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Transfer Pricing Chapter

Transfer Pricing Chapter

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Transfer pricing
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Published by: Amisha Shah Mody on Dec 07, 2013
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Information Transactional What Transfer


Transfer Pricing

Reporting and Methods. Pricing? Net

Adjustment Requirements.


.'J[502 .'J[503 .'J[504







The operating units of a multinational corporation usually engage in a variety of intercompany transactions. For example, a U.S. manufacturer may market its products abroad through foreign marketing subsidiaries. The same U.S. parent corporation also may provide managerial, technical, and admittistrative services for its subsidiaties. Another common arrangement is for a U.S. parent corporation to license its manufacturing and marketing intangibles to its foreign subsidiaries for exploitati,on abroad. A "transfer price" must be computed for these controlled transactions in order to satisfy various financial reporting, tax, and other regulatory requirements. Although transfer prices do not affect the combined income of a controlled group of corporations, they do affect how that income ~ allocated among the group members. Example' 5.1: USAco, a domestic corporation, manufactures sm~ engines for sale both in the United States and abroad. Foreign sales are made through FORco, a wholly owned foreign corporation. USAco's engines cost $600 to manufacture and $100 to market, and sell for $1,000 abroad (see Figure 5.1). Regardless of the transfer price used for sales by USAco to FORco, the combined income from a foreign sale is $300 per engine [$1,000 final salesprice -$600 manufacturing cost -$100 selling expense]. However, transfer prices do affect the allocation of that combined profit between USAco and FORco. Figure 5.1 Transfer pricing example
Transfer price = ?

Resale price = $1,000


"""" r'
Unrelated customers



Expenses = $100


At one extreme, a transfer price of $600would allocate the combined profit of $300entirely to FORco,as follows. r



U.S. Taxation of International Transactions
Effecton USAco
E{fecton PORro

Manufacture engine Controlled sale Foreign sellin activities Sale to foreign customer

Production cost = $600 Salesreven~ $600 ~ Cost of sales=~ Selling e ense = $100 Salesrevenue = $1,000 Net Net profit = $300

At the other extreme, a transfer price of $900 would allocate the co bined profit of $300entirely to USAco, as follows.

Effi!cton USAco

ERtct on FaRro

Manufacture en .e Controlled sale Fore" ctivities

Production cost = $600 Salesre~e = $900 Cost of saI~900 = $100

Sale to foreigncusto


For income tax purposes, multinational corporations must alloca e their worldwide profits among the,various countries in which they operate. e ideal allocation would permit each country to tax an appropriate portio of the taxpayer's total profit, while avoiding taxation of the same income by m<l>re than one country. The mechanism for allocating a multinational's worldwid~ profits between its U.S. and foreign affiliates is the transfer price used for inte C mpany transactions. When tax rates vary across countries, transfer pricing c have a significant effect on the taxpayer's total tax costs.


For example, the foretgn tax credit limitation prevents U.S. co panies operating in high-tax foreign jurisdictions from claiming a credit for those excess foreign taxes. These noncreditable f{)reign taxes increase the worldwide tax rate on foreign earnings above the U.S. corporate rate of 35%} A domestic ~orporation may be able to avoid these higher foreign taxes by altering its transf~r prices l "a U.S. so as to shift income out of these high-tax jurisdictions. For examPl manufacturer may be able to reduce a foreign marketing subsidiary's hare of worldwide,profits by using higher prices for controlled inventory sales. Example 5.2: The facts are the same as in Example 5.1. Assume that the U.S. tax rate is 35% and the applicable foreign tax rate is 45%. Given'tms rate differential, the USAco group can reduce its worldwide taxes qy using higher transfer prices for its controlled sale. For example, if a trans~er price of $600 is used for a s~le by USAco to FORco, the $300 gross iprofit is allocated entirely to FORco, and the total tax on that profit equals thf foreign tax of $1.35 [$300 of income x 45% foreign tax rate]. If a transfer pric~ of $900 is used for the controlled sale, the $300 gross profit is allocated entirely to USAco, and the total tax on that profit equals the U.S. tax of $105 [$300 of income x 35% U.S. tax rate]. Transfer pricing also is a relevant issue lor U.S. companies with operations in low-tax foreign jurisdictiof\S. In these situations, a U.S. parent corporation has
1 See discussion of excessforeign tax credits in Chapter3.


th w re in a distri bein a divi tha is sub to a wi ta E if th foreig coun mar corp tax rat is hig th U m corpo tax rate the add of the wit tax m re in a o U. incom taxe at rate of 38% any div dis by U to C will be subj to a 5% with tax res in an ef U ta ra Transfer Pricing I 1 09 1)501 .S wit ta on di B empl aggr ca go ba to th fo comp while leav few ear and pro in the U. tax on thos lowfore ear it do de th ta U th foreig subs repa tho thr a div di S~ar tran pric is a rele iss fo comp .Exa 5.S dis su (" ~ u U Altho USS doe not hav any ma fu U b e ploys its own adm and sal sta wh us C distri softw to ens tha the are no an di p ill an effor to ens that US is fina so U h term to CAN of six mo (US av co pe is o mon US5 cus do not pa US en th us o C colle staff I This ~xam illus fou inte tra fo w V must pay CAN at arm leng Firs the pu of wi co a purch of tang prop Sec us th un d softw cons a tran of inta pro for wh U m p a royal Third the gen pay ter co a lo on w U may pay an arm' leng rate inte Fo the pr of th c staff serv for whi US wil ha to pa an a amou r n With resp to the tran pric pra of for U nies.A sume the top com Can fed pro t r te is a 40% CAN own a U.3: CAN Ca co m a s widg in the Unit Sta Du to inc wi or fr custo CAN dec to form a U. trans prici is con a rep me to br ca b to the forei com With pay U.S. tax rate that is high than fore cou ra This prob may be par acu wh fo ex th f re paren coun doe not tax the divi an the W ta is co e an out-o cash cos Exam 5.an incel to shift inco to its low for su by fo e using lowe tran pric on con inv sa A s incom to a lowfore sub doe no pe av th r~ U.S.S sub ("U tha pu ga fr CAN for resa in the Uni Sta wh the co fe a s effec tax rate is 38% ill add to the U.4: CAN is a trad com or in C .


