By Anthony Diosdi
Introduction
Transfer pricing must be taken into consideration by any business involved in cross-border transactions. Although many have heard of the term “transfer pricing,” few understand how transfer pricing works. This article is designed to provide the reader with a very basic understanding of how transfer pricing works. To understand transfer pricing we must think of the operating units of a multinational corporation. Multinational corporations usually engage in a variety of arrangements of intercompany transactions. For example, a U.S. manufacturer may market its products through foreign marketing subsidiaries. A domestic parent corporation may provide managerial, technical, and administrative services for its subsidiaries, and may license its manufacturing and marketing intangibles to its foreign subsidiaries for commercial exploitation abroad. A “transfer price” must be computed for each of these controlled transactions. Although a transfer price does not affect the combined income of commonly controlled corporations, it does affect how that income is allocated among the group members. Therefore, when tax rates vary across countries, transfer pricing can have a significant effect on a multinational corporation’s total tax costs.
Congress enacted Internal Revenue Code Section 482 to ensure that related corporations report and pay tax on their actual share of income arising from controlled transactions. The regulations under Section 482 adopt an arm’s length standard for evaluating the appropriateness of a transfer price. Under this standard, a taxpayer should realize the same amount of income from a controlled transaction as an uncontrolled party would have realized from a similar transaction under similar circumstances.
To arrive at an arm’s length result, the taxpayer must select and apply the method that provides the most reliable estimate of an arm’s length price. The reliability of a pricing method is primarily a function of the degree of comparability between the controlled and uncontrolled transaction. The regulations under Section 482 provide specific methods for determining an arm’s-length transfer price for various types of transactions, including transfers of tangible property, transfers of intangible property, loans, and services. The regulations provide five specified methods for estimating an arm’s-length charge for transfers of tangible property, including the comparable uncontrolled price method, the resale price method, the cost plus method, the transactional net margin method, and the transactional profit split method. In addition to the five specified methods, the taxpayer also has the option of using an unspecified method. However, an unspecified method can only be used if it provides the most reliable estimate of an arm’s-length price.
The Transfer Pricing Methods
The purpose of Internal Revenue Code Section 482 is to ensure that taxpayers report and pay tax on their actual share of income arising from controlled transactions. To this end, the regulations under Section 482 adopt a so-called arm’s length standard for evaluating the appropriateness of a transfer price. Under this standard, a taxpayer should realize the same amount of income from a controlled transaction as an uncontrolled party would have realized from a similar transaction under the same or nearly identical situations.
To arrive at an arm’s length result, the taxpayer must select and apply a method that provides the most reliable estimate of an arm’s length price. Thus, the primary focus in selecting a transfer pricing method is the reliability of the result. The reliability of a pricing method is determined by the degree of comparability between the controlled and uncontrolled transactions, as well as the quality of the data and the assumptions used in the analysis. The principal factors to consider in assessing the comparability of controlled and uncontrolled transactions include:
1. Functions performed;
2. Risks assumed;
3. Contractual terms;
4. Economic conditions and markets;
5. Nature of the property or services transferred in the transaction.
Transfers of Intangible Property
For transfer pricing purposes, an “intangible” includes any of the following items:
1. Patents, inventions, formulae, processes, designs, patterns, or know-how;
2. Copyrights and literary, musical, or artistic compositions;
3. Trademarks, trade names, or brand names;
4. Franchises, licenses, or contracts;
5. Methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data.
The owner of an intangible for tax purposes ordinarily is the taxpayer who owns the legally protected right to exploit that intangible. There are three specific methods for estimating an arm’s length charge for transfers of intangibles:
1. The comparable uncontrolled transaction method;
2. The comparable profits method; and
3. The profit split method.
The taxpayer must select and apply the method which provides the most reliable estimate of an arm’s length price. In addition to the three specified methods, the taxpayer also has the option of using an unspecified method. However, an unspecified method can only be used if it provides the most reliable estimate of an arm’s length price. Below, we will walk through the different methods of determining arm’s length pricing for the transfer of intangibles.
Comparable Uncontrolled Transaction (“CUT”) Method
The first method for determining the arm’s length value of an intangible is the comparable uncontrolled transaction (“CUT”) method. The CUT method generally provides the most direct and reliable measure of an arm’s length royalty. It may also be used if the same intangible is transferred in both the controlled and uncontrolled transactions and only minor differences exist between the uncontrolled and the controlled transactions, provided that these differences have a definite and reasonably ascertainable effect on pricing and that appropriate adjustments are made for them. See Treas. Reg. Section 1.482-4(c)(2)(ii).
To be considered comparable both intangibles must be used in connection with similar products or processes with the same general industry or market and must have similar profit potential. See Treas. Reg. Section 1.482-4(c)(2)(iii)(B). Basically, controlled and uncontrolled transfers of intangibles used for the same product type in the same industry will be comparable if they are anticipated to generate substantially the same pre-tax benefits for the transferees.
