=$600~ "'"' r'-"-' WHAT IS TRANSFER PRICING? 1]501

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1 107 Informtion Trnsctionl Wht Trnsfer Is Trnsfer Pricing Methods. Pricing? Net Reporting nd Adjustment Requirements. Penlties. Developing Trnsfer Pricing Strtegy..'J[501.'J[502.'J[503.'J[504.'J[ WHAT IS TRANSFER PRICING? The operting units of multintionl corportion usully engge in vriety of intercompny trnsctions. For exmple, U.S. mnufcturer my mrket its products brod through foreign mrketing subsidiries. The sme U.S. prent corportion lso my provide mngeril, technicl, nd dmittistrtive services for its subsidities. Anor common rrngement is for U.S. prent corportion to license its mnufcturing nd mrketing intngibles to its foreign subsidiries for exploitti,on brod. A "trnsfer price" must be computed for se controlled trnsctions in order to stisfy vrious finncil reporting, tx, nd or regultory requirements. Although trnsfer prices do not ffect combined income of controlled group of corportions, y do ffect how tht income ~ llocted mong group members. Exmple' 5.1: USAco, domestic corportion, mnufctures sm~ engines for sle both in United Sttes nd brod. Foreign sles re mde through FORco, wholly owned foreign corportion. USAco's engines cost $600 to mnufcture nd $100 to mrket, nd sell for $1,000 brod (see Figure 5.1). Regrdless of trnsfer price used for sles by USAco to FORco, combined income from foreign sle is $300 per engine [$1,000 finl sles price -$600 mnufcturing cost -$100 selling expense]. However, trnsfer prices do ffect lloction of tht combined profit between USAco nd FORco. Figure 5.1 Trnsfer pricing exmple " ~ """" Trnsfer price =? Resle price = $1,000 r' =$600~ "'"' r'-"-' v Expenses = $100 Unrelted customers At one extreme, trnsfer price of $600 would llocte combined profit of $300 entirely to FORco, s follows. r 1]501

2 108 U.S. Txtion of Interntionl Trnsctions 11'nsction Effect on USAco Mnufcture engine Production cost = $600 E{fecton PORro Controlled sle Sles reven~ $600 ~ Cost of sles =~ ~ Foreign sellin ctivities Selling e ense = $100 Sle to foreign customer Sles revenue = $1,000 Net Net profit = $300 At or extreme, trnsfer price of $900 would llocte co bined profit of $300 entirely to USAco, s follows. Trnsction Effi!ct on USAco Mnufcture en.e Production cost = $600 ERtct on FRro Controlled sle Sles re~e = $900 Cost of si~900 Fore" ctivities = $100 Sle to foreign custo $1,000 rofit For income tx purposes, multintionl corportions must lloc e ir worldwide profits mong, vrious countries in which y operte. e idel lloction would permit ech country to tx n pproprite portio of txpyer's totl profit, while voiding txtion of sme income by m<l>re thn one country. The mechnism for llocting multintionl's worldwid~ profits between its U.S. nd foreign ffilites is trnsfer price used for inte1c mpny trnsctions. When tx rtes vry cross countries, trnsfer pricing c hve significnt effect on txpyer's totl tx costs. For exmple, foretgn tx credit limittion prevents U.S. co pnies operting in high-tx foreign jurisdictions from climing credit for those excess foreign txes. These noncreditble f{)reign txes increse worldwide tx rte on foreign ernings bove U.S. corporte rte of 35%} A domestic ~orportion my be ble to void se higher foreign txes by ltering its trnsf~r l " prices U.S. so s to shift income out of se high-tx jurisdictions. For exmpl mnufcturer my be ble to reduce foreign mrketing subsidiry's hre of worldwide,profits by using higher prices for controlled inventory sles. Exmple 5.2: The fcts re sme s in Exmple 5.1. Assume tht U.S. tx rte is 35% nd pplicble foreign tx rte is 45%. Given'tms rte differentil, USAco group cn reduce its worldwide txes qy using higher trnsfer prices for its controlled sle. For exmple, if trns~er price of $600 is used for s~le by USAco to FORco, $300 gross iprofit is llocted entirely to FORco, nd totl tx on tht profit equls thf foreign tx of $1.35 [$300 of income x 45% foreign tx rte]. If trnsfer pric~ of $900 is used for controlled sle, $300 gross profit is llocted entirely to USAco, nd totl tx on tht profit equls U.S. tx of $105 [$300 of income x 35% U.S. tx rte]. Trnsfer pricing lso is relevnt issue lor U.S. compnies with opertions in low-tx foreign jurisdictiof\s. In se situtions, U.S. prent corportion hs 1 See discussion of excess foreign tx credits in Chpter

3 Trnsfer Pricing I 1 09 n incel to shift inco to its low for suby foe using lowe trn pric on con inv s As incom to lowfore sub doe no pev th r~ U.S. tx on thos lowfore er it do de th tuth foreig subs rep tho er thr div di S~r trn pric is rele iss fo fou comp.ex 5.3: CAN C coms widg in Unit St Du to inc wi or fr~u custo CAN dec to form U.S dis su ("u Altho USS doe not hv ny m fuube ploys its own dm nd sl st wh us Cu distri softw to ens th re no n di p ill n effor to ens tht US is fin souhp term to CAN of six mo (US v cope iso mon US5 cus do not p US en thus oc colle stff I This ~xm illus fou inte tr fowv must py CAN t rm leng Firs pu of wi co purch of tng prop Sec us of thun d softw cons trn of int pro for wh Ump royl Third gen py ter co lon wu my py n rm' leng rte of inte Fo pr of thc stff cons serv for whi US wil h top n rn mou With resp to trn pric pr of for Uc nies, trns prici is con rep me tobr c bto forei com With py U.S wit ton dib empl ggr trn pric pr c go b to th fo comp while lev few er nd pro in U. thwre in distri bein divi th isub to wi teif th foreig coun mr corp tx rt is hig th thum corpo tx rte dd of wit tx mre ino U.S. tx rte tht is high thn fore cou tx r This prob my be pr cu wh foex th f re pren coun doe not tx divi n Wt isco e n out-o csh cos Exm 5.4: CAN is trd com or inc.a sume top com Cn fed n pro int r te 40%is CAN own U.S sub ("U th pu g fr CAN for res in Uni St wh co fes effec tx rte is 38% ill dd to U. co fes incom txe t rte of 38% ny div dis by UtoC will be subj to 5% with tx res in n ef Ut r 1)501

