The software industry is one of the fastest-growing segments today. The emergence of advanced technologies such as AI and quantum computing, coupled with increased connectivity and growing demand for automation, has led to the creation of many new companies in this industry.
The software industry is a big pillar of the services sector today, and instead of the traditional goods of the manufacturing industry, what is exchanged here is intellectual property and services. From a valuation perspective, these are much harder to evaluate and track than physical goods. To accurately price these products and ensure they are taxed appropriately, the IRS has developed a practice called transfer pricing. In this article, we will discuss this practice in detail.
What is Transfer Pricing?
Transfer pricing is an accounting and taxation practice for evaluating the cost of services and intellectual property exchanged between two entities that are related to each other. Typically, the relationship can be among affiliates, parent-subsidiary, or intercompany transfers, where both parties are connected through a common legal entity.
Why Transfer Pricing Matters for Software Companies
Section 482 of the IRS code deals with transfer pricing. The goal of this transfer pricing is to adjust the income, deductions, credits, and allowances of commonly-controlled money to prevent tax evasion and ensure accurate accounting practices that reflect the exact value of the transactions.
This is an important practice for software companies, as it keeps the valuation fair and transparent. Many software companies tend to have teams spread across different countries, and this makes it challenging to calculate the taxable income across regions. It can lead to errors and disputes with taxation authorities, resulting in long-term financial implications and loss of trust.
Transfer pricing avoids these consequences and helps the company to accurately price every transaction.
How Transfer Pricing Works in a Software Company
Software companies tend to move intangible things like services, code, rights to use an intellectual property, access, licenses, etc., across borders. These transfers can be between departments within the same company or subsidiaries and affiliates.
Domestic vs. International Transactions
Transfer pricing applies to both domestic and international transactions. Within the United States, all software companies must follow the provisions of Section 482 to compute the value of these transactions between related companies. When the company operates across countries, additional rules apply under the OECD transfer pricing guidelines.
In general, international transfers include:
- Development services between teams in different countries.
- Licensing of intellectual property from the parent to a subsidiary
- Payment for hosting or other services from affiliates to the main company or among affiliates
- Any other service that involves a transaction, which a company will charge another independent company
Every country involved in the transaction tends to apply its own rules. This means companies must have the supporting documents to prove the pricing in each location.
Pricing Intangibles and Software Services Between Entities
The most challenging part of transfer pricing is estimating the value of intangibles. When it comes to intellectual property, it may produce income for many years, and this is why its future value is uncertain.
The World Intellectual Property Organization (WIPO) has laid down three ways to price intangibles:
- Income method: This is the most common method, and it values the IP asset based on the amount of economic income that it is expected to generate. The value is adjusted to its present-day value.
- Market method: This is a simple method, where the value of the intangible is compared to a similar asset and its valuation. Many times, this method is used as the input for the income method.
- Cost method: This method calculates the cost of producing a similar IP asset and is often used when the exact value of the IP cannot be determined. However, it does not account for wastages or the unique or novel characteristics of the asset.
Common Transfer Pricing Methods
In the United States, transfer pricing follows the arm’s length principle, which mandates that the pricing between entities must be the same as the price that is charged to independent and unrelated third parties. Based on this principle, the following methods are available.
Comparable Uncontrolled Price (CUP) Method
The CUP method compares the price of a product that is transferred between related companies with the price of a similar product transferred among independent and unrelated companies. Based on this comparison, the tax authorities determine if the pricing is fair and at arm’s length.
The comparison price can be internal or external:
- Internal CUP: The company’s transactions with another company
- External CUP: A third party’s transaction with another third party
This method works well in the following cases:
- When the company licenses the software to external entities.
- There is a clear market rate for a comparable service.
- The product is standardized and easy to compare.
The challenge with this method is to find independent transactions that match the transaction being evaluated.
Cost-Plus and Profit Split Methods
The cost-plus method adds an appropriate profit margin to the costs incurred in creating the IP. This profit must be based on the norms followed in the industry for such transactions. The costs of producing the asset include both the direct and indirect costs. This method works well for companies that perform development or support work for another company because the actual costs incurred for the service, plus a reasonable profit, are charged. The advantage of this method is its simplicity and low risk.
The profit split method, on the other hand, divides the total profits based on the value contributed by each entity. This method works well when multiple entities come together to build or support a product. Also, it is helpful when intangible assets are hard to compare because of their uniqueness and the value they add to organizations. The downside is that it can be complex to apply and requires a reliable approach to splitting the profits.
Choosing the Right Method for Your Software Business
The biggest decision is to determine the right transfer pricing method for your business, as it can impact your financial models and decisions. In general, the right method depends on the type of transaction and the data available for similar transactions.
