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Talking Expat Taxes #12

Transfer Pricing for Every Business: Documentation, Methods & Risk with Jinkan Khatadia

Transfer pricing isn't just for Fortune 500 companies. Whether you're running a US business with overseas operations, managing cross-border transactions, or even operating between different US states, understanding proper intercompany pricing could save you thousands in taxes while protecting you from costly IRS penalties. From the fundamental arm's length standard to advanced documentation strategies, this episode provides the roadmap for compliance and advanced tax optimization.

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Show Notes

You don't have to be a multimillion dollar company for transfer pricing to make sense or be practical for you.

Takeaways

  • Risk Mitigation Through Documentation

    Proper transfer pricing documentation protects against IRS penalties and provides negotiation leverage during audits.

  • Small Business Applicability

    Transfer pricing isn't just for large corporations - small and medium businesses can benefit significantly from proper intercompany pricing strategies.

The amount could essentially be equivalent of the entire value of your business... you don't have business. Essentially the next day you're bankrupt.

Today's Guest
Jinkan Khatadia

Jinkan Khatadia

From a single audited class at Texas A&M University to becoming a sought-after transfer pricing consultant, Jinkan's journey began with a "lightbulb moment" that changed everything. Under the guidance of renowned transfer pricing academic Dr. Lorraine Eden, he discovered his passion for the economics-driven world of intercompany transaction pricing. 15+ years later, Jinkan has become the go-to expert for businesses that need transfer pricing solutions but don't want to get lost in academic jargon. Through his firm CAPAM Consulting, he's made it his mission to democratize transfer pricing knowledge—proving that small and medium businesses deserve the same caliber expertise as Fortune 500 companies, without the Fortune 500 price tag.capamconsulting.comEmail Jinkan

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00:00:00Alex

Welcome to another episode of Talking Expat Taxes. I'm Alex McGowan with McGowan Tax, LLC, where we help individuals and small businesses with international transactions save on their taxes, but also stay compliant with the IRS. And one of the big things that I've been running into lately is, you know, individuals with companies in different jurisdictions, and we're gonna jump more into this.

00:00:00Alex

Where they have intercompany transactions, or maybe there's a company, you know, trying to do business into the US and setting up their own company, and there's gonna be intercompany transactions, actions, pricing those transactions is a big part of what has a big play in what we do from a tax perspective and just from a business perspective overall. And today, I'm really excited to have on somebody that specializes in that type of pricing. Uh, Jinkans here with me. We've been working together for a long time. We worked together at Grant Thornton back when I was doing international tax there, and he was, he was doing transfer pricing.

00:00:34Alex

But glad to have you on Jinkan. We're gonna talk about, uh, transfer pricing in general and how it applies to how it applies to a lot of people and why it's important. But, but yeah, glad to have you on.

00:00:44Jinkan

Thank you so much, Alex. Um, uh, I'm glad to be on here. Um, my name is Jinkan. Um, I've been doing transfer pricing for a little over 15 years, as Alex mentioned. Um, Alex and I, we connected at Grand Thornton, uh, for the past two years. Uh, I have my own firm where I specialize in providing transfer pricing consulting services, as well as training services, um, which is really applicable to companies that want, uh, some transparency training in order to be able to either do it in-house or it's also applicable to professionals who want to. Learn more about transfer pricing and add that additional service under the same roof for their clients.

00:01:25Alex

I guess I've seen that with you, working on both sides. Yeah. Working, helping train people so they can do that type of work. And also consulting with them on the side, which is how you and I generally work together at, you know, at.

00:01:37Jinkan

I mean, the one unique feature about transfer pricing compared to the rest of the. Fields in taxation is that transfer pricing is purely based on economics. are no, nitty gritty rules that you typically see, um, in the general tax world. Um, rules do not really apply in transfer pricing. Yes, absolutely. Uh, there are separate rules and regulations for transfer pricing purposes, but when you look at those regulations, they are heavily economics oriented. So it's going to be a fun topic to discuss.

00:02:17Alex

For sure. And I think just starting from the top, because it's kind of a buzzword, you know, at least if you're in the industry of economics and business, it's, it's a buzzword. But you know, let's start with the top. You know, what is transfer pricing? What does that mean when somebody says that word to you?

What is Transfer Pricing?

