Presentation:
International Income Taxation
Chapter 8: TRANSFER PRICING
Professors Wells
March 30, 2016
Chapter 8 – Transfer Pricing
Code §482
Issues re establishing the “arm’s length” price between related parties in the
following situations:
1)
2)
3)
4)
5)
Loans
Sales of tangible personal property
Leases of tangible personal property
Licensing of intangibles
Providing of services
Purpose of these rules is to place a “controlled taxpayer” on tax parity with
an “uncontrolled taxpayer.”
In this analysis, it is assumed that all the facts are known and both related
parties are knowledgeable in the industry.
2
Why Engage in Aggressive Transfer Pricing?
1)  Tax – to shift (a) income from
the U.S. or (b) deductions into
the United States.
US
Parent
Income Shifting
2)  Customs duties – to reduce
inbound price for imports
and, therefore, the amount of
customs duties.
Worldwide
Taxation
Foreign
Subsidiary
3)  Corporate planning – reduce
amount of income of a
particular subsidiary where
employees or JV partners may
participate in profits.
Deferral
Privilege
Source Country
Taxation
3
Code §482 Essentials – Arm’s Length Pricing
1)  Commonly controlled entities.
3)  To “prevent evasion of taxes or
clearly to reflect the
income . . .”
A tax accounting provision – to
facilitate the determination of the
true taxable income of a taxpayer.
US
Parent
Income Shifting
2)  Apportionment of gross income,
deductions, etc. between parties.
Worldwide
Taxation
Foreign
Subsidiary
Deferral
Privilege
Source Country
Taxation
4
Challenge to the Pricing Adjustment by Taxpayer
Requirement for correlative
allocations and deductions for
related parties (if possible).
Worldwide
Taxation
US
Parent
Income Shifting
An accounting adjustment –
therefore ordinarily more deference
to the Service’s position on the
adjustment. Taxpayer has the
burden of proving that any IRS
adjustment is “arbitrary, capricious
or unreasonable”.
Foreign
Subsidiary
Deferral
Privilege
Source Country
Taxation
5
Defining “Control” for Code §482 Purposes
p. 715
No specific ownership attribution rules.
What about a 50-50 joint venture, particularly where parallelism of interest
exists between the two joint venturers?
Example: a joint purchasing arrangement for raw materials.
X
Y
50%
50%
JV, Inc.
Standard: “Control” means “any kind of control, direct or indirect, whether
legally enforceable, and however exercised.”
1.  Reality rather than formal control is the critical inquiry. A
presumption of control exists if income is artificially shifted.
2.  Control exists if two or more unrelated taxpayers act in concern for a
common goal.
6
Secondary Consequences of Adjustment Under §482
Dividend
Contribution
P
Rev. Rul. 78-83, p. 716
Excessive amount transferred is treated as:
X
1)  Dividend distribution (§301) upstream to
the common parent corporation; this
assumes “earnings and profits” and
Excess Value
Variations on Rev. Rul. 78-83
P
X
Y
P
Contribution
Dividend
2)  Capital contribution downstream to the
other entity (including foreign). §351.
Y
I.L.M. 201349015 (Sept. 16, 2013) (can you guess the FTC issue???)
Dividend
Triangular dividend treatment.
X
Y
7
Impact of Foreign Law Restrictions
p. 718
Proctor & Gamble: (1) P&G – U.S. owned (2) AG – Swiss which
owned (3) Espana. Increase the royalty from Espana to AG? Spanish
law applied a limitation on the permitted royalties. (Note: This
limitation is not permitted under current EU law.) Held: For taxpayer
& no income allocation to AG (which would have been Subpart F
income).
IRS Position:
P&G
(US)
Subpart F inclusion
(FPHCI- royalty)
P&G A.G.
Royalty
(Swiss)
P&G Espana
(Spain)
8
Regs. Concerning Foreign Law Restrictions
p.719
1)  Must be publicly promulgated and generally applied.
2)  Taxpayer must exhaust all available local country remedies in seeking a
waiver of these rules.
3)  The restrictions must prevent receipt.
4)  Related parties must not have engaged in arrangements to circumvent the
restrictions.
5)  Taxpayers must elect to apply this regulation and identify affected
transactions on its tax return.
