INSIGHT: Healthcare Systems Intersect With Transfer Pricing

Stakeholders are demanding increased accountability and transparency from the organizations they support financially, transact with, invest in, and regulate. Nearly every decision stakeholders make is refracted through the lens of environmental, social, and governance (ESG) criteria. Consumers want to know the environmental impact of goods and services, tax authorities and regulators evaluate compliance vis-à-vis societal fairness, and investors want to see profits without sacrificing sustainability. Financial documents such as annual reports, financial statements, and tax returns are the primary venue for providing transparency between a business and its stakeholders. Consequently, these stakeholder questions are interlinked with financial information, resulting in elevated transparency expectations for business leaders, executives, and board members.

The public pressure and business risks associated with transparency in the corporate world are magnified in the nonprofit and healthcare sectors, where funds, services, and medical technologies are scrutinized for their alignment with the entity’s not-for-profit purpose and the overall public good. For instance, the chairman of the Senate Finance Committee sent a letter in December 2019 to a large tax-exempt hospital in relation to its tax-exempt status, asking for greater transparency on debt collection services and the costs of various healthcare services (See the Letter from the Chairman of the U.S. Senate Committee on Finance dated December 3, 2019). This inquiry is only one example of the heightened tax transparency issues hospitals and healthcare systems face.

Modern healthcare systems have complex business models that involve providing clinical care services and integrating other aspects of the healthcare supply chain, including providing health insurance, conducting medical research, and offering pharmacy services. Healthcare systems’ business models were already evolving to accommodate patients’ needs, and Covid-19 put that evolution into overdrive. These changes include more public and private partnerships, artificial intelligence, and patient care technology. In the new contact-free economy, physical distance may become a consumer preference (See article by Sneader and Singhal (2020) for more details). As detailed in a recent McKinsey & Company report, telemedicine services are booming; for example, Teladoc Health reported a 50% increase in services as of March 20, 2020, and KRY International reported a 200% increase (see id). Telemedicine or other virtual healthcare delivery techniques may be critical for healthcare systems to both maintain sufficient capacity and align with market demand. Healthcare systems are accelerating the adoption and integration of virtual healthcare solutions to combat Covid-19 (See blog by Matthews and Shah (2020) for more details).

While a substantial portion of the overall healthcare system consists of tax-exempt entities, for strategic business or legal reasons, certain business ventures use other tax structures, some of which include both for-profit and joint ventures. These tax structures create potential transfer pricing risks for related-party transactions within healthcare systems under tax code Section 482 and Treasury Regulation 1.482 (SeeTreas. Reg. 1.482-1(i)(1); Forman & Co. v. Commissioner; Southern College of Optometry v. Commissioner.

From a tax perspective, transfer pricing risks arise when transactions between controlled parties do not reflect an arm’s-length result, due to pricing that results in tax avoidance or failure to clearly reflect income (See Treas. Reg. 1.482-1(a)(1) and Treas. Reg. 1.482-1(a)(3)). Healthcare participants regularly enter into related-party transactions with controlled affiliates, including the provision of services, financing, and intellectual property use. An arm’s-length result is obtained if “the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances.” (SeeTreas. Reg. 1.482-1(b)(1). The regulations also note that because identical transactions can seldom be identified, the arm’s-length result may be evaluated by reference to comparable transactions between uncontrolled parties). In essence, the results of related-party transactions should be consistent with the results of identical or similar transactions between unrelated parties, which is deemed to produce tax parity between similar controlled and uncontrolled transactions.

In an age of increased expectations of financial transparency, coupled with Covid-19-related business changes, the ability of healthcare systems to identify, determine, and document transfer pricing policies may be important to stakeholders. The following sections discuss how stakeholders’ heightened transparency concerns and changing business models, accelerated by Covid-19, impact transfer pricing considerations and risks.

Transfer pricing and control

The U.S. transfer pricing regulations were issued to implement Section 482. That provision gives the Internal Revenue Service (IRS) the authority to allocate income, deductions, and other items to reflect the true taxable income between two or more controlled organizations, trades, or businesses, and to prevent tax evasion. Tax exempt organizations are included in the definition of organizations under Section 482 (See Treas. Reg. 1.482-1(i)(1)). Still, to grasp the full impact of Section 482 on applicable taxpayers, an understanding of the term “control” is necessary.