To conclude that the profits that the profit potential of two intangibles is similar, it is necessary to have an acceptable reliable measure of the profit potential of the two intangibles. The profit potential of an intangible involves calculating the net present value of the benefits to be derived from use of the intangible by the transferee. Profit potential is most reliably measured by direct calculations, based on reliable projections, of the net present value of the benefits to be realized through use of the intangible. While this information frequently will be available with respect to an uncontrolled transaction unless one of the controlled persons was a party to it. In recognition of this difficulty, the regulations provide that, in certain cases, it may be acceptable to refer to evidence other than projections to compare profit potentials. For example, such evidence may include the terms of the transfer, the uniqueness of the intangibles and their stage of development. See Treas. Reg. Section 1.482-4(c)(2)(iii)(B)(1)(ii) and 4(c)(2)(iiii)(B)(2). Such indirect comparisons of profit potentials will be useful in cases in which it is not possible to calculate directly the profit potential of the intangibles in either the controlled or uncontrolled transactions.
Comparable Profits Method
The comparable profits method looks at the profits of uncontrolled entities, rather than the prices used in uncontrolled transactions, to determine an arm’s length allocation of profit between two related corporations. Under this method, the profitability of comparable companies is used as a benchmark for determining an arm’s length net profit for one of the controlled parties (the “tested party”) and then a transfer price is established that leaves the tested party with that amount of net profit. See Treas. Reg. Section 1.482-5(b)(1). The methodology for developing an arm’s length profit involves the following seven steps:
1. Determine the tested party- the tested party should be the participant in the controlled transaction for which the most reliable data regarding comparable companies can be located. This is likely to be the least complex of the controlled parties and the controlled party that does not own valuable intangible property or unique assets that distinguish it from potential uncontrolled comparable companies.
2. Search for comparable companies and obtain their financial data- the key factors in assessing the comparability of the tested party to comparable companies are the resources employed and the risks assumed. Because resources and risks usually are directly related to functions performed, the functions performed must also be considered to determine the degree of comparability between the tested party and comparable companies. Another important factor is the consistency between the accounting methods used by the tested and comparable companies to compute their operating profits. Adjustments must be made for any differences between the tested party and the comparable companies that would materially affect the profitability measures used.
3. Select a profit level indicator (“PLI”)- examples of PLIs that can be used include the ratio of operating profit to operating assets, the ratio of operating profit to sales, and the ratio of gross profit to operating expenses. To enhance the reliability of a PLI, the taxpayer should perform a multiyear analysis which generally should encompass at least the taxable year under review and the two preceding years.
4. Develop an Arm’s Length Range of PLIs- the arm’s length range of PLIs is the interquartile range (the middle 50%) of the PLIs of the comparable companies. The interquartile range is the range from 25% to 75% percentile. More specifically, the 25th percentile is the PLI when at least 25% of the results are at or below that PLI. The 75th percentile is the PLI when at least 25% of the results are at or below that PLI.
5. Develop an arm’s length range of comparable operating profits- to construct an arm’s length range of comparable profits, the selected PLI (e.g., the ratio of operating profits to operating assets) for the comparable companies in the arm’s length range is applied to the tested party’s most narrowly identified business activity for which data incorporating the controlled transaction is available.
6. Determine if an adjustment must be made- an adjustment is required if the tested party’s reported profit lies outside the arm’s length range of comparable operating profits developed in step 5.
7. Adjust the transfer price used for the controlled transaction- if the tested party’s reported profit lies outside the arm’s length range, an adjustment is made equal to the difference between the tested party’s reported profit and the benchmark arm’s length profit, such as the mean or the median of the arm’s length range of comparable operating profits.
In conclusion, the comparable profits method looks to the operating profits of the entire enterprise rather than operating profit attributable to a particular intangible. It focuses on the total operating profit based on all functions performed, capital invested and risks assumed. The comparable profits method also looks to the profitability of uncontrolled taxpayers that engage in similar business activities under similar circumstances.
Below, please see the Illustration below which demonstrates comparable profits method for transfer pricing purposes.
Illustration.
Ajax, a European pharmaceutical company, owns 100 percent of Greenway, a domestic corporation. Ajax develops a drug “CoronaAway,” the cure for covid. Ajax licenses the drug to Greenway with the rights to use the CoronaAway trade name in the United States. Without considering the appropriate arm’s length royalty rate that Greenway must pay Ajax, Greenway’s average financial results for the last three years are as follows:
Sales $20 million
Cost of goods sold $12 million
Operating expenses $2 million
Operating profit $4 million
Greenway is selected as the tested party as a result of engaging in relatively routine manufacturing and sales activities, whereas Ajax engages in a variety of activities. Thus, the marketing and selling of pharmaceuticals is the ratio of operating profits to sales and the most appropriate PLI.
