Transfer Pricing for Business Owners (Not Tax Geeks)

Hello again from Phil, and welcome to the Friday Edition. Every other Friday you get an international tax topic – sometimes a deep dive, sometimes a breezy overview. You can stop getting these emails by clicking on the Unsubscribe link at the bottom of the email.This week I am going to do something different. I will tackle a difficult international tax topic with a self-imposed constraint: no tax jargon will be used, except to tell you the topic. (“Transfer Pricing”.)If Shakespeare had iambic pentameter to use as a framework, well, I can live with plain English words, ideally with three or fewer syllables. (I won't be too dogmatic on the self-imposed syllable constraint, though.)This is for U.S. companies – or U.S. people who own companies here or abroad. I want owners, founders, and officers to understand what they are being told (and sold) when the topic of “transfer pricing” comes up. (There you go – my only use of tax jargon will be that magic phrase, in scare quotes).

The Problem Defined

Think of a normal American business – let's say a clothing company. It buys inventory from a third party supplier at wholesale prices and sells to customers at retail. Profit is easy to figure out: retail dollars collected minus wholesale dollars spent equals profit. Tax is easy to figure out, too: profit multiplied by tax rate equals income tax payable.This business gets larger and starts manufacturing its own inventory. It builds a factory in Thailand, buys some fabric, hires some people, and the sewing machines get busy. Business being business, and government regulations being government regulations, our normal company forms a Thai corporation to own the factory, employ the workers, etc. All standard stuff.Imagine it costs $4 to manufacture a particular item in Thailand, and when that item is sold in the United States, the retail price is $10. We have $6 of profit when that item is sold.We have two governments that would like to tax that profit:

• the USA (because our clothing company is American and the USA taxes every citizen and domestic corporation on worldwide income) and
• Thailand (because, after all, there is a factory churning out products).

“Transfer pricing” as a tax problem exists because two countries (Thailand and the USA) would like to tax the same $6 of profit. An alternate view is that “transfer pricing” is an opportunity for you, the business owner, to get a dollar of profit taxed in the country where the tax rate is the lowest.

Whose Profit Is It?

The item of clothing is in Thailand, owned by the Thai corporation. How can the American corporation sell that item of clothing to its American retail customer?The way most people do it? The American corporation buys inventory from the Thai corporation (which it owns), in addition to buying inventory from other suppliers (which it does not own).What follows next is the crux of the tax problem.

Who sets the wholesale price at which the American corporation buys inventory from the Thai corporation?

Answer: the American company. It is the buyer, and it owns the seller (the Thai corporation). It can force the seller to accept the price. One person (the American corporation) controls both sides of the transaction.

Example 1.The American company pays the Thai company $9 for the item, and sells it to a retail customer in the USA for $10.The Thai corporation has $5 of profit ($9 received from the American corporation minus $4 of manufacturing cost). The American corporation has $1 of profit (it bought an item of inventory for $9 and sold it for $10).The Thai government is happy that it has $5 of profit to tax. The IRS cries in its beer when it realizes that there is only $1 of profit that can be taxed in the USA.

The Government Response

The tax law countermeasure is “transfer pricing”. The IRS has the power to call “BS” on the price that the American corporation paid the Thai corporation for the item. If the IRS does this, then the profit booked by the two corporations changes. The tax bills in the two countries will change, too.

Example 2.The IRS audits the American corporation and says “$9 is a bad price, and $6 is the correct price you should have paid for that item”. The American corporation loses the audit.Now the American corporation has $4 of profit (it bought the item for $6 and sold it for $10 to its retail customer). The Thai corporation has a $2 profit (manufacturing costs of $4, sale price to the American corporation of $6).The IRS hoists a triumphant flagon of ale, happy because it can tax $4 of profit. The Thai government is sad because it has only $2 of profit to tax.

