Transfer Pricing and Tax Planning
Opportunities for U.S. Corporations Operating Abroad

By W. Joey Styron

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NOVEMBER 2007 - Since the late 1970s, U.S. tax law has been evolving. Several approaches designed to increase U.S. companies’ ability to compete in global markets have been tried. Current law allows U.S. companies to have foreign subsidiaries. The income of a foreign subsidiary is taxed in the country in which the subsidiary operates. The U.S. company can “sell” products to the foreign subsidiary and use the transfer price for the “sale” in tax planning for the related group of companies. Current law allows considerable flexibility in setting the transfer price. Within the limits allowed, the price can be set to maximize taxable income for the entity with the lower marginal tax rate and to minimize taxable income for the entity with the higher marginal tax rate.

U.S. Export Incentives

Evolution of the law. The United States has offered various export incentives over the years, in an attempt to encourage exports of U.S.-manufactured products. Laws allowing the use of domestic international sales corporations (DISC) were enacted in the late 1970s. These provisions allowed part of the income of a DISC to be deferred until repatriation of that income. However, the General Agreement on Tariffs and Trade (GATT) charged that these provisions were a prohibited export subsidy. The DISC provisions were then curtailed.

In 1984, the foreign sales corporation (FSC) provisions were enacted. FSCs were allowed similar tax deferrals similar to DISCs. Instead of a deferral of foreign income until repatriation, FSCs were allowed a permanent exclusion of a certain percentage of export income. The World Trade Organization (WTO) charged that the FSC incentives were an illegal export subsidy. In 2000, the United States repealed those provisions.

The United States replaced the FSC provisions with the extraterritorial income (ETI) provisions. The ETIs were very similar to the FSCs. Not surprisingly, they were found to be illegal export subsidies. The American Jobs Creation Act of 2004 (AJCA) repealed the ETIs, phasing them out in 2005 and 2006. With the AJCA, Congress took a different approach.

Beginning in 2005, all U.S. manufacturers and certain other producers can qualify for a “domestic production activities deduction.” Once fully phased in, the deduction will be 9% of qualified production activities income, subject to numerous limitations. This represents a marked difference from prior incentives. This deduction is allowed for all U.S. manufacturers and other qualified producers, even if they are not exporters.

Domestic production activities deduction. The AJCA created the domestic production activities deduction (PAD). The deduction is phased in starting at 3% in 2005 and increasing to 9% in 2010. The deduction amount for 2005 is 3% of the lesser of qualified production activities income (QPAI) or taxable income before the PAD. For an individual taxpayer, modified adjusted gross income (AGI) is used instead of taxable income. For alternative minimum tax (AMT) purposes, AMT income is used instead of taxable income.

QPAI is computed item by item, then all QPAI items are netted together. This could result in a negative QPAI, and thus no deduction. QPAI is the excess of domestic production gross receipts (DPGR) over the sum of: 1) cost of goods sold for those receipts, 2) other deductions directly associated with those receipts, and 3) the ratable portion of indirect deductions. Three categories of DPGR qualify for the PAD:

  • The lease, license, sale, exchange, or other disposition of qualified production property that was manufactured, produced, grown, or extracted in the United States. This category also includes qualified films largely created in the United States, and the production of electricity, natural gas, or potable water.
  • Construction performed in the United States, excluding self-production.
  • Engineering and architectural services for domestic construction.

Items specifically excluded from DPGR include food and beverages provided by retail establishments, and the distribution or transmission of electricity, natural gas, or potable water.

Multiplying the 3% times the lesser of the two amounts imposes a taxable income limit on the deduction. For this purpose, taxable income is computed after subtracting any allowable net operating loss carryback or carryforward. If the deduction is reduced because of the taxable income limit, this amount is lost forever.

Another limitation on the PAD is that it cannot exceed 50% of the taxpayer’s W-2 wages allocable to production. For this purpose, wages include elective deferrals such as elective retirement account contributions.

Qualifying Foreign Subsidiaries

In addition to the PAD, a U.S. producer can establish a foreign sales subsidiary. The subsidiary’s income will be taxed in the country in which the subsidiary operates. The U.S. parent manufacturers the goods and sells them to the foreign subsidiary. The subsidiary then sells the goods to an unrelated party. Using a foreign sales subsidiary in this way would avoid application of the Subpart F provisions related to a foreign-based company’s sales income.

