Transfer pricing and thin capitalization rules

The U.S. tax law allows the Treasury inspectorate to recalculate or redistribute the amounts of income and expenses arising from transactions between U.S. taxpayers and related parties. This is transfer pricing rules.

Taxpayers are required to calculate their profits from transactions with related parties to the extent that they could have been made in transactions between independent parties. In particular, the following transactions may be subject to price control by the Treasury inspectorate:

  • sale of property and other valuables;
  • transfer of intangible assets;
  • provision of services;
  • issuance of loans;
  • use of property.

In general, for all the above operations, the price is determined by comparing the prices of similar operations, but there are special rules for certain types of operations. The provisions to the Internal Revenue Code also specify the methods that the taxpayer should use when determining the market price.

In the case of requests from the Treasury inspectorate, the taxpayer will have to prove the reliability of the chosen method compared to the rest of them. If the transfer pricing rules are not followed, the taxpayer will be penalized with 20% of the amount of unpaid tax additionally charged by the Treasury inspectorate when adjusting prices. If the price adjustment is significant, the amount of penalties is increased to 40%.

To protect yourself from the penalties, you can conclude an Advance Pricing Agreement, in which the Treasury inspectorate will give its consent for the taxpayer to use the method of calculating the price of transactions with related parties. However, the conclusion of this agreement is quite expensive, due to the preparation of the necessary documentation, including the opinion of independent experts, and it is quite lengthy in time. Mainly this agreement is used by large multinational corporations with high turnover due to significant penalties that may arise during the inspection of transfer prices by the tax inspectorate.

As you can see, the system of taxes in the USA is quite complicated. Corporations attract professional companies to work with taxes. Here is an example of one of such companies that can help with tax preparation tucson az You can use their services if you need help with taxes. Let’s take a closer look at thin capitalization rules.

Thin capitalization rules

The following points should be taken into account when financing U.S. companies by means of loans: in general, interest expense reduces the income tax base, but the U.S. tax legislation has rules that limit or prohibit, under certain conditions, the reduction of income by interest expense. These rules prohibit the reduction of the income tax base by interest expense if it is paid to a related party and is not taxable in the U.S. due to the application of the double tax treaty. A deduction is prohibited only if there are two conditions:

  • net interest expense is more than 50% of taxable income;
  • the ratio of liabilities to own funds is higher than 1.5:1 (all debts).    

Excess interest income may be carried forward by 3 years.