Middle Market Companies Need Strong Transfer Pricing Policies

Many middle-market companies—those that are too big to be considered small but not big enough to be considered large—may view transfer pricing as nothing more than a compliance burden that comes with a price tag that’s detached from the amount of revenue the cross-border activity generates.

Of course, companies should conduct transfer pricing studies properly to help allay compliance issues. But in addition, a proper transfer pricing policy can have big operational benefits for a company’s functions—such as cash management, supporting net operating losses, and a company’s capital structure.

So why are these operational benefits frequently overlooked? The answer lies within the definition of the term “middle market” itself. The term is used so often that it implies a homogeneity in the market segment, but nothing could be further from the truth.

Companies commonly use annual revenue as a metric to classify whether their business falls within the middle-market segment. The ranges of annual revenue used in that definition are broad and lack consensus as to what the endpoints are. The low end may be $5 million or $10 million; the high end may be $250 million or $1 billion. Clearly, it’s hard to determine the thread of commonality between a company with $5 million of annual revenue and a company with $1 billion of annual revenue.

Because of this expansive range, the term middle market may be further segmented into three bands: the lower ($5 million to $50 million), the middle ($50 million to $500 million), and the upper ($500 million to $1 billion). There can be major variations in a company’s headcount, talent, systems, and technology even within the same band. This is why some companies have the resources to proactively employ transfer pricing policies, while others are debating whether it’s a “must have” tax compliance item.

Transfer Pricing Policies

A company that applies transfer pricing rules to arrive at arm’s-length rates for intercompany transactions can benefit from operational efficiencies in cash management, certainty in monetization of prior year net operating losses, and clarity in capital structure.

Using an arm’s-length price can help with cash management without the additional costs of making distributions or intercompany loans. Below are several hypothetical scenarios that set forth the case for why a transfer pricing policy provides operational benefits beyond tax compliance.

Scenario 1: Cash may get trapped in a limited-risk entity that has little need for it and getting it to the risk-bearing parent comes with additional tax and compliance costs.

Let’s say USCo is a domestic corporation that sells custom hats. It wants to expand overseas to F-Jurisdiction. USCo establishes FC, an F-Jurisdiction private limited company.

USCo bears all the risk associated with the design, manufacturing, inventory, and marketing of the hats both in the US and in F-Jurisdiction and sells hats at cost to FC. Then FC on-sells the hats at full retail value in F-Jurisdiction. As a result, USCo loses money on its sales to FC, and FC has a healthy profit margin and the cash from those profits.

From a cash management perspective, FC has too much cash from its F-Jurisdiction profits, and USCo needs cash to fund its continued investments in the hat business. For FC to return the excess cash to USCo, that transfer of cash would either need to be done as a distribution or a loan. In either instance, there could be additional tax and legal compliance costs.

If FC wishes to transfer the cash as a distribution, FC needs to ensure it complies with F-Jurisdiction’s companies laws on determining FC’s distribution capacity. Additionally, F-Jurisdiction will impose a withholding tax of 10% on FC’s distribution to USCo. USCo may or may not be able to take a foreign tax credit for the withholding tax F-Jurisdiction imposed on the distribution.

If FC wishes to transfer the cash as a loan, then FC will need to charge interest on that loan. FC and USCo will need a transfer pricing analysis to determine the arm’s length interest rate for that loan. The US will impose a 30% withholding tax on payments of interest to F-Jurisdiction. USCo will need to confirm the amount of that interest that is deductible under the US’s interest deductibility rules of Section 163(j).

FC will incur tax on the interest charged and will want to analyze whether it may be able to take a foreign tax credit for the withholding tax USCo imposed on the interest charge.

The above type of scenario may that true for many companies with little experience in international expansion. A company’s leadership team can be surprised in the resulting timing lag and additional taxes and expenses that lead to overall less net cash. These surprises can impact capital investment and external debt service.

Scenario 2: Sticking with USCo’s custom hat business and its expansion into F-Jurisdiction, let’s tweak how FC is compensated as a limited risk distributor.

The facts are the same as Scenario 1. This time, the price USCo sells to FC has been validated by a comprehensive transfer pricing study that supports FC earning a small, guaranteed arm’s-length return as a limited-risk distributor of hats.

As a result of the arm’s-length price on the sale, USCo earns a healthy profit and has the corresponding cash. FC can cover its costs and has a small return and corresponding cash sufficient to continue its operations.

Now, USCo has cash to invest in the continued development of its hats, service external debt, or make other strategic investments. USCo has that cash without FC needing to transfer it outside of the ordinary course of business as a distribution or loan. USCo has that cash without incurring additional expenses and time lag it would have incurred had FC transferred the cash as a distribution or loan.

This logic of aligning profits with the location of value drivers to help get cash to the party making investments applies equally when it’s losses in question.