5: USAco. 1]502.tOThe use of multipleReg. often are not readily available for the types of transactioru. This includes the similarity of geographic markets.7 As a practical matter. and markets-This comparability factor focuses on the economic conditioru. USAco must compare prices charged for. are publicly traded fungible goods such as oil.Nature of the property or services transferred in the transaction-As discussed more later in this chapter. §1. generally using either the mean or the median of the range as the benchmark price. However.482-1(d)(2).Transfer Pricing - 111 . the IRS will not make an adjustment. if the taxpayer chooses a profit-based method. for the same period.S.the appropriate arm'slength price is ambiguous. wholesale or retail). comparable transactioru. and the alternatives realistically available to either party.482-1(e)(2)(ili)..then the range is limited by 7 statisticaltechniques. If the taxpayer's transfer prices lie within the range.482-1(e)(1) and (e)(2)(i). televisioru. the level of the market (e.S. If it were to use one of the transaction-based methods. assuming the effect of the difference can be ascertained with enough accuracy to improve the reliability of the results. entered into by affiliates of a vertically integrated multinational corporation. a Japanese parent corporation. Adjustments must be made for any material differences between the controlled and uncontrolled transactioru.equence. a taxpayer may use two or more comparable uncontrolled transactioru. " Example 5. the extent of competition in each market. Under this provision. performed and the risks assumed.Economic conditioru.. the economic conditioru.If adjustmentscannot be made for all material differences. the comparability of property sold or services provided is more relevant to the transaction-based methods than the profit-based methods.01 .482-1(f)(2)(ili). 10 Reg. such as restricting the range to those comparable uncontrolled transactionswhich fall within the 25th and 75th percentiles of the range. 9Reg. under certain circumstances. such as the comparable profits method. §1..482-1(e)(3). 8Reg. For example. a U. then the IRS will make an adjustment. USAco must merely find companies comparable to itself with respectto the type of functioru. of the particular industry. for which information regarding market prices is readily available. As a coru.81f the taxpayer's transfer prices lie outside the arm's-length range.Reg. §1. from its Japanese parent that USAco markets in the U.g. The only significant exceptioru. subsidiary of ASIAco. to satisfy the arm's-length requirement by showing that the average result for a multiple-year period is comparable to that of uncontrolled transactioru. that could affect the prices to be charged. purchases televisioru. . All comparable uncontrolled transactionsare included in the range if adjustmentscan be made for all of the material differencesbetweenthe controlled and uncontrolled transactions. lumber.9 Taxpayers also are allowed.. The concept of the arm's-length range helps taxpayers deal with this uncertainty. and agricultural products. §1. § 1.(of similar comparability and reliability) to establish an arm's-length range of prices. inventory sales between affiliated companies often involve component parts and semifinished goods that are unique and are not sold in public markets.

which is the end of USAco's taxable year. During the current year. 13 Reg. 18Reg. §1. §1. 17Reg. Under this safe harbor. On November 1.ider all relevant factors. § 1. a domestic corporation. the credit standing of the borrower. however. Since the $1 million intercompany trade receivable was outstanding for only two months.482-2(a)(2)(iii)(B). Example 5. USAco does not have to recognize any interest income. owns 100% of EURco. 16Reg. "502. that are unrelated to transfer pricing. The $1 million debt. 15 Reg. including the amount and duration of the loan. §1. owns 100% of ASIAco. § 1.482-2(a)(1)(i).482-2(a)(1)(iii)(C).1274(d). 19Reg. a foreign corporation. 14 Reg.482-2(a)(2)(i). . an interest rate is deemed to be an arm's-length rate if it is between 100% and 130% of the applicable federal rate}9 The applicable federal rate is the average interest rate (red. on which ASIAco pays no interest. and the interest rate prevailing at the situs of the lender for comparable loans between uncontrolled parties}8 If an arm's-length rate is not readily determinable. is still outstanding on December 31. a domestic corporation. Taxation oflntemationalTransactions year data helps reduce the effects of short-term variatioru. 20Code Sec.482-2(a)(1)(iii)(E). § 1. the taxpayer can still protect itself against an IRS adjustment by satisfying the requirements of a safeharbor provision. it is not necessaryto charge interest on an intercompany trade receivable until the first day of the.482-2(a)(1)(iii)(D). the interest-fre-e period extends to the first day of the third month following the month in which the receivable arises}4 This exception reflects the common business practice of not charging interest on trade receivables. 12 Reg.7: USAco.482-2(a)(1)(i).13 If the controlled borrower is located within the United States. §1. for intercompany trade receivables. such as the effects of an industry business cycle.§ 1.482-2(a)(1)(iii)(B).2O Example 5.6: USAco. which are debts that arise in the ordinary course of business and are not evidenced by a written agreement requiring the payment of interest}2 If the controlled borrower is located outside the United States. a foreign corporation.16 Intercompany debt other than a trade receivable generally must bear an arm's-length interest charge}7 To determine the arm's-length rate. of the federal government with maturities similar to the term on the intercompany loan. § 1. in prices. USAco borrows $1 million 11Reg. the taxpayer must coru.112 u. Longer interest-free periods are possible if the controlled lender ordinarily allows unrelated parties a longer interest-free period)5 or if a controlled borrower purchases the goods f<:?r resale in a foreign country and the average collection period for its salesis longer than the interest-free period.fourth month following the month in which the receivable arises.02 Loans and Advances Controlled entities generally must charge each other an arm's-length rate of interest on any intercompany loans or advances}1 There is an exception.eterminedmonthly) on obligatioru.02 .s. the security involved. ASIAco purchases$1 million of inventory on account from USAco.482-2(a)(1)(iii)(A).

