Transfer Pricing in the United States 
A Primer

© 2007 Peter J. Loughlin, Esq., J.D., LL.M. 

Part I

History and Discussion of General Concepts

The collection of income tax from individuals and corporations commenced on October 1913 following the passing of the 16^th Amendment to the Constitution.[1] U.S. tax policy, while initially focusing within its borders quickly began to shift gears to consideration of foreign credit, and eventually capture economic activity on an international scale with the enactment of the Revenue Act of 1918.[2]   The following decade brought about an international spirit of cooperation following World War I and, at the urging of President Woodrow Wilson, culminated in the organizing of the League of Nations.  Ironically the United States did not join the moribund organization, however, the League has left the world a legacy that established the basis of modern international taxation, namely, the first model income tax treaty – which serves as the basis of all modern tax treaties today.[3]   The United States, then, has been an innovator, developer and originator of international tax policy from time immemorial, at least in terms of modern principles.  Not surprisingly, then, the world’s first intercompany pricing regulations under IRC § 482 was passed in the U.S. in 1934[4] and set forth what has become known as the arms length standard. 

 In 1961 the process of revamping § 482 began as prompted by presidential recommendation and culminated in substantial changes to the legislation but preserving the core focus of the arms length standard.  The U.S. model has been well received throughout the word and has formed the basis of the O.E.C.D Model Income Tax Convention in 1969 and the O.E.C.D. Guidelines on transfer pricing promulgated in 1995.  Thus the regulation and control of intercomany pricing may be, to some degree, traced back to the United States in the early 20^th Century.  However, intercompany pricing, or transfer pricing has been practiced by companies and taxpayers as a form of profit shifting at least the past several centuries.[5]  

In order to proceed to our examination of U.S. policy under IRC § 482, we must first review some core concepts essential to our understanding.

What is the transfer price?

The transfer price, as its terms would imply is, at its heart, the selling price at which goods, services, or intangibles are exchanged between related parties.  This definition itself raises two sub questions:

·        What is a related party?  Under § 482 related parties, the law looks to de facto control of the parties rather than mere legal control[6] thus any control, even control by one entity over another that lacks legal enforceability, will satisfy the section’s definition of a related party.[7]   This concept also finds support in case law under the Tax Court decision in DHL Corporation v. Commissioner.[8]

·        What restrictions, if any, are placed on the intercompany pricing?  Companies are free to establish any intercompany pricing scheme they wish, and for any purpose, for example, profit shifting. Notwithstanding, § 482 authorizes the Internal Revenue Service to reallocate the “shifted” gross income, deductions, credits, etc., between the related parties to avoid tax evasion or reflect the true effect as determined by application of the arms length standard.[9]

What is meant by the “arms length standard”? 

This is succinctly answered by looking to the O.E.C.D Guidelines, which you will recall having its genesis in § 482:

            “[When] conditions are made or imposed between . . . two [associated] enterprises in their commercial or financial relations which differ from those that would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.”[10]

How do related parties, and the IRS, determine the arms length price?

The arms length price is determined by comparing the transaction(s) of the controlled or related entities with the transaction(s) of the transaction(s) of uncontrolled entities.  Note that the comparable transaction need not be identical, in fact, identical comparables are frequently unavailable.  However there must be sufficient similar factors from which a reasonable comparison may be made. 

Factors to be considered in determining the sufficiency of comparability between controlled and uncontrolled parties’ transactions are, the functions, risks, contract terms, economic conditions and the nature of the property and services.[11]

Functional Analysis

One way to assure comparability is for the controlled enterprise to undertake a functional analysis with respect to the controlled enterprise(s) and the relevant transaction(s).  In brief, functional analysis is the process of decomposing the transactional price in order to come close to finding the arms length price.  Functional analysis is critical to the arms length principle, in fact the “US Internal Revenue states that the importance of functional analysis cannot be over emphasized and that virtually all IRC Sec. 482 cases can be reduced to the following questions:

a)                 What was done?

b)                 What economically significant functions were involved in doing it?

c)                  Who performed each function?

d)                 What is the measure of economic value of each function performed by each party?

e)                 What economic risks were assumed?

f)                    Are there any valuable intangibles used in performing the given function?