Now, just for fun, let's imagine that the Thai government doesn't agree with what the IRS did. The Thai government thinks that the original price was right (see Example 1) and $5 of profit should be taxed in Thailand.We have the Worst of All Possible Worlds: two countries are taxing $3 of profit at the same time. The IRS taxes $4 of profit, and Thailand taxes $5 of profit. Unfortunately there was only $6 of profit in real life.That's the business problem for you, as the founder, owner, or officer of that American clothing company. How do I set the price at which I buy inventory from myself, so I don't get screwed by two governments at once?There is also an opportunity available. Let's say that instead of Thailand, you set up your factory in Dubai (zero income tax)? Now a dollar of profit is either taxed in the United States, or not taxed at all (in Dubai). How do I set a price so I can allocate as much profit to be earned by a tax-free corporation (Dubai) and as little profit as possible to be earned by a taxable U.S. corporation?

Demystifying the IRS Weapons

When you (the founder, owner, or officer of the American company) talk to your tax people about this, you will hear a lot of complicated stuff. You will see diagrams with boxes and arrows and all that stuff. We can't help it. We are tax geeks.Ignore it all. Here is what is happening:

• The IRS has the power to change the price. You must find a way to fight this if they audit you. In other words, how do you set the “correct” price and win a challenge by the IRS? This is what your tax advisors are trying to do – find “correct”, and be able to prove it. The standard by which the IRS measures “success”: by setting the price according to what you would pay if you bought from a random person instead of your own factory.
• If the IRS wins (by re-setting the price), they can impose penalties. You must find a way to minimize those penalties. Hint: being wildly wrong means you will pay big penalties. Being modestly wrong means low penalties. Your tax advisors are trying to reduce the risk penalties if the IRS challenges the price you paid to your own company, and you lose.

If the other country also has tax rules like the U.S. ones, you want to avoid the example I gave above: where the USA and Thailand both want to tax you at the same time. Thailand thinks a $9 price is right, while the USA thinks a $6 price is right. What if you lose your fight with the tax authorities in both places? Your tax advisors will be thinking about this, too.

Discussions With Your Tax Advisors

This is all about business risk and reward. Tax law is just the playground.The reward you are chasing is to make $1 of profit be taxed in the country where the tax rate is the lowest.The risk you will manage is the cost (in extra taxes, penalties, and professional fees) if you are wrong. Talk to your tax people about risk reduction. What needs to be done? What will it cost? What is the measurable reduction in risk if the train goes off the rails, metaphorically speaking?But one thing you may not hear from your tax advisors is the opportunity cost of all of this. This kind of work is the highest and best use of their time. It is possibly the worst and least profitable use of your time. Every hour that you – the founder/owner/officer – spend thinking about this junk is an hour that is spent NOT developing new products, NOT creating new customers, NOT focusing on future growth.The opportunity cost of fussing around (hehe see what I did there?) with tax planning may be 50X the supposed tax savings from “transfer pricing” fun and games. (Sorry, I used jargon for the last time today).When you talk to your tax people, keep this in mind.

Future Topics, and New Newsletter Coming

This is just the first of a number of emails on this topic. In future emails and blog posts I will talk about the practical considerations of “transfer pricing” (in scare quotes because it is jargon!). I will also write about other topics that matter to owners and managers of cross-border businesses.We are gearing up to create a new email newsletter.It will for “micromultinationals” or “minimultinationals” – companies that are bigger than a loaf of bread and smaller than the Hoover Dam. Or put in financial terms, they could be anything from start-ups to pretty big (hundreds of millions in annual sales).And private ownership, not (usually). The incentives are different when the owner is sitting in the meeting. If the “owners” are a diffuse set of mutual funds, high-frequency traders, and pension plans, the decision-making takes on quite a different flavor.The countries we care about operate across borders, of course. Because otherwise it wouldn't be international tax, would it?Stand by for the announcement of the new newsletter. It's not ready for signup yet. But it will be soon.If you have any topic questions or suggestions, please let me know what real-life problems you have. Those are the best things to write about. Be sure to sign up when we go live.See you in a couple of weeks.Phil.