23 Example 5. a wholly owned foreign marketing subsidiary. 23 Reg. taking into account all of the relevant facts and circumstances. § 1. USAco borrows $10 million from a German bank at a 10% rate. increased by any associated borrowing costs.22 A special rule applies if the controlled lender obtains the funds used to make the intercompany loan at the situs of the controlled borrower.8: USAco. §1. another controlled entity. Under 21Reg. .03 Performance of Services Currently existing final regulations. 24Reg. or on behalf of.Transfer Pricing 113 from EURco.482-2(b)(3)-(b)(5). 11502. During the current year.03 .25 This safe harbor reflects the reality that intercompany services sometimes are provided for reasons of convenience. § 1.482-2(a)(2)(ii).4%also can be used if the taxpayer can establish that it is an arm's-length rate. A rate lower than 8% or higher than 10. 25Reg. The loan is denommated in U. a domestic corporation. a charge equal to the direct and indirect costsincurred by the controlled entity in provid~g the service is deemed to be an arm's-length charge.the controlled lender is treated as a mere conduit for the loan entered into with the unrelated lender.l or if the controlled lender is in the business of making loans to unrelated parties.24However.482-2(a)(2)(ili)(D). During the current year. Example 5. § 1. USAco markets its products abroad through FORco. 22Reg. under a safe-harbor provision. a domestic corporation. The costs associated with these services include $10. a German corporation. dollars and has a three-year term.4% (130% of the applicable federal rate) is automatically acceptable to the IRS. In such cases. taking into account all of the relevant facts and circumstances.000. owns 100% of GERco. USAco performs some payroll services for FORco as a convenience fpr FORco's management.000of salaries plus an overhead allocation of $3. An arm's-length fee generally must be charged if one controlled entity performs services for the benefit of.482-2(a)(2)(ili)(E).482-2(b)(1).9: USAco.S. an interest rate of between 8% (100% of the applicable federal rate) and 10. Thus. the arm's-length rate on such pass-through loans is assumed to be equal to the rate paid by the controlled lender on the original loan. produces food products at its U. and then relends the funds to GERco.The arm's-length rate on the intercompany loan is dee~ed to be equal to 10% plus any borrowing costsincurred by USAco in securing the original loan. A rate other than 10% also can be used if USAco can establish that such a rate is arm's length.S. plant for sale domestically and abroad. Under the safe-harborprovision. The safe harbor is not available if the intercompany debt is denommated in a foreign currency. rather than profit. the applicable federal rate for a three-year obligation is 8%. At the time of the loan. unless the taxpayer can establish that a different rate is more appropriate under the general rules. § 1.


the controlled lessor is treated as a mere conduit for the lease it entered into with the unrelated lessor.34 A special rule applies if the controlled lessor first leased the property from an unrelated person and then subleased it to the controlled lessee. §1.§1. and the profit split methodS.Examples 1 and 2. the owner's maintenance expenses. a charge would have to be made. The IRS issued proposed regulations for intercompany services on September5.30 Proposed regulations. § 1.482-9(f). Reg. Thus. if the taxpayer has not charged a markup.32 . The SCBM applies when the taxpayer charges a markup of 10% or less.and the type and condition of the property. The parent need not charge the subsidiary for this service because it merely duplicates those performed by the subsidiary itself. As proposed. repairs. More specifically.. § 1. maintenance. § 1. 34Reg.33 The arm's-length rental is the amount that would have been charged for the use of the same or similar property in a transaction between unrelated parties under similar circumstances.S. 35Reg. 32 Prop. These include the comparable uncontrolled services price method.482-2(c)(2)(i).Transfer Pricing 115 U. a taxpayer's markup of 9% is not subject to adjustment unless the IRS determines that the arm's length markup is 10%or greater. the owner's investment in the property. increased by any associated rental costs (e. the IRS cannot make an adjustment unless the arm's length markup exceeds6%. 2003. parent corporation's home office reviews the report. Under the SCBM.35 This rule does not apply if either the controlled 30Compare Reg. r Unlike the final regulations. utilities. including the period and location of the property's use. the proposed regulations also provide coun~erparts to the traditional methods for determining arm's-length pricing for services. these regulations do not have the effect of law. the gross services margin method. the comparable profits method.482-2(c)(2)(iii)(A). First.482-2(b)(2)(ii). All relevant factors must be considered in determining the arm's-length rental.482-2(c)(1).g. and managerial expenses). 33Reg. ~ 502. but are indicative of the IRS's position. the proposed regulations eliminate the safe harbor charge equal to the direct and indirect costs for non-integral services. the cost of services plus method. Instead.In such cases. the IRS must determine that the arm's length markup is at least 6% to make an adjustment.482-9(b)-(g).04 . Furthermore. such as routine administrative services. § 1. if the foreign subsidiary did not have a financial staff. 31Prop. the regulations propose the simplified cost-basedmethod ("SCBMj31 for non-integral services. based on a sliding scale. the arm's-length rental for such pass-through leasesis deemed to be equal to the rental paid by the controlled lessor on the original lease. These prop<!lsed regulations contain several changes from the old final regulations. On the other hand. Reg. and the home office executive perfonned the original analysis rather than merely reviewing it.04 Use of Tangible Property Intercompany leases of tangible property generally must bear an arm'slength rental charge.