Once the functions performed by [the] entity have been identified, you can use the information to lay the groundwork for selecting comparables”.[12]   Thus the comparable parties should, by-and-large, perform the same functions, for example, research and development, warranty, marketing, or risk, etc.

Again, although the transactions must be comparable, the do not have to be identical.  Where the transactions differ § 482 provides for a variety of adjustments to be made.[13]

Adjustments

There is a general recognition that distortions to the comparable models may exist which need to be considered and to allow for certain adjustments to be made whereby the transactions may be brought back into a comparable perspective.  Typically comparables may differ in their market strategy, for example, one may contemplate a reduced product cost in order to penetrate a new market or one may have undertaken greater risk such as variations in monetary exchange rates, or perhaps advertising or even contractual terms.  Since the ultimate goal is to arrive at the arms length price adjustments are warranted to reflect the comparable functions of the controlled and uncontrolled transactions being tested.  This is more of an art than a science and the code provides scant assistance beyond examples of some adjustments that would be relevant to arriving at the arms length price.  Notwithstanding, § 482 recognizes and provides for adjustments where transactions are reasonably comparable but resist determining the arms length price without some tweaking. (See US Steel Corp. v. Commissioner).[14]  

Intent of the Related Parties

As stated above, § 482 authorizes the Internal Revenue Service to reallocate the “shifted” gross income, deductions, credits, etc., between the related parties to avoid tax evasion or reflect the true effect as determined by application of the arms length standard.[15]  

However, the IRS may only make such allocations where the related parties transfer price is not reflective of the arms length price and allocations may not be arbitrary even if there is tax evasion.[16]   This means that managers of such entities may shift profits for administrative, management or even tax planning purposes as they see fit.[17]   For example, companies may conduct their affairs in the manner that will attract the least amount of tax or they may even wish to address the needs of shareholders by shifting profits to a jurisdiction more favorable to distribution of dividends. However, the profits, deductions, etc., involved in the transactions may be reallocated by the IRS if it is determined that they do not reflect the arms length price.[18]

Therefore, the actual intent of the related entities, good or bad, is largely irrelevant where the end result of their transactions fall outside § 482.  Notwithstanding, it is recognized that the purpose behind the transaction(s) may be helpful to the IRS in understanding the transaction.  Therefore, on a practical level, the IRS’s view of the pricing arrangement may be shaped by the perceived purpose behind it.  Further, identifying a bona fide business purpose behind the transaction will be an important factor in an examination or court decision.[19]

Concerns of the Revenue Authorities

The tax authorities in the United States share common goals with their counterparts in governments throughout the world.  One obvious goal is the collection of taxes on income properly allocated to it, however, tax authorities have a much more positive objective as well, that is to promote international trade and to adopt a policy consistent with the concepts of tax neutrality such as avoiding double taxation ad the reduction of barriers to free trade.[20]

Such noble aspirations aside, The IRS has some very real concerns about eroding tax revenues due to multinationals shifting profits to low or no tax offshore financial centers by manipulating transaction thus moving taxable assets beyond its jurisdictional reach.  While such profit shifting goes on at the domestic level, that is among the state taxing authorities, it is normally of little concern of the IRS unless the taxpayers are taxed at differing marginal rates.[21]  

Where multinationals shift profits offshore, the IRS is concerned that these related entities would be motivated to milk profits, engage in fictitious or dubious intercompany sales and related business deductions.  Even where non-suspect transactions between domestic companies and their offshore partners are made, the loss in tax revenue may prove to be devastating.  For example, the Treasury Department statistics noted a remarkable rise in the dollar volume of international trade since the 1960’s due to the expansion in international marketing of goods and services and global sourcing of commodities.[22]   § 482 has proven to be an effective remedy to such potential erosion, so effective that it has been exported, nearly unaltered to countries and tax authorities throughout the world.[23]

Part II

Methodology

In 1994 the Treasury Department issued revised regulations suggesting the logic of using certain specified transfer pricing methodologies to be applied to test for the arms length price of tangible goods.[24]   These methods, some of which are known as the traditional transactional methods, are the comparable uncontrolled price method (CUP), the resale price method (RPM), and the cost plus method (CPM).  The regulations do not require that any specific method to used by the related taxpayer.  Where circumstances are such that more than one method may be applicable, the regulations provide that the taxpayer consider the level of comparability, the quality and accuracy of the comparable data and assumptions. In the end, the method resulting in the most reliable arms length price is to be used.[25] This is known as the “best method rule.