00:02:33Jinkan

sure. Transfer pricing in a nutshell means pricing of intercompany transactions. Um, what does that mean? Uh, uh, like you had mentioned previously, you've been getting a lot of, uh, inquiries from your clients regarding, um, the clients that have, set up in multiple tax jurisdictions, let's say. example, you have US and China, a US parent company with, a related party Chinese manufacturer. Obviously whatever China is manufacturing is going to be sold to the us. Now, what is the price at which the Chinese entities going to sell the products to the US is referred to as transfer pricing?

00:03:17Alex

Yeah.

00:03:18Jinkan

what I do is I help clients identify that optimal price, that optimal transfer price. At which the Chinese manufacturer would sell the product to the us. And that's what what transfer pricing essentially means. Now, I would also like to add that transfer pricing is not necessarily only applied to cross border transactions, it also applicable to intrastate within the US domestic transactions as well,

00:03:51Alex

Right. Just any jurisdiction that has different tax system. Right,

00:03:55Jinkan

exactly. Because the different states have different tax rates, there is always this arbitrage to benefit from

00:04:02Alex

right.

00:04:03Jinkan

do not have state income taxes whatsoever. So it is also important to note that transfer pricing, while the intent of transfer pricing was to account for cross-border transactions. But over a period of time, it has also been applied to the domestic trans, the domestic transactions as well.

00:04:22Alex

Yeah.

00:04:22Jinkan

when you are set up in different states and you know, if the tax rates between both the states are the same, then it's not as much of an issue be. Or rather, I must say, if the states where you're transacting in are unitary states. Where you are filing a combined, tax return for

00:04:41Alex

I see. Yeah.

00:04:42Jinkan

of an issue. However, if it is not, if it is not combined states, it is just unitary states, and especially the states that do not have any state income taxes, then transfer pricing is a big deal, for

Domestic vs. Cross-Border Transfer Pricing Applications

00:04:56Alex

Yeah. Yeah, it makes sense. That's a good point. I mean, of course, I, I focus on international work and so I'm usually seeing it from the international side and I. Also when I see a lot of states going on at a company, I usually hide under my desk or run and hide 'cause state taxes scare me 'cause they're so complicated.

00:05:14Alex

So I have other people that help me with that stuff. But, uh, but you know, interesting point. I talked to a guy yesterday, he's in Florida. I think he, I can't remember, he is British or something, but he was looking to leave the US and he was looking for, you know, a tax friendly way to leave. And the best option on the table for a US citizen is Puerto Rico.

00:05:33Alex

And not to get in the weeds of Puerto Rico. Puerto Rico has the Act 60, and one of the benefits of Act 60 is that you, if you're self-employed, you have your own business, you can set up a business in Puerto Rico and your existing business in the us, pay a commission to your business in Puerto Rico, and you get a 4% rate. But the thing that his advisors in Puerto Rico didn't mention, and I'm gonna get you plugged into this guy as well, is. You can't just pick a number and send it over to the jurisdiction in Puerto Rico. 'cause both Puerto Rico and the US, although complicated with the territory thing going on, but they're two different tax jurisdictions and they can, you can't just make up the price.

00:06:14Alex

So there has to be economically and, what's the words? Arms length, Right?

00:06:19Jinkan

So. Ris, um, I was gonna get to the arm's length standard, shortly, but thank you for bringing that up Alex. Pricing of transaction is one thing and what strategy you are using, what fundamental you are using to price that transaction is another right most people. Performing transactions between related parties is. Nothing different from moving money from right pocket to left pocket, right? It's all staying under one consolidated entity. However, if you think about it a bit differently from a tax recipient standpoint, is two different tax jurisdictions, so two different tax collectors, has the right to tax, what plays an even more important role? So in case of Puerto Rico and the US. I don't know off the top of my head what the tax rates are in Puerto Rico, but, you know, it sounds like, based on what you just mentioned, sounds like the tax rates in Puerto Rico are much, much, much lower than what it is in the us

00:07:25Jinkan

yeah. So now the, the IRS wants to tax you on the fair income that should belong to the us Poor Rico wants to tax on the fair income that belongs to poor Rico. in your situation, you cannot just blindly say, oh, why don't I pay 50% commission and move all of my profits to Puerto Rico?

00:07:44Alex

Yeah, of course. No brainer.

00:07:45Jinkan

Yeah. While, while Puerto Rico authorities are going to be happy about it, they're gonna get more income to tax. But the IRS isn't going to be happy about it.

00:07:53Jinkan

Right. So, IRS is gonna want to know, what policy are you using for this intercompany transaction in the intercompany payment that you're making?

