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Chapter Eleven International Transfer Pricing
Learning Objectives
After reading this chapter, you should be able to Describe the importance of transfer pricing in achieving goal congruence in decentralized organizations. Explain how the objectives of performance evaluation and cost minimization can conflict in determining international transfer prices. Show how discretionary transfer pricing can be used to achieve specific cost minimization objectives. Describe governments reaction to the use of discretionary transfer pricing by multinational companies. Discuss the transfer pricing methods used in sales of tangible property. Explain how advance pricing agreements can be used to create certainty in transfer pricing. Describe worldwide efforts to enforce transfer pricing regulations.
INTRODUCTION
Transfer pricing refers to the determination of the price at which transactions between related parties will be carried out. Transfers can be from a subsidiary to its parent (upstream), from the parent to a subsidiary (downstream), or from one subsidiary to another of the same parent. Transfers between related parties are also known as intercompany transactions. Intercompany transactions represent a significant portion of international trade. In 2003, intercompany transactions comprised 42 percent of U.S. total goods trade: $594 billion (48 percent) of the $1.24 trillion in U.S. imports, and $233 billion (32 percent) of the $728 billion in U.S. exports.1 There is a wide range of types of intercompany transactions, each of which has a price associated with it. A list is provided in Exhibit 11.1. The basic question that must be addressed is, At what price should intercompany transfers be made? This chapter focuses on international transfers, that is, intercompany transactions that cross national borders.
1 U.S. Goods Trade: Imports and Exports by Related Parties, 2003, U.S. Department of Commerce News, April 14, 2004, p. 1.
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EXHIBIT 11.1
Types of Intercompany Transactions and Their Associated Price
Transaction Sale of tangible property (e.g., raw materials, finished goods, equipment, buildings) . . . . . . . . . Use of tangible property (leases) (e.g., land, buildings) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Use of intangible property (e.g., patents, trademarks, copyrights) . . . . . . . . . . . . . . . . . . . . Intercompany services (e.g., research and development, management assistance) . . . . . . . . Intercompany loans . . . . . . . . . . . . . . . . . . . . . . . . .
Price Sales price Rental or lease payment Royalty, licensing fee Service charge, management fee Interest rate
Two factors heavily influence the manner in which international transfer prices are determined. The first factor is the objective that headquarters management wishes to achieve through its transfer pricing practices. One possible objective relates to management control and performance evaluation. Another objective relates to the minimization of one or more types of costs. These two types of objectives often conflict. The second factor affecting international transfer pricing is the law that exists in most countries governing the manner in which intercompany transactions crossing their borders may be priced. These laws were established to make sure that multinational corporations (MNCs) are not able to avoid paying their fair share of taxes, import duties, and so on by virtue of the fact that they operate in multiple jurisdictions. In establishing international transfer prices, MNCs often must walk a fine line between achieving corporate objectives and complying with applicable rules and regulations. In a recent survey, 90 percent of respondents identified transfer pricing as the most important international tax issue they face.2 We begin this chapter with a discussion of management accounting theory with respect to transfer pricing. We then describe various objectives that MNCs might wish to achieve through discretionary transfer pricing. Much of this chapter focuses on government response to MNCs discretionary transfer pricing practices, emphasizing the transfer pricing regulations in the United States.
DECENTRALIZATION AND GOAL CONGRUENCE

Business enterprises often are organized by division. A division may be a profit center, responsible for revenues and operating expenses, or an investment center, responsible also for assets. In a company organized by division, top managers delegate or decentralize authority and responsibility to division managers. Decentralization has many advantages: Allowing local managers to respond quickly to a changing environment. Dividing large, complex problems into manageable pieces. Motivating local managers who otherwise will be frustrated if asked only to implement the decisions of others.3
Ernst & Young, Transfer Pricing 2003 Global Survey, p. 7. Michael W. Maher, Clyde P. Stickney, and Roman L. Weil, Managerial Accounting, 8th ed. South-Western, 2004), p. 484.
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However, decentralization is not without its potential disadvantages. The most important pitfall is that local managers who have been granted decision-making authority may make decisions that are in their self-interest but detrimental to the company as a whole. The corporate accounting and control system should be designed in such a way that it provides incentives for local managers to make decisions that are consistent with corporate goals. This is known as goal congruence. The system used for evaluating the performance of decentralized managers is an important component in achieving goal congruence. The price at which an intercompany transfer is made determines the level of revenue generated by the seller, becomes a cost for the buyer, and therefore affects the operating profit and performance measurement of both related parties. Appropriate transfer prices can ensure that each division or subsidiarys profit accurately reflects its contribution to overall company profits, thus providing a basis for efficient allocation of resources. To achieve this, transfer prices should motivate local managers to make decisions that enhance corporate performance, while at the same time providing a basis for measuring, evaluating, and rewarding local manager performance in a way that managers perceive as fair.4 If this does not happen (that is, if goal congruence is not achieved), then the potential benefits of decentralization can be lost. Even in a purely domestic context, determining a transfer pricing policy is a complex matter for multidivision organizations, which often try to achieve several objectives through such policies. For example, they may try to use transfer pricing to ensure that it is consistent with the criteria used for performance evaluation, motivate divisional managers, achieve goal congruence, and help manage cash flows. For MNCs, there are additional factors that influence international transfer pricing policy.
TRANSFER PRICING METHODS

The methods used in setting transfer prices in an international context are essentially the same as those used in a purely domestic context. The following three methods are commonly used: 1. Cost-based transfer price. The transfer price is based on the cost to produce a good or service. Cost can be determined as variable production cost, variable plus fixed production cost, or full cost, based on either actual or budgeted amounts (standard costs). The transfer price often includes a profit margin for the seller (a cost-plus price). Cost-based systems are simple to use, but there are at least two problems associated with them. The first problem relates to the issue of which measure of cost to use. The other problem is that inefficiencies in one unit may be transferred to other units, as there is no incentive for selling divisions to control costs. The use of standard, rather than actual, costs alleviates this problem. 2. Market-based transfer price. The transfer price charged a related party is either based on the price that would be charged to an unrelated customer or determined by reference to sales of similar products or services by other companies to
Robert G. Eccles, The Transfer Pricing Problem: A Theory for Practice (Lexington, MA: Lexington Books, 1985), p. 8.
unrelated parties. Market-based systems avoid the problem associated with cost-based systems of transferring the inefficiencies of one division or subsidiary to others. They help ensure divisional autonomy and provide a good basis for evaluating subsidiary performance. However, market-based pricing systems also have problems. The efficient working of a market-based system depends on the existence of competitive markets and dependable market quotations. For certain items, such as unfinished products, there may not be any buyers outside the organization and hence no external market price. 3. Negotiated price. The transfer price is the result of negotiation between buyer and seller and may be unrelated to either cost or market value. A negotiated pricing system can be useful, as it allows subsidiary managers the freedom to bargain with one another, thereby preserving the autonomy of subsidiary managers. However, for this system to work efficiently, it is important that there are external markets for the items being transferred so that the negotiating parties can have objective information as the basis for negotiation. One disadvantage of negotiated pricing is that negotiation can take a long time, particularly if the process deteriorates and the parties involved become more interested in winning arguments than in considering the issues from the corporate perspective. Another disadvantage is that the price agreed on and therefore a managers measure of performance may be a function more of a managers ability to negotiate than of his or her ability to control costs and generate profit. Management accounting theory suggests that different pricing methods are appropriate in different situations. Market-based transfer prices lead to optimal decisions when (1) the market for the product is perfectly competitive, (2) interdependencies between the related parties are minimal, and (3) there is no advantage or disadvantage to buying and selling the product internally rather than externally.5 Prices based on full cost can approximate market-based prices when the determination of market price is not feasible. Prices that have been negotiated by buyer and seller rather than being mandated by upper management have the advantage of allowing the related parties to maintain their decentralized authority. A 1990 survey of Fortune 500 companies in the United States found that 41 percent of respondent companies relied on cost-based methods in determining international transfer prices, 46 percent used market-based methods, and 13 percent allowed transfer prices to be determined through negotiation.6 The most widely used approach was full production cost plus a markup. Slightly less than half of the respondents reported using more than one method to determine transfer prices.
OBJECTIVES OF INTERNATIONAL TRANSFER PRICING