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5 Trnsfer Pricing Economic conditioru; nd mrkets-this comprbility fctor focuses on economic conditioru; tht could ffect prices to be chrged. This includes similrity of geogrphic mrkets, level of mrket (e.g., wholesle or retil), extent of competition in ech mrket, economic conditioru; of prticulr industry, nd lterntives relisticlly vilble to eir prty..nture of property or services trnsferred in trnsction-as discussed more lter in this chpter, comprbility of property sold or services provided is more relevnt to trnsction-bsed methods thn profit-bsed methods. " Exmple 5.5: USAco, U.S. subsidiry of ASIAco, Jpnese prent corportion, purchses televisioru; from its Jpnese prent tht USAco mrkets in U.S. If it were to use one of trnsction-bsed methods, USAco must compre prices chrged for. televisioru;. However, if txpyer chooses profit-bsed method, such s comprble profits method, USAco must merely find compnies comprble to itself with respect to type of functioru; performed nd risks ssumed. Adjustments must be mde for ny mteril differences between controlled nd uncontrolled trnsctioru;, ssuming effect of difference cn be scertined with enough ccurcy to improve relibility of results..7 As prcticl mtter, comprble trnsctioru; often re not redily vilble for types of trnsctioru; entered into by ffilites of verticlly integrted multintionl corportion. For exmple, inventory sles between ffilited compnies often involve component prts nd semifinished goods tht re unique nd re not sold in public mrkets. As coru;equence, pproprite rm'slength price is mbiguous. The only significnt exceptioru; re publicly trded fungible goods such s oil, lumber, nd griculturl products, for which informtion regrding mrket prices is redily vilble. 7 Reg (d)(2). 8 Reg (e)(1) nd (e)(2)(i). All comprble uncontrolled trnsctions re included in rnge if djustments cn be mde for ll of mteril differences between controlled nd uncontrolled trnsctions. If djustments cnnot be mde for ll mteril differences, n rnge is limited by The concept of rm's-length rnge helps txpyers del with this uncertinty. Under this provision, txpyer my use two or more comprble uncontrolled trnsctioru; (of similr comprbility nd relibility) to estblish n rm's-length rnge of prices. If txpyer's trnsfer prices lie within rnge, IRS will not mke n djustment.81f txpyer's trnsfer prices lie outside rm's-length rnge, n IRS will mke n djustment, generlly using eir men or medin of rnge s benchmrk price.9 Txpyers lso re llowed, under certin circumstnces, to stisfy rm's-length requirement by showing tht verge result for multiple-yer period is comprble to tht of uncontrolled trnsctioru; for sme period.to The use of multiplesttisticl techniques, such s restricting rnge to those comprble uncontrolled trnsctions which fll within 25th nd 75th percentiles of rnge. Reg (e)(2)(ili). 9 Reg (e)(3). 10 Reg (f)(2)(ili). 1]502.01

6 112 u.s. Txtion oflntemtionl Trnsctions yer dt helps reduce effects of short-term vritioru; in prices, such s effects of n industry business cycle, tht re unrelted to trnsfer pricing..02 Lons nd Advnces Controlled entities generlly must chrge ech or n rm's-length rte of interest on ny intercompny lons or dvnces}1 There is n exception, however, for intercompny trde receivbles, which re debts tht rise in ordinry course of business nd re not evidenced by written greement requiring pyment of interest}2 If controlled borrower is locted outside United Sttes, it is not necessry to chrge interest on n intercompny trde receivble until first dy of - fourth month following month in which receivble rises.13 If controlled borrower is locted within United Sttes, interest-fre-e period extends to first dy of third month following month in which receivble rises}4 This exception reflects common business prctice of not chrging interest on trde receivbles. Exmple 5.6: USAco, domestic corportion, owns 100% of ASIAco, foreign corportion. On November 1, ASIAco purchses $1 million of inventory on ccount from USAco. The $1 million debt, on which ASIAco pys no interest, is still outstnding on December 31, which is end of USAco's txble yer. Since $1 million intercompny trde receivble ws outstnding for only two months, USAco does not hve to recognize ny interest income. Longer interest-free periods re possible if controlled lender ordinrily llows unrelted prties longer interest-free period)5 or if controlled borrower purchses goods f<:?r resle in foreign country nd verge collection period for its sles is longer thn interest-free period.16 Intercompny debt or thn trde receivble generlly must ber n rm's-length interest chrge}7 To determine rm's-length rte, txpyer must coru;ider ll relevnt fctors, including mount nd durtion of lon, security involved, credit stnding of borrower, nd interest rte previling t situs of lender for comprble lons between uncontrolled prties}8 If n rm's-length rte is not redily determinble, txpyer cn still protect itself ginst n IRS djustment by stisfying requirements of sfehrbor provision. Under this sfe hrbor, n interest rte is deemed to be n rm's-length rte if it is between 100% nd 130% of pplicble federl rte}9 The pplicble federl rte is verge interest rte (red,eterminedmonthly) on obligtioru; of federl government with mturities similr to term on intercompny lon.2o Exmple 5.7: USAco, domestic corportion, owns 100% of EURco, foreign corportion. During current yer, USAco borrows $1 million 11 Reg ()(1)(i). 12 Reg ()(1)(iii)(A). 13 Reg ()(1)(iii)(C). 14 Reg ()(1)(iii)(B). 15 Reg ()(1)(iii)(D). 16 Reg ()(1)(iii)(E). 17 Reg ()(1)(i). 18 Reg ()(2)(i). 19 Reg ()(2)(iii)(B). 20 Code Sec.1274(d). "502.02