00:08:02Alex

Right.

The Arm's Length Standard: Foundation of Transfer Pricing Compliance

00:08:03Jinkan

whether it is arm's length or not. So arm's length is the, one defining fundamental, not just the US but globally, that all the tax jurisdictions globally follow. If you have any intercompany transactions, need to be priced on an arm's length basis. What does that mean? Arm's length basis simply means. How much would you charge for a similar transaction to a third party? So, AMS length essentially means what is the market driven price, associated with a particular transaction in question here.

00:08:46Alex

Yeah. Yeah, it makes sense. I mean, yeah, and, and I think the point I wanted to stress is it comes up more often than people think. I. You know, like, like of course when we were at Grant Thornton and you're working with these big companies that have 30 subsidiaries all over the world with inter intellectual property and royalties.

00:09:07Alex

Of course that's an obvious, but people don't realize how much it comes up with small businesses as well, whether it's interstate. I mean, I work with, for example, I was one of, one of the things I advise on for people, you know, maybe a higher net worth person that's looking to move outside the US one way, one deferral of income strategy that I use with people is, let's say they have an S corp or a partnership in the US and then they move to a foreign country and they can siphon.

00:09:40Alex

Yeah, that's probably the wrong word to use, but they can, they can take,

00:09:45Jinkan

back.

00:09:46Alex

you said you set up a foreign co, a foreign company to, to, I guess do some work for the US company that, and you own both. So now you have two companies you own and two different tax jurisdictions and a payment go into the foreign company.

00:10:01Alex

And in a way we can find a way to potentially defer income to the foreign company. But I mean, it's all a fun game to talk about, like move money from here out of the US into the foreign country, into the foreign company. And it all, you can make it make sense from a tax perspective. But again, we have to go back to the economics of it.

00:10:20Alex

And I guess this is where I kind of wanted to jump into some of the benefits versus risks of transfer pricing in that. Let's say like my scenario, you just picked a number for Puerto Rico, or whichever scenario you want, you just pick a number that benefits you to send it outside the us. There's obviously a risk there, but there's also a benefit,

00:10:41Jinkan

taxpayers want to do, right? They just pick a number. What are the risks associated with it? They don't even think about it, and

00:10:47Alex

right?

00:10:47Jinkan

it kind of becomes a crucial matter to think about more.

Transfer Pricing Benefits vs. Risks: Why Documentation Matters

00:10:50Alex

Right. So can we, can you kind of hone in a little bit on. The practical side of doing transfer pricing. So if somebody calls you and they're like, Hey, I have this inter company transaction, of course the point of it is to have the most beneficial price from a tax perspective possible. So how do we document that and stay out of trouble?

00:11:11Alex

And what are our options?

00:11:12Jinkan

Yeah, so many different things going on here. I'll tell you, through my experiences. When I'm talking to a CFO of a company, the CFO is like, why do I even care about transfer pricing? It's right pocket versus left pocket, right? And that's when you have to explain to the CFO or anyone who's asking this question that it's not really about the company, but it's about the taxation authority where all of your companies are operating in and what is the fair share of taxes that they want to be collecting from the. Income associated with that particular country. Right.

00:11:44Alex

Right.

00:11:45Jinkan

your example, you have Puerto Rico and the us. Now obviously in the US we have , a global taxation system, but you're not being taxed until the money is remitted back into the us Right?

00:11:56Alex

Right.

00:11:57Jinkan

of Puerto Rico and the us,

Common Transfer Pricing Scenario: US-India Business Operations

00:11:58Alex

Let's throw real quick, let's throw a more common scenario out there. 'cause I just threw two, like really like out, out there type of scenario. A more common scenario that I see is US company that sets up an Indian private limited company and they have a, you know, it's a support center. India's gonna wanna make sure, India's gonna wanna make sure there's a profit there, but it's, it only exists for the US company as a scenario, and there's transactions going back and forth.

00:12:25Alex

That's a very common scenario we see.

00:12:27Jinkan

one of the most common scenarios you'll come across. Not just India, I would say pretty much

00:12:32Alex

Yeah.

00:12:32Jinkan

Uh, cheaper labor, relatively cheaper labor countries where you wanna set up your, back office support functions and whatnot. Obviously for, you know, availing the cheaper labor and, increasing your bottom line.

