Understanding Transfer Pricing Studies in Puerto Rico
Puerto Rico's status as a US commonwealth and the various tax incentives if offers, like Act 20 for Export Services, make it particularly attractive for US entrepreneurs.
Entrepreneurs create businesses in Puerto Rico and service clients in the United States or other countries, but some of those entrepreneurs own all or part of an existing entity in the States to which the new Puerto Rico business will export services. Because a Puerto Rican company is a non-US entity under US tax law, any cross-border service export transactions between it and a related entity will be subject to transfer pricing rules. For more on the differences between Puerto Rico and US taxation, see our guide.
What is transfer pricing?
A transfer price is the price charged between related entities, i.e. companies with shared ownership, in different tax jurisdictions. For example, a price charged by a company in Puerto Rico for services exported to its corporate parent in Delaware would be a transfer transaction. Another example that is common for new Act 20 companies is to export your services from the PRNewCo to the USCurrentCo. Since you are an owner of both companies, they are related, and it’s important to establish fair market pricing on what one company is charging/paying the other.
Transfer pricing means, therefore, assigning a value to such a transaction. Typical scenarios involve pricing transfers of goods (tangibles), intellectual property (intangibles), services, and loans or guarantees between related entities.
What is a Transfer Pricing Study?
According to David Nissman, a tax consultant and former US Attorney, “The transfer pricing study shouldn’t be about tax, it should be about value: the value of the service provided, the value of the intangible assets and, if a sale is involved, the value of the company.” The purpose of the study is to document a fair market rate for the products or services provided to the related US entity to ensure that the proper amount of income is allocated to the correct entity so that the taxation is properly reported and paid.
Often performed by an economist or CPA who specializes in market evaluations, transfer pricing studies present a full analysis of the value of your business relative to the market. They usually range in price between $10,000 and $50,000, depending on the complexities of your business and industry.
Transfer pricing is a hot topic in tax planning
All tax authorities have a vested interest in keeping business income inside – and therefore taxable in – their jurisdiction. And all taxpayers would prefer to pay as low a tax bill as possible. That means that in a transfer pricing scenario, there are three competing sets of interests from three different parties: the tax authority in the “sending” jurisdiction (i.e. the US, for most Act 20 companies), the tax authority in the “receiving” jurisdiction (i.e. Puerto Rico), and the multinational group of companies.
At the intersection of these interests is transfer pricing, which 66% of multinationals ranked as their number one tax risk in Ernst and Young's 2013 Global Transfer Pricing Survey. In the 2010 edition of the survey, 32% of respondents ranked transfer pricing as an important tax challenge, while 75% of respondents reported having undergone a transfer-pricing audit from tax authorities. Of those audited, 20% reported paying a material penalty as a result.
For multinationals, the tax risk stems from tax authorities' requiring adherence to the “Arm's Length” principle when setting transfer prices.
The "Arm's Length" principle in transfer pricing
A transaction between two related entities is at "arm's length" when the agreed price would be reasonable if, hypothetically, the transaction were between non-related entities. In other words, one related entity needs to charge the other related entity a reasonable market price and not a special price designed purely to optimize the group's overall tax bill.
In an audit, tax authorities are verifying that transactions between related entities are at arm's length. If the authorities find that a transfer price was not at arm's length and resulted in a too-low tax bill, they may assess penalties.
USA-Puerto Rico transfer pricing rules
In the case of a Puerto Rican Act 20 company exporting a service to a related entity in the mainland US, the income will flow to the Puerto Rican entity and be taxable in Puerto Rico at a rate of 4% but the critical issue is, will the IRS accept the deduction from the stateside company who is paying the consulting fee to the PR entity? IF the IRS disallows the deduction, no tax savings has been accomplished and Interest and penalties may be assessed.
Because Puerto Rican tax revenues go up – 4% is higher than 0%, after all – the Hacienda (the Puerto Rican tax authority) is unlikely to question the transfer pricing arrangement in the transaction(s). Moreover, the Hacienda has not made transfer pricing an enforcement priority and there are no specific Puerto Rican tax regulations dealing with it.
