owner or the service provider who does the scheduling and supplies tools, specific instructions and training.
• Who hires, supervises and trains assistants.
• Whether regular and recurring services are provided.
• Whether the service provider has a separate office or business.
• Whether the service provider performs more than minimal services for others.

Evaluation of the factors involved in determining employee or independent contractor status can be a subjective process, and the IRS historically has been aggressive in finding for the former. Florence Posy of Geller & Company points out that during a tax audit, a key focus of the tax examiner will be whether the job title and description of the independent contractor are identical to that of an employee of the company. If this is the case, the tax examiner will take this as proof that the independent contractor should be characterized as an employee.

In an attempt to stem that aggressiveness, Congress enacted Section 530 of the Revenue Act of 1978, which states, in a nutshell, that an employer has the right to treat someone as an independent contractor if that has been common practice in the industry in which the employer is involved.

Employer Requirements for Section 530 Relief
IRS Publication 1976 spells out the requirements a business must meet to have the IRS accept the status of its workers as independent contractors. To receive Section 530 relief, a business must meet three broad requirements:

• It must have a reasonable basis for not treating its workers as employees. The IRS offers four options for demonstrating reasonable basis: relying on a court case about federal taxes or a ruling issued to the business by the IRS; having undergone a previous audit that did not result in reclassification of the workers as employees; common industry practice; relying on some other reasonable basis, such as the advice of a business lawyer or accountant.
• It must have demonstrated substantive consistency in treating the workers, and any similar workers, as independent contractors.
• It must have demonstrated reporting consistency in filing Form 1099-MISC for each worker who earned $600 or more.

Importance of Obtaining Expert Advice
Unfortunately, Section 530 still leaves room for a great deal of subjectivity in discerning between an employee and an independent contractor. The IRS has developed a list of 20 common-law factors to help businesses determine whether an individual is an employee or an independent contractor. Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) requests information that is based on the 20 common-law factors. However, since the potential costs of a change in independent contractor status or of appealing such a decision can be quite substantial, business owners should obtain expert advice if they have any question about their standing in this matter.

For more information, please contact Florence Posy at fposy@gellerco.com.

INDIVIDUAL
Plan Charitable Giving to Make the Most of Tax Deductions

As a group, Americans have a giving nature. More than 37 million U.S. taxpayers reported deductible charitable contributions of more than $140 billion in 2000, according to the Internal Revenue Service’s most recent data. Since some contributions are not deductible, the actual total is even higher. Officially, the IRS supports charitable giving, a position reaffirmed by IRS Commissioner Mark W. Everson in testimony to the Senate Finance Committee in June. However, taxpayers who deduct charitable contributions on their income tax returns must be able to document the value of their donations in case of an audit.

No matter what type of donation is being made, taxpayers should first confirm that the status of the organization receiving the gift makes a tax deduction allowable. In order for a charitable contribution to be deductible, it must, in most cases, be made to a Section 501(c)(3) organization. About one-third of the nation’s 3 million tax-exempt entities are Section 501(c)(3) charities, and information on many of them can be found online at GuideStar (www.guidestar.org), a national database of nonprofit organizations.

Gifts of Cash
Cash is the simplest way to give and generally the easiest gift to document. For tax purposes, the donor should retain a detailed receipt that includes the date the donation was made, the name of the organization and the amount. In some cases, such as a fundraising dinner, the cost of a portion of the event may not be deductible, and that should be noted on the receipt. If payment is made by check, retain the canceled check, in addition to the receipt or other acknowledgement from the charity. Cash payments should be noted as such on the receipt.

Appreciated Assets
Donating appreciated assets, such as securities rather than contributing cash, is one of the tax-planning ideas recommended by Tate Elliott of Geller & Company. Stock that has been held for more than a year is considered long-term capital gain property, and the donor is entitled to take a deduction equal to its fair market value, as long as the deduction does not exceed 30% of adjusted gross income. The donor also avoids any capital gains tax that might have been due on the sale of the stock. A security that has decreased in value from its original purchase price should never be donated to a charity. Instead, the donor should sell the stock, take any allowable capital loss deduction and donate the proceeds from the sale.

Determining the Value of Tangible Property
Taxpayers may also want to donate other assets. Commonly donated assets include clothing, household goods, artwork and antiques. The issues raised in donating these types of tangible property are more complex because the value of the property must be determined in a manner that will withstand IRS scrutiny in case of an audit. Fair market valuation methods acceptable to the IRS include:

• Cost or selling price of donated property for an “arm’s-length” transaction that took place close to the valuation date in an open market.
• Sales of comparable properties, dependent on degree of similarity, time and circumstances of the sale and relevant market conditions.
• Replacement cost, less depreciation, and subject to current market demand for the property.
• Opinions of experts, dependent on the knowledge and competence of the expert and thoroughness of the supporting opinion.

Tax Deduction Guidelines
For income tax purposes, donations are only deductible in the year in which they are made. One exception is that donations charged to a credit card are deductible in the year charged, even though paid in a later year. An amount paid for a ticket to a charity event (e.g., a ball, bazaar, show or athletic event) is presumed to represent the fair market value of the event. In order for a taxpayer to receive a tax deduction, the taxpayer must demonstrate that the payment exceeded the fair market value of the admission or other privileges associated with the event.

Donations of $250 or more must be substantiated by a contemporaneous written acknowledgment from the charitable organization. Taxpayers report their donations by entering the total amount contributed on Form 1040, Schedule A. For noncash donations over $500, Form 8283 (Noncash Charitable Contributions) must be completed and attached to the taxpayer’s return. In addition, for noncash donations exceeding $5,000 (other than publicly traded securities), the donor must obtain a qualified appraisal and attach a summary (Section B of Form 8283) to the return.

The IRS has identified vehicle donations—a deduction claimed by 733,000 taxpayers in 2000—as a potential area of abuse and is targeting it for more aggressive enforcement action. President Bush’s FY2005 budget includes a proposal to allow donated-vehicle deductions only if the taxpayer obtains a qualified appraisal of the vehicle, even if less than $5,000, and both the House and the Senate have passed tax bills that contain changes to the rules affecting deductibility of noncash donations.

Despite the hurdles that taxpayers must overcome to obtain the charitable deduction, remember that taxpayers are benefiting society as well as receiving a tax benefit. Keeping careful records and retaining all paperwork required to document your donations make it easier to substantiate your deductions at tax time.

For more information, please contact Tate Elliott at telliott@gellerco.com.

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The information contained in TaxView is for general purposes only and is not intended, and should not be construed, as legal, accounting, or tax advice or opinion provided by Geller & Company to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs. Therefore, the information should not be used as a substitute for consultation with professional accounting, tax, or other competent advisors.