Broadly speaking, there are two possible objectives to consider in determining the appropriate price at which an intercompany transfer that crosses national borders should be made: (1) performance evaluation and (2) cost minimization.
Charles T. Horngren, George Foster, and Srikant M. Datar, Cost Accounting: A Managerial Emphasis, 10th ed. (Upper Saddle River, NJ: Prentice-Hall, 2000), p. 796. 6 Roger Y. W. Tang, Transfer Pricing in the 1990s, Management Accounting, February 1992, pp. 2226.
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Performance Evaluation
To fairly evaluate the performance of both parties to an intercompany transaction, the transfer should be made at a price acceptable to both parties. An acceptable price could be determined by reference to outside market prices (e.g., the price that would be paid to an outside supplier for a component part), or it could be determined by allowing the two parties to the transaction to negotiate a price. Policies for establishing prices for domestic transfers generally should be based on an objective of generating reasonable measures for evaluating performance; otherwise, dysfunctional manager behavior can occur and goal congruence does not exist. For example, forcing the manager of one operating unit to purchase parts from a related operating unit at a price that exceeds the external market price will probably result in an unhappy manager. As a result of the additional cost, the units profit will be less than it otherwise would be, perhaps less than budgeted, and the managers salary increase and annual bonus may be adversely affected. In addition, as upper management makes corporate resource allocation decisions, fewer resources may be allocated to this unit because of its lower reported profitability. Assume that Alpha Company (a manufacturer) and Beta Company (a retailer) are both subsidiaries of Parent Company, located in the United States. Alpha produces DVD players at a cost of $100 each and sells them both to Beta and to unrelated customers. Beta purchases DVD players from Alpha and from unrelated suppliers and sells them for $160 each. The total gross profit earned by both producer and retailer is $60 per DVD player. Alpha Company can sell DVD players to unrelated customers for $127.50 per unit, and Beta Company can purchase DVD players from unrelated suppliers at $132.50. The manager of Alpha should be happy selling DVD players to Beta for $127.50 per unit or more, and the manager of Beta should be happy purchasing DVD players from Alpha for $132.50 per unit or less. A transfer price somewhere between $127.50 and $132.50 per unit would be acceptable to both managers, as well as to Parent Company. Assuming that a transfer price of $130.00 per unit is agreed on by the managers of Alpha and Beta, the impact on income for Alpha Company, Beta Company, and Parent Company (after eliminating the intercompany transaction) is as follows:
Alpha Sales . . . . . . . . . . . . . . Cost of goods sold . . . Gross profit . . . . . . . . . Income tax effect . . . . After-tax profit . . . . . . $130.00 100.00 $ 30.00 10.50 (35%) $ 19.50
Beta $160.00 130.00 $ 30.00 10.50 (35%) $ 19.50
Parent $160.00 100.00 $ 60.00 21.00 $ 39.00
Now assume that Alpha Company is located in Taiwan and Beta Company is located in the United States. Because the income tax rate in Taiwan is only 25 percent, compared with a U.S. income tax rate of 35 percent, Parent Company would like as much of the $60.00 gross profit to be earned by Alpha as possible. Rather than allowing the two managers to negotiate a price based on external market values, assume that Parent Company intervenes and establishes a discretionary
transfer price of $150.00 per unit.7 Given this price, the impact of the intercompany transaction on income for the three companies is as follows:
Alpha Sales . . . . . . . . . . . . . . Cost of goods sold . . . . Gross profit . . . . . . . . . Income tax effect . . . . . After-tax profit . . . . . . . $150.00 100.00 $ 50.00 12.50 (25%) $ 37.50 Beta $160.00 150.00 $ 10.00 3.50 (35%) $ 6.50 Parent $160.00 100.00 $ 60.00 16.00 $ 44.00
The chief executive officer of Parent Company is pleased with this result, because consolidated income for Parent Company increases by $5.00 per unit, as will cash flow when Alpha Company and Beta Company remit their after-tax profits to Parent Company as dividends. The president of Alpha Company is also happy with this transfer price. As is true for all managers in the organization, a portion of the presidents compensation is linked to profit, and this use of discretionary transfer pricing will result in a nice bonus for her at year-end. However, the president of Beta Company is less than pleased with this situation. His profit is less than if he were allowed to purchase from unrelated suppliers. He doubts he will receive a bonus for the year, and he is beginning to think about seeking employment elsewhere. Moreover, Beta Companys profit clearly is understated, which could lead top managers to make erroneous decisions with respect to Beta.
Cost Minimization
When intercompany transactions cross national borders, differences between countries might lead an MNC to attempt to achieve certain cost-minimization objectives through the use of discretionary transfer prices mandated by headquarters. The most well-known use of discretionary transfer pricing is to minimize worldwide income taxes by recording profits in lower-tax countries. As illustrated in the preceding example, this objective can be achieved by establishing an arbitrarily high price when transferring to a higher-tax country. Conversely, this objective is also met by selling at a low price when transferring to a lower-tax country.
Conflicting Objectives
There is an inherent conflict between the performance evaluation and costminimization objectives of transfer pricing. To minimize costs, top managers must dictate a discretionary transfer price. By definition, this is not a price that has been negotiated by the two managers who are party to a transaction, nor is it necessarily based on external market prices or production costs. The benefits of decentralization can evaporate when top managers assume the responsibility for determining transfer prices. One way that companies deal with this conflict is through dual pricing. The official records for tax and financial reporting are based on the cost-minimizing transfer prices. When it comes time to evaluate performance, however, the actual records are adjusted to reflect prices acceptable to both parties to the transaction factoring out the effect of discretionary transfer prices. Actual transfers are invoiced so as to minimize costs, but evaluation of performance is based on simulated prices.
7 The price is discretionary in the sense that it is not based on market value, cost, or negotiation but has been determined at Parents discretion to reduce income taxes.
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Other Cost-Minimization Objectives

In addition to the objective of minimizing worldwide income taxes, a number of other objectives can be achieved through the use of discretionary transfer prices for international transactions.
Avoidance of Withholding Taxes

A parent company might want to avoid receiving cash payments from its foreign subsidiaries in the form of dividends, interest, and royalties on which withholding taxes will be paid to the foreign government. Instead, cash can be transferred in the form of sales price for goods and services provided the foreign subsidiary by its parent or other affiliates. There is no withholding tax on payments for purchases of goods and services. The higher the price charged the foreign subsidiary, the more cash can be extracted from the foreign country without incurring withholding tax. For example, assume that the European subsidiary of Kerr Corporation purchases finished goods from its foreign parent at a price of 100 per unit; sells those goods in the local market at a price of 130 per unit; and remits 100 percent of its profit to the parent company, upon which it pays a 30 percent dividend withholding tax. Ignoring income taxes, the total cash flow received by Kerr Corporation from its European subsidiary is 121 per unit; 100 from the sale of finished goods and 21 (30 [30 30%]) in the form of dividends after withholding tax. If Kerr Corporation were to raise the selling price to its European subsidiary to 120 per unit, the total cash flow it would receive would increase to 127 per unit; 120 in the form of transfer price plus 7 (10 [10 30%]) in net dividends. Raising the transfer price even further to 130 per unit results in cash flow to Kerr Corporation of 130 per unit. Selling goods and services to a foreign subsidiary (downstream sale) at a higher price reduces the amount of profit earned by the foreign subsidiary that will be subject to a dividend withholding tax. Sales of goods and services by the foreign subsidiary to its parent (upstream sale) at a lower price will achieve the same objective.
Minimization of Import Duties (Tariffs)

Countries generally assess tariffs on the value (based on invoice prices) of goods being imported into the country. These are known as ad valorem import duties. One way to reduce ad valorem import duties is to transfer goods to a foreign operation at lower prices.
Circumvent Profit Repatriation Restrictions

Some countries restrict the amount of profit that can be paid as a dividend to a foreign parent company. This is known as a profit repatriation restriction. A company might be restricted to paying a dividend equal to or less than a certain percentage of annual profit or a certain percentage of capital contributed to the company by its parent. When such restrictions exist, the parent can get around the restriction and remove profit indirectly by setting high transfer prices on goods and services provided the foreign operation by the parent and other affiliates. This strategy is consistent with the objective of avoiding withholding taxes.
Protect Cash Flows from Currency Devaluation

In many cases, some amount of the net cash flow generated by a subsidiary in a foreign country will be moved out of that country, if for no other reason than to distribute it as a dividend to stockholders of the parent company. As the foreign currency devalues, the parent currency value of any foreign currency cash decreases.
For operations located in countries whose currency is prone to devaluation, the parent may want to accelerate removing cash out of that country before more devaluation occurs. One method for moving more cash out of a country is to set high transfer prices for goods and services provided the foreign operation by the parent and other related companies.
Improve Competitive Position of Foreign Operation

MNCs also are able to use international transfer pricing to maintain competitiveness in international markets and to penetrate new foreign markets. To penetrate a new market, a parent company might establish a sales subsidiary in a foreign country. To capture market share, the foreign operation must compete aggressively on price, providing its customers with significant discounts. To ensure that the new operation is profitable, while at the same expecting it to compete on price, the parent company can sell finished goods to its foreign sales subsidiary at low prices. In effect, the parent company absorbs the discount. The parent company might want to improve the credit status of a foreign operation so that it can obtain local financing at lower interest rates. This generally involves improving the balance sheet by increasing assets and retained earnings. This objective can be achieved by setting low transfer prices for inbound goods to the foreign operation and high transfer prices for outbound goods from the foreign operation, thereby improving profit and cash flow. Exhibit 11.2 summarizes the transfer price (high or low) needed to achieve various cost-minimization objectives. High transfer prices can be used to (1) minimize worldwide income taxes when transferring to a higher-tax country, (2) reduce withholding taxes (downstream sales), (3) circumvent repatriation restrictions, and (4) protect foreign currency cash from devaluation. However, low transfer prices are necessary to (1) minimize worldwide income taxes when transferring to a lower-tax country, (2) reduce withholding taxes (upstream sales), (3) minimize import duties, and (4) improve the competitive position of a foreign operation. It should be noted that these different cost-minimization objectives might conflict with one another. For example, charging a higher transfer price to a foreign affiliate to reduce the amount of withholding taxes paid to the foreign government will result in a higher amount of import duties paid to the foreign government. Companies can employ linear programming techniques to determine the optimum transfer price when two or more cost-minimization objectives exist. Electronic spreadsheets also can be used to conduct sensitivity analysis,
EXHIBIT 11.2
Cost Minimization Objectives and Transfer Prices
Objective Minimize income taxes Transferring to a country with higher tax rate . . . . . . . . . Transferring to a country with lower tax rate . . . . . . . . . . Minimize withholding taxes Downstream transfer . . . . . . . . . . . . . . . . . . . . . . . . . . . Upstream transfer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Minimize import duties . . . . . . . . . . . . . . . . . . . . . . . . . . . . Protect foreign cash flows from currency devaluation . . . . . Avoid repatriation restrictions . . . . . . . . . . . . . . . . . . . . . . . Improve competitive position of foreign operation . . . . . . .
Transfer Pricing Rule High price Low price High price Low price Low price High price High price Low price
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examining the impact different transfer prices would have on consolidated profit and cash flows.
Survey Results
A survey conducted in the late 1970s found the following to be the top five factors influencing the international transfer pricing policies of U.S. MNCs:8 1. 2. 3. 4. 5. Overall profit to the company. Repatriation restrictions on profits and dividends. Competitive position of subsidiaries in foreign countries. Tax and tax legislation differentials between countries. Performance evaluation.
For Japanese MNCs, the top five factors were the following: 1. 2. 3. 4. 5. Overall profit to the company. Competitive position of subsidiaries in foreign countries. Foreign currency devaluation. Repatriation restrictions on profits and dividends. Performance evaluation.
Differences in income tax rates between countries ranked only 14th for the Japanese MNCs surveyed. In an updated survey of U.S. MNCs published in 1992, the top four factors remained the same.9 Import duty rates were the fifth most important factor influencing international transfer pricing policies. Performance evaluation dropped to the 10th position.
GOVERNMENT REACTIONS
National tax authorities are aware of the potential for MNCs to use discretionary transfer pricing to avoid paying income taxes, import duties, and so on. Most countries have guidelines regarding what will be considered an acceptable transfer price for tax purposes. Across countries, these guidelines can conflict, creating the possibility of double taxation when a price accepted by one country is disallowed by another. The Organisation for Economic Cooperation and Development (OECD) developed transfer pricing guidelines in 1979 that have been supplemented or amended several times since then. The basic rule is that transfers must be made at arms-length prices. The idea is that OECD member countries would adopt the OECD guidelines and thereby avoid conflicts. The OECD rules are only a model and do not have the force of law in any country. However, most developed countries have transfer pricing rules generally based on OECD guidelines with some variations. The next section of this chapter discusses the specific transfer pricing rules adopted in the United States. Although the rules we discuss are specific to the United States, similar rules can be found in many other countries.
8 Roger Y. W. Tang and K. H. Chan, Environmental Variables of International Transfer Pricing: A JapanUnited States Comparison, Abacus, 1979, pp. 312. 9
Roger Y. W. Tang, Transfer Pricing in the 1990s, Management Accounting, February 1992, pp. 2226.
SECTION 482 OF THE U.S. INTERNAL REVENUE CODE

