Transfer Pricing Considerations for Healthcare Industry Operators

Healthcare is the third largest industry in the U.S. economy, worth an estimated $808 billion as of 2021. Healthcare spending increased by 7.5% in 2023 to $4.8 trillion, outpacing GDP growth during the same period and comprising approximately a fifth of the total U.S. GDP. The scale and breadth of the healthcare industry are ripe for related party tax structures. This article examines the industry-specific attributes that give rise to transfer pricing (TP) risks for industry operators.

What is Transfer Pricing, and Why Does It Matter?

On Oct. 20, 2023, the IRS announced that it had launched several new initiatives using funding from the Inflation Reduction Act of 2022 (IRA), “ensuring large corporations and high-income, high-wealth individual taxpayers pay taxes owed.” These initiatives include increased compliance efforts targeting U.S. subsidiaries of foreign parent companies that improperly use transfer pricing to avoid reporting appropriate U.S. profits. According to Bloomberg Tax, the IRS’s transfer pricing unit will add 70 additional economists, tax specialists and revenue agents to bolster its enforcement measures by the end of 2024. Therefore, we expect to see enforcement measures produce transfer pricing audits for open years.

TP is a critical aspect of international taxation and corporate finance for multi-entity companies, including multinational entities. It ensures that transactions between related parties are conducted at arm’s length, preventing tax avoidance, profit shifting and double taxation. Adhering to TP regulations is necessary for compliance, transparency and good corporate governance, thereby protecting the interests of governments, shareholders and other stakeholders.

The purpose of Internal Revenue Code (IRC) Section 482 is to ensure that taxpayers clearly reflect income attributable to controlled transactions to prevent the avoidance of taxes concerning such transactions. The U.S. TP regulations adopt arm’s length pricing, requiring transactions between related parties to be priced as if they were conducted between unrelated parties.

In the healthcare industry, there are tax structures with tax-exempt entities engaged in transactions with related party non-tax-exempt entities. Transactions may include the provision of services, transfers of tangible and intangible property and financial transactions. From a tax perspective, the government is a stakeholder in allocating income and expenses between related parties. Mispricing of related party transactions so that non-arm’s length pricing is achieved leads to potential tax avoidance through base erosion and the failure to reflect accurate income and expenses in financial statements.

The following scenarios present a set of common related party transactions in the healthcare industry.

TP Scenario 1 – Tax-exempt Entities

In the healthcare industry, tax-exempt entities such as hospitals, clinics or healthcare organizations qualify for this status under IRC 501(c)(3) if they are organized and operated exclusively for charitable purposes. In this example, the tax-exempt entity is a part of a larger tax structure and provides services, including payroll, IT support, administrative or marketing to a for-profit related party. The fee paid by this entity to the tax-exempt related party is considered unrelated business income (UBI) and must be determined following the arm’s length standard. UBI is income a tax-exempt entity earns from a trade or business unrelated to its tax-exempt purpose. This income is taxed at the same rate as a comparable for-profit entity. In this scenario, it is critical for the tax-exempt entity to accurately reflect its UBI and ensure arm’s length pricing to mitigate transfer pricing risks and be compliant with the regulations.

TP Scenario 2 – Cross-border Intercompany Services

Like other industries, outsourcing is a common practice within the healthcare industry. In this example, the U.S. corporate parent, a home healthcare agency, has established a related party service provider in Puerto Rico, which has high levels of human capital available with lower labor costs compared to comparable U.S.-based labor. Additionally, the Puerto Rican government passed Act 60 in 2019 to boost the local economy. Act 60 aims to promote economic development in Puerto Rico by offering tax incentives for various industries, including manufacturing, export services, tourism, renewable energy and others. It allows companies a tax rate of 4% for eligible export services and a 100% tax exemption on dividends from earnings and profits. However, those incentives apply only to income Puerto Rican companies earn from performing services within the territory for customers outside it. Therefore, overall proximity, available human capital, lower labor costs, and tax incentives make Puerto Rico a desirable location to establish an offshore services entity.

U.S. corporations operating in Puerto Rico are subject to the same U.S. federal tax rules as those operating in other U.S. states and territories, with some exceptions and special tax incentives available under Puerto Rican law. Given the much higher corporate tax rate in the U.S., the IRS seeks to ensure that the fees paid by the U.S. corporate entity to its related party service provider in Puerto Rico is priced per the arm’s length standard. The objective is to ensure income is not shifted from a high tax to a low tax jurisdiction, thereby eroding the U.S. tax base. Finally, to qualify for preferential tax treatment in Puerto Rico, the taxpayer must show good faith effort in pricing related party transactions per the arm’s length standard through a robust analysis and documentation.

Compliance and Tax Planning

In its recent strategic operating plan update issued on May 2, 2024, the IRS presented its future priorities, which notably include an enhanced audit focus targeting high-net-worth individuals, multinational corporations, and partnerships. The plan highlights the IRS will nearly triple audit rates on large corporations with assets over $250 million to 22.6% in tax year 2026, up from 8.8% in tax year 2019. Global declines in tax revenues spurred first by COVID and then by inflation and the resulting deflationary policies, have created an urgency for global tax authorities to increase tax revenues and thereby increasing the risk of transfer pricing audits. This trend will hold for the foreseeable future.

A proper and robust transfer pricing analysis and documentation is required to meet the basic compliance requirements for income tax and tax incentives purposes. The lack of proper documentation may lead to significant adjustments with penalties and interest related to underpayment of taxes, which can range from 20% to 40% in the U.S., depending on the level of misstatement. There are additional penalties for filing TP disclosures and forms, if required. There is also potential disallowance of net operating losses, withholding taxes and double taxation when expense deductions are disallowed and the need to prepare a Financial Statement Disclosure (ASC 740, formerly FIN 48).

As important as TP compliance, TP planning allows for optimizing intragroup prices leading to potential cost savings. As an example, the U.S. TP allow for valuation of certain intragroup services to be provided at the cost, which could lead to group wide savings in costs.

Particularly in an environment of rising costs and increased audits of related party transactions, TP planning and compliance work together to optimize the corporate taxpayer’s income tax position and avoid potential adjustments, interest, and penalties.

To learn more about transfer pricing for the healthcare industry, please connect with our professionals.