The “transfer price” for the goods is the price charged by the parent when the goods are sold to the subsidiary. This transfer price can be determined in a manner that minimizes the combined global taxes of the parent and the subsidiary.

Establishing a foreign subsidiary. A foreign subsidiary can be established in the following ways:

  • The U.S. parent can start a new corporation outside the United States. If it meets the requirements of IRC section 351, the transfer of assets into that newly formed corporation is a tax-free event.
  • An existing U.S. subsidiary can be liquidated into an existing foreign subsidiary. If the requirements of IRC section 332 are met, this also can be tax-free.
  • A foreign branch of a U.S. corporation can be incorporated, forming a new foreign subsidiary. This also is tax-free under the provisions of section 351.
  • A stock swap can be used to allow a foreign corporation to acquire an existing U.S. subsidiary. This Type B reorganization is tax-free.
  • A Type C reorganization can be used. In this type of reorganization, a foreign corporation acquires substantially all of a U.S. corporation’s net assets.

In any of these approaches to establishing the foreign subsidiary, the assets transferred must be used in a trade or business carried on outside the United States. However, for certain “tainted” assets, gains must be immediately recognized when the assets are transferred outside the United States. Tainted assets (under IRC section 367) include inventory, installment obligations, foreign currency, and property leased by the transferor (unless the transferee is the lessee).

Whichever approach a company uses to establish the foreign subsidiary, an effective transfer pricing strategy can minimize the combined global taxes of the parent and the subsidiary. Transfer prices can be set so that the entity in the higher-taxing jurisdiction minimizes its taxable income. The entity in the lower-taxing jurisdiction reports a higher taxable income, but it is taxed at a lower rate.

Transfer Pricing

Tax Code and Treasury Regulations. IRC section 482 gives the IRS the authority to allocate income and deduction items among companies that are part of a controlled group. A U.S. parent and its foreign subsidiary are an example of a controlled group. The IRS relies on this provision of the IRC, which provides no further guidance, as authority to challenge the transfer price that a company uses.

Treasury Regulations section 1.482 describes the allowable methods for setting transfer prices. Section 1.482-1 provides an overview and describes factors that affect comparability of prices. Sections 1.482-2 through 6 describe specific methods for setting transfer prices. Section 1.482-2 describes the methods to be used for certain specific situations. Section 1.482-3 applies to transfers of tangible property, and 1.482-4 applies to intangibles. Sections 1.482-5 and 6 describe the comparable profits and profit-split methods. Section 1.482-7 describes the method to evaluate whether a qualified cost sharing arrangement results in an appropriate price. Section 1.482-8 provides examples, and Proposed Regulation section 1.482-94 describes the methods that a company should use for a transfer of services. This guidance is discussed in further detail below.

Treasury Regulations section 1.482-2, specific circumstances. Section 1.482-2 provides guidance for taxpayers in certain specific circumstances. These circumstances include: 1) loans or advances, 2) services provided to a member of a controlled group by another member of the group, and 3) a lease of tangible property from one member of a controlled group to another member of the group. These specific circumstances lie mostly outside the scope of this article.

Treasury Regulations section 1.482-3, methods for tangible products. IRC section 1.482-3 describes the six methods of determining transfer prices:

  • Comparable uncontrolled price method. This compares the transfer price to a comparable transaction between unrelated parties. The key is comparability. The two transactions being compared might not be the same in all respects. Adjustments must be made for any differences between the transactions. If the differences are not material, or if the effect of any material differences can be quantified, then this method often results in the best estimation of an arm’s-length price. The regulations list eight factors that often cause differences between transactions. These factors include quality of the product and contractual terms. If one can identify a comparable uncontrolled price, and if all relevant information is available to ensure a reasonable degree of comparability, this is the preferred method for setting the transfer price.
  • Resale price method. This uses the gross profit margin on the transaction to determine if the transfer price is an accurate estimation of an arm’s-length price. The method compares the gross profit earned on the transfer with the gross profit that would be earned on a comparable transaction between unrelated parties. This method is most useful for companies that buy and resell identical tangible products. Changes in packaging or labeling do not constitute changes to the product. This method should not be used by taxpayers who use intangibles to add value to a product.
  • Cost-plus method. This method evaluates whether the transfer price approximates an arm’s-length price by comparing the market upon cost for the product. It is used primarily by companies that manufacture products and sell them to related parties. Several factors related to the manufacturing process must be considered when assessing comparability. Those factors include complexity of the manufacturing process, production and process engineering, and testing. This method is also useful for a U.S. manufacturer selling goods to a foreign subsidiary.
  • Comparable profits method. See description below.
  • Profit split method. See description below.
  • Unspecified methods. Treasury Regulations section 1.482-3 provides for “unspecified methods,” allowing the taxpayer the option of using some method other than those described above. The primary requirement is that the general principles in Treasury Regulations section 1.482-1 are followed. The regulations use the example of a manufacturer that sells a product to a subsidiary where there have been no comparable completed transactions between unrelated parties, but there has been a bona fide offer from an unrelated party to purchase the goods. The offer from the unrelated party was never accepted and the exchange never occurred. The price offered by the unrelated party could be used as the transfer price, provided other factors in the transactions are comparable. This method would be particularly useful when the other methods do not yield the desired tax result. This example appears in the regulations, but “unspecified methods” could be any approach that does not directly conflict with the general principles for transfer prices. This allows considerable flexibility in setting transfer prices.

