The United States’ Internal Revenue Service is taking a much closer look at transfer pricing and the associated documentation in more substance focused audits concerning captives.
Speaking on a GCP Short released on 23 February, Mikhail Raybshteyn, EY Partner and Americas Captive Insurance Services Co-Leader, and Nicole Henderson, EY Financial Services Transfer Pricing Senior Manager, explained how to get transfer pricing right for multinationals and the impact of this work on premium allocation, recharged premium, IPT and self-procurement taxes in the US.
Transfer pricing refers to the rules which are designed to ensure that the price agreed in a transaction between two related parties is the same price that’s agreed in a comparable transaction between two unrelated parties.
“The IRS has hired and will continue to hire in 2023 additional agents and attorneys to perform audits related to transfer pricing, and that includes an area called economic substance,” Henderson said.
“And the goals of those audits really is to ensure that the IRS is taxing the appropriate amount of profits in the US. So as part of these audits, the auditors will look to assess that intercompany transactions are conducted on an arm’s length basis, and also that there’s the appropriate substance to make decisions for the captive.”
Although it is increasingly common for captives domiciled offshore to elect to be a US taxpayer, Henderson explained that getting transfer pricing documentation right is still important to demonstrate risk transfer occurred and that the captive is treated as an insurance company for US tax purposes.
“Transfer pricing helps to support the accelerated tax deductions in year one as an insurance company or when a new product is added to the captive,” Henderson added.
“Also, if we think about how transfer pricing applies in the state context, a good number of states apply transfer pricing principles under the Internal Revenue Code in their state laws.
“As a result, ensuring that the premium is arm’s length and allocated amongst the group could impact the amount of state tax due.
“We’ve seen some states, including California in particular, taking an active audit position against captives to ensure really that they are able to collect the correct amount of state tax.”
Raybshteyn said that navigating the self-procurement tax landscape, state by state in the US, is still presenting a struggle for captives and captive owners, describing it as “the new 800 pound gorilla in the room”.
“Unfortunately, the self-procurement tax, or direct placement tax, is where it gets really hairy when you talk about allocating premiums and transfer pricing,” he said.
“While different states have various laws on self-procurement tax and how those laws apply, the general rule is that self-procurement tax is based on the policy-by-policy approach, and it requires understanding the location of the home state for each policy.
“In an affiliated group such home state may actually vary from policy to policy. Properly allocated premium may actually shift such home state for a particular policy depending on facts and circumstances.
“There’s definitely balance here between accepted industry standards, actuarial analysis, and transfer pricing methodologies, but neither should be ignored.
“No one size fits all answer unfortunately. And that is why each company needs to take into account the specific facts, technical merits, and of course, its ability to support the position that will ultimately be taken, including the efforts needed to pull together the appropriate and defensible position across the board.”
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