Under the resale price method. Independent foreign distributors typically earn commissions of 10% (expressed as a percentage of the resale price) on the purchase and resale of products comparable to those produced by USAco. The gross profit margin realized by independent distributors (or even the related distributor) on similar uncontrolled sales provides an estimate of the arm'slength gross profit. Resale price method. the most important factor is product similarity. 44Reg. which is expressedas a percentage of the resale price.44 Under this method.500-(10% x $1. the estimate of the arm's-length price is $750. 45Reg. 11502. § 1. § 1. USAco and MEXco should use the comparable uncontrolled price method.500)]. 43Reg. a Canadian corporation. In assessing the comparability of controlled and uncontrolled transactions for purposes of the comparable uncontrolled price method. the estimate of the arm's-length price is $1. and adjusted for any material differences that exist between the controlled and uncontrolled transactions. a domestic corporation. the comparable uncontrolled price method is usually difficult to apply in practice. USAco manufactures medical equipment at a cost of $1. The type of transaction envisioned by the resale price method is a controlled sale of finished goods followed by the related distributor's resale of the goods to unrelated customers. Other significant factors include the similarity of contractual terms and economic conditions. which resells the goods (without any further processing) to unrelated foreign customers for $1.05 . § 1.482-3(c)(2) and (c)(3)(ii)(C).4S Example 5. the arm's-length price is the resale price charged by the related distributor. reduced by the arm'slength gross profit margin for such resales. owns 100% of CANco.13: USAco.Transfer Pricing - 117 tion is available regarding comparable uncontrolled sales.350[$1.2).500 each (see Figure 5. Under this method.482-3(b)(2)(ii)(A).482-3(c)(1).43 Because information regarding comparable uncontrolled transactions is usually not available.000 per unit and sells the equipment to CANco.


USAco attaches its trade name to the power tools (which has a significant effect on their resale price) and resells them to unrelated customers in the United States for $100 each (see Figure 5. which is expressed as a percentage of the manufacturing costS. 49Reg. the estimate of the arm's-length price is $72 [$60+ (20% x $60)]. FORco manufactures power tools at a cost of $60 each and sells them to USAco. and adjusted for any material differences that exist between the controlled and uncontrolled transactions.05 . a foreign corporation.3). The gross profit realized by independent manufacturers (or even the related manufacturer) on similar uncontrolled sales provides an estimate of the arm's-length gross profit markup. a domestic corporation. ~ 502.482-3(d)(2) and (d)(3)(ii)(C). Under the cost plus method. Independent foreign manufacturers producing similar power tools typically earn a gross profit markup of 20%.49 Example 5. § 1.Transfer Pricing - 119 length gross profit markup for such manufacturers. owns 100% of FORco.14: USAco.

120 U. the profitability of comparable uncontrolled entities is used as a benchmark for determining an arm's-length net profit for one of the controlled parties (the "tested party"). in assessingthe comparability of controlled and uncontrolled transactions for purposes of the cost plus method.05 .51 Comparable profits method.482-3(d)(3)(ii)(A) and (B). and contractual terms agreed to is relatively more important. product similarity is less important than under the comparable uncontrolled price method. Under this method. risks borne. and then a transfer price is established which leaves the tested party with that amount of net profit. rather than the prices used in uncontrolled transactions. Taxation of International Transactions FigureS. § 1. §1. 51Reg. 52Reg. to determine an arm's-length allocation of profit between two related corporations.52 50 Reg. 11502.482-3(d)(3)(ili)(B).482-5(b)(1). §1. The comparable profits method looks to the profits of.3 Example of cost plus method -- As with the resale price method.S. uncontrolled entities. while the similarity of the functions performed.50Consistency between the accounting methods used to compute the gross profit markup for the controlled and uncontrolled transactions also is important.

482-5(b)(1).57 (4) Developan arm's-lengthrangeof comparable operatingprofits-To construct an arm's-length range of comparable operating profits. Because resources and risks usually are directly related to functions performed. an adjustment is made equal to the difference between the tested party's re53Reg.58 (5) Determineif an adjustmentmust be made-An adjustment is required if the tested party's reported profit lies outside the arm's-length range of comparable operating profits developed in step 4. ~502.the ratio of operating profit to sales.g. § 1.54 Another important factor is the consistency between the accounting methods used by the controlled and uncontrolled parties to compute their operating profits. However. This is likely to be the least complex of the controlled parties. § 1.482-5(e).05 . §1.56 (3) Selecta profit levelindicatorc--Examplesof the profitability measures that can be used include the ratio of operating profit to operating assets.482-5(c)(2)(ii). 54Reg.59 (6) Adjust the transfer price used for the controlled transaction. and the ratio of gross profit to operating expenses.Transfer Pricing 121 The methodology for developing an arm's-length profit involves the following six steps: (1) Determinethe tested party-The tested party should be the participant in the controlled transactions for which the most reliable data regarding comparable uncontrolled parties can be located. §1. 59 Reg. 55Reg. 56Reg. any required adjustments are made on a year-by-yearbasis. § 1. § 1. §1.g.55 Adjustments must be made for any differences between the tested party and the comparable uncontrolled parties that would materially affect the profitability measures used.53 (2) Obtain financial data regarding comparable uncontrolled parties-The key factors in assessing the comparability of the tested party to uncontrolled parties are the resources employed and the risks assumed."the operating assetsused in the manufacture and sale of inventory).482-5(b)(4). To enhance the reliability of a profitability measure. the selected profitability measure (e. 57 Reg. the taxpayer should perform a multiyear analysis which generally shotJld encompass at least the taxable year under review and the two preceding years.. and the controlled party that does not own valuable intangible property or unique assetsthat distinguish it from potential uncontrolled comparables.482-5(b)(2)(i). Example2.If the tested party's reported profit lies outside the arm's-length range.482-5(b)(1). the ratio of operating profits to operating assets)is applied to the tested party's most narrowly identifiable business activity for which data incorporating the controlled transaction is available (e. §1. Reg. 58 Reg. it also is important to consider the functions performed in determining the degree of comparability between the tested party and an uncontrolled party.482-5(c)(2)(iv).482-5(c)(3)(ii).

