Transfer pricing rules are underpinned by the arm's length principle: transactions between related entities (e.g., a parent company and subsidiary, or different divisions within the same contractor) should be priced as if they were conducted between independent parties bargaining at arm's length.
But government contractors face additional layers of complexity. Let’s dive into a few of the most common.
Regulatory Framework
Government contractors face significantly more tax and financial regulation—and scrutiny— than those operating exclusively in the private sector. In the U.S., rules and regulations such as the Federal Acquisition Regulation (FAR), Cost Accounting Standards (CAS), and the Truthful Cost or Pricing Data Act (formerly the Truth in Negotiations Act) specify how government contracting entities must account for, allocate, and document their costs for charge-out purposes.
These rules extend to costs allocated to or from foreign affiliates—common examples include foreign R&D or back-office service centers.
Development and Application of Transfer Pricing Policies
Government contracts require transfer prices to approximate arm’s length pricing, especially for cost-reimbursement or cost-plus contracts. Achieving this requires careful benchmarking using comparable companies and agreements, and a focus on comparability across geographies, functions, risks, and accounting standards.
A contract manufacturer selling to the government operates in a different business environment than one serving the private sector. This demands a distinct set of comparables and comparability adjustments.
Multi-Layered Reporting and Review
It’s not just tax authorities who scrutinize transfer pricing policies. In the U.S., agencies like the Defense Contract Audit Agency (DCAA) may also conduct audits. Their focus often overlaps with that of tax authorities—particularly around cost allocation and pricing justification.
Summary: Alignment Is Key
For multinational government contractors and their advisors, the key transfer pricing word is alignment: aligning tax goals, regulatory obligations, and audit preparedness in a way that is transparent and justifiable.
A well-designed and managed transfer pricing structure reflects the group’s unique supply and value chains and ensures that planning, implementation, and documentation meet both income tax and broader government regulatory standards.
This requires close coordination between tax, operations, legal, and other departments—as well as with outside advisors.
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