Transfer Pricing Fundamentals What Every International Business Owner Should Know

Why This Matters Even If You've Never Heard the Term

Transfer pricing sounds like an obscure tax concept that only Fortune 500 companies need to worry about. That assumption costs smaller international businesses millions in overpaid taxes, IRS penalties, and denied deductions.

If your business has operations, subsidiaries, or related entities in multiple countries or if you pay or receive fees, royalties, or payments from related foreign entities transfer pricing rules directly affect how much tax you pay and whether your deductions survive IRS examination.

What Transfer Pricing Actually Is

Transfer pricing governs how you price transactions between related entities in different tax jurisdictions. When your U.S. company pays your Irish subsidiary for services, or when your Singapore entity licenses IP from your U.S. parent, the price you set for those transactions determines where income is taxed.

Set prices too low for payments to foreign affiliates, and IRS will increase your U.S. income, denying deductions and assessing tax plus penalties. Set prices too high, and foreign tax authorities may make adjustments that create double taxation because the U.S. won't recognize the foreign adjustment.

The requirement is simple in concept but complex in application: related-party prices must be what unrelated parties would have agreed to under similar circumstances—arm's length pricing.

Why This Catches Business Owners by Surprise

Most business owners think about transfer pricing only when IRS raises it in an audit. By then, you're defending transactions completed years ago without documentation supporting your pricing, facing adjustments you can't easily contest.

The common scenario: Your U.S. company needs technology support, so you have your Indian subsidiary provide it. You pay $200,000 annually a number you chose because it seemed reasonable and covered costs. IRS examines the arrangement and determines arm's length pricing would be $400,000. They disallow $200,000 of your deduction, assess tax plus 20-40% penalties on the adjustment.

You protest that $200,000 was reasonable, but you have no comparability analysis, no documentation of how you determined the price, and no contemporaneous support for your position. IRS wins by default.

The Arm's Length Standard in Practice

Determining arm's length pricing requires analyzing comparable transactions between unrelated parties. This sounds straightforward until you realize that truly comparable transactions often don't exist in searchable form, or when they do exist, the details aren't public.

Functions, assets, and risks analysis. What functions does each entity perform? What assets does each entity contribute? What risks does each entity bear? Arm's length pricing should compensate entities based on value creation from their functions, assets, and risks.

A common mistake: allocating income based on where entities are located or what expenses they incur, rather than what value they create. The entity that performs routine functions under low risk should receive routine returns. The entity that performs unique, high-value functions and bears significant risk should receive returns commensurate with that value and risk.

Selecting the appropriate method. Transfer pricing regulations describe several methods for determining arm's length pricing: comparable uncontrolled price, resale price, cost plus, comparable profits, profit split. Each method works better for different transaction types.

The challenge: you must select the best method for your specific facts, document why you chose it, and apply it consistently. Many businesses skip this analysis entirely, setting prices based on convenience or desired tax results.

What Requires Transfer Pricing Documentation

Tangible goods transactions. When related entities buy or sell inventory or equipment, those transaction prices must be arm's length. This requires comparability analysis of similar transactions, adjusted for differences in product specifications, quantities, payment terms, and market conditions.

Services between related entities. Management fees, technical support, administrative services, marketing services—any services provided between related entities require arm's length pricing. You can't simply allocate costs; you must charge what independent providers would charge for similar services.

Intangible property licenses. When one entity licenses patents, trademarks, know-how, or other intangibles to related entities, the royalty rate must be arm's length. This requires analysis of comparable license agreements, adjusted for the exclusivity, field of use, geographic scope, and underlying intangible value.

Financing transactions. Loans, guarantees, and other financing between related entities must use arm's length interest rates and terms. You can't simply use the parent's borrowing rate when lending to subsidiaries; you must consider the subsidiary's creditworthiness and the terms independent lenders would demand.

Cost sharing arrangements. When related entities share development costs for intangibles, the arrangement must allocate costs and benefits appropriately. These arrangements require complex documentation and periodic adjustment as benefits change.

The Documentation Requirement Nobody Explains Clearly

U.S. transfer pricing regulations require contemporaneous documentation for related-party transactions. "Contemporaneous" means prepared by the tax return due date (including extensions) for the year in question—not when IRS raises questions during an audit.