7 Trnsfer Pricing 113 from EURco. The lon is denommted in U.S. dollrs nd hs three-yer term. At time of lon, pplicble federl rte for three-yer obligtion is 8%. Under sfe-hrbor provision, n interest rte of between 8% (100% of pplicble federl rte) nd 10.4% (130% of pplicble federl rte) is utomticlly cceptble to IRS. A rte lower thn 8% or higher thn 10.4% lso cn be used if txpyer cn estblish tht it is n rm's-length rte, tking into ccount ll of relevnt fcts nd circumstnces. The sfe hrbor is not vilble if intercompny debt is denommted in foreign currency;l or if controlled lender is in business of mking lons to unrelted prties.22 A specil rule pplies if controlled lender obtins funds used to mke intercompny lon t situs of controlled borrower. In such cses, controlled lender is treted s mere conduit for lon entered into with unrelted lender. Thus, rm's-length rte on such pss-through lons is ssumed to be equl to rte pid by controlled lender on originl lon, incresed by ny ssocited borrowing costs, unless txpyer cn estblish tht different rte is more pproprite under generl rules.23 Exmple 5.8: USAco, domestic corportion, owns 100% of GERco, Germn corportion. During current yer, USAco borrows $10 million from Germn bnk t 10% rte, nd n relends funds to GERco. The rm's-length rte on intercompny lon is dee~ed to be equl to 10% plus ny borrowing costs incurred by USAco in securing originl lon. A rte or thn 10% lso cn be used if USAco cn estblish tht such rte is rm's length, tking into ccount ll of relevnt fcts nd circumstnces..03 Performnce of Services Currently existing finl regultions. An rm's-length fee generlly must be chrged if one controlled entity performs services for benefit of, or on behlf of, nor controlled entity.24 However, under sfe-hrbor provision, chrge equl to direct nd indirect costs incurred by controlled entity in provid- ~g service is deemed to be n rm's-length chrge.25 This sfe hrbor reflects relity tht intercompny services sometimes re provided for resons of convenience, rr thn profit. Exmple 5.9: USAco, domestic corportion, produces food products t its U.S. plnt for sle domesticlly nd brod. USAco mrkets its products brod through FORco, wholly owned foreign mrketing subsidiry. During current yer, USAco performs some pyroll services for FORco s convenience fpr FORco's mngement. The costs ssocited with se services include $10,000 of slries plus n overhed lloction of $3,000. Under 21 Reg ()(2)(ili)(E). 22 Reg ()(2)(ili)(D). 23 Reg ()(2)(ii). 24 Reg (b)(1). 25 Reg (b)(3)-(b)(5)

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9 Trnsfer Pricing 115 U.S. prent corportion's home office reviews report. The prent need not chrge subsidiry for this service becuse it merely duplictes those performed by subsidiry itself. On or hnd, if foreign subsidiry did not hve finncil stff, nd home office executive perfonned originl nlysis rr thn merely reviewing it, chrge would hve to be mde.30 Proposed regultions. The IRS issued proposed regultions for intercompny services on September 5, As proposed, se regultions do not hve effect of lw, but re indictive of IRS's position. These prop<!lsed regultions contin severl chnges from old finl regultions. First, proposed regultions eliminte sfe hrbor chrge equl to direct nd indirect costs for non-integrl services. Insted, regultions propose simplified cost-bsed method ("SCBMj31 for non-integrl services, such s routine dministrtive services. The SCBM pplies when txpyer chrges mrkup of 10% or less. Under SCBM, IRS cnnot mke n djustment unless rm's length mrkup exceeds 6%. More specificlly, if txpyer hs not chrged mrkup, IRS must determine tht rm's length mrkup is t lest 6% to mke n djustment. Furrmore, bsed on sliding scle, txpyer's mrkup of 9% is not subject to djustment unless IRS determines tht rm's length mrkup is 10% or greter. r Unlike finl regultions, proposed regultions lso provide coun~erprts to trditionl methods for determining rm's-length pricing for services. These include comprble uncontrolled services price method, gross services mrgin method, cost of services plus method, comprble profits method, nd profit split methods Use of Tngible Property Intercompny leses of tngible property generlly must ber n rm'slength rentl chrge.33 The rm's-length rentl is mount tht would hve been chrged for use of sme or similr property in trnsction between unrelted prties under similr circumstnces. All relevnt fctors must be considered in determining rm's-length rentl, including period nd loction of property's use, owner's investment in property, owner's mintennce expenses, nd type nd condition of property.34 A specil rule pplies if controlled lessor first lesed property from n unrelted person nd n sublesed it to controlled lessee. In such cses, controlled lessor is treted s mere conduit for lese it entered into with unrelted lessor. Thus, rm's-length rentl for such pss-through leses is deemed to be equl to rentl pid by controlled lessor on originl lese, incresed by ny ssocited rentl costs (e.g., mintennce, repirs, utilities, nd mngeril expenses).35 This rule does not pply if eir controlled 30 Compre Reg (b)(2)(ii), Exmples 1 nd Prop. Reg (f). 32 Prop. Reg (b)-(g). 33 Reg (c)(1). 34 Reg (c)(2)(i). 35 Reg (c)(2)(iii)(A). ~