In a perfect world, all businesses would be profitable, but businesses suffer losses for a variety of reasons. Many governments allow the use of net operating losses to be carried forward to offset future years’ taxable income. Taxpayers must be able to support any net operating loss that is reported for tax purposes and carried forward.

An unsupportable or “phantom” net operating loss is generated because of improper allocations of income, gains, deductions, credits, and/or losses in a controlled transaction. These losses are generated and suffered economically by the generating company but done so only because of improper transfer pricing causes that loss to be generated.

Scenario 3: Phantom net operating losses are generated. Here, the facts are the same as in Scenario 1, but this time, USCo sells the hats to FC at the same market value that FC can sell hats for in F-Jurisdiction. FC makes no money on the sale of the hats because its cost of goods sold is equal to the retail value of the hats. When FC factors in the costs of its operations, it generates a net operating loss.

The price USCo sells hats to FC isn’t supported by a transfer pricing study and isn’t arm’s length under US or F-Jurisdiction tax laws. FC’s net operating loss was a phantom loss because it was generated because of a non-arm’s-length price on FC’s purchase of hats from USCo.

FC is at risk for any penalties and interest related to the underpayment of tax in F-Jurisdiction. Both FC and the USCo risk being fined for failing to have a transfer pricing study available and able to be provided timely if requested by a revenue authority.

Taxpayers in such cases may argue that no transfer pricing was needed because the entity was “generating a loss.” This is a faulty argument. First, the correct transfer pricing could mean the taxpayer should not have a net operating loss at all. Second, putting that primary reason aside, in the future if the taxpayer can monetize a prior-year phantom net operating loss, it brings an additional layer of tax risk.

In Scenario 3, FC should never have generated the net operating loss that it generated.If in a future year, FC uses that wrongfully- generated net operating loss to offset taxable income, the risk is compounded. FC’s use of that prior year net operating loss to offset taxable income could result in the underpayment of taxes, which often comes with penalties and interest.

Potentially even worse is the message for leadership that what was thought of a tax asset (the net operating loss to be used in the future) wasn’t real, and more taxes are owed than anticipated.

Capital Structure Integrity

Interest-free loans between US companies and foreign subsidiaries are one of the most common transfer pricing misses in the lower middle market. These loans go both ways—parent to subsidiary, subsidiary to parent.

These intercompany loans often have sparse documentation because they are made without consulting counsel and often as in-the-moment cash management techniques. But even if the loan is documented, there often is not a stated interest rate on the loan document. A 0% interest rate doesn’t seem like the type of interest rate you’d get from an unrelated bank, so how can that be arm’s length? It can’t.

First, while the absence of an arm’s length rate—specifically a 0% interest rate—doesn’t itself cause recharacterization of the loan as equity, it does invite scrutiny. A revenue authority’s scrutiny is rarely a taxpayer’s goal. If that closer examination discovers the hallmarks of debt are missing, the loan could be equity for tax purposes.

If such a loan is recharacterized as equity, any prior payments of principal must be revisited and likely recharacterized as distributions. Now the debtor subsidiary must work through any local companies’ law questions on distribution capacity, and local tax law on potential withholding taxes on distributions. A US creditor parent must do a similar analysis on the effects of the distribution on both the subsidiary’s attributes and on its tax liability.

Second, assuming the loan that should be respected as debt for tax purposes, a 0% interest rate means the taxpayer gifted to a revenue authority the right to calculate the arm’s length rate for the debt. In such a circumstance, the taxpayer can expect the revenue authority’s rate to be less favorable than if the taxpayer had done the calculation.

Assuming that 0% isn’t an arm’s-length interest rate, a revenue authority will do its own transfer pricing analysis to arrive at a rate it considers arm’s length and then proceed to impute such interest.

It’s important to revisit any prior payments of principal to consider imputed interest. If the adjustment is from the debtor subsidiary’s revenue authority, the company must work through local tax law on potential withholding taxes and limits on interest deductions.

If the adjustment is from the creditor parent’s revenue authority, the company must consider the effects of the additional interest expense in the subsidiary for US tax purposes (such as tested income or subpart F calculation), the addition of interest income on the US tax return (and any penalties or fines for prior year underreporting of income), and other items.

Looking Ahead

Whatever companies do to prioritize the cash and time savings from not having a transfer pricing policy is short-sighted.

The potential for fines and penalties, additional taxes, and related interest charges—plus professional fees for support either proactively amending prior positions and/or defending previously taken positions—will far surpass the price proper transfer pricing documentation even for lower middle market companies.

Further, the investment in a complete transfer pricing policy for intercompany transactions, whether loans, services, sales, rents, or royalties, can be a proactive tool with significant operational benefits.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Nelson C. Yates II is a partner and international tax leader at Cherry Bekaert, advising clients on cross-border transactions, international tax structuring, and transfer pricing.

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