Ch. 8 - Transfer Pricing
Code §482
Issues re establishing appropriate prices between
related parties in the following transactions
between those parties:
1) Loans of money
2) Sales of tangible personal property
3) Leases of tangible personal property
4) Licensing of intangibles
5) Providing of services
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Why Engage in Aggressive
Transfer Pricing?
1) Federal Income Tax - to shift (a) income from
the U.S., or (b) deductions into the United States.
2) Customs duties - to reduce the inbound price
for imports and, therefore, the amount of customs
duties payable upon import is reduced.
3) Corporate planning - reduce the amount of
income of a particular subsidiary where
employees may participate in profit sharing.
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Code §482 Essentials Arm’s Length Pricing
1. Commonly controlled entities (or parallel
interests).
2. Apportionment of gross income, deductions,
etc. between parties.
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.
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Challenge to the Pricing
Adjustment by Taxpayer
An accounting adjustment - therefore ordinarily
more deference to the Service's position on the
adjustment.
Query: Is the adjustment by IRS reasonable?
Taxpayer can succeed if the adjustment is found
to be "arbitrary, capricious or unreasonable".
Further: A requirement for correlative
allocations and deductions for the related parties
(if possible); cf., tax treaty & foreign country.
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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, each venturer obtaining product.
X____________Y
50%
JV, Inc.
50%
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Secondary Consequences
of Adjustments under §482
Rev. Rul. 78-83, p. 716.
Triangular dividend treatment.
Excessive amount transferred is treated as:
1) Dividend distribution (§301) upstream to the
common parent corporation; this assumes
the payor has “earnings and profits;” &
2) Capital contribution downstream by parent
corporation to the other entity (including a
foreign entity). §351.
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Impact of Foreign Law
Restrictions
p.718
Proctor & Gamble: (1) P&G-US owned (2) AGSwiss which owned (3) Espana. Increase the
royalty to be paid 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
was required (the allocation would have produced
Subpart F income to P&G).
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Regs. Concerning Foreign
Law Restrictions
p.719
1) Must be publicly promulgated and generally
applied.
2) Taxpayer must exhaust local country remedies
in seeking a waiver of these rules.
3) The restrictions must prevent income receipt.
4) The related parties must not have
circumvented these restrictions.
Reg. §1.482-1(h)(2).
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Mechanisms to reduce double
economic taxation
1) Correlative adjustments to be made - if all
entities are subject to U.S. income taxation.
2) Competent Authority mechanism for use to
challenge these adjustments where cross-border
situations.
See 2006 U.S. Model Income Tax Treaty, Article
25 (p. 720, concerning “Mutual Agreement
Procedure”).
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Concepts of Arm’s Length
Pricing under Code §482
"Best method" rule. Reg. §1.482-1(c)(1). Since a
range of economic results can occur the parties
must examine these important factors (p.722):
1. Functions.
2. Contractual terms between the parties.
3. Economic risks.
4. Economic conditions.
5. The nature of the property or services.
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Arm’s Length Pricing &
Special Circumstances
Factors which may impact on having different
pricing strategies in different situations:
1) Market share strategy.
2) Differences in geographic markets.
3) Location savings.
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Interest on Debt Between
Related Parties
p.723
Use a “safe haven” rate based on the "applicable
federal rate“ - if U.S. taxpayer is not in the
“business” of making loans.
Range of not less than 100% of the AFR nor
more than 130% of the applicqble AFR.
Reg. §1.482-2(a)(2) (revised 2009).
What about short term debt for receivables?
What treatment of foreign currency loans?
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Rental of Tangible
Property
p.724
Establish an arm's length rental amount based
on:
1) The period and the location of the 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).
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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.
Reg. §1.482-2(b) & Reg. §1.482-9 (2009) which
identify various potential methods to apply.
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U.S. Steel Corp. T.C. case
p.725
Services situation
Delaware mining company (activities in
Venezuela) & Liberian shipping co. (Navios).
Excessive charge for the shipping services?
One planning objective was to limit Venezuelan
taxes.
An objective was to cause transportation costs to
be increased to equalize costs for domestic and
foreign ore when sold in the United States. §482
allocation was partially approved.