Section 482 of the Internal Revenue Code (IRC) gives the Internal Revenue Service (IRS) the power to audit international transfer prices and adjust a companys tax liability if the price is deemed to be inappropriate. The IRS may audit and adjust transfer prices between companies controlled directly or indirectly by the same taxpayer. Thus, Section 482 applies to both upstream and downstream transfers between a U.S. parent and its foreign subsidiary, between a foreign parent and its U.S. subsidiary, or between the U.S. subsidiary and foreign subsidiary of the same parent. The IRS, of course, is primarily concerned that a proper amount of income is being recorded and taxed in the United States. Similar to the OECD guidelines, Section 482 requires transactions between commonly controlled entities to be carried out at arms-length prices. Arms-length prices are defined as the prices which would have been agreed upon between unrelated parties engaged in the same or similar transactions under the same or similar conditions in the open market. Because same or similar transactions with unrelated parties often do not exist, determination of an arms-length price generally will involve reference to comparable transactions under comparable circumstances. The U.S. Treasury Regulations supplementing Section 482 establish more specific guidelines for determining an arms-length price. In general, a best-method rule requires taxpayers to use the transfer pricing method that under the facts and circumstances provides the most reliable measure of an arms-length price. There is no hierarchy in application of methods, and no method always will be considered more reliable than others. In determining which method provides the most reliable measure of an arms-length price, the two primary factors to be considered are the degree of comparability between the intercompany transaction and any comparable uncontrolled transactions, and the quality of the data and assumptions used in the analysis. Determining the degree of comparability between an intercompany transaction and an uncontrolled transaction involves a comparison of the five factors listed in Exhibit 11.3. Each of these factors must be considered in determining the degree of comparability between an intercompany transaction and an uncontrolled transaction and the extent to which adjustments must be made to establish an arms-length price. Treasury Regulations establish guidelines for determining an arms-length price for various kinds of intercompany transactions, including sales of tangible property, licensing of intangible property, intercompany loans, and intercompany services. Although we focus on regulations related to the sale of tangible property because this is the most common type of international intercompany transaction, we also describe regulations related to licensing intangible assets, intercompany loans, and intercompany services.
Sale of Tangible Property

Treasury Regulations require the use of one of five specified methods to determine the arms-length price in a sale of tangible property (inventory and fixed assets): 1. 2. 3. 4. 5. Comparable uncontrolled price method. Resale price method. Cost-plus method. Comparable profits method. Profit split method.
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EXHIBIT 11.3
Factors to Be Considered in Determining the Comparability of an Intercompany Transaction and an Uncontrolled Transaction
Source: U.S. Treasury Regulations, Sec. 1.482-1(d).
1. Functions performed by the various parties in the two transactions, including Research and development. Product design and engineering. Manufacturing, production, and process engineering. Product fabrication, extraction, and assembly. Purchasing and materials management. Marketing and distribution functions, including inventory management, warranty administration, and advertising activities. Transportation and warehousing. Managerial, legal, accounting and finance, credit and collection, training, and personnel management services. 2. Contractual terms that could affect the results of the two transactions, including The form of consideration charged or paid. Sales or purchase volume. The scope and terms of warranties provided. Rights to updates, revisions, and modifications. The duration of relevant license, contract, or other agreement, and termination and negotiation rights. Collateral transactions or ongoing business relationships between the buyer and seller, including arrangements for the provision of ancillary or subsidiary services. Extension of credit and payment terms. 3. Risks that could affect the prices that would be charged or paid, or the profit that would be earned, in the two transactions, including Market risks. Risks associated with the success or failure of research and development activities. Financial risks, including fluctuations in foreign currency rates of exchange and interest rates. Credit and collection risk. Product liability risk. General business risks related to the ownership of property, plant, and equipment. 4. Economic conditions that could affect the price or profit earned in the two transactions, such as The similarity of geographic markets. The relative size of each market, and the extent of the overall economic development in each market. The level of the market (e.g., wholesale, retail). The relevant market shares for the products, properties, or services transferred or provided. The location-specific costs of the factors of production and distribution. The extent of competition in each market with regard to the property or services under review. The economic condition of the particular industry, including whether the market is in contraction or expansion. The alternatives realistically available to the buyer and seller. 5. Property or services transferred in the transactions, including any intangibles that are embedded in tangible property or services being transferred.
If none of these methods is determined to be appropriate, companies are allowed to use an unspecified method, provided its use can be justified.
Comparable Uncontrolled Price Method

The comparable uncontrolled price method is generally considered to provide the most reliable measure of an arms-length price when a comparable uncontrolled transaction exists. Assume that a U.S.-based parent company (Parentco) makes sales of tangible property to a foreign subsidiary (Subco). Under this method, the price for tax purposes is determined by reference to sales by Parentco of the same or similar product to unrelated customers, or purchases by Subco of the same or similar product from unrelated suppliers. Also, sales of the same product between two unrelated parties could be used to determine the transfer price. To determine whether the comparable uncontrolled price method results in the most reliable measure of arms-length price, a company must consider each of the factors listed in Exhibit 11.3. Section 1.482-3 of the Treasury Regulations indicates specific factors that may be particularly relevant in determining whether an uncontrolled transaction is comparable: 1. 2. 3. 4. 5. 6. 7. 8. Quality of the product. Contractual terms. Level of the market. Geographic market in which the transaction takes place. Date of the transaction. Intangible property associated with the sale. Foreign currency risks. Alternatives realistically available to the buyer and seller.
If the uncontrolled transaction is not exactly comparable, some adjustment to the uncontrolled price is permitted in order to make the transactions more comparable. For example, assume that Sorensen Company, a U.S. manufacturer, sells the same product to both controlled and uncontrolled distributors in Mexico. The price to uncontrolled distributors is $40 per unit. Sorensen affixes its trademark to the products sold to its Mexican subsidiary but not to the products sold to the uncontrolled distributor. The trademark is considered to add approximately $10 of value to the product. The transactions are not strictly comparable because the products sold to the controlled and uncontrolled parties are different (one has a trademark and the other does not). Adjusting the uncontrolled price of $40 by $10 would result in a more comparable price and $50 would be an acceptable transfer price under the comparable uncontrolled price method. If the value of the trademark could not be reasonably determined, the comparable uncontrolled price method might not result in the most reliable arms-length price in this scenario.
Resale Price Method

The resale price method determines the transfer price by subtracting an appropriate gross profit from the price at which the controlled buyer resells the tangible property. In order to use this method, a company must know the final selling price to uncontrolled parties and be able to determine an appropriate gross profit for the reseller. An appropriate gross profit is determined by reference to the gross profit margin earned in comparable uncontrolled transactions. For example, assume that Odom Company manufactures and sells automobile batteries to its Canadian affiliate, which in turn sells the batteries to local retailers at a resale price of $50 per unit.
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Other Canadian distributors of automobile batteries earn an average gross profit margin of 25 percent on similar sales. Applying the resale price method, Odom Company would establish an arms-length price of $37.50 per unit for its sale of batteries to its Canadian affiliate (resale price of $50 less an appropriate gross profit of $12.50 [25 percent] to be earned by the Canadian affiliate). In determining an appropriate gross profit, the degree of comparability between the sale made by the Canadian affiliate and sales made by uncontrolled Canadian distributors need not be as great as under the comparable uncontrolled price method. The decisive factor is the similarity of functions performed by the affiliate and uncontrolled distributors in making sales. For example, if the functions performed by the Canadian affiliate in selling batteries are similar to the functions performed by Canadian distributors of automobile parts in general, the company could use the gross profit earned by uncontrolled sellers of automobile parts in Canada in determining an acceptable transfer price. Other important factors affecting comparability might include the following: Inventory levels and turnover rates. Contractual terms (e.g., warranties, sales volume, credit terms, transport terms). Sales, marketing, advertising programs and services, including promotional programs, and rebates. Level of the market (e.g., wholesale, retail). The resale price method is typically used when the buyer/reseller is merely a distributor of finished goodsa so-called sales subsidiary. The method is acceptable only when the buyer/reseller does not add a substantial amount of value to the product. The resale price method is not feasible in cases where the reseller adds substantial value to the goods or where the goods become part of a larger product, because there is no final selling price to uncontrolled parties for the goods that were transferred. Continuing with our example, if Odom Companys Canadian affiliate operates an auto assembly plant and places the batteries purchased from Odom in automobiles that are then sold for $20,000 per unit, the company cannot use the resale price method for determining an appropriate transfer price for the batteries.
Cost-Plus Method
The cost-plus method is most appropriate when there are no comparable uncontrolled sales and the related buyer does more than simply distribute the goods it purchases. Whereas the resale price method subtracts an appropriate gross profit from the resale price to establish the transfer price, the cost-plus method adds an appropriate gross profit to the cost of producing a product to establish an armslength price. This method is normally used in cases involving manufacturing, assembly, or other production of goods that are sold to related parties. Once again, the appropriate gross profit markup is determined by reference to comparable uncontrolled transactions. Physical similarity between the products transferred is not as important in determining comparability under this method as it is under the comparable uncontrolled price method. Factors to be included in determining whether an uncontrolled transaction is comparable include similarity of functions performed, risks borne, and contractual terms. Factors that may be particularly relevant in determining comparability under this method include the following: Complexity of the manufacturing or assembly process. Manufacturing, production, and process engineering.
Procurement, purchasing, and inventory control activities. Testing functions. To illustrate use of the cost-plus method, assume that Pruitt Company has a subsidiary in Taiwan that acquires materials locally to produce an electronic component. The component, which costs $4 per unit to produce, is sold only to Pruitt Company. Because the Taiwanese subsidiary does not sell this component to other, unrelated parties, the comparable uncontrolled price method is not applicable. Pruitt Company combines the electronic component imported from Taiwan with other parts to assemble electronic switches that are sold in the United States. Because Pruitt does not simply resell the electronic components in the United States, the resale price method is not available. Therefore, Pruitt must look for a comparable transaction between unrelated parties in Taiwan to determine whether the cost plus method can be used. Assume that an otherwise comparable company in Taiwan manufactures similar electronic components from its inventory of materials and sells them to unrelated buyers at an average gross profit markup on cost of 25 percent. In this case, application of the cost-plus method results in a transfer price of $5 ($4 + [$4 25%]) for the electronic component that Pruitt purchases from its Taiwanese subsidiary. Now assume that Pruitts Taiwanese subsidiary manufactures electronic components using materials provided by Pruitt on a consignment basis. To apply the cost-plus method, Pruitt would have to make a downward adjustment to the otherwise comparable gross profit markup of 25 percent, because the inventory risk assumed by the manufacturer in the comparable transaction justifies a higher gross profit markup than is appropriate for Pruitts foreign subsidiary. If Pruitt cannot reasonably ascertain the effect of inventory procurement and handling on gross profit, the cost-plus method might not result in a reliable transfer price.
Comparable Profits Method

