Small Business Market-Share Strategies and Transfer-Pricing Certainty

Expanding into foreign markets has typically been associated with large businesses that have the capital and resources necessary to accomplish such growth. However, with decreasing communication and transportation costs, many small businesses are also growing internationally. In lieu of independent sales agents or contract manufacturers in foreign markets, expansion plans may include related-party sales offices or manufacturing locations. Further, to penetrate these new markets, small businesses may consider temporarily lowering prices (perhaps incurring losses) on sales of their products relative to prices for otherwise comparable products in the same markets. Or, they may incur temporarily higher marketing costs while penetrating a new foreign market. To the extent that wholly owned or controlled entities are used for such market-share strategies, the transfer-pricing implications are important. In particular, if potential exists for less-than-normal profits or higher-than-normal operating expenses or both for several years, small businesses must determine the allocation of these among parties through transfer- pricing policies.

The final transfer-pricing regulations provide little guidance for implementing market-share strategies. Despite this, taxpayers can expect the transfer-pricing policy behind these types of business strategies to be subject to close scrutiny by taxing authorities in all jurisdictions. For example, in the IRS Guide for International Examiners, examiners are instructed to closely analyze any transfer-pricing arguments that emphasize market penetration. The IRS expects taxpayers to provide contemporaneous documentation substantiating that (1) the time period for the market-share strategy is reasonable (considering the industry and product) and (2) the market-share strategy has economic substance, or a reasonable likelihood exists that it will produce future profits. Further, on audit, the Service's examiners are likely to ask for marketing studies, feasibility studies, etc.

With all of the aforementioned considerations and required documentation, many may consider market-share strategies to be accessible only to the most daring of taxpayers. However, the IRS has programs that provide taxpayers with transfer-pricing certainty and ensure that it does not audit transfer-pricing policies that may otherwise seem aggressive. The Service instituted the Advance Pricing Agreements (APAs) Program to assist taxpayers in complying with transfer-pricing regulations. Under an APA, the IRS and a taxpayer agree on a transfer-pricing method to be prospectively (and sometimes retroactively) applied to an apportionment or allocation of income between two or more businesses owned or controlled by common interests. The Service will consider APA requests that involve market-share strategies. However, the majority of the IRS's completed APAs are large taxpayers with substantial income and assets. To date, most small business taxpayers reject the APA process as extremely costly, burdensome and timely.

To make the APA program more accessible to small businesses, the Service began a special program (Notice 98-10). The IRS defines a "small business" as any U.S. taxpayer with total gross income of $200 million or less. Under the program, taxpayers need not submit special materials, but may apply for an APA using the documentation already required under the Sec. 6662(e) transfer-pricing penalty regulations. Some of the benefits of the small taxpayer program include (1) a reduced user fee and fewer documentation requirements than under the usual APA process, (2) fewer trips by the taxpayer and its outside counsel and economists to negotiate an APA and (3) less time to complete the APA (the program has a goal of six months, which is substantially less than the usual APA process). Therefore, for the small business taxpayer entering a foreign market with an aggressive market-share strategy that desires transfer-pricing certainty, the small taxpayer APA program may be a little known, but attractive, consideration.

From Kirk Hesser, Chicago, IL