Pricing and Tax Planning
Opportunities for U.S. Corporations
W. Joey Styron
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
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
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 In 2000, the United States repealed
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The American Jobs Creation Act of 2004 (AJCA) repealed the ETIs,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.
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.
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
- 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.
performed in the United States, excluding self-production.
and architectural services for domestic construction.
excluded from DPGR include food and beverages provided by retail
establishments, and the distribution or transmission of electricity,
natural gas, or potable water.
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.
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.
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
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.
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
- 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
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).
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.
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
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.
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.
Regulations section 1.482-3, methods for tangible products. IRC
section 1.482-3 describes the six methods of determining transfer
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.
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.
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.
profits method. See description below.
split method. See description below.
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.
Regulations section 1.482-4, intangibles. For intangible
property, the transfer price must be determined using one of four
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.
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
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.
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).
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).
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.
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.
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.
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
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.
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
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.
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.
much more work for USP than for URC, and it would likely be appropriate
to adjust the price for a quantity discount.
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.
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
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.
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).
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.
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.
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.
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.
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.
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.
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.
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.
of Data and Assumptions
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
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.
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.
Joey Styron, PhD, is an associate professor in the James
L. Hull College of Business of Augusta State University, Augusta,