482-5(e). Example 2.05 . owns 100% of USAco. the interquartile range of comparable operating profits is used for purposes of testing USAco's profits.<$40million> ' <$9million> $lmi1lion USAcois selected as the testedparty because it engages in activi~e.. $2 million..5 million. § 1.61 Example 5. This adjustment'increases USAco's U... The median of the interquartile range of comparable operating profits (i.s that are less complex than those of EURco..482-5(b)(1). §1.482-1(e)(3).' $50million . a domestic corporation."'. Therefore.60such as the mean or the median of the arm's-length range of comparable operating profits. 62This example is based on Reg. § 1. USAco imports EURco's finished goods for resale in the United States. a foreign corporation.4%.5 million. Profit split method. Therefore.S.5 million. and 7%. The profit split method is the most complicated of the specified pricing methods for transfers of tangible property. taxable income by $1. Taxation oflntemationalTransactions ported profit and the benchmark arm's-length profit.5 million. the transfer prices that USAco pays EURco for its inventory are reduced by $1. $2.USAco's average financial results for the last three years are as follows: Sales.63 The relative value of each 60 Reg. and $3.482-6(a). and $2.5 million.5 million.".s.5 million. $2. an adjustment is required. EURco manufactures consumer products for worldwide distribution.5%. and therefore is difficult to apply in practice.15: 62 EURco. § 1.5 million. Cost of goods sold Operatingexpenses Operating profit '. 63 Reg.e. 1]502. 61Reg.5 million per year. This range includes $2 million. the average ratio of operating profit to sales for each uncontrolled distributor is as follows: 3%.'. with a corresponding decreasein EURco's taxable income.'.S. After adjustments have been made to account for material differences between USAco and the uncontrolled distributors.122 u. $2. Applying these percentages to USAco's sales of $50 million yields the following arm's-length range of comparable operating profits: $1. distributors indicates that the ratio of operating profits to sales is the most appropriate profitability measure. which equals the difference between USAco's reported profit of $1 million and the arm's-length profit of $2.5 million) is determined to be the arm's-length profit for USAco. Because USAco's reported operating profit of $1 million lies outside the arm's-length range. The profit split method evaluates whether the allocation of the combined operating profit attributable to a controlled transaction is arm's length by reference to the relative value of each controlled taxpayer's contribution to that combined profit. An analysis of five comparable uncontrolled U.5%. $2.

For transfer pricing purposes. (v) methods. inventions. In such cases. processes.06 Transfer or Use of Intangibles Introduction.482-4(f)(3)(ii)(A).S. it may be unclear which of the controlled parties is the owner of the intangible. 67Reg. customer lists. Under the comparable profit split method. 66Code Sec.68However. or artistic compositions. patterns. § 1.66This ceiling is designed to prevent taxpayers from simultaneously avoiding U. Routine contributions ordinarily include contributions of tangible property and services. the comparable profits method is used to estimate and allocate an arm's-length profit for the routine contributions made by eachcontrolled taxpayer. formulae.482-6(c)(3). and (vi) other similar items. The residual profit not allocated on. trade names.S. surveys. 1]502. an "intangible" includes any of the following items: (i) patents.designs. Examples of such transactions include a U.estimates. There is a statutory ceiling (i)n the transfer prices used for property imported into the United States in a transaction between controlled parties. (iv) franchises.06 . programs.S. . or a U. (ill) trademarks.482-4(b).64 Under the residual profit split method. forecasts. In such cases. § 1. parent corporation purchasing goods from a foreign manufachiring subsidiary.S.or contracts.65 Ceiling on transfer price for imported goods. income taxes by using a low transfer price for custom purposes and a high price fO1: income tax purposes.the controlled party that bore the largest 64Reg. campaigns. procedures.the transfer price used by the controlled purchaser for income tax purposes (which becomes the controlled purchaser's cost basis for computing the gain on resale) cannot exceed the value amount taken into account for purposes of determining custom duties. 65Reg. (ii) copyrights and literary. lO59A. systems. or knowhow. musical. custom duties and U. 68Reg. if an intangible is not legally protected. the allocation of the combined operating profit between two controlled taxpayers is based on how uncontroHed taxpayers engaged in similar activities under similar circumstances allocate th~ir joint profits.482-6(c)(2). or brand names. § 1. § 1. or t~hnical data.67 The owner of an intangible for tax purposes ordinarily is the taxpayer who owns tl:le legally protected right to exploit that intangible. marketing subsidiary purchasing goods from its foreign pareht corporation. licenses. studies.Transfer Pricing 1g3 controlled taxpayer's contribution is determined using either the comparable profit split method or the residual profit split method. the basis of routine functions is then allocated between the tWo controlled taxpayers on the basis of the relative value of the intangible property contributed by each party .

(ii) the comparable profits method. However. 75 Reg. 70 Reg.482-4(c)(2)(ii). § 1.71In addition to the three specified methods.Taxation of International Transactions portion of the direct and indirect costs of developing the intangible ordinarily is treated as the owner for tax purposes. 74 Reg. 76This exampleis based on Reg. §1.70 The taxpayer JIlust selectand apply the method which provides the most reliable estimate of an arm's length price. §1.482-5(e).482-4(c)(1). an unspecified method can be used only if it provides the most reliable estimate of an arm's-len.72 69 Reg.69 There are three specified methods for estimating an arm's-length charge for transfers of intangibles: (i) the comparable uncontrolled transaction method. 71Reg.482-4(a). §1. §1. Example4. the owner must allocate an arm's-length compensationto that party.482-4(£)(3)(ii)(B).l?.S.th price.482-4(d)(1).482-1(c)(1). and (ill) the profit split method. Reg. 73 Reg.06 . §1. 11502.124 U. §1. §1. §1.482-4(c)(2)(ili)(B)(1). If any other controlled party contributed to the developmentof the intangible. the taxpayer also has the option of using an unspecified method.482-4(f)(3)(iii). 72 Reg.