00:12:44Jinkan

So in those situations, you have to ensure that transactions are being conducted, let's say India, right in, in your example that you just gave, once upon a time, India had a tax holiday on foreign companies setting up, operations in India. And because of those tax holidays, the US company would think, why do I not, you know, through transfer pricing, why do I not, send all of my profits to India?

00:13:11Alex

Right.

00:13:11Jinkan

I'm not being taxed in the US because on in, on the US' books, you are going to be showing a zero taxable income. And on India's books you'll be showing all of the profits. Right?

00:13:21Alex

So in other words, when you say show the profits, so you're gonna have expenses in India. And so you are going to compensate the Indian subsidiary more than you probably would from an arms length suspect. So if you have a hundred thousand dollars of expenses in India, maybe you pay 'em $200,000 for those expenses and book the profit over there.

00:13:41Alex

That's where that's kind of, that's what we're talking about,

00:13:44Jinkan

correct. So now that, obviously this is a very made up scenario. Uh, so in this situation,

00:13:48Alex

right?

00:13:49Jinkan

what the companies would want to do. And the CO would be like, Hey, why do I care? It's a right pocket, left pocket. I can, you know, this is just benefiting me from tax standpoint. And the answer to that question, the biggest red flag , is your pricing of that intercompany transaction.

00:14:04Jinkan

Is it arm's length? Is that the amount of money you being in the US paid to a third party? a similar third party, uh, let's say a similar, company, which is a third party in India. You were to avail outsourcing services from them, would you have paid $200,000 to them? The answer to that question more like, uh, most likely is going to be no.

00:14:25Jinkan

Right.

00:14:26Alex

Right,

00:14:27Jinkan

to be some amount, whatever that amount is, but it's not going to be moving all of your profit through transfer pricing from the US to India. Right.

00:14:34Alex

right.

00:14:35Jinkan

that's where, um, you know, I have to educate, the stakeholders of the company. That it's not what you want to do, it's about what the tax authorities, it's, it's about what the tax authorities can charge you on, right?

00:14:50Jinkan

Can tax you on. And that tax needs to be, on the basis of a fair income that, that, that you need to earn through transfer pricing purposes.

00:14:59Alex

Right.

00:15:00Jinkan

number one. Which is, obviously, you know, it creates a lot of risk. Now assume for a minute,, the tax holiday situation that I just explained, forget about tax holiday.

00:15:10Jinkan

Let's say in India you have a tax rate of 30% you have a tax rate of 30%. Okay? Now, in that situation, the CFO comes in and says, why do I care about transfer pricing? I'm not trying to. I'm not trying to cheat here. I'm not trying to avail a lower tax rate in any country by moving profit from one country to another.

00:15:31Jinkan

Right? So why do I even care about transfer pricing that situation, especially if there is no tax arbitrage to avail from whatsoever.

00:15:39Alex

Right.

00:15:40Jinkan

those situations, what happens is, let's say you moved all of your profit to India, right? You're paying 30% tax. In India,

00:15:46Alex

Mm-hmm.

00:15:47Jinkan

comes in and says, wait a minute, you have not applied transfer pricing on an AMS length manner. You should have. Paid India half of what you paid, right? So I am going to make an assessment on your US tax return as if you earned that income in the US and therefore I'm going to assess your additional taxes on that, right?

00:16:08Alex

Right.

00:16:09Jinkan

one hand already paid 30% tax in India on a hundred percent of the income that you shifted to India.

00:16:16Alex

Right.

00:16:17Jinkan

and we don't wanna say that, you know, you meshed up your transfer pricing or whatever. For whatever reason, you didn't care. Uh, you didn't look into it, you didn't care about it. Just so happened that a hundred percent of your profit moved to India. You paid taxes in India. In the US you showed zero taxable income.

00:16:34Jinkan

IRS came in, audited you and said, I'm gonna assess taxes on you because your transfer pricing was not uns length. The iris is going to assess taxes on the income that it thinks. It feels is arm's length for us purposes.

00:16:50Alex

Right, but you still pay in India, right?

00:16:54Jinkan

You've already paid the taxes in India, right? And now you are going to pay extra taxes in the US based on whatever assessment the IRIS is doing

00:17:02Alex

So now you gotta go change. You gotta go convince India that the IRS was right.

00:17:06Jinkan

which is going to be next to impossible because.

00:17:10Alex

Right.

00:17:12Jinkan

Uh, it's a very, very, very lengthy process. You will have to involve experts, consultants,

00:17:19Alex

Mm-hmm.

