Transfer pricing and its effect on financial reporting

Multinational companies face high-risk tax accounting.

This article examines the relationship between transfer pricing and an entity’s tax and financial reporting. Due to increased IRS audit procedures, transfer pricing has become one of the riskiest areas for multinational corporations from both a compliance and tax planning perspective.

Amazon, AOL, Adobe, Hewlett-Packard, Microsoft, and other multinationals have made headlines because of transfer-pricing disputes over potential adjustments to income ranging from tens of millions to upward of a billion dollars. However, the impact of transfer pricing could also apply, for example, to a small, closely held manufacturing company in Canton, Ohio, looking to expand overseas. Because transfer pricing is a niche area for practitioners, this article gives a general overview of major transfer-pricing issues facing practitioners from a financial reporting and tax perspective.


A transfer price is the price charged between related parties (e.g., a parent company and its controlled foreign corporation) in an intercompany transaction. Although intercompany transactions are eliminated when consolidating the financial results of controlled foreign corporations and their domestic parents, for tax purposes such entities are not consolidated (Sec. 1504(b)(3)), and the transactions are therefore not eliminated. Transfer prices directly affect the allocation of groupwide taxable income across national tax jurisdictions. Hence, a company’s transfer-pricing policies can directly affect its after-tax income to the extent that tax rates differ across national jurisdictions.

Sec. 482 gives the IRS the authority to adjust taxable income between two related parties to more accurately reflect the income earned by each party. As detailed in Regs. Sec. 1.482-1(b), the standard to be applied to determine the true taxable income of a controlled taxpayer is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer. Generally, a controlled transaction meets the arm’s-length standard if the income from the transaction is consistent with the income that would have been realized if unrelated taxpayers had engaged in a comparable transaction under comparable circumstances.

Any transfers of economic value among related parties must meet the requirements of Sec. 482. Not only does it apply to the transfer of tangible goods (e.g., a foreign manufacturing unit sells its output to a U.S. distributor, both owned by a U.K. parent company), but also to intercompany services performed. Provision of intragroup services (e.g., call center support, development of marketing plans, and legal and accounting services), intragroup financing, and the use of intellectual property legally owned by a particular group member are all examples of transactions subject to scrutiny under Sec. 482.

Determining a company’s transfer prices requires identifying where value is created in an organization and transferred across group members. Typically, value can be characterized and the comparability of a transaction with one between unrelated parties can be determined by factors including the assets used, the risks assumed, and the functions performed by each group member in an intercompany transaction (Regs. Secs. 1.482-1(c) and (d)). Taxpayers choose an appropriate economic method specified in Regs. Sec. 1.482-3(a) to determine a range of arm’s-length prices (or profits) (see Regs. Sec. 1.482-1(e)) for the transaction in question. Most foreign tax authorities also specify similar methods to choose from. The transfer price ultimately used to determine taxable income across borders is considered to be at arm’s length if it falls into the range computed.


Transfer pricing is in the cross hairs of tax policy as it relates to the competing objectives of three parties: the revenue-maximizing objective of the domestic tax authority, the revenue-maximizing objective of the foreign tax authority, and the tax-minimizing objective of the taxpayer. Because of the inherent differences in judgment and interpretation of facts when analyzing a company’s transfer pricing, together with the clashing revenue objectives of multiple tax authorities and taxpayers, the risk of adjustments to taxable income, double taxation, and potential for penalties is nontrivial, even for multinationals that make good-faith efforts to comply with Sec. 482.

Disputes between tax authorities and taxpayers may arise in many areas, including:

  • Tax authorities may question the assumptions used when applying the particular economic method chosen.
  • Tax authorities may question the choice of the economic method.
  • Tax authorities may disagree with the taxpayer’s characterization of the value chain within the group.

As an example of the last type of dispute, in 2006 the IRS and GlaxoSmithKline Holdings (Americas) Inc. (GSK U.S.) settled a transfer-pricing dispute covering 1989 through 2005 for $3.4 billion, the largest settlement ever obtained by the IRS. At issue was the price charged GSK U.S. by its U.K.-based parent, GlaxoSmithKline plc, through its worldwide operating group (Glaxo Group) for cost of goods sold, royalties, and other expenses, related in part to manufacturing and distributing Zantac and other prescription drugs. The position of GSK U.S. was that the drugs were developed outside the United States, as was the marketing strategy it used to sell them. As such, GSK U.S. was performing routine distribution and was charged prices and royalties based on the “resale price method,” which determines the appropriate arm’s-length range by the markups received by comparable distributors in uncontrolled, arm’s-length transactions.