The comparable profits method is based on the assumption that similarly situated taxpayers will tend to earn similar returns over a given period.10 Under this method, one of the two parties in a related transaction is chosen for examination. An armslength price is determined by referring to an objective measure of profitability earned by uncontrolled taxpayers on comparable, uncontrolled sales. Profit indicators that might be considered in applying this method include the ratio of operating income to operating assets, the ratio of gross profit to operating expenses, or the ratio of operating profit to sales. If the transfer price used results in ratios for the party being examined that are in line with those ratios for similar businesses, then the transfer price will not be challenged. To demonstrate the comparable profits method, assume that Glassco, a U.S. manufacturer, distributes its products in a foreign country through its foreign sales subsidiary, Vidroco. Assume that Vidroco has sales of $1,000,000 and operating expenses (other than cost of goods sold) of $200,000. Over the past several years, comparable distributors in the foreign country have earned operating profits equal to 5 percent of sales. Under the comparable profits method, a transfer price that provides Vidroco an operating profit equal to 5 percent of sales would be considered arms length. An acceptable operating profit for Vidroco is $50,000 ($1,000,000 5%). To achieve this amount of operating profit, cost of goods sold
10
The comparable profits method is described in Treasury Regulations, Sec. 1.482-5.
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must be $750,000 ($1,000,000 $200,000 $50,000); this is the amount that Glassco would be allowed to charge as a transfer price for its sales to Vidroco. This example demonstrates use of the ratio of operating profit to sales as the profit-level indicator under the comparable profits method. The Treasury Regulations also specifically mention use of the ratio of operating profit to operating assets and the ratio of gross profit to operating expenses as acceptable profit-level indicators in applying this method.
Profit Split Method

The profit split method assumes that the buyer and seller are one economic unit.11 The total profit earned by the economic unit from sales to uncontrolled parties is allocated to the members of the economic unit based on their relative contributions in earning the profit. The relative value of each partys contribution in earning the profit is based on the functions performed, risks assumed, and resources employed in the business activity that generates the profit. There are in fact two versions of the profit split method: (1) comparable profit split method and (2) residual profit split method. Under the comparable profit split method, the profit split between two related parties is determined through reference to the operating profit earned by each party in a comparable uncontrolled transaction. Each of the factors listed in Exhibit 11.3 must be considered in determining the degree of comparability between the intercompany transaction and the comparable uncontrolled transaction. The degree of similarity in the contractual terms between the controlled and comparable uncontrolled transaction is especially critical in determining whether this is the best method. In addition, Treasury Regulations specifically state that this method may not be used if the combined operating profit (as a percentage of the combined assets) of the uncontrolled comparables varies significantly from that earned by the controlled taxpayers.12 When controlled parties possess intangible assets that allow them to generate profits in excess of what is earned in otherwise comparable uncontrolled transactions, the residual profit split method should be used. Under this method the combined profit is allocated to each of the controlled parties following a two-step process. In the first step, profit is allocated to each party to provide a market return for its routine contributions to the relevant business activity. This step will not allocate all of the combined profit earned by the controlled parties, because it will not include a return for the intangible assets that they possess. In the second step, the residual profit attributable to intangibles is allocated to each of the controlled parties on the basis of the relative value of intangibles that each contributes to the relevant business activity. The reliability of this method hinges on the ability to measure the value of the intangibles reliably.
Licenses of Intangible Property

Treasury Regulations, Section 1.482-4, list six categories of intangible property:
11 12
Patents, inventions, formulae, processes, designs, patterns, or know-how. Copyrights and literary, musical, or artistic compositions. Trademarks, trade names, or brand names. Franchises, licenses, or contracts.
The profit split method is described in Treasury Regulations, Sec. 1.482-6. Treasury Regulations, Sec. 1.482-6 (c)(2).
Methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data. Other similar items. An item is considered similar if it derives its value from its intellectual content or other intangible properties rather than from physical properties. Four methods are available for determining the arms-length consideration for the license of intangible property: Comparable uncontrolled transaction method. Comparable profits methods. Profit split method. Unspecified methods.
The comparable profits method and profit split method are the same methods as those available for establishing the transfer price on tangible property. The comparable uncontrolled transaction method is similar in concept to the comparable uncontrolled price method available for tangible property.
Comparable Uncontrolled Transaction (CUT) Method

The comparable uncontrolled transaction (CUT) method determines whether or not the amount a company charges a related party for the use of intangible property is an arms-length price by referring to the amount it charges an unrelated party for the use of the intangible. Treasury Regulations indicate that if an uncontrolled transaction involves the license of the same intangible under the same (or substantially the same) circumstances as the controlled transaction, the results derived from applying the CUT method will generally be the most reliable measure of an arms-length price. The controlled and uncontrolled transactions are substantially the same if there are only minor differences that have a definite and reasonably measurable effect on the amount charged for use of the intangible. If substantially the same uncontrolled transactions do not exist, uncontrolled transactions that involve the transfer of comparable intangibles under comparable circumstances may be used in applying the CUT method. In evaluating the comparability of an uncontrolled transaction, the following factors are particularly relevant:13 The terms of the transfer, including the exploitation rights granted in the intangible, the exclusive or nonexclusive character of any rights granted, any restrictions on use or any limitation on the geographic area in which the rights may be exploited. The stage of development of the intangible (including, where appropriate, necessary governmental approvals, authorizations, or licenses) in the market in which the intangible is to be used. Rights to receive updates, revisions or modifications of the intangible. The uniqueness of the property and the period for which it remains unique, including the degree and duration of protection afforded to the property under the laws of the relevant countries. The duration of the contract or other agreement, and any termination or renegotiation rights.
13
Treasury Regulations, Sec. 1.482-4 (c)(2).
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Any economic and product liability risks to be assumed by the transferee. The existence and extent of any collateral transactions or ongoing business relationships between the transferee and transferor. The functions to be performed by the transferor and transferee, including any ancillary or subsidiary services. Furthermore, differences in economic conditions also can affect comparability and therefore the appropriateness of the CUT method. For example, if a U.S. pharmaceutical company licenses a patented drug to an uncontrolled manufacturer in Country A and licenses the same drug under the same contractual terms to its subsidiary in Country B, the two transactions are not comparable if the potential market for the drug is higher in Country B because of a higher incidence of the disease the drug is intended to combat.
Profit Split Method