Reg. §1.482-1(h)(2).
9
Mechanisms to Reduce Double Economic Taxation p. 720
1)  Correlative adjustments – if all entities are subject to U.S. income
taxation.
2)  Competent Authority mechanism to challenge the adjustment
where cross-border situations.
See 2006 U.S. Model Income Tax Treaty, Article 25.
Example: What is the transfer pricing adjustment and correlative adjustments?
P
X
$100x (overpriced by $5x)
$100x Sales Price
$ 60x COGS
$ 40x Reported profit
Y
$100x
Customer
$100x Sales Price
$100x Purchase Price
$
0x Reported profit
10
Concepts of Arm’s Length Pricing Under Code §482
p. 722
“Best method” rule. Reg. §1.482-1(c)(1).
Since a range of economic results can occur parties must examine
these factors to determine the comparability of uncontrolled
transactions to that of the “controlled transaction” that is being tested:
1.
2.
3.
4.
5.
Functions.
Contractual terms between the parties.
Economic risks.
Economic conditions.
The nature of the property or services.
See Treas. Reg. §1.482-1(d).
11
Interest on Debt Between Related Parties
p. 724
Use a safe haven rate based on the “applicable federal rate” – if not in
the “business” of making loans.
Range of not less than 100% of the AFR nor more than 130% of the
AFR.
See Treas. Reg. §1.482-2(a)(2) (revised 2009).
12
Rental of Tangible Property
p. 724
Establish an arm’s length rental amount based on:
1)  The period and the location of use.
2)  The owner’s investment in the property.
3)  Expenses of maintaining the property.
4)  The type of property involved.
Reg. §1.482-2(c).
13
Providing Services to a Related Party
p. 724
Code §482 – determine that amount which would be charged for
similar services in independent transactions between unrelated parties
under similar circumstances.
Treas. Reg. §1.482-2(b) & Treas. Reg. §1.482-9.
14
U.S. Steel Corp. Case
Services Situation
p. 725
Delaware mining company (activities
in Venezuela) & Liberian shipping
company (Navios).
US Steel
(US)
One planning objective was to limit
Venezuelan taxes.
CASH
(Liberia)
nez
CASH
(US)
Navios
(Ve
)
Question: Which entity is entitled to
the location savings?
Orinco
FOB
Objective to cause transportation
costs to be increased to equalize costs
for domestic and foreign ore when
sold in the United States. §482
allocation partially approved.
Unrelated Customer
15
UPS Case
Customer
p. 732
UPS
(US)
OPL
(Bermuda)
Reinsurance
Excess Value Charges
National Union
(Fronting Entity)
Income from “excess value charge” deflected from U.S. to Bermuda (with
intermediary National Union (independent) & reinsurance with OPL. Court
of Appeals held arrangement not a sham transaction and remanded. But,
subsequently, a §482 analysis.
Section 482 issue: which is the tested party: UPS or OPL?
16
“Specified Methods” For Services Set forth in
Treas. Reg. §1.482-9
1.  Services cost method, no mark-up (new).
2.  Comparable uncontrolled services price method.
3.  Gross services margin method.
4.  Cost of service plus method.
5.  Comparable profits method.
6.  Profit split method.
7.  Unspecified methods.
p. 733
Note: These are
“One-Sided TP
Methodologies”
where the “tested
party” gets a
routine profit
determined under
the specified
method but
importantly the
“residual profits”
goes to the
untested party.
Note: This is a “TwoSided TP Methodology”
where both parties are
tested and “residual
profits” gets shared
between the parties.
17
Supervisory / Stewardship Expense
p. 734
Cf., the cost for management services provided for the benefit of the related/
parent corporation.
Young & Rubicam case – p. 734
No §482 allocation required, since for the benefit of the parent corporation.
Compare Treas. Reg. §1.482-9(l)(3) with Treas. Reg. §1.861-8(e)(4)
18
Rev. Rul. 87-71
Compare in Same Market
Foreign sub sells product to (i)
Parent corporation and (ii)
unrelated purchasers.
p. 736
P
(US)
A Market Customer
Price?
1)  Sub can sell product to
unrelated purchasers at a
higher price because of market
conditions in one jurisdiction
as contrasted with another
jurisdiction.