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11 117 Trnsfer Pricingtion is vilble regrding comprble uncontrolled sles, USAco nd MEXco should use comprble uncontrolled price method. Under this method, estimte of rm's-length price is $750. In ssessing comprbility of controlled nd uncontrolled trnsctions for purposes of comprble uncontrolled price method, most importnt fctor is product similrity. Or significnt fctors include similrity of contrctul terms nd economic conditions.43 Becuse informtion regrding comprble uncontrolled trnsctions is usully not vilble, comprble uncontrolled price method is usully difficult to pply in prctice. Resle price method. The type of trnsction envisioned by resle price method is controlled sle of finished goods followed by relted distributor's resle of goods to unrelted customers.44 Under this method, rm's-length price is resle price chrged by relted distributor, reduced by rm'slength gross profit mrgin for such resles, nd djusted for ny mteril differences tht exist between controlled nd uncontrolled trnsctions. The gross profit mrgin relized by independent distributors (or even relted distributor) on similr uncontrolled sles provides n estimte of rm'slength gross profit, which is expressed s percentge of resle price.4s Exmple 5.13: USAco, domestic corportion, owns 100% of CANco, Cndin corportion. USAco mnufctures medicl equipment t cost of $1,000 per unit nd sells equipment to CANco, which resells goods (without ny furr processing) to unrelted foreign customers for $1,500 ech (see Figure 5.2). Independent foreign distributors typiclly ern commissions of 10% (expressed s percentge of resle price) on purchse nd resle of products comprble to those produced by USAco. Under resle price method, estimte of rm's-length price is $1,350 [$1,500 -(10% x $1,500)]. 43 Reg (b)(2)(ii)(A). 44 Reg (c)(1). 45 Reg (c)(2) nd (c)(3)(ii)(c)

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13 Trnsfer Pricing length gross profit mrkup for such mnufcturers, nd djusted for ny mteril differences tht exist between controlled nd uncontrolled trnsctions. The gross profit relized by independent mnufcturers (or even relted mnufcturer) on similr uncontrolled sles provides n estimte of rm's-length gross profit mrkup, which is expressed s percentge of mnufcturing costs.49 Exmple 5.14: USAco, domestic corportion, owns 100% of FORco, foreign corportion. FORco mnufctures power tools t cost of $60 ech nd sells m to USAco. USAco ttches its trde nme to power tools (which hs significnt effect on ir resle price) nd resells m to unrelted customers in United Sttes for $100 ech (see Figure 5.3). Independent foreign mnufcturers producing similr power tools typiclly ern gross profit mrkup of 20%. Under cost plus method, estimte of rm's-length price is $72 [$60 + (20% x $60)]. 49 Reg (d)(2) nd (d)(3)(ii)(c). ~

14 120 U.S. Txtion of Interntionl Trnsctions FigureS.3 Exmple of cost plus method -- As with resle price method, in ssessing comprbility of controlled nd uncontrolled trnsctions for purposes of cost plus method, product similrity is less importnt thn under comprble uncontrolled price method, while similrity of functions performed, risks borne, nd contrctul terms greed to is reltively more importnt.50 Consistency between ccounting methods used to compute gross profit mrkup for controlled nd uncontrolled trnsctions lso is importnt.51 Comprble profits method. The comprble profits method looks to profits of, uncontrolled entities, rr thn prices used in uncontrolled trnsctions, to determine n rm's-length lloction of profit between two relted corportions. Under this method, profitbility of comprble uncontrolled entities is used s benchmrk for determining n rm's-length net profit for one of controlled prties ( "tested prty"), nd n trnsfer price is estblished which leves tested prty with tht mount of net profit Reg (d)(3)(ii)(A) nd (B). 51 Reg (d)(3)(ili)(B). 52 Reg (b)(1)

15 Trnsfer Pricing 121 The methodology for developing n rm's-length profit involves following six steps: (1) Determine tested prty-the tested prty should be prticipnt in controlled trnsctions for which most relible dt regrding comprble uncontrolled prties cn be locted. This is likely to be lest complex of controlled prties, nd controlled prty tht does not own vluble intngible property or unique ssets tht distinguish it from potentil uncontrolled comprbles.53 (2) Obtin finncil dt regrding comprble uncontrolled prties-the key fctors in ssessing comprbility of tested prty to uncontrolled prties re resources employed nd risks ssumed. Becuse resources nd risks usully re directly relted to functions performed, it lso is importnt to consider functions performed in determining degree of comprbility between tested prty nd n uncontrolled prty.54 Anor importnt fctor is consistency between ccounting methods used by controlled nd uncontrolled prties to compute ir operting profits.55 Adjustments must be mde for ny differences between tested prty nd comprble uncontrolled prties tht would mterilly ffect profitbility mesures used.56 (3) Select profit level indictorc--exmples of profitbility mesures tht cn be used include rtio of operting profit to operting ssets, rtio of operting profit to sles, nd rtio of gross profit to operting expenses. To enhnce relibility of profitbility mesure, txpyer should perform multiyer nlysis which generlly shotjld encompss t lest txble yer under review nd two preceding yers.57 (4) Develop n rm's-length rnge of comprble operting profits-to construct n rm's-length rnge of comprble operting profits, selected profitbility mesure (e.g., rtio of operting profits to operting ssets) is pplied to tested prty's most nrrowly identifible business ctivity for which dt incorporting controlled trnsction is vilble (e.g." operting ssets used in mnufcture nd sle of inventory).58 (5) Determine if n djustment must be mde-an djustment is required if tested prty's reported profit lies outside rm's-length rnge of comprble operting profits developed in step 4.59 (6) Adjust trnsfer price used for controlled trnsction- If tested prty's reported profit lies outside rm's-length rnge, n djustment is mde equl to difference between tested prty's re- 53 Reg (b )(2)(i). 54 Reg (c)(2)(ii). 55 Reg (c)(3)(ii). 56 Reg (c)(2)(iv). 57 Reg (b)(4). However, ny required djustments re mde on yer-by-yer bsis. Reg (e), Exmple Reg (b)(1). 59 Reg (b)(1). ~502.05