Some aspects to consider while choosing the right method are:
- Does the company sell similar products to external customers?
- How much data is available for benchmarking?
- Does the transaction involve highly specialized intangibles?
- Is it possible to estimate the contribution of each entity?
Companies must document their choice and explain why it is appropriate for the transaction.
Preparing a Transfer Pricing Agreement
A written transfer pricing agreement lays down the rules for computing the value of intangibles and software services. It must include information about what each entity in a transaction does, who owns the intellectual property, how services are priced, and what the profit-sharing deal is among the entities. A clear agreement that puts down the above aspects reduces disputes and provides the necessary documentation during audits.
Key Components of a Transfer Pricing Agreement
While there is no standard format for a transfer pricing agreement, it must contain the following components:
A description of the services or assets being transferred.
- Pricing terms and calculation methods.
- Ownership of intellectual property.
- Roles and responsibilities of each entity involved.
- Payment timelines.
- Dispute procedures.
Note that the agreement must reflect the actual state of the business, as tax authorities are likely to verify the contents with real activity.
Documentation and Record-Keeping Requirements
Documentation is key to avoiding tax fines and penalties. You must maintain records that show the reasons for choosing a specific pricing method and its associated records. Also, it is good to have the following records:
- Cost reports
- Benchmarking studies or data
- Royalty rates
- Intercompany invoices
- Agreements signed by the parties involved
- Any other document that supports your process during tax audits
- Tax Compliance and Deadlines for Software Companies
Transfer pricing rules apply when the company files for the annual corporate taxes. It’s important to disclose these transactions and keep supporting documents ready for inspection.
Reporting Transfer Pricing on Corporate Tax Returns
All transactions must be reported on the corporate income tax form, which is Form 1120. If the transfer has happened across countries, the company must file IRS Form 8975, Country-by-Country Report. Also, certain untaxed provisions must be reported on Schedule UTP. Foreign-owned entities must report this income through Form 5472.
Risks of Non-Compliance
Non-compliance can lead to serious financial and legal risks that could eventually impact the credibility of the company and its ability to legally operate in the United States. Below are a few risks that arise due to non-compliance.
Penalties and Interest
All software companies must follow the arm’s length rule while calculating transfer pricing. If the IRS officials determine that the company did not use this rule properly or if the company did not file returns, it could result in high penalties and interest on the unpaid tax amount.
Audit Triggers for Software Companies
IRS audits are complex because the officials may require you to submit extensive documentation, and they may even identify other areas of non-compliance. Failing to provide these documents can result in penalties.
Some well-known audit triggers for software companies are:
- Inconsistency in accounting or profit reports when compared to previous years, and even across entities.
- Transfers of intellectual property.
- Sudden changes in pricing.
- Late filings.
- Missing documentation.
Best Practices for Minimizing Transfer Pricing Risk
Given the detailed audits and the potential for risks and penalties, companies must take proactive measures while calculating transfer pricing. A few best practices to consider are:
- Maintain detailed documentation of intercompany transfers.
- Create internal policies that determine how the transfer pricing is set and what calculation method is followed.
- Assign responsibilities to the legal, tax, finance, and compliance teams to keep the documents accurate and updated.
- Maintain working sheets to show how the costs are calculated.
- Use reliable tracking systems that record the charges and time automatically.
Working With a CPA or Transfer Pricing Specialist
Since transfer policies are complex, it helps to work with an experienced CPA or a transfer pricing specialist who understands how intangible assets and software services are calculated. These experts analyze business functions and the role of teams across different jurisdictions to suggest the appropriate computation method. They help draft transfer policy agreements as well.
Using Technology to Track Intercompany Transactions
Accurate tracking is key for transfer pricing, and this is why companies are increasingly turning to technology. Software companies rely on cloud-based accounting tools, tracking software, billing applications, cost forecasts, and more to calculate the costs of building and maintaining a service or intellectual property. Also, the share of each department is recorded automatically. These records increase the accuracy of calculations and reduce the chances of IRS audits.
How Manay CPA Can Help You with Transfer Pricing?
Manay CPA is a professional CPA firm that specializes in offering transfer pricing benchmarking, agreement drafting, recordkeeping, tax filing, and guidance on selecting the appropriate methods. It even conducts industry research and studies to back up the pricing decisions. A highlight of Manay CPA is that they work with US-based and foreign entities to maximize deductions while legally reducing tax liabilities and audits. They support long-term planning and taxation as well.
In short, they can guide right from creating transfer pricing agreements to filing taxes and reducing liabilities.
Schedule a free consultation with Manay CPA to understand how they can help you.