00:17:20Jinkan

pay significant amount of money to all of those people, and there is no guarantee that you are going to get the refund, right. The Indian Taxation Authority is going to be like. Hey, uh, you know what? You've paid me already. There's nothing we can do about it in the future. You, correct your transfer pricing calling right now.

00:17:36Alex

Right.

00:17:37Jinkan

are treaties between many countries to avoid double taxation. Um, but regardless of the treaties, you still have to follow the process

00:17:47Alex

Right,

00:17:48Jinkan

knows whether the process is going to work or not, right?

00:17:51Alex

right.

00:17:52Jinkan

not only is it a lengthy process, it's a very costly process to undertake as well, and. Companies are in the business of doing business. They're not in the business of figuring out the taxation stuff, getting the refund here, getting the refund there.

00:18:08Alex

Correct.

00:18:09Jinkan

um, you know, it's their consultants. They are tax experts who take care of all those things, right? So it becomes very important to consider those points as well. So

00:18:17Alex

So how do you, how would you document, so how would you, for example, how would, what would what are your options I guess in your scenario of the IRS coming to you and challenging your pricing? What do you need to have on your side to figure that out? Like how do you come up with the price?

00:18:37Jinkan

Yeah. Abso, I mean,

00:18:38Alex

I mean, that's a very, that's a loaded question.

How to Document Transfer Pricing: Methods and Best Practices

00:18:41Alex

I like generally. It's a comparable analysis based on some methodology, right?

00:18:48Jinkan

Comparable analysis. Yes. Uh, I mean, so you, said it correctly. Uh, there are many different components involved here. The first and foremost is conducting what we refer to as what we transfer pricing experts refer to as functional analysis. Functional analysis is a complete, it's a, it's a complete. Understanding of the company's business, right?

00:19:17Jinkan

business are you in? What, what kind of functions you are performing? Where are those functions being performed, so on and so forth. So in this example, India and the us, you figure out, okay, what is the business that you are in? What are the employees working in the us? How they are structured. What are the employees working in India, how they are structured? What is it that India is doing? So in this particular situation, you identify that India is simply providing you with back office support services, let's say call center services, right? They are inbound, outbound, they're just making calls to random customers. They are answering calls, that are coming inbound, so on and so forth. So in that, that situation, after conducting a thorough function analysis, you have a better understanding of the company. now you are determining what is the intercompany transaction that is being undertaken. The intercompany transaction is India, providing back office support services. Once you've identified the intercompany transaction, the next step is to identify the transfer pricing methodology that you want to use to derive the arm's length transfer price for this particular transaction.

00:20:24Alex

Okay.

00:20:25Jinkan

There are many, there are quite a few transfer pricing methods that are available to choose from.

00:20:31Jinkan

Each method has its own merits and demerits and you know,

00:20:34Alex

right. That's where somebody like you comes in and says, this is what we need to do and how we need to do it. But you have to follow the, you have to follow one of the pre prescribed methods and document your findings and find.

00:20:47Jinkan

your findings and based on the method that you've chosen. There may be a requirement of performing comparable analysis. That's where you are identifying third party comparable companies that are performing functions similar to what your India back office service provider is performing. And then identifying what is the profitability that these third party similar companies, comparable companies, are earning. And you would, you know, typically target, a range, a point within the range that you arrive at. And then the. The typical range that we rely on is referred to as Interquartile Range, and there are specialized databases available in the market

00:21:26Alex

Right,

00:21:27Jinkan

on in order to do this level of research,

00:21:29Alex

And the benefit of that is that. You can get A number that's beneficial from a tax perspective, but also documented. That's the goal. Because I mean, if we could, of course just make up a number that is beneficial from a tax perspective and we can, stick our finger in the air and say, this seems reasonable, but that's not an argument to the IRS when.

00:21:54Jinkan

all without documentation, none of

00:21:56Alex

They're gonna, if they, if the IRS sniffs out that you have no documentation on it, they're gonna go to the extreme because they can, because

00:22:05Jinkan

Exactly. Exactly.

00:22:05Alex

whereas if you hand them documentation for transfer pricing purposes, I haven't been in a lot of these audits, but I've been in a few, and I mean, they're, they're depending on the size of the company.

00:22:17Alex

They're pretty quick to fold on a very nice looking, you know, documentation on transfer pricing, you know.

00:22:25Jinkan

agree. So documentation becomes extremely critical in supporting the transfer pricing arrangement that you are doing.

00:22:34Alex

Yeah.