16 1] u.s. Txtion oflntemtionl Trnsctions ported profit nd benchmrk rm's-length profit,60 such s men or medin of rm's-length rnge of comprble operting profits.61 Exmple 5.15: 62 EURco, foreign corportion, owns 100% of USAco, domestic corportion. EURco mnufctures consumer products for worldwide distribution. USAco imports EURco's finished goods for resle in United Sttes. USAco's verge finncil results for lst three yers re s follows: Sles. $50 million Cost of goods sold '."."'..'..'.'...<$40million> Opertingexpenses ' <$9million> Operting profit $lmi1lion USAco is selected s tested prty becuse it engges in ctivi~e.s tht re less complex thn those of EURco. An nlysis of five comprble uncontrolled U.S. distributors indictes tht rtio of operting profits to sles is most pproprite profitbility mesure. After djustments hve been mde to ccount for mteril differences between USAco nd uncontrolled distributors, verge rtio of operting profit to sles for ech uncontrolled distributor is s follows: 3%,4%,5%,5%, nd 7%. Applying se percentges to USAco's sles of $50 million yields following rm's-length rnge of comprble operting profits: $1.5 million, $2 million, $2.5 million, $2.5 million, nd $3.5 million. Therefore, interqurtile rnge of comprble operting profits is used for purposes of testing USAco's profits. This rnge includes $2 million, $2.5 million, nd $2.5 million. Becuse USAco's reported operting profit of $1 million lies outside rm's-length rnge, n djustment is required. The medin of interqurtile rnge of comprble operting profits (i.e., $2.5 million) is determined to be rm's-length profit for USAco. Therefore, trnsfer prices tht USAco pys EURco for its inventory re reduced by $1.5 million, which equls difference between USAco's reported profit of $1 million nd rm's-length profit of $2.5 million. This djustment'increses USAco's U.S. txble income by $1.5 million per yer, with corresponding decrese in EURco's txble income. Profit split method. The profit split method is most complicted of specified pricing methods for trnsfers of tngible property, nd refore is difficult to pply in prctice. The profit split method evlutes wher lloction of combined operting profit ttributble to controlled trnsction is rm's length by reference to reltive vlue of ech controlled txpyer's contribution to tht combined profit.63 The reltive vlue of ech 60 Reg (b)(1). 61 Reg (e)(3). 62 This exmple is bsed on Reg (e), Exmple Reg ().

17 Trnsfer Pricing 1 g3 controlled txpyer's contribution is determined using eir comprble profit split method or residul profit split method. Under comprble profit split method, lloction of combined operting profit between two controlled txpyers is bsed on how uncontrohed txpyers engged in similr ctivities under similr circumstnces llocte th~ir joint profits.64 Under residul profit split method, comprble profits method is used to estimte nd llocte n rm's-length profit for routine contributions mde by ech controlled txpyer. Routine contributions ordinrily include contributions of tngible property nd services. The residul profit not llocted on. bsis of routine functions is n llocted between two controlled txpyers on bsis of reltive vlue of intngible property contributed by ech prty.65 Ceiling on trnsfer price for imported goods. There is sttutory ceiling (i)n trnsfer prices used for property imported into United Sttes in trnsction between controlled prties. Exmples of such trnsctions include U.S. prent corportion purchsing goods from foreign mnufchiring subsidiry, or U.S. mrketing subsidiry purchsing goods from its foreign preht corportion. In such cses, trnsfer price used by controlled purchser for income tx purposes (which becomes controlled purchser's cost bsis for computing gin on resle) cnnot exceed vlue mount tken into ccount for purposes of determining custom duties.66 This ceiling is designed to prevent txpyers from simultneously voiding U.S. custom duties nd U.S. income txes by using low trnsfer price for custom purposes nd high price fo1: income tx purposes..06 Trnsfer or Use of Intngibles Introduction. For trnsfer pricing purposes, n "intngible" includes ny of following items: (i) ptents, inventions, formule, processes, designs, ptterns, or knowhow, (ii) copyrights nd literry, musicl, or rtistic compositions, (ill) trdemrks, trde nmes, or brnd nmes, (iv) frnchises, licenses, or contrcts, (v) methods, progrms, systems, procedures, cmpigns, surveys, studies, forecsts, estimtes, customer lists, or t~hnicl dt, nd (vi) or similr items.67 The owner of n intngible for tx purposes ordinrily is txpyer who owns tl:le leglly protected right to exploit tht intngible.68 However, if n intngible is not leglly protected, it my be uncler which of controlled prties is owner of intngible. In such cses, controlled prty tht bore lrgest 64 Reg (c)(2). 65 Reg (c)(3). 66 Code Sec. lo59a. 67 Reg (b). 68 Reg (f)(3)(ii)(A). 1]502.06

18 124 U.S. Txtion of Interntionl Trnsctions portion of direct nd indirect costs of developing intngible ordinrily is treted s owner for tx purposes.69 There re three specified methods for estimting n rm's-length chrge for trnsfers of intngibles: (i) comprble uncontrolled trnsction method, (ii) comprble profits method, nd (ill) profit split method.70 The txpyer JIlust select nd pply method which provides most relible estimte of n rm's length price.71 In ddition to three specified methods, txpyer lso hs option of using n unspecified method. However, n unspecified method cn be used only if it provides most relible estimte of n rm's-len.l?;th price Reg ( )(3)(ii)(B). If ny or controlled prty contributed to development of intngible, owner must llocte n rm's-length compenstion to tht prty. Reg (f)(3)(iii). 70 Reg (). 71 Reg (c)(1). 72 Reg (d)(1). 73 Reg (c)(1). 74 Reg (c)(2)(ili)(B)(1). 75 Reg (c)(2)(ii). 76 This exmple is bsed on Reg (e), Exmple