Reversed on appeal (for taxpayer). P.731.
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UPS case note
p.732
UPS with OPL “subsidiary”? in Bermuda.
Received income from “excess value charges”
deflected from U.S. to Bermuda (with
intermediary National Union (independent) &
reinsurance with OPL. Tax Court says “sham.”
Court of Appeals held arrangement not a sham
transaction and remanded.
But, subsequently, a §482 analysis. But, did
“control” of OPL exist for §482 purposes?
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Regs. §1.482-9 (2009)
Re: Services
P.733
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
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Safe Haven for Costs of
Performing Services p.733
IRS will not adjust a charge that is equal to the
costs of performing services.
See Reg. § 1.482-9(b) (2009).
Both direct and indirect costs are to be included.
Former Reg. § 1.482-2(b)(4)(iii).
See Rev. Proc. 2007-13 – re no-mark-up
transactions – use of a “services cost method.”
See exclusions from eligibility for this approach,
p. 734, e.g., manufacturing & production.
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Supervisory 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, i.e., “stewardship
expenses.” These expenses are incurred in
protecting the interests of the
shareholders/owners.
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Sales of Tangible Personal
Property
p.735
Historic (prior) methods for arm’s length
standards for sale of tangible property:
1) Comparable uncontrolled price method (CUP)
2) Resale price method
3) Cost plus method
4) Other “appropriate” method
But, remember currently the “best method”
requirement.
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Rev. Rul. 87-71
p.736
Compare in the Same Market
Foreign sub sells product to both (i) Parent
corporation and (ii) unrelated purchasers.
1) Sub can sell product to unrelated purchasers at
a higher price because of market conditions
(Market B) in one jurisdiction as contrasted with
another jurisdiction.
2) Higher price to parent corporation than to
unrelated purchasers in the same jurisdiction
(Market A) - not an arm’s length price.
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Bausch & Lomb
Irish Mfg. Sub.
p.738
Irish sub was organized to manufacture and sell
contact lenses (i.e., as contract manufacturer?).
Product sold to Parent (or affiliates) for $7.50
but the manufacturing cost was only $1.50.
Sub also paid royalty to Parent of 5 percent of
sales to use “spin cast” manufacturing process.
IRS says use “cost plus”?
Held: OK to use the Irish subsidiary and $7.50
was an acceptable market price (using CUP).
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Current Pricing Rules for
Tangible Personal Property
“Best method” rule (Reg. §1.482-8 (2009)).
Reg. §1.482-3 choices (p. 746):
1) Comparable uncontrolled price method (CUP);
2) Resale price method (for a reseller operation);
3) Cost plus method (production cost &mark-up);
4) Comparable profits method (or CPM); based
on “profit level indicators” – see financial data;
5) Profit split method (profit divided based on
relative values of contributions by parties).
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Speakerhouse problem
p.749
Basic tax planning issue: Best pricing method
when taxpayer wants lowest possible price that
can withstand examination by the IRS?
1) Comparable uncontrolled price? Are the
systems the same? Are foreign & U.S. markets
the same? Same % mark-up? U.S. sale @ $150;
foreign sale @ $200; Sany sale @$300.
2) Resale price method? Limited contribution by
the seller? Same percentage of mark-ups for all
the products sold?
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Speakerhouse problem
p.749, cont.
3) Cost-plus method – for manufacturers. I.e.,
cost of production, plus a gross profit mark-up.
Relevant to U.S. production but not Eur. sales?
4) Comparable profits? If resources used and
risks assumed are similar. No data here?
5) Profit split? What contributions by each? See
50-50 split between competitors (Soundsgood &
RadioGeneva). But, is Soundsgood discounting to
get into the market?
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Problem 2
Comparability?
p.750
USM sells gizmos: (1) Delivered price to foreign
subs and (2) FOB factory to unrelated parties.
Same price.
Applicability of comparable sales method?
Query: Do transportation and insurance costs
have a reasonably ascertainable impact on price
so as to enable appropriate adjustments between
the two transactions?