00:22:34Jinkan

With the, in the absence of documentation, you have absolutely nothing, no power whatsoever to be able to negotiate with the IRS. Now, it is quite possible that despite having the documentation, let's say, whoever did the transfer pricing, whatever they were thinking, that transfer pricing was done completely incorrect. Right, but there is documentation in place. The fact that there is documentation in place, the fact that the taxpayer made a good faith effort to look into their transfer pricing arrangement itself gives you some negotiation power, right? Without documentation, you do not get anything whatsoever,

Section 6662 Documentation: Penalty Protection Strategies

00:23:19Alex

Right. That, that was a big, that was the big thing I wanted to talk to you about too, is that there's levels to documentation, right? I mean, with, with bigger companies, there is, and I'm, I'm gonna butcher the code section, but what do they, what do they call the documentation that actually gets you out of penalties, even if you're wrong?

00:23:38Jinkan

6662. Yeah,

00:23:39Alex

That's what I was gonna say. I was scared to say it. Okay. Alright. Yeah. Yeah, so the 6662 documentation, that's like your big, your big study that's gonna have your functional analysis and all the records, you know, it's a, it's a 5,200 page document sometimes, you know,

00:23:56Jinkan

Yeah. I mean, so there are two components here. Um, now obviously you have to consider what is the size of the company you're talking about,

00:24:03Alex

right.

00:24:04Jinkan

and whether you have to do the cost benefit analysis also, right?

00:24:09Alex

Right.

00:24:10Jinkan

The two components in is one, you are establishing ris, which is called your planning documentation, right?

00:24:17Alex

Mm-hmm.

00:24:18Jinkan

is your compliance documentation where you are justifying the arrangement that you're using documentation is purely, at least in the us, purely for the purposes of penalty protection. What does that mean? You did your planning study, you have a planning documentation, alright. the planning documentation, let's say in this particular example, India providing, back office support services to the us you're charging a cost plus markup of 10%. You have a planning documentation in place. The IRS comes in, you have a planning documentation and you're applying that transfer pricing arrangement, right?

00:24:54Jinkan

Three years down the line, the I Iris comes in and says, okay, show me your, transfer pricing, study. Right? They see the transfer pricing study and they say. Oh, by the way, it should not have been 10%. It should have been 5%, means you paid 5% extra markup to India. So then at that point of time, the IRS will say, let me make an adjustment of 5% income in the US and then they will tax you on that 5% income in the us.

00:25:21Jinkan

Right?

00:25:21Alex

Right,

00:25:22Jinkan

only will you have to pay additional taxes, but you will also have to pay penalties and interest. you do not have that compliance documentation, is

00:25:34Alex

right.

00:25:34Jinkan

under 66 62 section,

00:25:37Alex

Right.

00:25:37Jinkan

so compliance documentation will help you to protect from penalties. Now, for a smaller company, does it make sense to spend 5,000, $10,000 on compliance documentation every single year, especially if your transactions are worth only $50,000? The answer to that question is probably not right. Absolutely not. So that's when you have to ensure that the planning documentation that you have in place is so robust in nature that it will help you justify the pricing for next 3, 4, 5 years.

00:26:11Alex

Right. Yeah. So I mean, that's what I was gonna say is there's, there's different levels to transfer pricing. And I think at a smaller level, a more practical approach is yes, getting a defensible number that you can hand something to an auditor, you know, that lasts multiple years. And, and it's not just a finger in the air approach that gives you no leverage with the IRS whatsoever.

00:26:36Alex

And I'll add one more thing that I just thought about. 'cause you and I worked together on a recent client that in my experience, most people with that are, that have transfer pricing without really knowing what that means. They're making transactions between two commonly owned companies.

00:26:54Alex

And they do a cost plus analysis. That's what everybody does. You know, like if you, they think, they say, all right, here's the cost that's coming on over here. We'll just add 2% of it. We're good. That is rarely the correct way to do it, and not more important than that. It's not the most beneficial way to do it.

00:27:15Alex

Because you and I worked together on one recently where yeah, we had an African company and they were doing this cost plus on, on a number that didn't really, wasn't really the basis of the intercompany transaction in the first place. And you redid it completely to where we were using a totally different methodology than cost plus, and it gave them a much bigger benefit that they can now also defend the cost.

00:27:39Alex

Plus defense is not a defense at the end of the day unless.

00:27:42Jinkan

a defense exactly.