19 Sles. Operting Cost Roylty of goods pid expenses. ssets. profit tousaco sold. (5% of sles) ~ Trnsfer Priein/! 125 mrkets product in United Sttes. ASIAco's verge finncil results for lst three yers re s follows: million <$12 million> <$ 1 million> <$ 2 million> $ 5 million $ 25 million ASIAco is selected s tested prty becuse it engges in reltively routine -mnufcturing ctivities, wheres USAco engges in vriety of complex ctivities using unique nd vluble intngibles. Becuse ASIAco is engged in mnufcturing, rtio of operting profits to operting ssets is most pproprite profitbility mesure. After djustments hve been mde to ccount for mteril differences between ASIAco nd smple of five uncontrolled foreign mnufcturers for which dt is vilble, verge rtio of operting profit to operting ssets for ech uncontrolled distributor is s follows: 8%, 10%, 15%, 15%, nd 18%. Applying se percentges to ASIAco's operting ssets yields following rm's-length rnge of comprble operting profits for ASIAco: $2 million, $2.5 million, $3.75 million, $3.75 million, nd $4.5 million. Therefore, interqurtile rnge of comprble operting profits is used for purposes of testing ASIAco's profits. This rnge includes $2.5 million, $3.75 million, nd $3.75 million. Becuse ASIAco's reported operting profit of $5 million lies outside rm's-length rnge, n djustment is required. The medin of interqurtile rnge of comprble operting profits (i.e., $3.75 million) is determined to be rm's-length profit for ASIAco. Therefore, roylty tht ASIAco pys USAco is incresed by $1.25 million, which equls difference between ASIAco's reported profit of $5 million nd rm's-length profit of $3.75 million. This djustment increses USAco's U.S. txble income by $1.25 million per yer, with corresponding decrese in ASIAco's txble income. Profit split method. See discussion of profit split method under "Trnsfers of Tngible Property," bove. Commensurte with income requirement. Mny U.S. compnies hve moved opertions to foreign countries offering low-cost lbor, low tx rtes, less government regultion, nd new mrkets. These compnies typiclly hve mnufcturing nd mrketing intngibles tht y cn trnsfer to ir foreign subsidiries. For exmple, foreign mnufcturing subsidiry might mnufcture good under license from its domestic prent corportion nd n sell its entire output to prent t mrkup. If foreign subsidiry is locted in low-tx foreign jurisdiction, domestic prent will defer U.S. txes to extent intercompny roylty rte understtes economic vlue of

20 126 U.S. Txtion of Interntionl Trnsctions intngible. It is often very difficult to determine pproprite rm's-length roylty rte becuse informtion regrding comprble uncontrolled trnsctions is usully not vilble regrding intngible ssets such s ptents nd trdemrks. In response to se problems, in 1986 Congress encted requirement tht trnsfer prices for sles or licenses of intngibles must be "commensurte with income ttributble to intngible."77 In or words, trnsfer prices must reflect ctul profit experience relized subsequent to outbound trnsfer. To meet this requirement, originl sles price or roylty rte must be djusted nnully to reflect ny unnticipted chnges in income ctully generted by intngible.78 For exmple, if new ptent leds to product tht turns out to be fr more successful thn ws expected t time ptent ws licensed, txpyer must increse intercompny roylty pyments to reflect tht unnticipted profitbility. A determintion in n erlier yer tht roylty ws rm's length does not preclude IRS from mking n djustment in subsequent yer.79 The need to mke periodic djustments plces significnt dministrtive burden on txpyers. This burden is mitigted somewht by following exceptions: (i) De minimis exception-periodic djustments re not required if totl profits ctully relized by controlled trnsferee from use of intngible re between 80% nd 120% of profits tht were foreseeble when greement ws entered into, nd re hve been no substntil chnges in functions performed by trnsferee since greement ws executed, except for chnges required by unforeseeble events. Or requirements include existence of written roylty greement, nd preprtion of contemporneous supporting documenttion.so In ddition, if requirements of de minimis exception re met for ech of five consecutive txble yers, n no furr periodic djustments re required under ny conditions.81 (ii) Extrordinry event exception-even if totl profits ctully relized by controlled trnsferee from use of intngible re less thn 80% or more thn 120% of profits tht were foreseeble when greement ws entered into, txpyer need not mke periodic djustments if unexpected vrition in profits is due to extrordinry events tht could not hve been resonbly nticipted nd re beyond txpyer's control. In order to use this exception, ll of requirements of de minimis exception, or thn 80%-120% test, lso must be met Code Sec Reg (f)(2)(i). 79 Reg (f)(2)(i). 80 Reg (f)(2)(ii)(C». A slightly different set of requirements pplies if rm's-length mount ws determined under comprble uncontrolled trnsction method. Reg (f)(2)(ii)(B). 81 Reg (f)(2)(ii)(E). 82 Reg (f)(2)(ii)(D)

21 Trnsfer Pricing 127 (ill) Sme intngible exception-no periodic djustments re required if following requirements re met: (i) sme intngible ws trnsferred to n uncontrolled txpyer under circumstnces similr to those of controlled trnsction, (ii) uncontrolled trnsction serves s bsis for ppliction of comprble uncontrolled trnsction method, nd (ill) n rm's-length chrge is mde in first txble yer of trnsfer.83 Cost-shring rrngements. One wy for controlled prties to void dministrtive burden nd uncertinties ssocited with trnsfer pricing for intngibles is to enter into cost-shring rrngement. For exmple, u.s. prent corportion nd foreign subsidiry my gree to eqully shre costs of developing new product. Under such n greement, prent might own rights to mnufcture nd mrket new product in United Sttes, while subsidiry might own rights to mnufcture nd mrket new product brod. The dvntge of cost-shring rrngement is tht foreign subsidiry's ownership of foreign rights~o intngible negtes need to hve tht subsidiry py roylty to its U.S. prent: A bon fide cost-shring rrngement must llocte reserch nd development costs in proportion to profits erned by ech controlled prty from intngible, nd ech controlled prty must ber portion of costs incurred t ech stge of development of both successful nd unsuccessful intngibles Correltive Adjustments nd Setoffs When IRS increses txble income of relted prty through trnsfer pricing djustment, it will lso reduce income of relted prty for U.S. purposes. Exmple 5.17: USAco sells mchinery to FORco, its foreign subsidiry. The IRS mkes trnsfer pricing djustment, incresing income of USAco on sle of mchinery by $1 million. The IRS will lso decrese income of FORco by $1 million, which will reduce FORco's ernings nd profits nd ffect foreign tx credit computtion. Accordingly, IRS my permit USAco to estblish n ccount receivble so tht FORco's pyment of csh in mount of djustment will not result in dditionl income. The IRS will generlly permit txpyer to offset negtive trnsfer pricing djustment with fvorble trnsfer pricing djustment provided tht djustments re for sme two relted prties. Exmple 5.18: USAco sells mchinery to FORco, its foreign subsidiry. The IRS mkes trnsfer pricing djustment, incresing income of USAco on sle of mchinery by $1 million. If IRS lso determines tht USAco should hve pid FORco n dditionl $600,000 for services, djustments re offset for net djustment of $400,000. If, however, IRS mkes djustment for USAco's sles of mchinery to FORco nd 83 Reg (f)(2)(ii)(A). 84 Reg ~