S
X+Y B Market Customer
A Market Customer
2)  Higher price to parent
corporation than to unrelated
purchasers in the same
jurisdiction - not an arm’s
length price.
19
Bausch & Lomb Irish Mfg. Sub.
p. 738
Irish sub was organized to manufacture
and sell contact lenses.
B&L
Product sold to Parent for $7.50 but the
manufacturing cost was only $1.50.
Sub also paid royalty to Parent of 5
percent to use the spin cast
manufacturing process developed by
the parent.
Held: OK to use Irish subsidiary and
$7.50 was an acceptable market price.
But, the court then looked at royalty
rates and engaged in a profit split
approach.
(US)
B&L
$7.50
(Various)
B&L
(Ireland)
$1.50 cost
CUPS
•
•
•
•
Lombart
American Hydron
American Optical
Hydrocurve
20
Current Pricing Rules for Tangible Personal Property
p. 746
“Best method” rule (Reg. §1.482-1(c) and -8)
Reg. §1.482-3 choices:
1)  Comparable uncontrolled price method;
2)  Resale price method;
3)  Cost plus method;
4)  Comparable profits method (or CPM); based on
profit level indicators;
5)  Profit split method.
Note: These are
“One-Sided TP
Methodologies
where the “tested
party” gets a
routine profit
determined under
the specified
method but
importantly the
“residual profits”
goes to the
untested party.
Note: This is a “Two-Sided TP
Methodology where both parties are
tested and “residual profits” gets
shared between the parties.
21
One-Sided Transfer Pricing Methodologies:
Compaq Computer
(p.749)
Before
R
e
s
i
d
u
a
l
TP: Cost + 5%
Tested
Party
After
TP: Cost + 5%
Compaq
Parent
Compaql
Parent
Inter-Company
Computer
Sales
Compaq (Asia) PTE.
LTD. (Singapore)
TP: Residual
1 + 1 ≠ 10
8
22
Speakerhouse Problem
p. 749
Basic tax planning issue: What is the best pricing method when taxpayer
wants the lowest possible price that can withstand examination by the IRS?
1)  Comparable uncontrolled price ($150 if US Distributor sales are comparable)
2)  Resale price method ($150 gives Swisterco a 25% GPM- the same GPM as on its
3)
4)
5)
RT3000 sales)
Cost Plus ($150 sales price less $120 cost gives 25% GPM to Speakerhouse- the same
GPM as it earns on its S24 sales to US distributors)
Comparable profits (we don’t have profitability information for Soundsgood)
Profit split (50:50 profit split gives $155 price, but split is unclear)
Speakerhouse
S24 @ $150
US
Distributors
S24 @ $200
European
Distributors
(US)
S24 @ $200
US
Customers
Price?
Swisterco
(Switzerland)
•  RT3000 Net Profit $75
•  $10 Extra Cost for Packaging S24 & Advertising S24
23
Problem 2
Comparability?
p. 750
USM sells gismos: (1) delivered to foreign subs and (2) FOB factory to
unrelated parties. Same price.
Applicability of comparable sales method?
Do transportation and insurance costs have a reasonably ascertainable impact
on price so as to enable appropriate adjustments?
USM
(US)
FOB US
Unrelated Foreign Distributors
Related Foreign Distributors
24
Problem 3
Impact of Trademark?
p. 750
USM sells gismos: Trademark on gismos sold to subsidiaries but not
when sold to unrelated distributors.
Is the effect on price of the trademark probably material and,
therefore, not reasonably estimated?
Therefore, the CUP method is probably not reliable here.
USM
(US)
FOB US
Unrelated Foreign Distributors
Related Foreign Distributors
25
Problem 4
Different Area Markets
p. 750
USM sells gismos: Subsidiaries sold to European customers but
unrelated distributors sold in Asia.
If geographic differences have definitive and reasonably ascertainable
effects for which adjustments can be made the CUP method may be
acceptable.
USM
(US)
FOB US
Unrelated Asian Distributors
Related European Distributors
26
Problem 5
Foreign Sales Sub
Compco (US) sells items - $70
each to Singapore sub to
distribute item in Asia. $2
shipment cost (and net $68 to
U.S. corp.).