Treasury Regulations provide the following example to demonstrate application of the residual profit split method to licensing intangibles. P, a U.S.-based company, manufactures and sells products for police use in the United States. P develops and obtains a patent for a bulletproof material, Nulon, for use in its protective clothing and headgear. P licenses its European subsidiary, S, to manufacture and sell Nulon in Europe. S has adapted Ps products for military use and sells to European governments under brand names that S has developed and owns. Ss revenues from the sale of Nulon in Year 1 are $500, and Ss direct operating expenses (excluding royalties) are $300. The royalty the IRS will allow P to charge S for the license to produce Nulon is determined as follows: 1. The IRS determines that the operating assets used by S in producing Nulon are worth $200. From an examination of profit margins earned by other European companies performing similar functions, it determines that 10 percent is a fair market return on Ss operating assets. Of Ss operating profit of $200 (sales of $500 less direct operating expenses of $300), the IRS determines that $20 ($200 10%) is attributable to Ss operating assets. The remaining $180 is attributable to intangibles. In the second step, the IRS determines how much of this $180 is attributable to Ps intangibles and how much is attributable to Ss intangibles. The amount attributable to Ps intangibles is the amount the IRS will allow P to charge S for the license to produce Nulon. 2. The IRS establishes that the market values of P and Ss intangibles cannot be reliably determined. Therefore, it estimates the relative values of the intangibles from Year 1 expenditures on research, development, and marketing. Ps research and development expenditures relate to Ps worldwide activities, so the IRS allocates these expenditures to worldwide sales. By comparing these expenditures in Year 1 with worldwide sales in Year 1, the IRS determines that the contribution to worldwide gross profit made by Ps intangibles is 20 percent of sales. In contrast, Ss research, development, and marketing expenditures pertain to European sales, and the IRS determines that the contribution that Ss intangibles make to Ss gross profit is equal to 40 percent of sales. Thus, of the portion of Ss gross profit that is not attributable to a return on Ss operating assets, one-third (20%/60%) is attributable to Ps intangibles and two-thirds is attributable to Ss intangibles (40%/60%). Under the residual profit split method, P will charge S a license fee of $60 ($180 1 ) in 3 Year 1.
Intercompany Loans
When one member of a controlled group makes a loan to another member of the group, Section 482 of the U.S. Internal Revenue Code requires an arms-length rate of interest to be charged on the loan. In determining an arms-length interest rate, all relevant factors should be considered including the principal and duration of the loan, the security involved, the credit standing of the borrower, and the interest rate prevailing for comparable loans between unrelated parties. A safe harbor rule exists when the loan is denominated in U.S. dollars and the lender is not regularly engaged in the business of making loans to unrelated persons. Such would be the case, for example, if a U.S. manufacturing firm made a U.S.-dollar loan to its foreign subsidiary. In this situation, the stated interest rate is considered to be at arms length if it is at a rate not less than the applicable Federal rate and not greater than 130 percent of the applicable Federal rate (AFR). The AFR is based on the average interest rate on obligations of the federal government with similar maturity dates. The AFR is recomputed each month. Assuming an AFR of 4 percent on one-year obligations, the U.S. manufacturing firm could charge an interest rate anywhere from 4 percent to 5.2 percent on a one-year U.S.dollar loan to its foreign subsidiary without having to worry about a transfer pricing adjustment being made by the IRS.
Intercompany Services
When one member of a controlled group provides a service to another member of the group, the purchaser must pay an arms-length price to the service provider. If the services provided are incidental to the business activities of the service provider, the arms-length price is equal to the direct and indirect costs incurred in connection with providing the service. There is no need to include a profit component in the price in this case. However, if the service provided is an integral part of the business function of the service provider, the price charged must include profit equal to what would be earned on similar services provided to an unrelated party. For example, assume that engineers employed by Brandlin Company travel to the Czech Republic to provide technical assistance to the companys Czech subsidiary in setting up a production facility. Brandlin must charge the foreign subsidiary a fee for this service equal to the direct and indirect costs incurred. Direct costs include the cost of the engineers travel to the Czech Republic and their salaries while on the assignment. Indirect costs might include a portion of Brandlins overhead costs allocated to the engineering department. If Brandlin is in the business of providing this type of service to unrelated parties, it must also include an appropriate amount of profit in the technical assistance fee it charges its Czech subsidiary. No fee is required to be charged to a related party if the service performed on its behalf merely duplicates an activity the related party has performed itself. For example, assume that engineers employed by Brandlins Czech subsidiary design the layout of the production facility themselves and their plan is simply reviewed by Brandlins U.S. engineers. In this case, the U.S. parent company need not charge the foreign subsidiary a fee for performing the review.
Arms-Length Range
The IRS acknowledges that application of a specific transfer pricing method could result in a number of transfer prices thereby creating an arms-length range of prices. A company will not be subject to IRS adjustment so long as its transfer price falls within this range. For example, assume that Harrell Company determines the
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comparable uncontrolled price method to be the best method for purchases of Product X from its wholly owned Chinese subsidiary. Four comparable uncontrolled transactions are identified with prices of $9.50, $9.75, $10.00, and $10.50. Harrell Company can purchase Product X from its Chinese subsidiary at a price anywhere from $9.50 to $10.50 without the risk of an adjustment being made by the IRS. The company may wish to choose that price within the arms-length range (either the highest price or the lowest price) that would allow it to achieve one or more cost-minimization objectives.
Correlative Relief
Determination of an arms-length transfer price acceptable to the IRS is very important. If the IRS adjusts a transfer price in the United States, there is no guarantee that the foreign government at the other end of the transaction will reciprocate by providing a correlative adjustment. If the foreign government does not provide correlative relief, the total tax liability for the MNC increases. For example, assume that Usco Inc. manufactures a product for $10 per unit that is sold to its affiliate in Brazil (Brazilco) for $12 per unit. The Brazilian affiliate sells the product at $20 per unit in the Brazilian market. In that case, the worldwide income tax paid on this sale would be $2.70 per unit, calculated as follows:
Usco Sales . . . . . . . . . . . . . Cost of sales . . . . . . . . Taxable income . . . . . . Tax liability . . . . . . . . . $ 12 10 $ 2 $.70 (35%) Brazilco $ 20 12 $ 8 $2.00 (25%)
Assume further that Usco is unable to justify its transfer price of $12 through use of one of the acceptable transfer pricing methods, and the IRS adjusts the price to $15. This results in U.S. taxable income of $5 per unit. If the Brazilian government refuses to allow Brazilco to adjust its cost of sales to $15 per unit, the worldwide income tax paid on this sale would be $3.75 per unit, determined as follows:
Usco Sales . . . . . . . . . . . . . Cost of sales . . . . . . . . Taxable income . . . . . . Tax liability . . . . . . . . . $ 15 10 $ 5 $1.75 (35%) Brazilco $ 20 12 $ 8 $2.00 (25%)
Article 9 of the U.S. Model Income Tax Treaty requires that, when the tax authority in one country makes an adjustment to a companys transfer price, the tax authority in the other country will provide correlative relief if it agrees with the adjustment. If the other country does not agree with the adjustment, the competent authorities of the two countries are required to attempt to reach a compromise. If no compromise can be reached, the company will find itself in the situation described earlier. In the absence of a tax treaty (such as in the case of the United States and Brazil), there is no compulsion for the other country to provide a correlative adjustment. When confronted with an IRS transfer pricing adjustment, a taxpayer may request assistance from the U.S. Competent Authority through its Mutual Agreement
Procedure (MAP) to obtain correlative relief from the foreign government. In 2002, the IRS recommended $5.56 billion in transfer pricing adjustments. The MAP process resulted in a correlative adjustment in 38 percent of the adjustments.14 In an additional 27 percent of cases, MAP resulted in the withdrawal of the adjustment by the IRS. The MAP process is not speedy. Over the period 19972002, the MAP process took an average of 679948 days to secure a correlative adjustment.
Penalties
In addition to possessing the power to adjust transfer prices, the IRS has the authority to impose penalties on companies that significantly underpay taxes as a result of inappropriate transfer pricing. A penalty equal to 20 percent of the underpayment in taxes may be levied for a substantial valuation misstatement. The penalty increases to 40 percent of the underpayment on a gross valuation misstatement. A substantial valuation misstatement exists when the transfer price is 200 percent or more (50 percent or less) of the price determined under Section 482 to be the correct price. A gross valuation misstatement arises when the price is 400 percent or more (25 percent or less) than the correct price. For example, assume Tomlington Company transfers a product to a foreign affiliate for $10 and the IRS determines the correct price should have been $50. The adjustment results in an increase in U.S. tax liability of $1,000,000. Because the original transfer price was less than 25 percent of the correct price ($50 25% = $12.50), the IRS levies a penalty of $400,000 (40% of $1,000,000). Tomlington Company will pay the IRS a total of $1,400,000 as a result of its gross valuation misstatement.
ADVANCE PRICING AGREEMENTS

To introduce some certainty into the transfer pricing issue, the United States originated and actively promotes the use of advance pricing agreements (APAs). An APA is an agreement between a company and the IRS to apply an agreed-on transfer pricing method to specified transactions. The IRS agrees not to seek any transfer pricing adjustments for transactions covered by the APA if the company uses the agreed-on method. A unilateral APA is an agreement between a taxpayer and the IRS establishing an approved transfer pricing method for U.S. tax purposes. Whenever possible, the IRS will also negotiate the terms of the APA with foreign tax authorities to create a bilateral APA, which is an agreement between the IRS and one or more foreign tax authorities that the transfer pricing method is correct. The APA process consists of five phases: (1) application; (2) due diligence; (3) analysis; (4) discussion and agreement; and (5) drafting, review, and execution. The request for an APA involves the company proposing a particular transfer pricing method to be used in specific transactions. Generally, one of the methods required to be followed by Treasury Regulations will be requested, but another method can be requested if none of the methods specified in the regulations is applicable or practical. In considering the request for an APA, the IRS is likely to require the following information as part of the application: 1. An explanation of the proposed methodology. 2. A description of the company and its related partys business operations.
14
U.S. Department of the Treasury, Current Trends in the Administration of International Transfer Pricing by the Internal Revenue Service, September 2003, p. 13.
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3. An analysis of the companys competitors. 4. Data on the industry showing pricing practices and rates of return on comparable transactions between unrelated parties. For most taxpayers, the APA application is a substantial document filling several binders.15 The clear advantage to negotiating an APA is the assurance that the prices determined using the agreed-on transfer pricing method will not be challenged by the IRS. Disadvantages of the APA are that it can be very time-consuming to negotiate and that it involves disclosing a great deal of information to the IRS. The IRS indicates that new unilateral agreements take an average of 22 months to negotiate and bilateral agreements take even longer (41 months).16 Although thousands of companies engage in transactions that cross U.S. borders, by the end of 2002 only 434 APAs had been negotiated since the programs inception in 1991. The first completed APA was for sales between Apple Computer Inc. and its Australian subsidiary. In 1992, Japans largest consumer electronics firm, Matsushita (known for its Panasonic and Technics brands), announced that after two years of negotiation it had entered into an APA with both the IRS and the Japanese National Tax Administration.17 Companies in the computer and electronics product manufacturing industry have been the greatest users of APAs. Foreign companies with U.S. operations are as likely to request an APA as U.S. companies with foreign operations. Of a total of 58 APAs that were executed in 2003, 60 percent were between a U.S. subsidiary or branch and its foreign parent, and 40 percent involved transactions between a U.S. parent and its foreign subsidiary.18 Through the end of 2002, almost 60 percent of all APAs were with foreign parents of U.S. companies. In 1998, the IRS instituted an APA program for small business taxpayers that somewhat streamlines the process of negotiating an APA. IRS Notice 98-65 describes the special APA procedures for small businesses. In 2003, four new small-businesstaxpayer APAs were completed, taking an average of 12.5 months to complete.19 Most APAs cover transactions that involve a number of business functions and risks. For example, manufacturing firms typically conduct research and development, design and engineer products, manufacture products, market and distribute products, and provide after-sales services. Risks include market risks, financial risks, credit risks, product liability risks, and general business risks. The IRS indicates that in the APA evaluation process a significant amount of time and effort is devoted to understanding how the functions and risks are allocated amongst the controlled group of companies that are party to the covered transactions.20 To facilitate this evaluation, the company must provide a functional analysis as part of the APA application. The functional analysis identifies the economic activities performed, the assets employed, the costs incurred, and risks assumed by each of
15
U.S. Internal Revenue Service, Announcement and Report Concerning Advance Pricing Agreements, Internal Revenue Bulletin: 2004-15, April 13, 2004. 16 Ibid., Table 2. 17 Big Japan Concern Reaches an Accord on Paying U.S. Tax, New York Times, November 11, 1992, p. A1. 18 U.S. Internal Revenue Service, Announcement and Report Concerning Advance Pricing Agreements, Internal Revenue Bulletin: 2004-15, April 13, 2004, Table 10.
19 20
Ibid., Table 7. Ibid.
the related parties. The purpose is to determine the relative value being added by each function and therefore by each related party. The IRS uses the economic theory that higher risks demand higher returns and that different functions have different opportunity costs in making its evaluation. Each IRS APA team generally includes an economist to help with this analysis. Sales of tangible property are the type of intercompany transaction most frequently covered by an APA, and the comparable profits method is the transfer pricing method most commonly applied.21 This is because reliable public data on comparable business activities of uncontrolled companies may be more readily available than potential comparable uncontrolled price data, ruling out the CUP method. In addition, because the comparable profits method relies on operating profit margin rather than gross profit margin (as do the resale price and cost-plus methods), the comparable profits method is not as dependent on exact comparables being available. Companies that perform different functions may have very different gross profit margins, but earn similar levels of operating profit. A relatively large number of countries have developed their own APA programs. France introduced a procedure for APAs in 1999, and in 2000 the Ministry of Finance in Indonesia announced proposals to introduce APAs. Other countries in which APAs are available include, but are not limited to, Australia, Brazil, Canada, China, Germany, Japan, Korea, Mexico, Taiwan, the United Kingdom, and Venezuela.
REPORTING REQUIREMENTS IN THE UNITED STATES