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23 Trnsfer Pricing 129, - more thn 50% or more of stock, by vote or vlue, of foreign corportion must file Form 5471, 1nformtion Return of U.S. Persons With Respect to Certin Foreign Corportions.95 In Form 5471, U.S. shreholder must provide wide vriety of informtion regrding controlled foreign corportion, including dollr mounts of trnsctions it entered into with relted prties.96 Any U.S. person who fils to furnish required informtion my be subject to n nnul penlty of $10,000, s well s reduction in txpyer's foreign tx credit.97 As with Form 5472, prcticl importnce of Form 5471 is tht IRS often uses this form s strting point for conducting trnsfer pricing exmintion.98 (Form 5471 is reproduced in ppendix to Chpter 6.) 1]504 TRANSACTIONAL AND NET ADJUSTMENT PENALTIES In n ttempt to promote more voluntry complince with rm's-length stndrd, Congress hs encted two specil trnsfer pricing penlties: trnsctionl penlty nd net djustment penlty. Both penlties equl 20% of tx underpyment relted to trnsfer pricing djustment mde by IRS.99 The trnsctionl penlty pplies if trnsfer price used by txpyer is 200% or more (or 50% or less) of mount determined under Code Sec. 482 to be correct mount}oo The net djustment penlty pplies if net increse in txble income for txble yer s result of Code Sec. 482 djustments exceeds lesser of $5 million or 10% of txpyer's gross receipts}o1 Both penlties increse to 40% of relted tx underpyment if trnsfer price used by txpyer is 400% or more (or 25% or less) of mount determined under Code Sec. 482 to be correct mount, or if net djustment to txble income exceeds lesser of $20 million or 20% of txpyer's gross receipts}02 The trnsctionl nd net djustment penlties pply utomticlly whenever n IRS djustment exceeds numericl thresholds. The only wy to void penlty in such cses is to stisfy certin sfe-hrbor requirements. In cse of trnsctionl penlty, penlty is wived only if txpyer cn demonstrte tht it hd resonble cuse nd cted in good fith.103 In cse of net djustment penlty, resonble cuse nd good fith requirements cn be met only if txpyer cn demonstrte, through contemporneous documenttion provided to IRS within 30 dys of request, tht it cted resonbly in selecting nd pplying trnsfer pricing method}04 These dded requirements for voiding net djustment penlty re designed to force txpyers to develop nd hve witing for IRS ll of documenttion tht IRS ordinrily would need to review in trnsfer pricing exmintion. In ddition to providing protection ginst trnsfer pricing penlty, documenttion my lso persude IRS tht trnsfer pricing djustment is not 95 Reg () nd (b). % Reg (f). 97 Code Sec. 6038(b) nd (c). 98 See Internl Revenue Mnul, Interntionl Audit Guidelines Hndbook, April 1, 2002, Code SeC. 6662() nd (b)(3). 100 Code Sec. 6662(e)(1)(B)(i). 101 Code Sec. 6662(e)(1)(B)(ii) nd (e)(3)(a). 102 Code Sec. 6662(h). 103 Reg (b)(3) nd Reg (). 104 Code Sec. 6662(e)(3)(B)(i). Documenttion is considered contemporneous if it is in existence t time tx return is filed. Reg (d)(2)(iii)(A)

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25 Trnsfer Pricing 131 internl cost ccounting nd profit mrgin nlysis for trnsctions t issue nd ltest four yers' finncil sttements. The txpyer will hve to identify unrelted prty 'trnsctions, which my be between eir two unrelted prties or one of relted prties nd n unrelted prty. Exmple 5.19: USAco sells cheese to FORco, its foreign subsidiry, nd wnts to pply CUP method to determine pproprite trnsfer price. USAco hs to interview pproprite personnel to determine price USAco chrges unrelted prties in comprble cheese sles. In ddition, USAco lso needs to identify, to extent vilble, price chrged on comprble sles of cheese by or cheese wholeslers. The culmintion of informtion gring process is preprtion of functionl nlysis. This functionl nlysis reviews functions performed nd risks ssumed by respective prties, focusing on competition, mrket, nd or economic fctors tht my help to determine rm's-length pricing..03 Identifiction of Best Method The regultions require txpyer to pply "best method" to its intercompny trnsctions. This requires choosing one of methods prescribed in regultions nd supporting its pplicbility. At sme time, txpyer must explin why or prescribed methods re not pplicble. The txpyer must review ccurte nd relible dt for ppliction of method; degree of comprbility between controlled nd uncontrolled trnsctions or compnies to which methods re pplied; nd number, mgnitude, nd ccurcy of djustments required to pply method}09.04 Economic Anlysis The txpyer should retin n economist to nlyze trnsctionl dt nd obtin informtion concerning comprble compnies from relible dtbses. Exmple 5.20: USAco, U.S. subsidiry of ASlAco, Singpore prent corportion, purchses softwre from its prent tht USAco mrkets nd sells in U.S. USAco wnts to pply comprble profits method to determine pproprite trnsfer price. USAco must find compnies comprble to itself with respect to type of functions performed nd risks ssumed. As result, economist will hve to serch for potentiuy comprble compnies bsed, for exmple, on disclosures required by Securities nd Exchnge Commission, such s Form lo-k. The economic nlysis my furr compre finncil results of tested prty to finncil results of comprble trnsctions or compnies. In ddition to ssuring functionl comprbility, n economist my lso exmine finj:lcil rtios such s return on costs, return on sles, nd return on ssets. Where pproprite, n economist my mke djustments for differences in relevnt fctors such s reltive levels of inventory, receivbles, nd pybles. 109 Reg (d)(2).