Sales to unrelated distributors for
distribution elsewhere with terms
of sale at $80 FOB factory.
p. 750
Compco
(US)
$80 FOB US
US
Distributors
Net $68?
Pacifico
(Singapore)
Is the effect to transfer income to
the foreign subsidiary – and
therefore an adjustment should be
made?
27
Problem 6
Foreign Sub Pays Too Much?
p. 750
U.S. corp. sells items for $70 each
to Singapore sub to distribute item
Compco
(US)
in Asia. $2 shipment cost (and
Net $68?
net $68).
Sales to unrelated distributors for
distribution elsewhere with terms
of sale at $60 FOB factory.
$60 FOB US
US
Distributors
Pacifico
(Singapore)
Taxpayers cannot invoke §482 to
make an adjustment. File an
amended income tax return based
on different prices?
28
Problem 7
Foreign Sub Adds Its Own Trademark to Products
Comco affixes its valuable
Compco
trademark on the products sold to
(US)
Pacifico but none of its US
distributor sales have a trademark. Price?
Issue: What is the result now?
$80 FOB US
p. 683
US
Distributors
Pacifico
(Singapore)
29
Intangible Property Transfers
p. 751
Definition: Patents, copyrights, trademarks, confidential know-how,
trade secrets.
Transfer accomplished either by sale or licensing. Licensing can be
either co-extensive with the life of the property or for a shorter period.
30
Intangible Property Transfers – Regulations
p. 754
Best method rule for applicable methods:
Comparable uncontrolled method (CUT)
Comparable profits method
Profit split method (comparable profit split and residual profit split)
Unspecified methods.
Further consider the “super-royalty” provision in Code §482 –
requiring periodic adjustments using the “commensurate with income
test.” P. 755
31
Cost Sharing Arrangements
p. 755
Reg. §1.482-7T
Foreign-Owned MNE
Nestlé
Agreement to share
TP: Residual
costs and risks of
research and
development.
Tested
Party
Foreign-Owned
Parent
No royalties paid since each
participant in the cost-sharing
arrangement is an “owner.”
No Code §482 adjustments if
the arrangement is a “qualified
cost sharing arrangement.”
US-Owned MNE
Apple
TP: Cost + 5%
Products
US Domestic
Subsidiary
Parent
(US)
Customers
TP: Cost + 5%
Owner/Developer
(Ireland)
TP: Residual
32
Administration of Transfer Pricing Issues
p. 757
1)  Report and Contemporaneous Documentation Requirements - §§6038A
& 6038C.
2)  Penalty Provisions - §6662(e). Accuracy Related Penalty of 20% is
increased to 40% if price adjustment exceeds $20 million or 20% of the
taxpayer’s gross income. A “reasonable cause exception” only exists if
there were reasonable cause for the position plus documentation was
developed establishing that the taxpayer reasonably used one of the
methods as of the date that the tax return was filed. §6662(e)(3)(B).
33
APAs
Rev. Proc 2006-9 (2004-40)
p. 760
Factual items:
1)  Measurements of the profitability and the return on the
investment;
2)  Functional analysis of the economic contributions of each party;
3)  Industry pricing studies;
4)  Competitors and financial data;
5)  Criteria concerning comparables.
Further: Identify “critical assumptions”?
34
Alternatives for Apportionment
p. 761
1)  Formulary approach
State taxation – apportion on the basis of three factors: (i) labor
costs, (ii) asset values, and (iii) sales receipts.
2) Production sharing arrangements in the natural resource context.
Each party is entitled to a quantity of the product produced.
35
Transfer Pricing Approach for Global Trading
Notice 94-40
p. 762
p. 693
Global trading of commodities and derivative financial products.
Functionally fully integrated operations – concerning centralized
management of risk and personnel. Use profit split method to allocate
income of related operations between taxing jurisdictions.
36
Arbitration of Intercompany Pricing Disputes
p. 767
1)  In the U.S. – between the IRS and the taxpayer. Using “baseball
arbitration”? Tax Court Rule 124.
2)  Between the taxing authorities of several countries – e.g.
Germany, Netherlands, Canada & Belgium treaties, and other
newer treaties.
37