To determine whether intercompany transactions meet the arms-length price requirement, the IRS often must request substantial information from the company whose transfer pricing is being examined. Historically, the IRS has found it extremely difficult to obtain such information when the transaction involves a transfer from a foreign parent company to its U.S. subsidiary. The information might be held by the foreign parent, which is beyond the jurisdiction of the IRS. To reduce this problem, U.S. tax law now requires substantial reporting and record keeping of any U.S. company that (1) has at least one foreign shareholder with a 25 percent interest in the company and (2) engages in transactions with that shareholder. Accounting and other records must be physically maintained in the United States by a U.S. company meeting this definition. In addition, Form 5472 must be filed each year for each related party with which the company had transactions during the year. Failure to keep appropriate records results in a $10,000 fine, and a fine of $10,000 is assessed for each failure to file a Form 5472. If the company does not resolve the problem within 90 days of notification by the IRS, the fine doubles and increases by $10,000 for every 30 days delay after that. For example, a U.S. subsidiary of a foreign parent that neglects to file Form 5472 would owe the IRS $50,000 in penalties 180 days after being notified of its deficiency. In 2001, the IRS commissioned a study to determine the cost incurred by companies in maintaining contemporaneous transfer pricing documentation as required. Of 567 companies surveyed, 4 percent indicated spending $0, 60 percent reported spending between $1 and $100,000, and 35 percent said they spent more than $100,000 in preparing transfer pricing documentation.22 The survey also
21
U.S. Department of the Treasury, Current Trends in the Administration of International Transfer Pricing by the Internal Revenue Service, September 2003, p. 44. U.S. Department of the Treasury, Current Trends in the Administration of International Transfer Pricing by the Internal Revenue Service, September 2003, p. 15.
22
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found that 60 percent of respondents had from 1 to 10 full-time employees handling transfer pricing issues and documentation.
ENFORCEMENT OF TRANSFER PRICING REGULATIONS