For example, were the circumstances are such that the controlled transaction involve a related manufacturer who sells to a related distributor who resells the product without making any significant changes to the product, the resale price method may be a more appropriate testing method.  Alternatively, were the distributor makes significant additions, (e.g., intangibles) to the product, the cost plus method may be more accurate. Again, no particular method is mandated in any given set of facts save that the method resulting in the most accurate determination of the arms length price is to be used, that is, the best method rule.

How Selection of the Methods Work?

In using the traditional transactional methods the arms length price is determined by comparing the price, gross profit margins or the gross mark up in a controlled transaction with the uncontrolled transaction dependent upon the particular circumstances surrounding the transactions.  For example, where the related parties are a manufacturer and a distributor who resells the manufactured products without adding or effecting any significant changes the related taxpayer may consider using the resale price method.  Alternatively, following this scenario, where the related distributor adds to or effects significant changes to the product, the cost plus method may be more appropriate. Notwithstanding, the “best method rule” will ultimately determine the method to be used by the related taxpayer.

Further, § 482, and case law, recognize that the arms length price is elusive and not an exact science and, as such, the IRS will normally find a particular arms length price derived from one of the testing methods to be acceptable if the testing results falls within a range of arms length prices. 

The Comparable Uncontrolled Price (CUP)

“The CUP method is the purest expression of the arms’-length standard . . .”[26] Although there is technically no hierarchy of methods, CUP is normally favored in situations where comparable uncontrolled methods may be found, however, other methods may be employed where the results are more accurate.

One feature of the CUP method is that it focuses directly on the price of the controlled transaction as compared to the price of the uncontrolled transaction In essence, the CUP method combines the resale price and cost plus methods thus focusing on a single price.[27]   Further, the CUP is price rather than function driven unlike the two other traditional transactional methods which, perforce, focus on the functions being performed by the parties of the transaction(s).[28]

Note that as discussed in Part I, transactions are reasonably comparable where the products and circumstances are substantially similar and the differences having effect on the price are either immaterial or can be eliminated through the use of adjustments to the uncontrolled price.[29]

The Resale Price Method (RPM)

The focus of the resale price method is on the gross margin obtained by the distributor. The gross margin is the selling price of the goods less the cost of operating costs and functions performed.  The arms length margin is obtained by comparing the controlled margin with an independent distributor performing substantially similar functions as the related distributor.[30]   Differences having effect on the gross margin are not disqualifying where they are immaterial or can be eliminated through the use of adjustments.

The resale price method may not be used arbitrarily and the related taxpayer must be prepared to make a reasonable argument to the IRS/court concerning a comparability nexus.[31]   Further, RPM, subject to the best method rule, is generally considered to be most applicable where a manufacturer sells to a related distributor who resells to an uncontrolled market and adds little additional value to the product,[32] particularly in terms of intangibles.[33]   Additionally, there are a number of relevant factors which aid in determining comparability for the resale price method. They are:

·        Type of property sold.

·        Functions performed by the distributor. (e.g., Adverts, packaging, minor assembly, service, etc.

·        Effect on price of any intangible property used by the seller.

·        Geographic market.[34]

Note that physical similarity of the products is not relevant as it does not generally reflect the mark-up.[35]

The Cost Plus Method (CPM)

The cost plus method is, subject to the best method rule, most applicable where a manufacturer sells to a related distributor who resells to an uncontrolled market and adds substantial additional value to the product,[36] particularly in terms of intangibles and most commonly used where there are no comparable unrelated sales.[37] The method focuses on the manufacturer’s gross mark-up with the related manufacturer’s costs being determined and, an appropriate gross profit mark-up applied to arrive at the deemed sales price.[38]  

Application of CPM is effected by adding to the controlled sellers production cost a cost equal to that multiplied by the appropriate gross profit percentage – the appropriate gross profit percentage is equal to the gross profit percentage earned on the uncontrolled transaction(s) most comparable to the related parties’ transaction.[39]   Comparability may be determined by considering the same factors discussed under the resale price method. Further, where the circumstances are such that there are no specific comparables readily available, the related taxpayer may use the gross profit percentages of the particular industry.[40] Notwithstanding, the related taxpayer should proceed cautiously where opting to use “industry averages” as the court has indicated an aversion to it use based on dubious reliability.[41]

