Transfer Pricing

MANAGING TRANSFER PRICING

Sarbanes-Oxley requires a company to establish that it has internal controls to ensure accurate financial reporting and that the auditor attest to the assessment of those controls. An obvious concern for all multinationals after SOX is whether there are effective controls in place to deal with transfer pricing exposure.

An increasingly important element of transfer pricing documentation relates to the influence of legislation, ethical standards, and associated matters that do not specifically target transfer pricing but nonetheless impose a range of incremental requirements on transfer pricing compliance, documentation opinions, and implementation of controls to make sure that intended transfer pricing results are actually achieved. The state of transfer pricing documentation was fairly simple prior to the transfer pricing penalty final Regulations in 1996 ( TD 8656 , February 8, 1996). 1 While the U.S. penalty Regulations created a flurry of activity, including a veritable cottage industry of external consultants offering their own version of documentation compliance, 2 most multinational enterprises (MNEs) had developed their own documentation models, or relied on external consultants, by the late 1990s. The cost of transfer pricing documentation compliance clearly had increased from pre-1996.

By 2004, some 20 other countries had adopted their own transfer pricing penalty and related documentation regimes, each seemingly more draconian than its predecessors. The consistent theme of these regimes was to offer the carrot of contemporaneous documentation of transfer pricing methodologies (TPMs) to avoid the grasp of nondeductible penalties. These regimes spread extensively as tax authorities sought to protect their domestic tax base from erosion by MNEs. The cost of transfer pricing documentation, of course, increased with the additional requirements, whether done internally or externally.

Congress reacted to the financial scandals of Enron, WorldCom, Tyco, among others, by enacting the Corporate Fraud Accountability Act of 2002 (Title XI of the Sarbanes-Oxley Act of 2002 (P.L. 107-204, July 30, 2002)) (“SOX”). Among the impositions of SOX was the requirement in section 404 that a company establish that it has controls in place to ensure accurate financial reporting, and that a company's auditor must attest to the auditor's assessment of those internal controls. Since transfer pricing is a significant potential exposure for all MNEs, an obvious source of concern was whether there were effective controls in place to deal with such transfer pricing exposures.

At about the same time that SOX was enacted, Congress, the Securities and Exchange Commission (SEC), and Treasury were all appropriately concerned about the independence of auditors. The death of Arthur Andersen & Co., shocking revelations of apparent complicity with the shenanigans in the financial scandals, as well as the public's perceived inability to trust the accounting profession to police itself, led to the establishment of the Public Company Accounting Oversight Board (PCAOB). One issue of immediate concern to the PCAOB was whether the auditor could provide transfer pricing opinions to its audit clients. As a result of SOX and the PCAOB directives, many MNEs stopped using their auditors for transfer pricing services, including documentation advice or opinions.

A further element of the financial scandals of the late 1990s and early 2000s related to the proliferation of tax shelters, promoted by accounting firms, financial firms, law firms, and other promoters. This led to litigation by the IRS under the phalanx of anti-tax shelter provisions in the Internal Revenue Code, seeking to impose liability, penalties, and the prohibition of practicing before the IRS on perceived promoters. There was also litigation by taxpayers against promoters and advisors as the IRS succeeded in shutting down many of the most egregious shelter schemes.

While the legal and accounting professions were appropriately aghast at the activities of members in good standing, there was little progress in the way of appropriate upgrading of ethical obligations of professional members. On the other hand, Treasury undertook a searching review of the ethical standards of practice before it, resulting in the final restatement of Circular 230. There are now much stricter requirements for opinions relating to tax shelters, as well as any opinion depending on the level of opinion being provided. Circular 230 applies to lawyers, accountants, and others practicing before the Treasury, including the IRS. While the new