Many SaaS companies build part of the team abroad: engineers in one country, a sales office in another. Once there is a legal entity overseas, every dollar between the parent and the subsidiary is an intercompany transaction that both countries' tax authorities can examine. Transfer pricing is the discipline of pricing those transactions as if the two companies were unrelated.
The arm's-length principle
Section 482 lets the IRS reallocate income between related companies so it reflects what unrelated parties would have agreed. Most other countries apply the same principle through their own rules and the OECD Transfer Pricing Guidelines. In practice, both sides want documentation showing the price is reasonable.
The common SaaS setup: a cost-plus service subsidiary
| Role | Entity | Typical arrangement |
|---|---|---|
| Owns the IP, contracts with customers | U.S. parent | Earns the residual profit or loss |
| Performs development or support services | Foreign subsidiary | Charges the parent its costs plus a markup |
The subsidiary is a low-risk service provider: it earns a steady, modest profit regardless of whether the product succeeds. The markup is supported by a benchmarking study of comparable service companies.
A worked example
A subsidiary employs 12 engineers. Its annual costs are $1,500,000, and the benchmark supports a 7% markup.
| Item | Amount |
|---|---|
| Subsidiary costs | $1,500,000 |
| Markup at 7% | $105,000 |
| Intercompany service fee charged to the parent | $1,605,000 |
| Subsidiary taxable profit (local) | $105,000 |
| Parent deduction (subject to U.S. rules, including Section 174 for research performed abroad) | $1,605,000 |
Foreign research expenditures are amortized over 15 years for U.S. tax under Section 174, so the parent's deduction for an offshore development team is spread out rather than immediate.
The documents that hold it together
- Intercompany services agreement signed before the services start: scope, pricing method, invoicing and payment terms, IP ownership.
- Transfer pricing documentation: a benchmarking study and a functional analysis, updated periodically, plus local-country documentation where required.
- Monthly intercompany invoices that match the agreement.
- Settlement: actual cash payments, so balances do not build up.
U.S. filings
- Form 5471 for each controlled foreign corporation, filed with the parent's Form 1120, with schedules for the subsidiary's income, balance sheet and related-party transactions.
- U.S. rules can tax some foreign subsidiary income currently even if it is not distributed; a service subsidiary paid cost plus a modest markup usually produces limited amounts, but it must be calculated.
- Foreign bank account reporting may apply for accounts the parent controls.
The books
The subsidiary keeps local books in its own currency, under local rules. For group reporting, those books are translated into U.S. dollars, intercompany balances are eliminated in consolidation, and the parent and subsidiary balances must agree to the cent at each month end.
We set up the intercompany agreement and monthly billing, keep the subsidiary's results in the consolidation, and prepare Form 5471 with the parent's return, working with local accountants abroad.
Sources
- IRS, Transfer pricing
- 26 U.S.C. §482, Allocation of income and deductions among taxpayers (Cornell LII)
- IRS, About Form 5471
- FASB Accounting Standards Codification, Topic 810, Consolidation
Questions founders ask
Do we need a subsidiary to hire abroad?
No. An employer of record can employ people in another country for the company. A subsidiary becomes worth it when the team grows, the company wants its own presence, or local rules make it the better route.
What is the penalty for missing Form 5471?
The penalty for failure to file a required Form 5471 starts at $10,000 per form per year, and it can also keep the statute of limitations open for the whole return.
