Paying too much in taxes is a “you problem.” You can either keep complaining or look into the alternatives life has to offer… legal and illegal tax planning strategies. In this post I’ll talk about what’s legal and what’s not and why you need a transfer pricing study to know the difference.
Depleted economies have governments installing tax haven plans to boost revenues. With all the tax havens hoping for your business, there is a fine line between tax avoidance (which is legal) and tax evasion (which is illegal). A transfer pricing study is often the difference between the two.
Most Americans want to do what’s right and legal… I know this because it’s the opening line of 90% of the inquiries we get for tax planning. But these Americans are often lead astray by promoters in foreign tax havens. They promotor gives you all kinds of fancy sounding advice that will allow you to avoid paying the IRS. It sounds so smooth that you fall for it… and now you’re in a world of trouble.
Throughout the rest of this article I’ll talk about what’s legal and what’s not. Just remember, only a US tax expert understands the intricacies of the US tax code. Only a US firm can draft a US compliant transfer pricing study. Only a US attorney, CPA or EA is liable to the IRS for bad advice. A promoter in Panama will tell you what the laws in their country say. A US expert will help you combine those with the laws of your home country to maximum legal effect.
As a US citizen, 100% of your risks lie with the IRS. If you’re going offshore, you should always have a US tax expert quarterback your structure. And you should have written evidence of this plan in the form of a transfer pricing study.
Before I begin, here are a few definitions:
The desire to legally reduce and eliminate really high tax rates, under tax reductions. Examples of this are; buying properties, getting married, opening IRAs, maximizing your deductions (reporting granny as a dependent), and setting up tax deferred accounts and structures.
Defined as an illegal practice where you, your organization or corporation intentionally avoids or explicitly abstains from paying your tax liabilities. Tax evasion applies to both the illegal nonpayment as well as the illegal underpayment of taxes. If the taxman in your country finds out the scheme exceeds $10K then, you might not be able to play the innocent card. Evasion looks like actor Nicholas Cage buying 2 albino king cobras and a private island because of a “bad” financial manager. Raising a red flag is that easy, unless there was no predetermination to have unreported cash lying around for flamboyant expenses. Intent is the word of the day, if taxman can prove intent to evade, you’re toast.
Not quite heaven, although close to it. This is a country, island or nation with special allocations of tax, and preferential tax agreements/laws, which allow you to receive more your own income, through a lesser tax rates or zero tax rates. Countries considered as tax havens will open their doors to let poor wealthy entities, suffering from high tax rates in their homeland, to establish new tax efficient businesses on their shores. Transferring income into these tax havens is complex and can be accomplished through the right network.
- For more, see What is a Tax Haven in 2017
- A tax haven can be offshore or in a low tax US territory like Puerto Rico. See Panama vs. Puerto Rico, Which is Right for Your Business for more information.
Transfer pricing study-
A transfer pricing study (“TPS”) analyzes possible business transactions between your existing company in a high tax country and your new company in a low tax jurisdiction. Some tax havens offer business development as services to existing mainland companies, meaning you can receive tax cuts through legally transferring income establishing a business as a service provider offshore. Although this should be accomplished harmoniously with TPS, so you don’t get PTSD, when taxman decides to audit you.
Owning related businesses in different tax jurisdictions can be a juggle. So long as you cover your bases by getting a TPS and showing intent of compliance, you limit your exposure and risks as much as possible. TPS covers a variety of issues… it’s not a mere legal opinion, but a full length study on products or services, comparable market pricing, market fluctuations, labor costs, fair market value, arms length transactions through the use of comparables, etc. It’s an economic study of your business. The time it takes to complete the study, depends on the intricacies of your business, so be aware it may take a while to produce a TPS.
Intent is doing something knowingly and with purpose, with predetermination. Intent can also make or break a tax audit. Intent in a tax audit is demonstrated through contemporaneous documentation (documents prepared in the same period of time).
Arm’s length transaction-
Is how you danced when parents watched in high school. In an arm’s length transaction, the parties are independent, self serving and aren’t subject to duress. When we’re talking about transfer pricing, the parties are related (same owner). So we say that the transaction should be valued as if it were arm’s length.
