Case Study: The Arm's Length Principle
Discuss with your partner/teacher:
Read the email from the CFO. Click the blue words to learn them!
TO: Tax Director
RE: Pricing of Arabica Beans to UK Subsidiary
The IRS is challenging our Transfer Pricing policy. We currently sell unroasted beans to our UK subsidiary at $5.00/kg. This is exactly what it costs us to grow them.
The auditor argues this is not an Arm's Length price. They claim that if we sold to a stranger, we would add a profit markup of at least 20%.
They want to propose an adjustment of $2M to our taxable income. We need to find a comparable transaction (CUP) to prove our price is fair.
1. The company is selling beans to the UK at a very high price.
2. The "Arm's Length Principle" means treating your subsidiary like a stranger.
3. An "Adjustment" means the tax authority will decrease your taxes.
In Transfer Pricing, we constantly compare transactions.
1. We must price the goods ________ the parties were independent.
Hypothetical situation.
2. Our margin is ________ market rates.
Matches / is aligned with.
3. ________ to our competitors, we operate with lower overheads.
Comparing differences.
Complete the response to the IRS explaining why our price is correct.
Subject: Response to Proposed Adjustment
Dear Officer,
We dispute the adjustment regarding sales to our UK .
You argued that a markup is required. However, our UK entity acts only as a limited-risk . They do not hold inventory risk or perform marketing.
Based on the limited they perform, they should not earn a high profit. Our pricing is similar arrangements in the industry.
We have performed a study which confirms our prices are within the range.
Sincerely,
Head of Tax