The United States has made periodic attempts over the years to make sure that MNCs doing business in the United States pay their fair share of taxes. Enforcement has concentrated on foreign companies with U.S. subsidiaries, but U.S. companies with foreign operations also have been targeted. Anecdotal evidence suggests that foreign companies are using discretionary transfer pricing to waft profits out of the United States back to their home country. In one case cited in a Newsweek article, a foreign manufacturer was found to sell TV sets to its U.S. subsidiary for $250 each, but charged an unrelated U.S. company only $150.23 In yet two additional cases, a foreign company was found to charge its U.S. distributor $13 a piece for razor blades, and a U.S. manufacturer sold bulldozers to its foreign parent for only $551 a piece.24 As a result, foreign companies doing business in the United States are able to pay little or no U.S. income tax. For example, according to the IRS, Yamaha Motor U.S.A. paid only $5,272 in corporate tax to Washington over four years. Proper accounting would have shown a profit of $500 million and taxes of $127 million.25 In two of its biggest victories in the 1980s, the IRS was able to make the case that Toyota and Nissan had overcharged their U.S. subsidiaries for products imported into the United States. Nissan paid $1.85 billion and Toyota paid $850 million to the U.S. government as a result of adjustments made by the IRS. In both cases, however, the competent authorities in the United States and Japan agreed on the adjustments and the Japanese government paid appropriate refunds to the companies. In effect, tax revenues previously collected by the Japanese tax authority were given to the IRS. Japanese companies are not the only ones found to violate transfer pricing regulations. In a well-publicized case, Coca-Cola Japan was found by the Japanese tax authority to overpay royalties to its parent by about $360 million. In another case, the IRS proposed an adjustment to Texacos taxable income of some $140 million. In his 1991 presidential campaign, candidate Bill Clinton claimed that beefed up enforcement of existing transfer pricing rules could raise about $45 billion in additional revenues over four years. In 1992, the House Ways and Means Committee introduced a bill into Congress that would have required U.S. subsidiaries of foreign parent companies to report a minimum amount of taxable income equal to at least 75 percent of the income reported by similar firms in the U.S. In addition to violating the nondiscrimination clause in U.S. tax treaties, concern was raised over the likely retaliatory effect of other countries. Not surprisingly, the bill was not passed. In 1994, the IRS was armed with the ability to impose penalties (discussed earlier) for misstating taxable income through the use of non-arms-length transfer prices. The administration hoped that the threat of additional penalties would provide an incentive for companies to comply with the regulations.
23 24
The Corporate Shell Game, Newsweek, April 15, 1991, pp. 4849. Legislators Prepare to Crack Down on Transfer Pricing, Accounting Today, July 1326, 1998, pp. 10, 13. 25 Corporate Shell Game.
The transfer pricing saga continues. In 2004, the U.S. General Accounting Office released a report indicating that a majority of large corporations paid no U.S. income tax for the period 19962000.26 During that period, from 67 percent to 73 percent of foreign-controlled corporations and from 60 to 63 percent of U.S.controlled corporations paid no federal income tax. As a result, Congress has put renewed pressure on the IRS to enhance its enforcement of transfer pricing regulations. Discretionary transfer pricing is likely to be an issue so long as intercompany transactions exist.
Worldwide Enforcement
Over the last several years, most major countries have strengthened their transfer pricing rules, often through documentation requirements and penalties, and have stepped up enforcement. According to one of the international accounting firms, the top 10 most aggressive countries on transfer pricing are, in order, the United States, Japan, Germany, the United Kingdom, Australia, Korea, China, France, Canada, and Mexico.27 In most of these countries, the concept of an arms-length price is used in accordance with OECD guidelines. However, enforcement of these rules varies across countries. In Japan, for example, an adjustment made by the income tax authority is very difficult to reverse. The French tax authority is more likely to challenge technology transfers and management fees. Canada attempts to resolve disputes via advance pricing agreements and competent authority negotiations. China passed a new transfer pricing law in 1998, and enforcement is a high priority: Unlike most of its Asian neighbors, China has explicit transfer pricing regulations and a specific audit plan. There are more than 500 tax officials in China who have been specially trained to conduct transfer pricing audits.28 Worldwide, there are certain types of transfers and certain industries that are more at risk for examination by tax authorities. For example, imports are more likely to be scrutinized than exports, partly for political reasons. Exports help the balance of trade; imports do not, and they compete with the local workforce. In addition, royalties paid for the use of intangible assets such as brand names, management service fees, research and development conducted for related parties, and interest on intercompany loans are all high on tax authorities radar screen for examination. The industries most at risk are (1) petrochemicals, (2) pharmaceuticals, (3) financial services, (4) consumer electronics, (5) computers, (6) branded consumer goods, (7) media, and (8) automobiles. Each of these industries has a high volume of international intercompany transactions.29 There are a number of red flags that can cause a tax authority to examine a companys transfer prices. The most important of these is if the company is less profitable than the tax authority believes it should be. For example, a domestic company with a foreign parent that makes losses year after year is likely to fall under scrutiny, especially if its competitors are profitable. Price changes and royalty rate changes are another red flag. Companies that have developed a poor relationship with the tax authority are also more likely to be scrutinized. A reputation for aggressive tax planning is one way to develop a poor relationship.
26 U.S. General Accounting Office, Comparison of the Reported Tax Liabilities of Foreign- and U.S.Controlled Corporations, 19962000, February 2004, p. 15. 27
Price Waterhouse, Transfer Pricing: PW Partners Discuss Recent Developments and Planning at Hong Kong MNC Meeting, International Tax Review 21, no. 5 (September/October 1995), p. 1. 28 PricewaterhouseCoopers, Chinas Special Approach to Transfer Pricing, www.pwcglobal.com. 29 Price Waterhouse, Transfer Pricing.
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As evidence of the extent to which tax authorities investigate MNCs transfer pricing policies, a survey conducted by Ernst & Young in 2003 discovered that almost 50 percent of parent company respondents experienced a transfer pricing audit somewhere in the world in the previous three years, and 76 percent thought that an audit was likely in the next two years.30 One-third of completed audits resulted in an adjustment being made by a tax authority, and in 40 percent of those cases no correlative adjustment was provided. Ernst & Young concludes by stating that MNCs should expect a transfer pricing audit as a rule rather than an exception.
Summary
1. Two factors heavily influence the manner in which international transfer prices are determined: (1) corporate objectives and (2) national tax laws. 2. The objective of establishing transfer prices to enhance performance evaluation and the objective of minimizing one or more types of cost through discretionary transfer pricing often conflict. 3. Cost-minimization objectives that can be achieved through discretionary transfer pricing include minimization of worldwide income tax, minimization of import duties, circumvention of repatriation restrictions, and improving the competitive position of foreign subsidiaries. 4. National tax authorities have guidelines regarding what will be considered an acceptable transfer price for tax purposes. These guidelines often rely on the concept of an arms-length price. 5. Section 482 of the U.S. tax law gives the IRS the power to audit and adjust taxpayers international transfer prices if they are not found to be in compliance with Treasury Department regulations. The IRS also may impose a penalty of up to 40 percent of the underpayment in the case of a gross valuation misstatement. 6. Treasury Regulations require the use of one of five specified methods to determine the arms-length price in a sale of tangible property. The best-method rule requires taxpayers to use the method that under the facts and circumstances provides the most reliable measure of an arms-length price. The comparable uncontrolled price method is generally considered to provide the most reliable measure of an arms-length price when a comparable uncontrolled transaction exists. 7. Application of a particular transfer pricing method can result in an arms-length range of prices. Companies can try to achieve cost-minimization objectives by selecting prices at the extremes of the relevant range. 8. Advance pricing agreements (APAs) are agreements between a company and a national tax authority on what is an acceptable transfer pricing method. So long as the agreed-on method is used, the companys transfer prices will not be adjusted. 9. Enforcement of transfer pricing regulations varies from country to country. Transfer pricing is the most important international tax issue faced by many U.S. multinational corporations (MNCs). The United States is especially concerned with foreign MNCs not paying their fair share of taxes in the United States.
30
Ernst & Young, Transfer Pricing 2003 Global Survey, p. 5.
Questions
1. What are the various types of intercompany transactions for which a transfer price must be determined? 2. What are possible cost-minimization objectives that a multinational company might wish to achieve through transfer pricing? 3. What is the performance evaluation objective of transfer pricing? 4. Why is there often a conflict between the performance evaluation and cost minimization objectives of transfer pricing? 5. How can transfer pricing be used to reduce the amount of withholding taxes paid to a government on dividends remitted to a foreign stockholder? 6. According to U.S. tax regulations, what are the five methods to determine the arms-length price in a sale of tangible property? How does the best-method rule affect the selection of transfer pricing method? 7. What is the arms-length range of transfer pricing, and how does it affect the selection of a transfer pricing method? 8. Under what conditions would a company apply for a correlative adjustment from a foreign tax authority? What effect do tax treaties have on this process? 9. What is an advance pricing agreement? 10. What are the costs and benefits associated with entering into an advance pricing agreement? 1. Which of the following objectives is not achieved through the use of lower transfer prices? a. Improving the competitive position of a foreign operation. b. Minimizing import duties. c. Protecting foreign currency cash flows from currency devaluation. d. Minimizing income taxes when transferring to a lower-tax country. 2. Which of the following methods does U.S. tax law always require to be used in pricing intercompany transfers of tangible property? a. Comparable uncontrolled price method. b. Comparable profits method. c. Cost-plus method. d. Best method. 3. Which international organization has developed transfer pricing guidelines that are used as the basis for transfer pricing laws in several countries? a. World Bank. b. Organization for Economic Cooperation and Development. c. United Nations. d. International Accounting Standards Board. 4. Which of the following countries is considered to be one of the top 10 in how strictly it enforces its transfer pricing regulations? a. Brazil. b. China. c. India. d. Russia. 5. Which of the following is not a method commonly used for establishing transfer prices? a. Cost-based transfer price. b. Negotiated price.
Exercises and Problems
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6.
7.
8.
9.
c. Market-based transfer price. d. Industry-wide transfer price. Market-based transfer prices lead to optimal decisions in which of the following situations? a. When interdependencies between the related parties are minimal. b. When there is no advantage or disadvantage to buying and selling the product internally rather than externally. c. When the market for the product is perfectly competitive. d. All of the above. U.S. Treasury Regulations require the use of one of five specified methods to determine the arms-length price in a sale of tangible property. Which of the following is not one of those methods? a. Cost-plus method. b. Market-based method. c. Profit split method. d. Resale price method. Which group has negotiated the greatest number of advance pricing agreements with the U.S. Internal Revenue Service (IRS)? a. Foreign parent companies with branches and subsidiaries in the United States. b. U.S. parent companies with branches and subsidiaries in Canada and Mexico. c. U.S. parent companies with branches and subsidiaries in Japan. d. None of the above. The IRS has the authority to impose penalties on companies that significantly underpay taxes as a result of inappropriate transfer pricing. Acme Company transfers a product to a foreign affiliate at $15 per unit, and the IRS determines the correct price should have been $65 per unit. The adjustment results in an increase in U.S. tax liability of $1,250,000. Due to this change in price, by what amount will Acme Companys U.S. tax liability increase? a. $400,000 b. $1,250,000 c. $1,650,000 d. $1,750,000
Use the following information to complete Exercises 1012: Babcock Company manufactures fast-baking ovens in the United States at a production cost of $500 per unit and sells them to uncontrolled distributors in the United States and a wholly owned sales subsidiary in Canada. Babcocks U.S. distributors sell the ovens to restaurants at a price of $1,000, and its Canadian subsidiary sells the ovens at a price of $1,100. Other distributors of ovens to restaurants in Canada normally earn a gross profit equal to 25 percent of selling price. Babcocks main competitor in the United States sells fast-baking ovens at an average 50 percent markup on cost. Babcocks Canadian sales subsidiary incurs operating costs, other than cost of goods sold, that average $250 per oven sold. The average operating profit margin earned by Canadian distributors of fast baking ovens is 5 percent. 10. Which of the following would be an acceptable transfer price under the resale price method? a. $700 b. $750
c. $795 d. $825 11. Which of the following would be an acceptable transfer price under the costplus method? a. $700 b. $750 c. $795 d. $825 12. Which of the following would be an acceptable transfer price under the comparable profits method? a. $700 b. $750 c. $795 d. $825 13. Lahdekorpi OY, a Finnish corporation, owns 100 percent of Three-O Company, a subsidiary incorporated in the United States. Required: Given the limited information provided, determine the best transfer pricing method and the appropriate transfer price in each of the following situations: a. Lahdekorpi manufacturers tablecloths at a cost of $20 each and sells them to unrelated distributors in Canada for $30 each. Lahdekorpi sells the same tablecloths to Three-O Company, which then sells them to retail customers in the United States. b. Three-O Company manufactures mens flannel shirts at a cost of $10 each and sells them to Lahdekorpi, which sells the shirts in Finland at a retail price of $30 each. Lahdekorpi adds no significant value to the shirts. Finnish retailers of mens clothing normally earn a gross profit of 40 percent on sales price. c. Lahdekorpi manufacturers wooden puzzles at a cost of $2 each and sells them to Three-O Company for distribution in the United States. Other Finnish puzzle manufacturers sell their product to unrelated customers and normally earn a gross profit equal to 50 percent of the production cost. 14. Superior Brakes Corporation manufactures truck brakes at its plant in Mansfield, Ohio, at a cost of $10 per unit. Superior sells its brakes directly to U.S. truck makers at a price of $15 per unit. It also sells its brakes to a wholly owned sales subsidiary in Brazil that, in turn, sells the brakes to Brazilian truck makers at a price of $16 per unit. Transportation cost from Ohio to Brazil is $0.20 per unit. Superiors sole competitor in Brazil is Bomfreio SA, which manufactures truck brakes at a cost of $12 per unit and sells them directly to truck makers at a price of $16 per unit. There are no substantive differences between the brakes manufactured by Superior and Bomfreio. Required: Given the information provided, discuss the issues related to using (a) the comparable uncontrolled price method, (b) the resale price method, and (c) the cost-plus method to determine an acceptable transfer price for the sale of truck brakes from Superior Brakes Corporation to its Brazilian subsidiary. 15. Akku Company imports die-cast parts from its German subsidiary that are used in the production of childrens toys. Per unit, Part 169 costs the German
516 Chapter Eleven
subsidiary $1.00 to produce and $0.20 to ship to Akku Company. Akku Company uses Part 169 to produce a toy airplane that it sells to U.S. toy stores for $4.50 per unit. The following tax rates apply:
German income tax . . . . . . U.S. income tax . . . . . . . . . . U.S. import duty . . . . . . . . . 50% 35% 10% of invoice price
Required: a. Determine the total amount of taxes and duties paid to the U.S. and German governments if Part 169 is sold to Akku Company at a price of $1.50 per unit. b. Determine the total amount of taxes and duties paid to the U.S. and German governments if Part 169 is sold to Akku Company at a price of $1.80 per unit. c. Explain why the results obtained in parts (a) and (b) differ. 16. Smith-Jones Company, a U.S.-based corporation, owns 100 percent of Joal SA, located in Guadalajara, Mexico. Joal manufactures premium leather handbags at a cost of 500 Mexican pesos each. Joal sells its handbags to Smith-Jones, which sells them under Joals brand name in its retail stores in the United States. Joal also sells handbags to an uncontrolled wholesaler in the United States. Joal invoices all sales to U.S. customers in U.S. dollars. Because the customer is not allowed to use Joals brand name, it affixes its own label to the handbags and sells them to retailers at a markup on cost of 30 percent. Other U.S. retailers import premium leather handbags from uncontrolled suppliers in Italy, making payment in euros, and sell them to generate gross profit margins equal to 25 percent of selling price. Imported Italian leather handbags are of similar quality to those produced by Joal. Bolsa SA also produces handbags in Mexico and sells them directly to Mexican retailers earning a gross profit equal to 60 percent of production cost. However, Bolsas handbags are of lesser quality than Joals due to the use of a less complex manufacturing process, and the two companies handbags do not compete directly. Required: a. Given the facts presented, discuss the various factors that affect the reliability of (1) the comparable uncontrolled price method, (2) the resale price method, and (3) the cost-plus method. b. Select the method from those listed in (a) that you believe is best, and describe any adjustment that might be necessary to develop a more reliable transfer price. 17. Guari Company, based in Melbourne, Australia, has a wholly owned subsidiary in Taiwan. The Taiwanese subsidiary manufactures bicycles at a cost equal to A$20 per bicycle, which it sells to Guari at an FOB shipping point price of A$100 each. Guari pays shipping costs of A$10 per bicycle and an import duty of 10 percent on the A$100 invoice price. Guari sells the bicycles in Australia for A$200 each. The Australian tax authority discovers that Guaris Taiwanese subsidiary also sells its bicycles to uncontrolled Australian customers at a price of A$80 each. Accordingly, the Australian tax authority makes a transfer pricing adjustment to Guaris tax return, which decreases Guaris cost of goods sold by A$20 per bicycle. An offsetting adjustment (refund) is made for the import duty previously paid. The effective income tax rate in Taiwan is 25 percent, and Guaris effective income tax rate is 36 percent.
Required: a. Determine the total amount of income taxes and import duty paid on each bicycle (in Australian dollars) under each of the following situations: (1) Before the Australian tax authority makes a transfer pricing adjustment. (2) After the Australian tax authority makes a transfer pricing adjustment (assume the tax authority in Taiwan provides a correlative adjustment). (3) After the Australian tax authority makes a transfer pricing adjustment (assume the tax authority in Taiwan does not provide a correlative adjustment). b. Discuss Guari Company managements decision to allow its Taiwanese subsidiary to charge a higher price to Guari than to uncontrolled customers in Australia. c. Assess the likelihood that the Taiwanese tax authority will provide a correlative adjustment to Guari Company. 18. ABC Company has subsidiaries in Countries X, Y, and Z. Each subsidiary manufactures one product at a cost of $10 per unit that it sells to each of its sister subsidiaries. Each buyer then distributes the product in its local market at a price of $15 per unit. The following information applies:
Country X Income tax rate . . . Import duty . . . . . . 20% 20% Country Y 30% 10% Country Z 40% 0%
Import duties are levied on the invoice price and are deductible for income tax purposes. Required: Formulate a transfer pricing strategy for each of the six intercompany sales between the three subsidiaries X, Y, and Z that would minimize the amount of income taxes and import duties paid by ABC Company. 19. Denker Corporation has a wholly owned subsidiary in Sri Lanka that manufactures wooden bowls at a cost of $3 per unit. Denker imports the wooden bowls and sells them to retailers at a price of $12 per unit. The following information applies:
United States Income tax rate . . . . . . . . . . . . . . . . . Import duty . . . . . . . . . . . . . . . . . . . . Withholding tax rate on dividends . . . 35% 10% Sri Lanka 25% 30%
Import duties are levied on the invoice price and are deductible for income tax purposes. The Sri Lankan subsidiary must repatriate 100 percent of after-tax income to Denker each year. Denker has determined an arms-length range of reliable transfer prices to be $5.00$6.00. Required: a. Determine the transfer price within the arms-length range that would maximize Denkers after-tax cash flow from the sale of wooden bowls. b. Now assume that the withholding tax rate on dividends is 0 percent. Determine the transfer price within the arms-length range that would maximize Denkers after-tax cash flow from the sale of wooden bowls.
518 Chapter Eleven
20. Ranger Company, a U.S. taxpayer, manufactures and sells medical products for animals. Ranger holds the patent on Z-meal, which it sells to horse ranchers in the United States. Ranger Company licenses its Bolivian subsidiary, Yery SA, to manufacture and sell Z-meal in South America. Through extensive product development and marketing Yery has developed a South American llama market for Z-meal, which it sells under the brand name Llameal. Yerys sales of Llameal in Year 1 were $800,000 and its operating expenses related to these sales, excluding royalties, were $600,000. The IRS has determined the following:
Value of Yerys operating assets used in the production of Z-meal . . . . . . . Fair market return on operating assets . . . . . . . . . . . . . . . . . . . . . . . . . . . Percentage of Rangers worldwide sales attributable to its intangibles . . . . Percentage of Yerys sales attributable to its intangibles . . . . . . . . . . . . . . . $300,000 20% 10% 15%
Required: Determine the amount that Ranger would charge as a license fee to Yery in Year 1 under the residual profit split method.
Case 11-1
Litchfield Corporation
Litchfield Corporation is a U.S.-based manufacturer of fashion accessories that produces umbrellas in its plant in Roanoke, Virginia, and sells directly to retailers in the United States. As chief financial officer, you are responsible for all of the companys finance, accounting, and tax-related issues. Sarah Litchfield, chief executive officer and majority shareholder, has informed you of her plan to begin exporting to the United Kingdom, where she believes there is a substantial market for Litchfield umbrellas. Rather than selling directly to British umbrella retailers, she plans to establish a wholly owned UK sales subsidiary that would purchase umbrellas from its U.S. parent and then distribute them in the United Kingdom. Yesterday, you received the following memo from Sarah Litchfield.
Memorandum SUBJECT: Export Sales Prices It has come to my attention that the corporate income tax rate in Great Britain is only 30 percent, as compared to the 35 percent rate we pay here in the United States. Since our average production cost is $15.00 per unit and the price we expect to sell to UK retailers is $25.00 per unit, why dont we plan to sell to our UK subsidiary at $15.00 per unit. That way we make no profit here in the United States and $10.00 of profit in the United Kingdom, where we pay a lower tax rate. We have plans to invest in a factory in Scotland in the next few years anyway, so we can keep the profit we earn over there for that purpose. What do you think?
Required:
Draft a memo responding to Sarah Litchfields question by explaining U.S. income tax regulations related to the export sales described in her memo. Include a discussion of any significant risks associated with her proposal. Make a recommendation with respect to how the price for these sales might be determined.
Case 11-2
Global Electronics Company