After adjustments have been made to account for material differences between Greenway and a sample of eight comparable companies for which data is available (sellers of pharmaceuticals), the average ratio of operating profit to sales for the comparable companies is as follows: 5%, 6%, 8%, 9%, 10%, 15%, 15%, and 18%. Consequently, the arm’s length range (the interquartile range) is 7% to 15% (the average of the second and third lowest PLIs and the average of the sixth and seventh lowest PLIs). Greenway’s return on sales is 20% ($4 million of operating profit divided by $20 million of sales) and the high profitability is attributable to Greenway’s use of Ajax’s intellectual property.
As a result, Greenway pays a royalty on sales that would result in Greenway having a return on sales in the arm’s length range of 7% to 15%. Greenway can pay a royalty of 5% to 13% of sales to Ajax and still be in arm’s length range.
Profit Split Method
If members of a controlled group are engaged in a functionally integrated business and each member uses valuable intangibles, it will normally be difficult to identify comparable uncontrolled transactions and comparable uncontrolled transfers of comparable intangibles that can be used to determine arm’s length pricing for particular tangible transfers. Without comparable transactions or comparable uncontrolled holders of similar intangible rights, the above discussed methods cannot be used. In this situation, a transactional profit split method may be applied.
Treasury Regulation Section 1.482-6 describes transactional profit split methods. The basic approach of a transactional split method is to estimate an arm’s length return by 1) comparing the relative economic contributions that the parties make to the success of a business venture and 2) dividing the returns from that venture between them on the basis of the relative value of such contributions. The relative value of each controlled taxpayer’s contribution to the success of the relevant business activity must be determined in a manner that reflects the functions performed, risks assumed, and resources employed by each participant in the relevant business activity, consistent with the comparability provisions of Treasury Regulation Section 1.482-1(d)(3). Such an allocation is intended to the division of profit or loss that would result from an arrangement between uncontrolled taxpayers, each performing functions similar to those of the various controlled taxpayers engaged in the relevant business activity.
Two transactional profit split methods are available: the comparable profit split and the residual profit split. A comparable profit split is derived from the combined operating profit of uncontrolled taxpayers, the transactions and activities of which are similar to those of the controlled taxpayers in the relevant business activity. Each uncontrolled taxpayer’s percentage of the combined operating profit or loss is used to allocate the combined operating profit or loss of each controlled taxpayer involved in the relevant business activity. See Treas. Reg. Section 1.482-6(c)(2).
The residual profit split method determines an arm’s length consideration in a two-step process, using the other methods discussed above, market returns for routine functions are estimated and allocated to the parties that performed them. The remaining, residual amount is then allocated between the parties on the assumption that this residual is attributable to property contributed to the activity by the controlled taxpayers. Using this assumption, the residual is divided based on the estimate of the relative value of the parties’ contributions of such property. Since the fair market value of the intangible property usually will not be readily ascertainable, other measures of the relative values of intangible property may be used, including capitalized intangible development expenses. The transactional profit split method is the most complicated of the specified pricing methods for transfers of intangible property and, therefore, is difficult to apply in practice.
Penalties Associated With Transfer Pricing and the Documents Needed for Transfer Pricing
The IRS takes transfer pricing seriously. It can assess a transactional penalty and net adjustment penalty if a taxpayer does not follow the transfer pricing rules. Both penalties equal to 20 percent of the tax underpayment related to the transfer pricing adjustment made by the IRS. The transactional penalty applies if the transfer price used is 200 percent or more of the amount determined under Section 482 to be the correct amount. The net adjustment penalty applies if the net increase in taxable income for the taxable year as a result of Section 482 adjustment exceeds the lesser of $5 million or 10 percent of the gross receipts. Both penalties increase to 40 percent of the related underpayment if the transfer price used is 400 percent or more of the related underpayment if the transfer price used is 400 percent or more of the amount determined under Section 482 to be correct or if the net adjustment to taxable income exceeds the lesser of $20 million or 20 percent of gross receipts.
The penalties associated with transfer pricing are no joke. Preparation is key to avoid IRS scrutiny. The following information should be gathered before a transfer pricing arrangement is considered.
1. An overview of the business.
2. A description of the organization structure covering all related parties engaged in potentially relevant transactions.
Prior to executing a transfer pricing arrangement, counsel should gather, prepare, and review the following with his or her client:
1. Any documentation required by the regulations of section 482;
2. A description of the pricing method selected and an explanation of why that method was selected;
3. A description of the alternative methods that were considered and an explanation of why that method was not selected;
4. A description of the controlled transactions;
5. A description of the comparables used;
6. An explanation of the economic analysis and projections used in the pricing transfer method selected.
Conclusion
Selecting the proper method of transfer pricing is no easy task. We devote a large part of our practice to the U.S. federal income tax rules applicable to U.S. businesses operating outside the United States, as well as foreign companies investing in the United States.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.