Treasury Regulations section 1.482-4, intangibles. For intangible property, the transfer price must be determined using one of four methods:

  • Comparable uncontrolled transaction;
  • Comparable profits;
  • Profit split; or
  • Unspecified.

The comparable uncontrolled transaction method for intangibles is basically the same as the comparable uncontrolled price method for tangibles. The regulations prefer this method in cases of a comparable transaction involving either the same or comparable intangible property. This article focuses on U.S.-manufactured products sold in another country without being altered in the other country.

Treasury Regulations section 1.482-5, comparable profits method. The comparable profits method may be used for either tangible or intangible property. The IRS selects one member of the controlled group as the “tested party,” then compares the profitability of the tested party to that of a similar company that is not part of the controlled group. The method would likely use the ratio of operating profit to sales for the comparison. The tested party is the member of the controlled group that can be most easily compared to another company, considering the complexity of operations, location, and other factors. The data used in the comparison should be adjusted for identifiable differences between the tested company and the comparable company. The IRS could then adjust the transfer price to reallocate profits between the control companies so that the tested company would have a profit margin of a comparable company.

Treasury Regulations section 1.482-6, profit split method. This method assesses the relative value contributed by each member of a controlled group to the combined profit or loss resulting from controlled transactions. A taxpayer must use the most “narrowly identifiable business activity” that includes the controlled transactions. In assessing the control member’s contribution to the success of the activity, a taxpayer should consider several factors—including functions performed, risks assumed, and resources employed by the individual members of the controlled group—compared with the combined totals for the activity. This method can be applied via the comparable profit split and the residual profit split.

The residual profit approach can be explained by the following example, based on an example in the regulations. A U.S. manufacturer (USCo) obtained a patent on a new invention that was produced and sold within the United States. The manufacturer also licensed its European subsidiary (EUCo) to use the patent to produce products in Europe. USCo incurred no additional expenses as a result of EUCo’s use of the patent. EUCo had sales of $500 and expenses (other than patent royalties) of $300, resulting in a profit of $200, before considering its royalty expense. It used operating assets costing $200. Assuming that a 10% return on investment is appropriate, EUCo’s normal profit should be $20 (10% of $200). This would result in a residual profit of $180 ($200 profit minus $20). USCo performed the research and development resulting in the patent. Its patent amortization as a percent of worldwide sales of products using the patent was 20%. EUCo also did research and development to get a patent to produce additional products. Its patent amortization rate was 40% of sales, and the total for the two companies was 60% of sales. EUCo’s rate was two-thirds of the total, and USCo’s rate was one-third of the total. The amount of royalty income that USCo should receive from EUCo should be $60 (one-third of the $180 residual profit).

Advanced Pricing Agreements

As described above, transfer prices can be determined by numerous methods, all of which require judgment to determine if the transfer price reflects a price that would result from an arm’s-length transaction. As a result, international companies often have disputes with the IRS over transfer pricing. One way to avoid these disputes is to enter into an advance pricing agreement (APA).

To obtain an APA, a taxpayer must negotiate with the IRS to determine the best method for setting transfer prices. Many tax treaties also allow a taxpayer to negotiate with tax authorities in certain countries. While the process of obtaining an APA involves considerable time and expense, the advantages include avoiding prolonged disputes with the IRS, reducing the number of information requests in an audit, and avoiding uncertainty about the outcome of an audit. The APA program has been in existence since 1991. IRS Revenue Procedure 2006-9 describes the process of obtaining an APA.