26 132 u.s. Txtion of Intemtionl Trnsctions.05 Trnsfer Pricing in Or Countries The U.S. trnsfer pricing rules re generlly more detiled nd stricter thn those in or countries. As result, mny of United Sttes' trding prtners hve become concerned tht multi-ntionls were reporting more income from intercompny trnsctions in U.S. nd less in or country. Becuse of this concern, mny of se countries hve specificlly dopted trnsfer pricing rules nd mny ors hve dopted guidelines issued by Orgniztion for Economic Corportion nd Development}10 A methodology nd trnsfer price tht IRS my ccept, my not, however, be cceptble to foreign country's txing uthority. Mny foreign countries hve preference for trnsction-bsed methods (i.e., comprble uncontrolled price method, resle price method, nd cost plus method) s opposed to profit-bsed methods (comprble profits method nd profit split methods).111 Exmple 5.21: USAco, U.S. subsidiry of CANco, Cndin prent corportion, purchses oil from its prent tht USAco mrkets nd sells in U.S. USAco properly pplies comprble profits method to justify to IRS trnsfer price of $100 brrel. The Cnd Customs nd Revenue Agency udits CANco, disregrds USAco's comprble profits method nlysis, nd pplies profit split method to support n djustment to CANco, incresing trnsfer price to $120 brrel. Although contemporneous documenttion provides protection in most developed countries from trnsfer pricing penlty, documenttion in se foreign countries is not s rigorous s U.S.'s requirement. For exmple, only Austrli,1I2 Jpn,1I3 nd Nerinds1I4 require tht documenttion explin why txpyer rejected lterntive methods. The expense of prepring documenttion for two different countries with respect to sme trnsction my be frught with dnger. The methodology employed s well s documenttion requirements my differ in two countries. As result, United Sttes, in conjunction with tx dministrtors of Austrli, Cnd, nd Jpn, nnounced documenttion requirements tht will provide penlty protection in multiple countries.lis Neverless, documenttion pckge does not provide certinty with respect to different methods preferred in vrious countries DEVELOPING A TRANSFER PRICING STRATEGY In current environment, trnsfer pricing strtegy is driven, to gret extent, by need to develop n effective defense ginst trnsctionl nd net djustment penlties. The first step in developing defense ginst se penlties is to ssess mount of risk ssocited with txpyer's current 110 Orgniztion for Economic Corportion nd Development, Trnsfer Pricing Guidelines for Multintionl Enterprises nd Tx Administrtion. 111 Culbertson, Robert E., "A Rose By Any Or Nme: Smelling Flowers t OECD's (Lst) Resort," Tx Notes Interntionl, (August 4, 1995); Revenue Cnd Informtion Circulr Division 13 of Prt ill, Income Tx Assessment Act; Finl Ruling TR 97/ STML-Enforcement Order 39-12, STML-Cir- Culr & Article 7 of Income Tx Act. 115 IR , Mrch 12, 2003.

27 Trnsfer Pricing 133 ~ --- position. One mjor determinnt of risk is ggregte dollr vlue of controlled trnsctions between U.S. nd foreign ffilites. Anor mjor determinnt of risk is reltive profitbility of U.S. nd foreign opertions, in prticulr, percentge of txpyer's worldwide profits tht is llocted to low-tx foreign jurisdictions. As prcticl mtter, trnsctionl penlty is likely to rise only if txpyer provides for no trnsfer price.116 In contrst, ny lrge corportion with significnt volume of cross-border trnsctions could conceivbly exceed $5 million net djustment threshold. For exmple, compny with $100 million of cross-border controlled trnsctions is potentilly subject to 20% penlty if its trnsfer prices re off by just 5%., The only sure wy to gurd ginst net djustment penlty is to demonstrte, through contemporneous documenttion provided to IRS within 30 dys of request, tht txpyer cted resonbly in selecting nd pplying trnsfer pricing method. As consequence,. keys to voiding net djustment penlty re use of trnsfer prices which re supported by sufficient documenttion nd llocting to ech ffilite resonble profit which reflects economic relities of prties' contrctul reltions. In this regrd, relince on trnsfer pricing study done by professionl qulified to conduct such n nlysis, such s n ttorney, ccountnt, or economist, is relevnt fctor in determining wher txpyer selected nd pplied trnsfer pricing method in resonble mnner.ii7 Therefore, forml trnsfer pricing study, wher prepred internlly by txpyer's employees or externlly through use of outside consultnts, is n importnt fctor in estblishing defensible trnsfer pricing positions. An lterntive strtegy for voiding trnsctionl nd net djustment penlties, s well s n djustment, is to obtin n dvnce pricing greement (or " APA "). Under APA procedure, IRS reviews nd grees to txpyer's trnsfer pricing method before txpyer implements ivi8 An APA spells out fctul nture of relted prty trnsctions, n pproprite pricing method, nd expected rnge of results from pplying greed-upon method to trnsctions. If greed-upon methodology is pplied fithfully by txpyer, IRS will not djust txpyer's trnsfer prices in ny future udits. Thus, dvntges of n APA include certinty of results for txpyer, s well s possibility of reduced record keeping becuse txpyer knows in dvnce wht informtion IRS considers to be relevnt. The disdvntges include cost of developing documenttion needed to obtin n APA (including opinions of independent experts), s well s up-front disclosure of informtion to IRS. Disclosure my be only timing issue, however, for lrge multintionl corportions which IRS routinely udits. Although txpyers my hve some concern tht y re disclosing 116 For exmple, if domestic prent corportion trnsfers n intngible to foreign subsidiry nd does not provide for ny roylty pyments, n ny price djustment will exceed 200% threshold. 117 Reg (d)(2)(ii)(D). 118 Rev. Proc , IRB

28 134 U.S. Txtion oflntemtionl Trnsctions informtion bout ir compny to potentil competitors, disclosure of written APAs nd ny bckground documents is prohibited.119 Txpyers tht hve trditionlly benefited most from APAs include lrge multintionl corportions, compnies with bd udit histories, conservtive compnies concerned bout penlties, nd U.S. subsidiries of foreign multintionl corportions. These businesses typiclly hve significnt trnsfer pricing exposure. 119 Code Secs nd ~505