This range includes $2. Therefore. companies have moved operations to foreign countries offering low-cost labor. the ratio of operating profits to operating assets is the most appropriate profitability measure. Many U. taxes to the extent the intercompany royalty rate understates the economic value of the 11502. The median of the interquartile range of comparable operating profits (i. See the discussion of the profit split method under "Transfers of Tangible Property.5million.S.75million.5 million. BecauseASIAco is engaged in manufacturing. 15%. $3. profit toUSAco sold. 10%.and 18%..75 million) is determined to be the arm's-length profit for ASIAco. $2. Because ASIAco's reported operating profit of $5 million lies outside the arm's-length range.Transfer Priein/! 125 markets the product in the United States. less government regulation. Therefore. assets. the domestic parent will defer U. For example. If the foreign subsidiary is located in a low-tax foreign jurisdiction. an adjustment is required. and $4. which equals the difference between ASIAco's reported profit of $5 million and the arm's-length profit of $3.75 million. Profit split method.e. $3. and new markets.ASIAco's average financial results for the last three years are as follows: Sales. taxable income by $1. the average ratio of operating profit to operating assetsfor each uncontrolled distributor is as follows: 8%. the royalty that ASIAco pays USAco is increased by $1.75 million.15%. Commensurate with income requirement. $3.25 million.5 million." above. with a corresponding decrease in ASIAco's taxable income. Applying these percentages to ASIAco's operating assetsyields the following arm's-length range of comparable operating profits for ASIAco: $2 million.S. $3.75million. This adjustment increases USAco's U. After adjustments have been made to account for material differences between ASIAco and a sample of five uncontrolled foreign manufacturers for which data is available. These companies typically have manufacturing and marketing intangibles that they can transfer to their foreign subsidiaries. (5% of sales) ~ million <$12 million> <$ 1 million> <$ 2 million> $ 5 million $ 25 million ASIAco is selectedas the tested party because it engagesin relatively routine -manufacturing activities.06 . low tax rates. and $3. a foreign manufacturing subsidiary might manufacture a good under a license from its domestic parent corporation and then sell its entire output to the parent at a markup. whereas USAco engages in a variety of complex activities using unique and valuable intangibles. the interquartile range of comparable operating profits is used for purposes of testing ASIAco's profits. Operating Operating Cost Royalty of goods paid expenses.S.25 million per year.75million.

§1. Taxation of International Transactions intangible. the taxpayer need not make periodic adjustments if the unexpected variation in profits is due to extraordinary events that could not have been reasonably anticipated and are beyond the taxpayer's control. 82 Reg. Other requirements include the existence of a written royalty agreement. also must be met. §1.81 (ii) Extraordinary eventexception-Even if the total profits actually realized by the controlled transferee from the use of the intangible are less than 80% or more than 120% of the profits that were foreseeable when the agreement was entered into. 80 Reg. all of the requirements of the de minimis exception. in 1986Congress enacted a requirement that transfer prices for sales or licenses of intangibles must be "commensurate with the income attributable to the intangible. transfer prices must reflect the actual profit experience realized subsequent to the outbound transfer."77In other words. and there have been no substantial changes in the functions performed by the transferee since the agreement was executed. the original salesprice or royalty rate must be adjusted annually to reflect any unanticipated changes in the income actually generated by the intangible. other than the 80%-120% test.482-4(f)(2)(ii)(C».79 The need to make periodic adjustments places a significant administrative burden on taxpayers. To meet this requirement.82 77CodeSec. and the preparation of contemporaneous supporting documentation. the taxpayer must increase the intercompany royalty payments to reflect that unanticipated profitability. §1. Reg. 81Reg.482-4(f)(2)(i).06 . then no further periodic adjustments are required under any conditions.126 U.78For example.S. except for changes required by unforeseeableevents. if the requirements of the de minimis exception are met for each of five consecutive taxable years. 482.soIn addition.482-4(f)(2)(ii)(E). This burden is mitigated somewhat by the following exceptions: (i) De minimis exception-Periodic adjustments are not required if the total profits actually realized by the controlled transferee from the use of the intangible are between 80% and 120% of the profits that were foreseeable when the agreement was entered into. §1. It is often very difficult to determinethe appropriate arm's-length royalty ratebecause information regardingcomparable uncontrolledtransactions is usually not available regarding intangible assets such as patents and trademarks.482-4(f)(2)(ii)(B). In response to these problems.482-4(f)(2)(i). if a new patent leads to a product that turns out to be far more successfulthan was expected at the time the patent waS licensed. 11502. §1.482-4(f)(2)(ii)(D). In order to use this exception. 78 Reg. 79 Reg. A determination in an earlier year that the royalty was arm's length does not preclude the IRS from making an adjustment in a subsequent year.A slightly different set of requirements applies if the arm's-length amount was determinedunder the comparableuncontrolled transaction method.§ 1.

One way for controlled parties to avoid the administrative burden and uncertainties associated with transfer pricing for intangibles is to enter into a cost-sharing arrangement.000 for services. the parent might own the rights to manUfacture and market the new product in the United States.54 . its foreign subsidiary. the adjustments are offset for a net adjustment of $400. The IRS makes a transfer pricing adjustment.482-7. it will also reduce the income of the related party for U.18: USAco sells machinery to FORco. parent corporation and a foreign subsidiary may agree to equally share the costs of developing a new product. If the IRS also determines that USAco should have paid FORco an additional $600. a u. Example 5. increasing the income of USAco on the sale of machinery by $1 million.83 Cost-sharing arrangements.482-4(f)(2)(ii)(A). The IRS will generally permit a taxpayer to offset a negative transfer pricing adjustment with a favorable transfer pricing adjustment provided that the adjustments are for the same two related parties.07 Correlative Adjustments and Setoffs When the IRS increases the taxable income of a related party through a transfer pricing adjustment. its foreign subsidiary. increasing the income of USAco on the sale of machinery by $1 million. The advantage of a cost-sharing arrangement is that the foreign subsidiary's ownership of the foreign rights~o the intangible negates the need to have that subsidiary pay a royalty to its U.07 . the IRS makes the adjustment for USAco's sales of machinery to FORco and a 83Reg.Transfer Pricing 127 (ill) Sameintangibleexception-No periodic adjustments are required if the following requirements are met: (i) the same intangible was transferred to an uncontrolled taxpayer under circumstances similar to those of the controlled transaction. 84Reg. Under such an agreement. For example.17: USAco sells machinery to FORco. the IRS may permit USAco to establish an account receivable so that FORco's payment of cash in the amount of the adjustment will not result in additional income. and (ill) an arm's-length charge is made in the first taxable year of the transfer. § 1. which will reduce FORco's earnings and profits and affect the foreign tax credit computation.S. § 1. Accordingly.If. however. The IRS makes a transfer pricing adjustment. Example 5. parent: A bona fide cost-sharing arrangement must allocate research and development costs in proportion to the profits earned by each controlled party from the intangible.S.s. purposes. (ii) the uncontrolled transaction serves as the basis for the application of the comparable uncontrolled transaction method. The IRS will also decreasethe income of FORco by $1 million.while the subsidiary might own the rights to manufacture and market the new product abroad.000. and each controlled party must bear a portion of the costs incurred at each stage of the development of both successfuland unsuccessfulintangibles. ~ 502.