APA agreements may be unilateral or bilateral. In a unilateral agreement, the taxpayer and the IRS agree to a method of setting transfer prices. Other countries’ taxing authorities are not bound by the agreement, however. In a bilateral agreement, the IRS, the taxpayer, and the other country’s taxing authority have agreed on the method. In a bilateral agreement, all parties involved are bound to the agreement.

Applying the Regulations

While the regulations are voluminous and somewhat complex, they have certain recurring concepts and principles. Treasury Regulations section 1.482-1 provides a description of these concepts and principles. First, the arm’s-length standard is pervasive. The methods described in the regulations are not trying to emulate the process for setting prices between unrelated parties. Instead, the regulations are fixated on whether the resulting price is consistent with the price that would have been used had the transactions not been between related parties. The method is unimportant; the resulting price is what matters. The goal of the regulations is to select which method best estimates what the resulting price would have been had the parties not been related to each other. This leads to the “best method” rule.

The best method provides the most reliable measure of an arm’s-length price. Two characteristics are most important in evaluating whether a method is the best method: comparability, and quality of data and assumptions.

Comparability

The first key component in evaluating a method is comparability. Whenever possible, a transaction between the related parties is compared to a similar transaction between unrelated parties. Where such an unrelated-party transaction can be identified, the transaction, the parties involved, and the environment in which the transaction occurs must be examined closely to determine whether the transaction is truly comparable. If the unrelated-party transaction is very comparable to the related-party transaction, then the result is more reliable. Differences between the two transactions reduce reliability. For each material difference, an adjustment must be made to compensate for the difference. The need to make material adjustments reduces reliability.

The transactions need not be identical to be comparable. If that were necessary, often there would be no qualifying comparison. Certain factors must be considered in determining comparability. The transactions must be significantly similar in terms of functional analysis, contractual terms, risks, economic conditions, and property or services.

Functional analysis examines the functions (e.g., research and development, fabrication, extraction, and assembly) that need to be accounted for. For transactions to be comparable, the functions being accounted for should be the same.

Contractual terms are likely to have numerous differences (e.g., volume or quantity of items, credit terms) between related-party transactions and unrelated-party transactions. Adjustments to the price must be made for any material differences in contractual terms. Another issue occurs when no written contract exists. Agreements between unrelated parties are often in written form, but this is often not true for transactions between related parties. The IRS has the authority to impute a contractual agreement based on the circumstances. To avoid this, taxpayers are advised to use written agreements even for transfers to divisions within a company or transfers to other members of a controlled group. The following examples are based on examples contained in the regulations. Some involved the transfer of services or intangibles, not just products, but the underlying principles are the same.

A U.S. producer and exporter (USP) purchases transportation services from its subsidiary, TransCo. TransCo operates in another country and delivers USP’s products in that country. TransCo also provides transportation services to an unrelated company (URC). Of TransCo’s total revenues, 90% are from USP and 10% are from URC. If USP and TransCo use the prices TransCo charged to URC for comparison, the amount must be adjusted for the difference in quantity of business.

TransCo does much more work for USP than for URC, and it would likely be appropriate to adjust the price for a quantity discount.

Risk is a third factor to consider in assessing comparability. Forms of risk include market risk and financial risk. One must determine which party in the controlled group bears the risk.

For example, consider USP, a U.S. producer that sells goods to SC, its subsidiary operating in another country. SC contracts to buy a certain quantity of goods at a specified price. SC is responsible for marketing the goods, and there are no rebate or return provisions between SC and USP. SC has sufficient financial resources to pay for the goods under any circumstances that might arise. In this case, SC bears all of the risks that an unrelated party would typically bear.

Now assume that SC has limited capital and is unable to obtain financing from an unrelated party. Furthermore, USP has agreed to extend credit to SC to finance the transaction. In this case, SC does not bear risks similar to an unrelated party. If this transaction is being compared to a sale of a similar product to an unrelated party, then the price for the unrelated sale should be adjusted to reflect the difference in risk.

Economics is a fourth factor to consider. The comparable uncontrolled transaction might be in a different economic environment, in a different geographic location, or in a location with a different size of market or a different market share. It might also be in a different level of the market (e.g., wholesale or retail).