A Transfer Pricing Study is a necessity. Here’s why:
Once you own companies in different tax jurisdictions (let’s say, in US burden town and Puerto Rico tax haven), these companies must establish “fair market pricing” on what one company is charging/paying the other. You must ensure that the proper amount of income is allocated to the correct entity, so that the tax is properly reported and paid. 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 Puerto Rico sourced income, see: What is Puerto Rico Sourced Income for an Act 20 Business
Transfer pricing refers to how we determine the prices at which services, tangible property, and intangible property are traded across international borders between related parties. The transfer pricing rules exist to prevent companies from using intercompany pricing for tax evasion by inflation or deflation of profits. A transfer pricing study allows you to estimate the value of services provided in the low tax jurisdiction and therefore provides the basis on which you file your US taxes.
In Puerto Rico and US, the burden of proof is generally placed on the taxpayers. Therefore, taxpayers looking to avoid penalties must demonstrate reasonable cause and good faith in their transfer pricing decisions. Thus, it is important to ensure that your documentation is accurate and complete. IRS and PR Department of Treasury conduct “random” audits to determine if the related parties have charged an “arm’s length” price and, if not, what the correct price should be.
And we expect the frequency of these audits to go way up in the next few years. Because Puerto Rico eliminated the 5 employee rule for Act 20, the floodgates are open. Along with the loosening of the requirements comes the possibility of abuse, of which the IRS is sure to take notice. See: Puerto Rico Eliminates 5 Employee Requirement
All companies must determine if the prices they charge are within the rules. Corporations should be prepared for an audit and to defend their positions with a contemporaneous transfer pricing study. By obtaining a transfer pricing study comprised of data, policy, pricing and documentation, you can build a fair and efficient tax plan as well as reduce the costs of an audit.
When tax authorities request a taxpayer’s transfer pricing documentation, you’ll generally will have 30 days to produce this document, although there are no laws, yet, providing that Transfer Pricing Studies are an obligation, a Transfer Pricing Study may be solicited under an IRS audit.
Say what!?!?! Yes you read correctly, you don’t need the TPS to do global related party transactions, but having it done beforehand can save you in an audit. Transfer pricing studies are the prophylactics of taxes, you never know when you may need them but keep’em handy.
What the IRS has to say about Transfer Pricing Studies:
“When a US parent (USP) sells a product to its controlled foreign corporation (CFC), IRC 482 requires USP to sell that product at an arm’s length price to its CFC. Under IRC 482, controlled entities should price transactions in the same way that uncontrolled entities would under similar circumstances. This is the “arm’s length standard”, which means that the price of the product that USP charges its CFC should be the same as it would charge to an unrelated party for the same product under similar circumstances.”
How to do it right!
Related foreign corporations can provide certain services for the US corporation, therefore parties must draft inter-company agreements between the two, which shall be subject to transfer pricing considerations. Transfer pricing studies are expensive ranging $15k- $50k or even more.
Get a transfer pricing done after obtaining a green light to do business in the tax haven of your choosing. First of all, you need to assess your business and the actual risks of getting audited. TPS auditor might identify risks that you were not even aware of.
With the transfer pricing study in hand, you can assess your corporation’s risk tolerance. Are you willing to take risk, or does your company value security? Are you willing to go to battle with the IRS over an aggressive transfer pricing model?
Third party professionals are not necessary. You can try to prepare a transfer pricing study for your business. Many larger corporations have entire departments that do nothing but prepare transfer pricing documentation and address compliance with global transfer pricing regulations.
However, US regulations outline very specific standards for evaluating the arm’s-length nature of intercompany pricing. To comply with economic principles outlined in the US regulations, you must adhere to certain methodologies and economic valuation techniques. Independent and experienced eyes have advantages that insiders don’t. This is why publicly traded companies are required to have their financial statements audited by an outside party.
The foundation of an international tax plan is a professional transfer pricing study. If you will setup a foreign division in a low tax country, you must have a transfer pricing study. If you move you and your business offshore, no study is required. If some of the work to generate the money is done in the US and some is offshore, you need a transfer pricing study.
If you’re looking for the best tax haven for your international business, you might take a read through Changes to Puerto Rico’s Act 20 and Act 22.
I hope you’ve found this article on why you need a transfer pricing study to be helpful. For more information, or to setup an international division, please contact us at firstname.lastname@example.org or call us at (619) 550-2743. All consultations are free and confidential.