97 As with Form 5472. 97Code Sec. § 1.6662-6(d)(2)(iii)(A).98(Form 5471is reproduced in the appendix to Chapter 6.482adjustments exceeds the lesser of $5 million or 10% of the taxpayer's gross receipts}O1Both penalties increase to 40% of the related tax underpayment if the transfer price used by the taxpayer is 400% or more (or 25% or less) of the amount determined under Code Sec.99 The transactional penalty applies if the transfer price used by the taxpayer is 200% or more (or 50% or less) of the amount determined under Code Sec. International Audit Guidelines Handbook. by vote or value. including the dollar amounts of transactions it entered into with related parties.000. the penalty is waived only if the taxpayer can demonstrate that it had reasonablecauseand acted in good faith.103 In the case of the net adjustment penalty. 101Code Sec. 6038(b) and (c).6662(a) and (b)(3). 1nformation Return of U. shareholder must provide a wide variety of information regarding the controlled foreign corporation. 6662(e)(1)(B)(i). § 1. the documentation may also persuade the IRS that a transfer pricing adjustment is not 95Reg. 4. §1. § 1. Reg. April 1. In the case of the transactional penalty.6664-4(a). 99Code SeC..6662-6(b)(3) and Reg. person who fails to furnish the required information may be subject to an annual penalty of $10. through contemporaneous documentation provided to the IRS within 30 days of a request. 482 to be the correct amount}OOThe net adjustment penalty applies if the net increase in taxable income for a taxable year as a result of Code Sec. the practical importance of Form 5471 is that the IRS often uses this form as a starting point for conducting a transfer pricing examination. 482 to be the correct amount.6038-2(a) and (b). % Reg. the reasonable cause and good faith requirements can be met only if the taxpayer can demonstrate. In addition to providing protection against the transfer pricing penalty. §1. The only way to avoid the penalty in such casesis to satisfy certain safe-harbor requirements. 98SeeInternal Revenue Manual. 103 Reg. Congress has enacted two special transfer pricing penalties: the transactional penalty and the net adjustment penalty. Persons With Respect to Certain Foreign Corporations. 6662(e)(3)(B)(i).3. Documentation is considered contemporaneous if it is in existence at the time the tax return is filed. 2002.95 In the Form 5471.S. Both penalties equal 20% of the tax underpayment related to a transfer pricing adjustment made by the IRS.6038-2(f). Transfer Pricing - 129 more than 50% or more of the stock.S.96Any U. 102Code Sec. of a foreign corporation must file a Form 5471. 6662(h). 6662(e)(1)(B)(ii) and (e)(3)(A). or if the net adjustment to taxable income exceedsthe lesserof $20 million or 20% of the taxpayer's gross receipts}02 The transactional and net adjustment penalties apply automatically whenever an IRS adjustment exceedsthe numerical thresholds. that it acted reasonably in selecting and applying a transfer pricing method}04 These added requirements for avoiding the net adjustment penalty are designed to force taxpayers to develop and have waiting for the IRS all of the documentation that the IRS ordinarily would need to review in a transfer pricing examination. the U.as well as a reduction in the taxpayer's foreign tax credit.) 1]504 TRANSACTIONAL AND NET ADJUSTMENT PENALTIES In an attempt to promote more voluntary compliance with the arm's-length standard. 104Code Sec. 100Code Sec.61. 11504 .S.


S. In addition. USAco has to interview the appropriate personnel to determine the price USAco charges unrelated parties in comparable cheese sales. § 1.03 Identification of the Best Method The regulations require the taxpayer to apply the "best method" to its intercompany transactions.19: USAco sells cheeseto FORco. and other economic factors that may help to determine arm's-length pricing. The economic analysis may further compare the financial results of the tested party to the financial results of the comparable transactions or companies. the market. . At the same time. subsidiary of ASlAco. and the number. purchases software from its parent that USAco markets and sells in the U. on disclosures required by the Securities and ExchangeCommission. The culmination of the information gathering process is the preparation of a functional analysis. an economist may make adjustments for differences in relevant factors such as the relative levels of inventory.Transfer Pricing 131 internal cost accounting and profit margin analysis for the transactions at issue and the latest four years' financial statements. receivables. its foreign subsidiary. for example. which may be between either two unrelated parties or one of the related parties and an unrelated party. return on sales. focusing on competition. and accuracy of adjustments required to apply the method}09 . an economist may also examine finaJ:lcial ratios such as return on costs. and return on assets. USAco also needs to identify. and wants to apply the CUP method to determine the appropriate transfer price. This requires choosing one of the methods prescribed in the regulations and supporting its applicability. a U. USAco wants to apply the comparable profits method to determine the appropriate transfer price. the taxpayer must explain why the other prescribed methods are not applicable.04 Economic Analysis The taxpayer should retain an economist to analyze the transactional data and obtain information concerning comparable companies from reliable databases. 109 Reg. In addition to assuring functional comparability. The taxpayer will have to identify unrelated party 'transactions.20: USAco. the economist will have to search for potentiaUy comparable companies based. Where appropriate. Example 5. magnitude.482-1(d)(2). the degree of comparability between controlled and uncontrolled transactions or companies to which the methods are applied. USAco must find companies comparable to itself with respectto the type of functions performed and the risks assumed. a Singapore parent corporation.and payables. such as Form lO-K. As a result.S. . The taxpayer must review accurate and reliable data for application of the method. Example 5. to the extent available. the price charged on comparable salesof cheeseby other cheesewholesalers. This functional analysis reviews the functions performed and risks assumed by the respective parties.