Based on the same facts, however, the IRS considered the marketing functions performed by GSK U.S. to have had a substantial role in creating demand for the drugs, and therefore, GSK U.S. deserved a much higher gross profit margin. The IRS applied the residual-profit-split method, which allocated Glaxo Group profit first between “routine” functions performed by GSK U.S. and GSK Group, then split the remaining profit according to where the largest part of the value was created.


Because of the inherent uncertainty in satisfying tax authorities and the potential dollar amounts involved, transfer pricing consistently ranks among the top tax concerns for multinationals. According to the results of a 2010 survey of multinational enterprises by EY (2010 Global Transfer Pricing Survey, available at, 32% of respondents ranked transfer pricing as one of the most important tax challenges facing their group. Two-thirds of respondents reported undergoing a transfer-pricing audit, compared with only 52% in EY’s 2007 survey. Of audits reported in the 2010 survey, 20% resulted in a material penalty, compared with less than 4% in 2005. In the 2013 EY survey (available at, 66% of respondents said managing tax risk was their top transfer-pricing priority, a 32% increase from 2007 and 2010.

The risk and uncertainty associated with transfer-pricing positions is expected to increase in coming years. Under pressure to raise revenue, governments are directing tax authorities to increase transfer-pricing audits. The IRS has made a substantial investment in its transfer-pricing resources. Last year, the Large Business and International (LB&I) Division launched its international practice networks to unify international compliance functions and bring institutional expertise to bear on them. Transfer pricing is among the networks’ top concerns (see “New LB&I Knowledge Management Strategies: IPGs and IPNs,” The Tax Adviser, Oct. 2012, page 668). In the next two years, the IRS will focus more transfer-pricing examination resources on medium-size taxpayers, those with assets as low as $10 million, than before (see “Practitioners Warn Middle-Market Companies of Heightened Transfer Pricing Scrutiny,” Tax Notes Today, July 18, 2013).


Given the uncertainty in a company’s ability to sustain its transfer-pricing positions, transfer pricing can often fall into the category of an uncertain tax position and has a direct impact on a company’s tax provision, with potential indirect effects on the ability to realize deferred tax assets.

FASB ASC Topic 740, Income Taxes, establishes a threshold condition that a tax position must meet for any part of the benefit of that position to be recognized in the financial statements. Uncertain tax positions are evaluated in a two-step process:

  • Recognition. A tax benefit may be reflected in the financial statements only if it is more likely than not that the company will be able to sustain the tax return position, based on its technical merits.
  • Measurement. A tax benefit should be measured as the largest amount of benefit that is cumulatively greater than 50% likely to be realized.

Companies must assume that the position will be litigated to the “highest court possible” and that the IRS has knowledge of all relevant facts. The portion of the tax benefit not recognized, called an unrecognized tax benefit (UTB), becomes a liability. Tax expense, as well as the entity’s effective tax rate, increases. UTBs associated with uncertain tax positions are reevaluated and updated as new information warrants.


Applying Topic 740 requires significant professional judgment, in perhaps no area more than transfer-pricing positions. Although evaluating a company’s transfer-pricing positions depends on its facts and circumstances, a few general insights can shed light on the process companies may go through to identify UTBs related to transfer pricing.

In the recognition phase, any intercompany transaction that could lead to an adjustment of income by the IRS or a foreign tax authority is considered to be an uncertain tax position.

In determining the likelihood that the position will be sustained under audit, or the expected benefits that will be upheld as a result of an audit, several factors can be taken into consideration. First, does an advance-pricing agreement (APA) cover the transaction in question? APAs are negotiated agreements between the taxpayer and tax authorities pertaining to the transfer pricing on particular future intercompany transactions. Provided that the taxpayer does not violate any part of the agreement by implementing a transfer-pricing policy different from what was specified in the agreement, tax authorities will consider a transaction covered by the APA to be priced at arm’s length. In this case, the full tax benefit from the position could be recognized.

In the absence of an APA, companies must assess the strength of their position based on the extent of the documentation and economic analysis supporting the position; the extent to which the actual transfer-pricing policy matches the documentation and economic analysis supporting the position; any history of treatment of the tax position by both the IRS and the foreign tax authority; and the extent to which one party in the transaction is recognizing a loss (typically a red flag that can increase the chance of a transfer-pricing audit).