The definition of control under Section 482 is much broader than the general understanding of the term control from a tax perspective, such as control resulting from greater than 50% ownership of stock (vote or value) or the sharing of common or overlapping directors. For U.S. transfer pricing purposes, control is not limited to any specific ownership percentage, but rather reflects practical considerations and the reality of control.

The U.S. transfer pricing regulations define control as follows:

“[i]ncludes any kind of control, direct or indirect, whether legally enforceable or not, and however exercisable or exercised, including control resulting from the actions of two or more taxpayers acting in concert or with a common goal or purpose. It is the reality of the control that is decisive, not its form or the mode of its exercise. A presumption of control arises if income or deductions have been arbitrarily shifted (See Treas. Reg §1.482-1(i)(4)).”

Under this definition, transfer pricing and tax risks for healthcare systems are not limited to tax-exempt parent/for-profit subsidiary structures but are potentially present in any case in which two or more parties are working in concert towards a common goal. Based on the facts and circumstances of the relationship, this definition can encompass both joint ventures and public/private partnerships.

While already prominent in the healthcare industry, the demand for innovative solutions will most likely increase in light of Covid-19 and further the need to work with partners across industries (including the technology, pharmaceuticals, and government sectors). Given that these partnerships could involve both private and public partners, financial transparency requirements surrounding the allocation of costs and profits/losses may be a leading issue for all stakeholders, including tax authorities. If these partnerships, like other current healthcare joint ventures, meet the definition of control under Section 482, transfer pricing requirements may need to be considered and properly documented to reduce the potential for an allocation of income, deductions, or other items by the IRS.

Transfer pricing considerations and risks

As discussed in the introduction, hospitals and other providers in the healthcare industry are often complex and integrated operations that utilize a range of tax structures, including structures with both taxable and tax-exempt legal entities. It is not uncommon for a single healthcare provider to include entities with tax code Section 501(c)(3) status (tax-exempt entities), C corporations, partnerships, joint ventures, and controlled foreign corporations, as well as various unrelated business activities. The different tax rules applicable to each of these entities and unrelated business activities may give rise to transfer pricing considerations for the healthcare provider.

Certain related-party transactions between different legal entity types (for example, a tax-exempt entity and a C corporation) create potential tax risks for healthcare systems if the transactions are not conducted at arm’s-length under Section 482. The transfer pricing regulations provide taxpayers with transfer pricing methods and other guidance for evaluating the arm’s-length result for controlled transactions (See Treas. Reg. 1.482-1(b)). However, consideration of the underlying economics and transaction details is critical to identify the best method and perform the appropriate transfer pricing analysis under the U.S. transfer pricing regulations or, in many cases, international standards under the Organisation for Economic Cooperation and Development (OECD) transfer pricing guidelines.

The following table presents common transfer pricing considerations for related-party transactions within a healthcare system.

Figure 1: Related-Party Transactions & Transfer Pricing Considerations*

Deloitte Tax LLP

*The information presented in this figure is sourced from the following: Treas. Reg. 1.482-9, Treas. Reg. 1.482-4, Treas. Reg. 1.482-2, and the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations published by the Organization for Economic Co-operations and Development in July 2017, as supplemented to date.

**Stewardship in this context is meant to be a broad term encompassing non-beneficial activities with respect to Treas. Reg. 1.482-9. For example, as defined in Treas. Reg. 1.482-9(l)(3)(iv), this would include “shareholder activities,” which are activities conducted solely to protect the renderer’s capital investment in other members of the controlled group or to facilitate compliance with reporting, legal, or regulatory requirements of the renderer.

As discussed, Treas. Regs. 1.482 requires that the results of controlled transactions be consistent with the results that would have been obtained if uncontrolled parties had engaged in the same transaction under the same circumstances (or arm’s-length result). Since identical transactions can be difficult to identify, it may be necessary to determine the arm’s-length result by reference to uncontrolled transactions under comparable circumstances. As such, related-party transactions that are not priced in accordance with the arm’s-length standard can lead to both tax and enterprise risks for healthcare systems.