“If Puerto Rico agrees with the analysis of their Puerto Rican taxpayer, then those two sides should be joined at the hip because there’s a commonality of interest. When we convinced the Governor of the Virgin Islands in 2009 to join with the VI taxpayers who had cases pending in the tax court, that really changed the dynamics of the federal litigation and the taxpayers started winning some of those cases” said David Nissman, of his experience representing clients being audited in the US Virgin Islands.
The IRS, however, is likely to take a keen interest in the transfer pricing arrangement. In fact, the IRS has a dedicated department, called Transfer Pricing Operations, whose only job is to analyze and assess these specific types of transactions. Internal Revenue Code Section 482 gives them the right to adjust taxable income to reflect economic reality in audits or, in other words, stop tax revenue leaking out of the country in the form of over-inflated transfer prices.
For transfer pricing purposes, the IRS' transfer pricing team defines economic reality on a case-by-case basis. Their Transfer Pricing Audit Roadmap suggests that "fact development is the bread-and-butter" of their exam teams, and that "the key in transfer pricing cases is to put together a compelling story of what drives the taxpayer’s financial success, based on a thorough analysis of functions, assets, and risks, and an accurate understanding of the relevant financial information." In other words, the IRS is trying to determine where a multinational organization creates value and how cross border transfers of goods, services, IP, or debt supports that value creation.
If a transfer price seems out of place in this “story,” for example if a management fee appears to be excessive relative to the actual management that took place, it can be grounds for penalties.
A transfer pricing audit "insurance policy"
For a Puerto Rico Act 20 company exporting services to a related entity in the US, it is strongly recommended to take steps to ensure transfer pricing compliance before (an increasingly likely) audit from the IRS. When an audit does take place, transfer pricing specialists should be involved as early as possible to eliminate costly missteps.
Ideally, specialists will have prepared a transfer pricing study for the transactions between the related entities. A transfer pricing study is documentary evidence of the economic rationale behind a multinational group's transfer pricing decisions. It is like an audit "insurance policy" that illustrates the compelling story that the IRS examiners will seek. Given the expense and time involved it also demonstrates to the IRS that you were thoughtful about the move.
Transfer pricing studies for US-Puerto Rico transactions
Key roles of specialists preparing US-Puerto Rico transfer pricing studies should include:
- Ensuring that transfers among related parties satisfy the requirements of IRC Sec. 482;
- Identifying where the organization currently creates value, e.g. by using certain assets or assuming certain risks;
- Providing guidance on where the organization can restructure value creation, e.g. via staffing decisions;
- Advising on which tax planning opportunities are worth pursuing;
- Avoiding transfer pricing delivering results that are "too good to be true."
Best practices for managing effective transfer pricing for US-Puerto Rico transactions include:
- Arm's length treatment of related parties, i.e. treatment of related parties like unrelated parties, as much as possible;
- Documented intercompany agreements for all intercompany transactions, especially recurring transactions;
- Clearly-worded invoices for intercompany transactions;
- Annual reviews of transfer pricing documentation requirements for both Puerto Rico and the US;
- Compliance with transfer pricing documentation requirements for both Puerto Rico and the US;
- Audit-readiness, i.e. being able to provide supporting documentation within a short timeframe.
Typical documentation found in transfer pricing studies includes descriptions of:
- The company's background, including organization structure;
- The company's intercompany transactions;
- Functional and risk analysis by entity;
- Relevant transfer pricing regulations;
- Reasons for choosing a particular economic analysis method;
- Relevant data;
- Factors used in determining comparability;
- Results of economic and financial analyses;
- Conclusive arguments that transfer prices were fixed at arm's length.
Real Opportunities, Real Risks
Puerto Rico Act 20 offers significant opportunities to American entrepreneurs wishing to relocate a service component of their business to Puerto Rico and export it back to a related entity in the US.
Doing so, however, will necessarily result in taxable income flowing into Puerto Rico and out of the US. That's a scenario the IRS does not take lightly, and the risk of an audit is just as real as the Act 20 tax planning opportunity itself.
A transfer pricing study should therefore be part of any risk management plan involving Puerto Rico Act 20 companies and related entities back on the mainland.
For more information, contact a Tax Consultant who specializes in Transfer Pricing Studies.