Case12-1 Litchfield Corporation
It is essential to understand the rules and regulations regarding transfer pricing. The U.S. Internal Revenue Service (IRS) can audit international liabilities if they feel the price is inappropriate. The IRS can adjust income, deductions, credits, allowances, taxable basis, or any other item affecting taxable income if actual taxable income has not been reported. Regarding the umbrella sales between Litchfield Corporation and its United Kingdom subsidiary, Section 482 of the U.S. Internal Revenue Code will apply; it gives the Internal Revenue Service (IRS) the authority to adjust any intercompany transfer prices that they deem not considered to be arm’s length (Doupnik and Perera, 2011).
Considering the information above, tax authorities worldwide have developed complicated transfer prices and income allocation regulations as a part of their national income tax systems. The regulations are based on the arm’s length principle; in regards to the prices, intrafirm transfers are as if they took place between unrelated parties in competitive markets. These methods resemble the arm’s length pricing method in Section 482. They are as follows: the comparable uncontrolled transaction method; the resale price method; the cost-plus method, and the comparable profit method. However, the regulations state that one of the five specified transfer pricing methods must be used in determining the arm’s length price in the sale of tangible property, in this case, the umbrellas (Doupnik and Perera, 2011). Due to the result of profits being made for Litchfield Corporation when applying any of the five methods, the sale of umbrellas to the subsidiary in the U.K. for the production cost is inconsistent with any transfer pricing methods.
It is essential to be aware that any volition found in connection with Section 482 could result in severe penalties (Doupnik and Perera, 2011). For instance, Litchfield Corporation could be penalized up to 40 percent of the additional taxes that result from income adjustments. In another instance, the IRS could adjust the transfer price upward; this would increase Litchfield’s
U.S. tax liability, but then the U.K. tax authority chooses not to provide a correlative adjustment; this would then reduce the U.K. subsidiary’s U.K. tax liability. However, if the U.S. and the U.K. have a tax treaty, it would reduce the possibility that the tax authority would deny a correlative adjustment.
Currently, the Litchfield Corporation’s sale of umbrellas to the subsidiary in the U.K. for the production cost is inconsistent with any transfer pricing methods; a recommendation would be to consider Section 482’s “best method rule.” This rule requires the taxpayer to select the best transfer pricing method based on the facts and circumstances of the case (Doupnik and Perera, 2011). The resale method is an option; however, when applying this method, the transfer price is determined by subtracting the gross profit from the price at which the controlled buyer resells the tangible property. Another possible option is the cost-plus method; however, the comparable uncontrolled sale price needs to be known when applying this method. The cost-plus method adds a gross profit to the cost of producing a product. This is a popular method when manufacturing, assembly, or production of goods are sold to related parties (Doupnik and Perera, 2011). Either method will only be able to be used if the appropriate conditions exist.
Reference
Doupnik, T., & Perera, H. (2012). International accounting (3rd ed.) New York, NY: McGraw-Hill Co., Inc
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Question
Litchfield Corporation
Read Case 12-1 in the textbook. Regarding Case 12-1, assume a company within a U.S.-controlled group applies a legally acceptable transfer pricing methodology. When and under what circumstances can that company adopt a different legally acceptable transfer pricing method?
Case12-1 Litchfield Corporation
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