Global Electronics Company (GEC), a U.S. taxpayer, manufactures laser guitars in its Malaysian operation (LG-Malay) at a production cost of $120 per unit. LG-Malay guitars are sold to two customers in the United StatesElectronic Superstores (a GEC wholly owned subsidiary) and Wal-Mart (an unaffiliated customer). The cost to transport the guitars to the United States is $15 per unit and is paid by LG-Malay. Other Malaysian manufacturers of laser guitars sell to customers in the United States at a markup on total cost (production plus transportation) of 40 percent. LG-Malay sells guitars to Wal-Mart at a landed price of $180 per unit (LG-Malay pays transportation costs). Wal-Mart pays applicable U.S. import duties of 20 percent on its purchases of laser guitars. Electronic Superstores also pays import duties on its purchases from LG-Malay. Consistent with industry practice, Wal-Mart places a 50 percent markup on laser guitars and sells them at a retail price of $324 per unit. Electronic Superstores sells LG-Malay guitars at a retail price of $333 per unit. LG-Malay is a Malaysian taxpayer and Electronic Superstores is a U.S. taxpayer. The following tax rates apply:
U.S. ad valorem import duty . . . . . . . . . U.S. corporate income tax rate . . . . . . . Malaysian income tax rate . . . . . . . . . . . Malaysian withholding tax rate . . . . . . . 20% 35% 15% 30%
Required:
1. Determine three possible prices for the sale of laser guitars from LG-Malay to Electronic Superstores that comply with U.S. tax regulations under (a) the comparable uncontrolled price method, (b) the resale price method, and (c) the costplus method. Assume that none of the three methods is clearly the best method and that GEC would be able to justify any of the three prices for both U.S. and Malaysian tax purposes. 2. Assume that LG-Malays profits are not repatriated back to GEC in the United States as a dividend. Determine which of the three possible transfer prices maximizes GECs consolidated after-tax net income. Show your calculation of consolidated net income for all three prices. You can assume that Electronic Superstores distributes 100 percent of its income to GEC as a dividend. However, there is a 100 percent exclusion for dividends received from a domestic subsidiary, so GEC will not pay additional taxes on dividends received from Electronic Superstores. Only Electronic Superstores pays taxes on the income it earns. 3. Assume that LG-Malays profits are repatriated back to GEC in the U.S. as a dividend, and that Electronic Superstores profits are paid to GEC as a dividend. Determine which of the three possible transfer prices maximizes net after-tax cash flow to GEC. Remember that dividends repatriated back to the United States are taxable in the United States and that an indirect foreign tax credit will be allowed by the U.S. government for taxes deemed to have been paid to the Malaysian government on the repatriated dividend. Show your calculation of net after-tax cash flow for all three prices.
520 Chapter Eleven
4. Assume the same facts as in (3) except that a United States/Malaysia income tax treaty reduces withholding taxes on dividends to 10 percent. Determine which of the three possible transfer prices maximizes net cash flow to GEC. Dont forget to consider foreign tax credits. Show your calculation of net cash flow for all three prices.
References
Big Japan Concern Reaches an Accord on Paying U.S. Tax. New York Times, November 11, 1992, p. A1. The Corporate Shell Game. Newsweek, April 15, 1991, pp. 4849. Eccles, Robert G. The Transfer Pricing Problem: A Theory for Practice. Lexington, MA: Lexington Books, 1985. Ernst & Young. Transfer Pricing 2003 Global Survey, 2003, available at www.ey.com. Horngren, Charles T.; George Foster; and Srikant M. Datar. Cost Accounting: A Managerial Emphasis, 10th ed. Upper Saddle River, NJ: Prentice-Hall, 2000. Legislators Prepare to Crack Down on Transfer Pricing. Accounting Today, July 1326, 1998, pp. 10, 13. Maher, Michael W.; Clyde P. Stickney; and Roman L. Weil. Managerial Accounting, 8th ed. South-Western, 2004. Price Waterhouse. Transfer Pricing: PW Partners Discuss Recent Developments and Planning at Hong Kong MNC Meeting. International Tax Review 21, no. 5 (1995). Tang, Roger Y. W. Transfer Pricing in the 1990s. Management Accounting, February 1992, pp. 2226. , and K. H. Chan. Environmental Variables of International Transfer Pricing: A Japan-United States Comparison. Abacus, June, 1979, pp. 312. U.S. Department of Commerce. U.S. Goods Trade: Imports and Exports by Related Parties, 2003. U.S. Department of Commerce News, April 14, 2004. U.S. General Accounting Office. Comparison of the Reported Tax Liabilities of Foreignand U.S.-Controlled Corporations, 19962000, February 2004, available at www.gao.gov. U.S. Internal Revenue Service. Announcement and Report Concerning Advance Pricing Agreements. Internal Revenue Bulletin: 2004-15, April 13, 2004.

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Chapter Eleven International Transfer Pricing

International Transfer Pricing 489

DECENTRALIZATION AND GOAL CONGRUENCE

490 Chapter Eleven

TRANSFER PRICING METHODS

International Transfer Pricing 491

OBJECTIVES OF INTERNATIONAL TRANSFER PRICING

492 Chapter Eleven

Beta $160.00 130.00 $ 30.00 10.50 (35%) $ 19.50

Parent $160.00 100.00 $ 60.00 21.00 $ 39.00

International Transfer Pricing 493

494 Chapter Eleven

Other Cost-Minimization Objectives

Avoidance of Withholding Taxes

Minimization of Import Duties (Tariffs)

Circumvent Profit Repatriation Restrictions

Protect Cash Flows from Currency Devaluation

International Transfer Pricing 495

Improve Competitive Position of Foreign Operation

496 Chapter Eleven

International Transfer Pricing 497

SECTION 482 OF THE U.S. INTERNAL REVENUE CODE

Sale of Tangible Property

498 Chapter Eleven

International Transfer Pricing 499

Comparable Uncontrolled Price Method

Resale Price Method

500 Chapter Eleven

International Transfer Pricing 501

Comparable Profits Method

The comparable profits method is described in Treasury Regulations, Sec. 1.482-5.

502 Chapter Eleven

Profit Split Method

Licenses of Intangible Property

International Transfer Pricing 503

Comparable Uncontrolled Transaction (CUT) Method

Treasury Regulations, Sec. 1.482-4 (c)(2).

504 Chapter Eleven

Profit Split Method

International Transfer Pricing 505

506 Chapter Eleven

International Transfer Pricing 507

ADVANCE PRICING AGREEMENTS

508 Chapter Eleven

Ibid., Table 7. Ibid.

International Transfer Pricing 509

REPORTING REQUIREMENTS IN THE UNITED STATES

510 Chapter Eleven

ENFORCEMENT OF TRANSFER PRICING REGULATIONS

International Transfer Pricing 511

512 Chapter Eleven

Ernst & Young, Transfer Pricing 2003 Global Survey, p. 5.

International Transfer Pricing 513

Exercises and Problems

514 Chapter Eleven

International Transfer Pricing 515

516 Chapter Eleven

International Transfer Pricing 517

518 Chapter Eleven