It is a common misconception that transfer pricing is only applicable to multinational companies that engage in cross-border trade between their affiliates located in different countries and that it is not applicable to domestic organizations, such as colleges and universities—especially not-for-profit ones. Unfortunately, tax-exempt and taxable colleges and universities are often ensnared in the thorny and complex issue of transfer pricing. To understand how these arcane rules would be applicable to colleges and universities, we first need to understand what transfer pricing is, and then we can apply its relevance to colleges and universities.
Transactions between related parties operating in different taxing jurisdictions are required to be conducted on an arm’s-length basis, i.e., as if the transactions occurred between two unrelated parties. This is to avoid the arbitrary shifting of profits from a high-tax jurisdiction to a low-tax (or no-tax) jurisdiction. Transactions subject to the transfer pricing rules typically involve the transfer of tangible and intangible property, provision of services, and financing arrangements. As mentioned above, transfer pricing is a common issue for multinational corporations, and tax authorities around the world have heightened their scrutiny of transfer pricing arrangements involving multinational corporations because of perceived abuses. Transfer pricing can apply in an international context for certain colleges and universities that have foreign entities overseas, which in most cases are taxable. These foreign entities are often set up to operate campuses abroad or manage joint ventures with unrelated non-U.S. colleges and universities.
However, it is not well known that the transfer pricing rules also are applicable in federal and state tax situations, even if the taxpayer does not have entities outside of the United States. In particular, transfer pricing for colleges and universities can apply in the federal context due to transactions that take place between a tax-exempt college or university and its related for-profit entities. If the transfer pricing rules did not exist, a tax-exempt entity could manipulate its dealings with its related for-profit entity to shift the income to the tax-exempt entity and shield income from U.S. income taxes.
The transfer pricing principles also can help determine a college or university’s unrelated business income (UBI) liability. Given that the transfer pricing regulations contain a prescriptive approach by which to allocate expenses and a UBI liability can be offset by the allocation of expenses, the rules can be a useful tool in determining and justifying the UBI liability. Moreover, the transfer pricing rules can help address the new UBI siloing rules, which require tax-exempt organizations to identify and isolate their different streams of UBI and related expenses. In addition, in certain instances, a college or university may not be able to determine the fair market value of income that is UBI. For example, certain aspects of a contract for services or goods may be UBI, while some may be tax-exempt. A transfer pricing analysis can determine the value of the taxable versus nontaxable elements of the total value of the contract.
The following example issues outline several real-life situations involving transfer pricing applied to “Waterbury College” (Waterbury)—a fictional institution located in a bucolic New England town.
Transfer Pricing Issue A – International
Waterbury is renowned for its foreign language programs. As a result, the majority of its students spend a semester overseas honing their foreign language skills and becoming familiar with the local culture. While Waterbury has relationships with numerous unrelated colleges and universities overseas for its study abroad programs, it established its own college campus in Rome, Italy, in 1991. Due to Italian tax rules, the legal entity comprising the Rome campus (Waterbury Rome) is required to be a taxable entity. Waterbury Rome uses the curriculum developed by Waterbury, operates under the Waterbury brand, receives management and administrative support from Waterbury, and borrows funds from Waterbury.
In Transfer Pricing Issue A, Waterbury’s dealings with its for-profit entity, Waterbury Rome, must be conducted on an arm’s-length basis, as the Italian tax authority would expect that any 1) license for the use of the Waterbury curriculum and name; 2) allocation of costs (and markup) related to the management and administrative services provision; and 3) loan of funds would be priced in accordance with the arm’s-length standard. Most countries, such as Italy, impose penalties for failure to have adequate transfer pricing documentation, and Waterbury Rome would be expected to prepare an annual transfer pricing study documenting its pricing arrangements.
Transfer Pricing Issue B – Transactions Between Related Tax-Exempt & Taxable Entities
In 1999, Waterbury purchased three retail buildings in downtown Waterbury. It intended to use the retail space for collegiate activities. However, several local businessmen were interested in leasing the space from Waterbury to operate a restaurant and retail stores. Waterbury established a for-profit subsidiary, Waterbury Real Estate, Inc. (WREI), to house the retail space’s leasing operations. Waterbury performs various management, administrative, and maintenance services on behalf of WREI, as it does not employ any personnel and is unable to perform the services itself.
In Transfer Pricing Issue B, WREI is a taxable entity that receives valuable services from its tax-exempt parent company, Waterbury. In addition, WREI does not have the wherewithal to perform the services, as it does not employ any personnel. Therefore, WREI should pay an arm’s-length fee to Waterbury related to its provision of management, administrative, and maintenance services. WREI should maintain proper transfer pricing documentation to avoid penalties associated with a transfer pricing adjustment imposed by the IRS.
Transfer Pricing Issue C – UBI
Waterbury was recently approached by a professional ice hockey team, the Mountaineers, to use its ice rinks and other facilities in the summer months. In particular, the Mountaineers will pay Waterbury in the form of a donation to use its ice rinks, dorms, weight rooms, laundry service, vehicles, security force, and cafeteria.
Transfer Pricing Issue C is not really a transfer pricing issue per se. Rather, the transfer pricing rules can be applied to solve the determination of Waterbury’s UBI related to its contract with the Mountaineers hockey team. Given that Waterbury’s mission is related to providing education, certain aspects of the donation from the Mountaineers would likely be taxable as UBI. Given that the transfer pricing rules provide guidance on how to develop arm’s-length prices, they are often used to determine UBI for tax-exempt organizations. In this case, they could be applied to determine the arm’s length (fair market value) of the different components/services related to the Mountaineers’ contract that are deemed to be UBI.
Transfer Pricing Issue D – Private Inurement Rules
The president of Waterbury, professor Jane Shelburne, has established a taxable LLC to conduct and monetize some research related to gene sequencing. Shelburne also serves as the chair of the Waterbury board of trustees. The LLC has established a relationship with Waterbury to collaborate on analyzing massive amounts of gene sequencing data. Shelburne plans to license her research results to pharmaceutical and biotechnology companies. Waterbury’s role is to assist students and professors with data analysis. In return for the provision of services, Waterbury receives a service fee and a small portion of the licensing fees.
Like Transfer Pricing Issue C, Transfer Pricing Issue D is not a transfer pricing issue per se; rather, it relates to the private inurement/private benefit rules. The IRS imposes inurement/private benefit rules on tax-exempt organizations. Services provided by Waterbury to Shelburne’s LLC cannot be priced below the market value rate, as this would violate the inurement/private benefit rules. Since Shelburne serves as president and is chair of the Waterbury board of trustees, she cannot unduly benefit from serving in that role. If the inurement/private benefit rules did not exist, Shelburne could potentially manipulate the service fee paid to Waterbury so her LLC would benefit from undercompensating Waterbury. The transfer pricing rules can be employed to help ensure that the services performed by Waterbury on behalf of Shelburne are priced on an arm’s-length basis to avoid the inurement/private benefit penalties.
Colleges and universities should assess if they have any exposure related to transfer pricing, whether it be transactions between related domestic tax-exempt and taxable entities or transactions involving their overseas foreign affiliates. Organizations also can apply the transfer pricing rules to the new UBI siloing and inurement/private benefit rules.
If you have any questions or need assistance, please reach out to a professional at FORVIS.