Under CPM adjustments, as with the other methods, may be made where there are differences in the controlled and uncontrolled models which have a reasonably ascertainable effect on the price.[42]

Transactional Profit Split Method

Intangible property and its genre may create much difficulty in the analysis of intercompany pricing arrangements. Inherent to this problem is the identification of developer of the intangible and in finding relevant comparables.  The former is easily addressed by Treasury Regulation 1.482-4(f)(3) or by the related parties engaging in cost sharing agreements,[43] however, this does not satisfy the latter issue of the dearth of comparables.

When faced with this dilemma, the related taxpayer may find it necessary to use the transactional profit split method.  Notwithstanding, the method is mutually inclusive and thus may be used in determining the arms length price for controlled transactions involving tangible goods or intangibles so long as the method results in the most accurate determination of the arms length price or range.

 Profit Split Method (PSM)

The profit split method starts by focusing on the combined profit to be split among the related parties, essentially treating them as an economic unit.  Once identified, those profits are allocated among the parties to reflect what each related party’s anticipated share based upon their contribution (function, etc.) would have been in an arms length agreement.[44]

The allocation of profit is then made under one of two schemes provided for in the regulations: the comparable profit split and the residual profit split.[45]

            Comparable Profit Split

Under this method the related entities’ combined operating profits are allocated to them in proportions with that of the operating profits of comparable uncontrolled

            Entities.

            Residual Profit Split

Under this method a market return is allocated to each controlled party in the economic unit based on its routine contributions to the unit. A contribution is deemed routine where uncontrolled parties make similar contributions to their economic unit.  Then the remaining operating profit is allocated to each controlled entity in proportions reflecting their nonroutine contributions such as intangibles not contributed in the uncontrolled model.[46]

Comparable Profits Method (CPM)

The comparable profits method is basically “ . . . a range of methods that examine the net profit margin realized by a taxpayer from a controlled transaction relative to an appropriate base.  Possible bases include the rate of return on assets, operating income to sales, and other suitable financial ratios”.[47]

More specifically, the arms length range is identified by selecting the uncontrolled entity, and referring to profit level indicators,[48] that is, financial ratios that measure the relationship between profits and other factors such as the cost incurred in obtaining that profit.  The uncontrolled profit level indicators are then applied to the tested (controlled party) and if its operating profits fall within the uncontrolled range, its profits are deemed to be within the arms length price range.[49]   Note that the CPM is sometimes referred to as the transactional net margin method or (TNMM).

Final Note

This article was designed to serve as the title indicates, that is, a primer.  The topic of transfer pricing is an ever-evolving field of “art”, masquerading as science.  There are wonderful arguments on both sides, each relevant when viewed with the opposition’s spectacles.  Transfer pricing will, in my opinion, undergo radical changes over the next decade and the reader is well advised to stay alert for the most current winds of change.  Still, any changes or modification in transfer pricing rules will be firmly based on the fundamental principles discussed in this article.

About The Author:  Peter J. Loughlin is a lawyer with Goldman & Loughlin, PLLC Law Firm and a former principle member of Juris Consults Group.  He holds two law degrees and is a member of the State Bar of California, Federal Bar Association, International Bar Association and Royal Society of Fellows.

Notice: United States Department of Treasury Regulation Circular 230 requires that we notify you that, with respect to any statements regarding tax matters made herein, including any attachments, (1) nothing herein was intended or written to be used, and cannot be used by you, to avoid tax penalties; and (2) nothing contained herein was intended or written to be used, and cannot be used, or referred to in any marketing or promotional materials. Further, to the extent any tax statement or tax advice is made herein, Peter J. Loughlin and Goldman & Loughlin, PLLC does not and will not impose any limitation on disclosure of the tax treatment or tax structure of any transactions to which such tax statement or tax advice relates. The Information provided here is for general information only and is not intended to nor does it constitute legal or tax advice to any person or entity. You should review your particular circumstances with your independent legal and tax advisors.