From a U.S. tax perspective, both the IRS and state tax auditors may propose transfer pricing adjustments upon audit. Furthermore, if contemporaneous transfer pricing documentation is not prepared, penalties can apply to any underpayment of tax, if the value of the property or the amount of the net transfer pricing adjustment exceeds certain numerical thresholds (See Treas. Reg. 1.6662(e). The determination of these penalties is complex and a detailed explanation of the rules is beyond the purpose of this article).

Additionally, because related-party transactions can affect the value assigned to tangible and intangible property as well as other tax attributes, transfer pricing constitutes an important area for merger and acquisition due diligence. For example, during an acquisition, the discovery of a new controlled transaction or a significant change in transfer pricing practices (e.g., charges for use of intellectual property, cost allocations) could influence the valuations and change the overall tax consequences of the acquisition.

These types of enterprise and tax risks demonstrate the relevance of transfer pricing methods under Section 482 to supporting related-party pricing. Similarly, these transfer pricing methods can be of assistance for healthcare systems in complying with the recently proposed regulations regarding unrelated business income tax (UBIT) segmentation and the allocation of indirect costs across various unrelated business activities (SeeProp. Treas. Reg. 512(a)(6)).

Transfer pricing and UBIT implications

As a result of U.S. tax reform through the Tax Cuts and Jobs Act, hospitals and healthcare systems may no longer net losses of one unrelated trade or business activity against the income of another unrelated trade or business under tax code Section 512(a)(6). In essence, this tax law mandated the segmentation of each unrelated trade or business and the creation of separate tax liability for each unrelated trade or business. The recently released proposed regulations, while providing some clarity, are silent on the proper allocation methodology for indirect costs across unrelated trades or businesses (id.).

The preamble of the proposed regulations state:

“Until publication of a separate notice of proposed rulemaking, these proposed regulations incorporate the existing allocation standard in §1.512(a)-1(c), which provides that an exempt organization must allocate deductions on a reasonable basis between separate unrelated trades or businesses (id.).”

Prior to these changes, the indirect cost allocation did not have a significant tax impact because of taxpayers’ ability to net losses against income. However, that is no longer the case and the indirect cost allocation has the potential to impact the outcome of the unrelated business income tax determination. In a complex healthcare system, it may be necessary to determine if separate allocation keys are required for each trade or business or if it is reasonable to use a single indirect allocation key for all parties. In such a case, transfer pricing principles may be useful to document and analyze the underlying economics to support the conclusion that the selected method was applied on a reasonable basis.

Treas. Reg. 1.482-9(k) provides a framework for the allocation of indirect costs under the arm’s-length standard between related parties. The methodology outlined in Treas. Reg. 1.482-9 is currently applied by multinationals to support the allocation of indirect costs across the globe to controlled affiliates, which is an exercise similar to the allocation of costs between separate unrelated trades or businesses as required for UBIT purposes. Given that the methodology is widely applied and outlined in Treas. Reg. 1.482-9, using this transfer pricing methodology can provide increased transparency to stakeholders that the cost allocation for UBIT purposes is being determined in a fair and sustainable manner following underlying arm’s-length and economic principles.

As previously discussed, Covid-19 has significantly affected healthcare systems and may continue to do so for the foreseeable future. The effects of Covid-19 could alter the underlying economics of a healthcare system and result in changes to the current cost allocation model. The cost drivers of separate unrelated business and trades may no longer align due to Covid-19-related market instability. As such, current allocation methodologies may no longer provide a reliable basis for allocating costs. Healthcare system officials should carefully review historic cost allocation models to ensure that those models take into account changes stemming from Covid-19 and that they produce results that are reasonable in light of current economic conditions.

Conclusion

In an integrated healthcare system, transfer pricing is linked to both tax and financial transparency. As the enterprise model of healthcare systems evolves, integrates technologies, and forms new joint ventures because of Covid-19, transparent and well-documented transfer pricing practices will continue to be important to stakeholders and leaders. These stakeholders and leaders are experiencing unprecedent uncertainty related to local and global markets. As a result, financial transparency through proper selection and application of transfer pricing methods, economic analysis, and transfer pricing documentation could prevent a healthcare system from bearing unnecessary enterprise and tax risks.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Nick Gaudioso is a manager with Deloitte Tax LLP in the U.S. transfer pricing group. Adam Kelfer is a senior manager, and Randy Price is a managing director.

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