For example, USP produces and sells its products to SC, its subsidiary operating in another country. SC bears all risks typically associated with distributors, and sells the products to the final consumers. SC’s customers might be able to buy from other distributors. When comparing the price charged by the other distributors in setting the transfer price from USP to SC, one must adjust for the fact that SC, as a customer of USP, is a distributor, and the final consumers are not distributors but are on the retail level.

The property or services being transferred comprise the fifth factor that should be considered in assessing comparability. For transfers of tangible property, are the properties in the comparable unrelated transfers truly the same as the properties in the controlled transfer? Any material differences in the product being transferred create the need for an adjustment to the price.

For example, USP has developed a special material that is used in producing bulletproof vests. Only USP has the patent and the right to produce this material, which is superior to that produced by other companies. USP manufactures the material in the United States. It sells the material in the United States and in another country. In the other country, USP sells only to its subsidiary, SC. If the companies are comparing the transactions between USP and SC to sales of similar but inferior materials by other manufacturers, they must adjust for the difference in quality of the materials.

Special circumstances may also affect the transfer price or the price in the comparable transaction. For example, a company might be trying to gain market share by offering its products at a reduced price, or the company might be spending much more than usual on marketing efforts. If the company that is trying to increase market share is an unrelated company used for comparison, the price it uses or profitability it reports should be adjusted.

Another example of a special circumstance is when the comparable transaction is in a different geographical market. Generally, comparisons with transactions that are in a different geographical market should be used only if no comparables exist in the same geographical market. If comparables are in different markets, the price must be adjusted for the difference between the two geographical areas.

For example, USP is a U.S. company that designs clothes and contracts with SC to manufacture the clothes. SC is a subsidiary of USP, and SC operates in a country with significantly lower operating costs. USP could contract with a number of other countries to manufacture its clothes. SC has no specialized skills, compared with other companies. The transfer price should be based on a comparison with what other companies in SC’s country would charge to manufacture those products, not with the price that a company operating in the U.S. would charge to manufacture the same products.

The above examples illustrate that some transactions might need to be adjusted to compensate for a lack in comparability. Some transactions are not usually accepted as comparables, however. For example, a special order for a manufacturer to make a product that it would not make in the normal course of its business would not be comparable. Another example is when a transaction is agreed on with an unrelated party for the purpose of creating a comparable to use in setting prices for a transaction with a related party.

As noted above, some comparable transactions might be more comparable than others, and some methods might be better than others. In some cases, a particular method clearly results in a single price that is the most reliable measure of an arm’s-length price, but in others the same method may produce different results depending on the assumptions. Because of this possibility, a method may determine a range of acceptable prices rather than just a single price. Under the regulations, the IRS is not allowed to adjust the taxpayer’s transfer price if the price used was within an arm’s-length range. Typically, arm’s length is the interquartile range, from the 25th to the 75th percentile of the results from the uncontrolled comparables.

Quality of Data and Assumptions

The second key component is the quality of data and assumptions used. Completeness and accuracy are important characteristics that affect quality of data. Often, complete data for comparable transactions is not available and assumptions must be made. The more data that are missing and the more assumptions that must be made, the more likely that the resulting price will not truly reflect an arm’s-length price. Some assumptions are very reliable and their soundness is not an issue; others are not so reliable. For example, the comparable transaction may have different payment terms. It is relatively easy to make adjustments for this difference, and the necessary assumptions are easily supported. On the other hand, the residual profit split method assumes that the value of an intangible is reflected in its capitalized development expenses. This assumption might often not be a sound one, and is often difficult to support.

A potential third factor to consider is confirmation. If the results of the method being considered can be confirmed by another method, this may be taken into account. Confirmation is most likely to be a consideration in a situation where the “best method” rule does not clearly indicate which method is preferable.

Importance of Planning

The methods that taxpayers can use for setting transfer pricing allow considerable flexibility. No one method is required or always desirable. The key is comparability. For differences between the related-party transfer and the uncontrolled comparable price, adjustments must be made to increase comparability. Identifying those differences, and exercising judgment in adjusting for the differences, allow considerable flexibility in setting a transfer price. The most important thing in applying any of the methods is advance planning. If the taxpayer plans and properly documents the process used in setting the transfer price and the adjustments made to improve comparability, the taxpayer can effectively plan transfer prices to reduce taxes for the controlled group as a whole.


W. Joey Styron, PhD, is an associate professor in the James L. Hull College of Business of Augusta State University, Augusta, Ga.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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