Beyond Cost-Plus: Optimizing Transfer Pricing Methodologies

00:27:45Alex

I guess I wanted to point that out, that finding a different methodology is, gives you a better benefit, not only a defensible one, but a better answer, you know?

00:27:54Jinkan

A better answer end of the day, you got to look into two aspects. One is tax optimization. If through transfer pricing you are able to optimize your taxes. And by optimization I mean obviously minimization of taxes, to get your better, effective tax rates. the second thing is risk mitigation. in the prior example, we saw the double taxation, right?

00:28:17Jinkan

In order to, mitigate the risk of, potentially being hit by double taxation. You have to ensure that not only your transparency is done ac accurately, but you have all the appropriate documentation and justification for that. then whether or not you want to do the compliance documentation is something that you can figure out over a period of time, right?

00:28:37Alex

Right.

00:28:38Jinkan

and you brought up a very good example, Alex, where, you and I, worked for this client. We went in, they had a cost plus in place. Not only was it an incorrect methodology to use to begin with, but even with the incorrect methodology, they had used the wrong cost base. They had used the wrong mockups and whatnot,

00:28:59Alex

Right, right, right.

00:29:00Jinkan

in, we did the whole functional analysis. As you recall. We discussed every single thing about the company, who's performing what, what are the functions being performed, in which country and whatnot. And then we arrived at a methodology that was entirely different from the costless methodology. And the answer that we came up with was not only, justifiable, but it gave them a huge tax benefit. obviously, you know, you're mitigating risk automatically by having this and documentation, right? So that would be a classic example. And in this company we are talking about, uh, had revenues of about $2 million, right? So not significant amount of profits, for this company, but. I mean, hey, whatever profits that you have, you got to ensure that you are, paying only the taxes that you should be paying. You shouldn't be paying more taxes.

00:29:52Alex

Don't have to worry about, and you don't have to worry year on year that you're gonna get audited and have no defense for the intercompany transactions you have.

00:30:00Jinkan

Exactly.

00:30:02Alex

So you can sleep at night and save money at the same time. That's kind of the,

00:30:06Jinkan

you don't,

00:30:07Alex

yeah.

00:30:07Jinkan

a situation where, the auditor comes in, Hey, how did you choose this? I don't know. I stuck my finger in the air and I felt like using this thing or, my, consultant told me to use this. Okay. If your consultant told you to use this particular methodology,

00:30:21Alex

Yeah,

00:30:22Jinkan

the proof for that?

00:30:23Jinkan

Show me the documentation.

00:30:24Alex

and so the point.

00:30:25Jinkan

have it at that point of time, you are already fighting a lost battle, right? You are just going to be hit with whatever taxes, penalties, interest that the tax authority wants to do, and the penalties. Could really creep up. In the US it's 20% or 40% of the assessed taxes, but globally it can potentially go as high as 400% of additional taxes assessed.

00:30:53Jinkan

So

00:30:53Alex

Right,

00:30:54Jinkan

play your cards really, really, really right.

Transfer Pricing for Small and Medium Businesses: Practical Considerations

00:30:56Alex

right. For sure. And I think that the thing I wanted to stress with the documentation part of this was. You don't have to be a multimillion dollar company for transfer pricing to make sense or be practical for you. And I think that's a misconception that a lot of small businesses have small, medium sized businesses, whatever that definition is, but yeah, they think, oh, the IRS isn't, first of all, it's usually the IRS isn't looking at me.

00:31:21Alex

I'm a small fish. Not necessarily true. I've seen that to be not true at all. It's actually in a lot of cases, easier and cheaper for the IRS to go after a small fish from a transfer pricing perspective. 'cause they're not gonna have anything. It's gonna be, yeah, they're gonna assess. They're gonna have no leverage.

00:31:38Alex

Whereas they know if they go to Coca-Cola, they're gonna have a decades long battle in their hands with transfer practice.

00:31:45Jinkan

Exactly.

00:31:46Alex

So, yeah.

00:31:48Jinkan

other point I would also add to what you said is you are not getting small and medium, business. Right. getting audited every single year. Audit needs to happen once,

00:32:00Alex

Right.

00:32:01Jinkan

For the IRS or any taxation authority to come in and challenge your transparency arrangement. If you don't have anything, then you're screwed to begin with. But if you have something, then it gives you some justification, you know, some leverage to negotiate on. But once you get audited, let's say 10 years down the line, you're getting audited. And the IRS for whatever reason, finds out that there is, all they have to do is say there is a fraud here.