What documentation must include:

• Overview of your business and industry

• Description of organizational and legal structure

• Nature of the intercompany transactions

• Comparability analysis supporting your pricing

• Description of method selected and why it's best

• Financial data supporting your pricing

• Copies of relevant intercompany agreements

Missing contemporaneous documentation triggers penalty exposure of 20-40% of any adjustment IRS makes. Strong documentation provides penalty protection even if IRS disagrees with your pricing.

The Penalty Structure That Changes Everything

Transfer pricing penalties are among the harshest in tax law. For transactions without adequate documentation, penalties start at 20% of tax deficiency and scale to 40% for substantial valuation misstatements.

A $1 million transfer pricing adjustment creates $370,000 in tax (at 37% corporate rate) plus $74,000-$148,000 in penalties. The penalty alone exceeds what many businesses pay annually for comprehensive transfer pricing documentation.

The critical detail: penalties don't apply if you have contemporaneous documentation and your pricing was reasonable based on that analysis, even if IRS ultimately disagrees. Documentation isn't about avoiding adjustments—it's about avoiding penalties on adjustments.

Common Structures That Create Issues

U.S. parent with foreign subsidiary providing services back to U.S. Many companies establish foreign entities to reduce payroll costs, then have those entities provide services to the U.S. parent. IRS closely scrutinizes these arrangements, particularly when the foreign entity is in a low-tax jurisdiction. You need strong documentation showing the foreign entity provides real value beyond cost reduction and that pricing is arm's length.

IP developed in U.S., licensed to foreign entities. U.S. companies often develop intangibles then license them to foreign subsidiaries for use in foreign markets. The royalty rate determines how much income remains in the U.S. versus shifting offshore. Both IRS and foreign tax authorities examine these arrangements closely.

Intercompany financing. U.S. parents often fund foreign subsidiaries through intercompany loans rather than equity contributions. The interest rate on these loans must be arm's length considering the subsidiary's creditworthiness, not just the parent's cost of capital. Inadequately documented intercompany debt can be recharacterized as equity, disallowing interest deductions.

Management fees and cost allocations. Many U.S. companies charge management fees or allocate costs to foreign subsidiaries. These charges must be for services that actually benefit the foreign entity and must be priced at arm's length. IRS will disallow charges for shareholder-level services that don't benefit the subsidiary or that exceed what independent service providers would charge.

What You Need to Do Now

Document your current related-party transactions. List every transaction between your U.S. entity and foreign related entities: services provided or received, goods purchased or sold, IP licensed, financing arrangements, cost allocations. Quantify annual amounts.

Assess your documentation gaps. Do you have contemporaneous documentation supporting arm's length pricing for each transaction? If not, you have penalty exposure for any adjustments IRS might assert.

Engage transfer pricing specialists before audits. Transfer pricing documentation requires specialized expertise that general tax practitioners don't typically develop. The cost of documentation is a fraction of penalty exposure for inadequate documentation.

Build transfer pricing into transaction planning. When establishing new international structures or entering new related-party arrangements, address transfer pricing upfront. It's far easier to establish appropriate pricing and documentation initially than to retrofit support for transactions structured without transfer pricing consideration.

Review and update documentation annually. Transfer pricing documentation isn't one-time—it should be updated annually as your business changes, transaction volumes shift, and comparable data becomes available.

The Planning Opportunity

Companies often view transfer pricing as pure compliance burden, but it's actually a planning tool. Proper transfer pricing enables you to structure international operations efficiently while maintaining defensible positions with tax authorities.

Strong transfer pricing documentation also facilitates advance pricing agreements with IRS, providing certainty that your pricing methodology will be accepted prospectively. This eliminates audit risk for covered transactions and enables long-term planning with confidence.

Let's Evaluate Your Transfer Pricing Risk

Transfer pricing affects every business with international related-party transactions. The question isn't whether these rules apply to you it's whether you have adequate documentation to avoid penalties when they're examined.

JHS USA's international tax team provides comprehensive transfer pricing documentation, planning, and audit defense services. We work with businesses of all sizes to establish defensible transfer pricing positions while optimizing international tax structures.

If you have any related-party transactions with foreign entities and haven't prepared formal transfer pricing documentation, let's discuss your penalty exposure and what documentation you need.

About JHS USA Transfer Pricing Services
JHS USA provides transfer pricing studies, documentation, planning, and controversy support to businesses with international related-party transactions. Our team combines technical transfer pricing expertise with practical business judgment to develop compliant, tax-efficient international structures.

This article is for informational purposes only and does not constitute tax, legal, or financial advice.