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Problem 3
Impact of Trademark?
p.750
USM sells gizmos: Trademark on the gizmos sold
to USM subsidiaries, but not when sold to
unrelated distributors.
Is the effect on price of the trademark probably
material and, therefore, not reasonably
estimated? Yes.
Therefore the CUP method is probably not
reliable here.
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Problem 4
p.750
Different Area Markets
USM sells gizmos: Subsidiaries sold gizmos to
European customers but unrelated distributors
sold gizmos in Asia.
If geographic differences have definitive and
reasonably ascertainable effects for which
adjustments can be made the CUP method may
be acceptable.
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Problem 5
Foreign Sales Sub
p.750
US Corp sells items – $70 each to Singapore sub
to distribute item in Asia. $2 shipment cost (&
net $68 to U.S. Corp).
Sales to unrelated distributors for distribution
elsewhere with terms of sale at $80 FOB factory.
Is the effect of arrangements to transfer ($12 per
unit) income to the foreign subsidiary – and,
therefore, an adjustment should be made?
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Problem 6
p. 750
Foreign Sub Pays Too Much?
US Corp sells items for $70 each to Singapore sub
to distribute item in Asia. $2 shipment cost (&
net $68). Sales to unrelated distributors for
distribution elsewhere with terms of sale at $60
FOB factory.
Taxpayers cannot invoke §482 to make an
adjustment. File an amended income tax return
based on different prices?
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Intangible Property
Transfers
p.751
Definition: Patents, copyrights, trademarks,
confidential know-how, trade secrets.
Transfer is accomplished either by (1) sale or (2)
licensing.
Licensing can be either (1) co-extensive with the
life of the property or (2) for a shorter period.
Obama 2016 Greenbook proposal (p.24):
Intangible property also to include “workforce in
place, goodwill and going concern value.”
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Intangible Property
Transfers – Regs
P.754
Best method rule for applicable methods:
CPM
Profit split
Comparable uncontrolled method (CUT)
Unspecified methods.
Further consider the “super-royalty” provision in
Code §482 – requiring periodic adjustments to
the pricing arrangements. P.755.
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Cost Sharing
Arrangements
p.755
Reg. §1.482-7 (2013) (§1.482-7T in casebook).
Agreement to share costs and risks of research
and development.
No royalties paid since each participant in the
cost-sharing arrangement is an owner of the
intangible as it is developed.
No Code §482 adjustments to be made if the
arrangement is a "qualified cost sharing
arrangement." How to price the “buy-in” to the
research by the foreign subsidiary?
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Administration of Transfer
Pricing Issues
p.757
1) Reporting and Documentation Requirements §§6038A & 6038C.
2) Penalty Provisions - §6662(e). P.759
Accuracy related penalty can be imposed.
Exception applicable if documentation was
developed establishing that the taxpayer
reasonably used one of the methods.
§6662(e)(3)(B).
Possible doubling of the penalty. §6662(h).
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APAs
Rev Proc. 2006-9
p.760
Factual items to be provided:
1) Measurements of the profitability and the
return on 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 the “critical assumptions”?
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APAs, continued
Rev Proc. 2006-9
P.760
Use APA on a bilateral/trilateral basis.
Use APA to solve issues for prior years?
Annual report to be provided as to performance
under the APA.
See APA Annual Report for the format for an
Advance Pricing Agreement and assumed pricing
methodology.
IRS APA Report for 2014, in IRS Announcement
2015-11, March 30, 2015.
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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.
3) Arbitrary formula – percentage of the local
expenses (as documented).
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Transfer Pricing Approach for
Global Trading
Notice 94-40 p.762
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.
See allocation factors (p.764) to determine
contribution: value, risk & activity.
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Arbitration of Intercompany
Pricing Disputes
p.768
1) In the U.S. - between the IRS and the
taxpayer. Using “baseball arbitration”
(defined?). U.S. Tax Court Rule 124.
2) Between U.S. IRS and taxing authorities of
other countries - e.g., Germany, Netherlands,
Canada & Belgium income tax treaties, and other
more recent U.S. income tax treaties.
But, is this giving up U.S. sovereignty to an
international body (like the United Nations!)?
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