To the extent that UTBs that represent probable future taxable amounts must be recognized, transfer pricing may indirectly affect companies’ ability to benefit from deferred tax assets. Future taxable amounts resulting from likely adjustments to income relating to transfer-pricing positions may enable a company to lower valuation allowances against deferred tax assets.

Earnings of foreign subsidiaries of U.S. corporations are not taxed until they are repatriated to the United States. Under Topic 740, multinational corporations do not need to recognize deferred tax liabilities on those unrepatriated earnings, provided that they are expected to be “permanently or indefinitely reinvested” outside the United States. Because transfer prices can play a role in determining the distribution of income among the members of a controlled multinational group, transfer pricing also affects the tax provision of a multinational through its effect on unrepatriated earnings.


In an academic study of GAAP financial statements prepared by multinational corporations, Susan Borkowski and Mary Anne Gaffney (“FIN 48, Uncertainty and Transfer Pricing: (Im)Perfect Together?” 21 Journal of International Accounting, Auditing & Taxation 32 (June 2012)) found a significant increase in both the quantity and quality of footnote disclosures related to transfer pricing as a result of Topic 740. The average size of a transfer-pricing note by U.S. corporations studied grew from 108.8 words in 2006 to 140.5, 163.8, and 156.5 words in 2007, 2008, and 2009, respectively. The authors also found that companies disclosed more information relating to the tax authorities currently disputing transfer-pricing positions and years under audit, enabling financial statement users to better ascertain the degree and nature of audit risk faced by a multinational.

Transfer-pricing issues that trigger UTBs eventually show up on Schedule UTP, Uncertain Tax Position Statement. Schedule UTP, which debuted for tax year 2010, is part of an IRS strategy to enhance transparency and foster greater compliance. U.S. or foreign corporations filing a U.S. corporate income tax return with assets at or above a specified amount must file Schedule UTP. For tax years beginning in 2012 and 2013, the asset threshold is $50 million; for tax years beginning in 2014 and after, the threshold is $10 million (for more, see “Schedule UTP: The Early Returns Are In,” JofA, Nov. 2012, page 54). For each tax position for which the corporation or a related party has recorded a reserve in an audited financial statement, Schedule UTP requires corporations to classify each position with a letter (for transfer-pricing positions the letter is T), a ranking number for the relative size of the UTB for each position, applicable Code section or sections, and a brief description of the position. Schedule UTP also requires the reporting of a corporation’s federal income tax positions for which the corporation or a related party has not recorded a reserve because the corporation expects to litigate the position. The IRS reported that, during the 2011 filing year, 21% of all UTPs disclosed were transfer-pricing issues, the second-highest category after the Sec. 41 credit for increasing research activities (see the IRS webpage “UTP Filing Statistics,” available at


No matter how small or aggressive the company, transfer pricing could have a material impact on a company’s financial statements. Therefore, all CPAs should be aware of the implications transfer pricing could have on their client base.


Transfer pricing—arm’s-length charges between related parties such as a parent corporation and a controlled foreign corporation—is an area of high-tax-compliance risk for multinational corporations and carries important implications for tax planning and financial reporting.

Determining an arm’s-length transfer price typically requires identifying where value is created and transferred; analyzing such factors as assets used, risks assumed, and functions of the respective parties; and correctly applying an appropriate economic method provided in Treasury regulations and other guidance.

Transfer-pricing issues often give rise to uncertain tax benefits, which under FASB ASC Topic 740, Income Taxes, require taxpayers to assess the strength of the uncertain position, based on its documentation and analysis. In addition, for applicable corporations, transfer-pricing issues that give rise to an uncertain tax position often are reportable on Schedule UTP, Uncertain Tax Position Statement. These issues also have increased the complexity of financial statements, requiring additional and longer footnote disclosures.

John McKinley ( ) is a lecturer of accounting and taxation at Cornell University and Ithaca College, both in Ithaca, N.Y. John Owsley ( ) is a senior associate in EY's financial services transfer-pricing practice.

To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at or 919-402-4434.


JofA article

Schedule UTP: The Early Returns Are In,” Nov. 2012, page 54

The Tax Adviser article

“New LB&I Knowledge Management Strategies: IPGs and IPNs,” Oct. 2012, page 668


  • Transfer Pricing Methods: An Applications Guide (#WI573604)
  • Transfer Pricing: Rules, Compliance and Controversy (#CC016564)
  • U.S. Taxation of International Operations: Key Knowledge (#091102, paperback; and #091103PDF, online access)


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