00:32:27Jinkan

You moved all of your income to a low taxing jurisdiction, or whatever the case may be. Right? In that situation, the statute of limitation go out of window. They are applying the transfer pricing adjustment to the beginning of time,

00:32:42Alex

Oh, based on the fraudulent nature of it.

00:32:45Jinkan

all they have to do, I mean, there could be a, there could be a chance, right?

00:32:49Jinkan

Where, you know, a

00:32:50Alex

Yeah.

00:32:50Jinkan

company, they're never going to catch me. Let me just move all of my in, in your example of Puerto Rico and the US let me just, charge a 50% commission. That way all of my US profits are going, sitting in Puerto Rico.

00:33:02Alex

Right.

00:33:03Jinkan

when you will realize like, maybe eight, nine years, you're not getting caught.

00:33:07Jinkan

But that one year, year, if you are getting caught. It would be a fraudulent case, and then all of the, the backyards will be open. There won't be any statute of limitation, which in the US we have three years by the way. But in case of fraudulent cases,

00:33:23Alex

Yeah, there's.

00:33:24Jinkan

going to be any statute of limitation, which means for each of the 10 years, not only will there be additional taxes assessed, but there will be significant amount of penalties and interest. For all the tax payments that you should have made but you never made,

00:33:43Alex

Yeah.

00:33:44Jinkan

amount could essentially be equivalent of the entire value of your business.

00:33:49Alex

Right,

00:33:50Jinkan

don't have business. Essentially the next

00:33:52Alex

right.

00:33:53Jinkan

bankrupt.

00:33:54Alex

Right. So yeah I think it just goes to show don't stick your finger in there. If you have two companies commonly controlled and you're certain, and you have transactions between them, let's find a reasonable way to find the correct price. You know? And there's,

00:34:09Jinkan

discuss. Discuss with your advisors, you

00:34:11Alex

yeah. Yeah.

00:34:12Jinkan

with your advisors. You do not necessarily have to perform a study in every single case, having some kind of handholding your advisors, some kind of, support justification from your advisors to be able to be in a better negotiation. Phase with the, with the taxation authority, very similar to what we did with the client that you and I are talking about, Alex, right?

00:34:39Alex

Yeah. Yeah, exactly.

00:34:40Jinkan

They didn't want to pay, tens of thousands of dollars to, to prepare a detailed transfer pricing study. We came up with a very simpler approach, but even with the simpler approach, we were able to justify the transfer pricing arrangement as well as give them a better tax answer,

00:34:55Alex

Yeah, exactly. And that's the balance that we're going after from a tax perspective. Always. Well, very good Jinkan. I really appreciate it. So how can people reach out to you if they have transfer pricing questions or need your help? I.

00:35:06Jinkan

they can reach out to you directly, Alex, they can reach out to me, they can email me at, Jinkan dot which is a pretty long email. You can just visit my website, cap consulting. You'll see, you can just reach out to me from there. But the best way to reach out would be through Alex as well.

00:35:25Jinkan

Alex and I, we work very closely. But before we close out, one, one point I would like to raise, and I cannot stress it enough, at least have a discussion. know many small and medium sized companies, they don't wanna spend money, especially on compliances. Do not consider transfer

00:35:48Jinkan

pricing as a compliance.

00:35:50Alex

Mm-hmm.

00:35:51Jinkan

it is an extremely efficient planning tool available to the small and medium sized businesses, all types of business businesses, really,

00:36:00Alex

Yeah.

00:36:01Jinkan

where you can really optimize your tax position and minimize risks drastically.

00:36:08Alex

Yeah.

00:36:09Jinkan

at least have a discussion. Do not worry about preparing a study right away. At least have a discussion to see what kind of risks are associated for not doing it. And what kind of benefits you will get to do it.

00:36:21Alex

Right, and are you even pricing are your, the flows of your intercompany transactions, do they even make sense? Having an economic conversation with somebody used to intercompany transactions and things like that. Yeah, that's a great point. So have these conversations, Jinkan, I really appreciate you coming on.

00:36:39Alex

We'll be talking again soon on here I'm sure, but,

00:36:42Jinkan

We should talk about tariff at some point of time.

00:36:45Alex

yeah, for sure. Yeah, let's do it. Well, thanks a lot, Jinkan. Thanks for coming on.

00:36:50Jinkan

a lot, Alex, for inviting me.

00:36:52Alex

All right, see ya.

00:36:53Jinkan

Thanks.

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