may not.e. transfer pricing rules are generally more detailed and stricter than those in other countries. The first step in developing a defense against these penalties is to assessthe amount of risk associated with the taxpayer's current 110Organization for Economic Corporation and 112Division 13 of Part ill. Taxation of IntemationalTransactions ." Tax Notes International. 1995). Revenue Canada Information Circular 87-2. Development. The expense of preparing documentation for two different countries with respect to the same transaction may be fraught with danger. 11504. many of the United States' trading partners have become concerned that multi-nationals were reporting more income from intercompany transactions in the U. comparable uncontrolled price method. and applies a profit split method to support an adjustment to CANco. disregards USAco's comparable profits method analysis. Robert E.S. a Canadian parent corporation.S.1I2Japan. the documentation in these foreign countries is not as rigorous as the U. and cost plus method) as opposed to the profit-based methods (comparable profits method and profit split methods). As a result. 111Culbertson. 115IR-203-32.05 Transfer Pricing in Other Countries The U. only Australia.05 . resale price method.s. the United States. 113STML-Enforcement Order 39-12. STML-CirCular 66-4-1-6&-4-9. transfer pricing strategy is driven.. Income Tax Assessment Act. The methodology employed as well as the documentation requirements may differ in the two countries.S.111 Example 5. and Japan.lIS Nevertheless.132 u. be acceptable to a foreign country's taxing authority. the documentation package does not provide certainty with respect to the different methods preferred in various countries.S. 114Article 7 of the Income Tax Act. announced documentation requirements that will provide penalty protection in multiple countries.. Final Ruling TR 97/05. USAco properly applies the comparable profits method to justify to the IRS the transfer price of $100a barrel. many of these countries have specifically adopted transfer pricing rules and many others have adopted the guidelines issued by the Organization for Economic Corporation and Development}10 A methodology and transfer price that the IRS may accept. For example. March 12. a U.'s requirement. subsidiary of CANco. Although contemporaneous documentation provides protection in most developed countries from a transfer pricing penalty. As a result. Transfer Pricing Guidelinesfor Multinational Enterprises and TaxAdministration. Many foreign countries have a preference for the transaction-based methods (i. to a great extent. increasing the transfer price to $120a barrel. (August 4.in conjunction with the tax administrators of Australia. 2003. Canada. purchases oil from its parent that USAco markets and sells in the U. "A Rose By Any Other Name: Smelling the Flowers at the OECD's (Last) Resort.21: USAco. by the need to develop an effective defense against the transactional and net adjustment penalties. 11505 DEVELOPING A TRANSFER PRICING STRATEGY In the current environment.S. The Canada Customs and Revenue Agency audits CANco. however. Becauseof this concern.1I3 and the Netheriands1I4require that documentation explain why the taxpayer rejected the alternative methods. and less in the other country.

As a consequence. a company with $100 million of cross-border controlled transactions is potentially subject to the 20% penalty if its transfer prices are off by just 5%. For example. The disadvantages include the cost of developing the documentation needed to obtain an APA (including the opinions of independent experts). Another major determinant of risk is the relative profitability of U. is to obtain an advance pricing agreement (or " APA "). 2004-40. that the taxpayer acted reasonably in selecting and applying a transfer pricing method. in particular. 11505 . An alternative strategy for avoiding the transactional and net adjustment penalties. whether prepared internally by the taxpayer's employees or externally through the use of outside consultants. any large corporation with a significant volume of cross-border transactions could conceivably exceed the $5 million net adjustment threshold. a formal transfer pricing study. an appropriate pricing method. is an important factor in establishing defensible transfer pricing positions.if a domesticparent corporation transfers an intangible to a foreign subsidiary and does not provide for any royalty payments. The only sure way to guard against the net adjustment penalty is to demonstrate. and foreign operations. through contemporaneous documentation provided to the IRS within 30 days of a request. the percentage of the taxpayer's worldwide profits that is allocated to low-tax foreign jurisdictions. If the agreed-upon methodology is applied faithfully by the taxpayer. as well as the possibility of reduced record keeping because the taxpayer knows in advance what information the IRS considers to be relevant. reliance on a transfer pricing study done by a professional qualified to conduct such an analysis. In this regard. Although taxpayers may have some concern that they are disclosing 116 For example. . Proc. As a practical matter. Under the APA procedure. as well as the up-front disclosure of information to the IRS.116 In contrast. the transactional penalty is likely to arise only if the taxpayer provides for no transfer price. for large multinational corporations which the IRS routinely audits.Transfer Pricing ~ 133 --- position. however.IRB 2004-29. .II7 Therefore. One major determinant of risk is the aggregate dollar value of controlled transactions between U. then any price adjustment will exceed the 200% threshold. accountant. 118 Rev.S. such as an attorney. as well as an adjustment.6662-6(d)(2)(ii)(D). is a relevant factor in determining whether the taxpayer selected and applied a transfer pricing method in a reasonable manner.S. Disclosure may be only a timing issue. §1.the keys to avoiding the net adjustment penalty are the use of transfer prices which are supported by sufficient documentation and allocating to each affiliate a reasonable profit which reflects the economic realities of the parties' contractual relations. 117 Reg. and foreign affiliates. the IRS will not adjust the taxpayer's transfer prices in any future audits. the advantages of an APA include the certainty of results for the taxpayer. and the expected range of results from applying the agreed-upon method to the transactions. Thus. or economist. the IRS reviews and agrees to the taxpayer's transfer pricing method before the taxpayer implements iVI8 An APA spells out the factual nature of the related party transactions.

These businesses typically have significanttransferpricing exposure.134 U.S.conservative companiesconcerned about penalties.the disclosureof the written APAs and any background documentsis prohibited. subsidiariesof foreign multinational corporations. 6103and 6110.and U.S. ~505 . 119 CodeSecs. Taxation oflntemationalTransactions information about their companyto potential competitors.119 Taxpayersthat have traditionally benefited the most from APAs include large multinational corporations.companieswith bad audit histories.

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