Ch. 8 - Transfer Pricing              Code §482

Issues re establishing appropriate prices between related parties in the following transactions between those parties:

1)  Loans of money

2)  Sales of tangible personal property

3)  Leases of tangible personal property

4)  Licensing of intangibles

5)  Providing of services



Why Engage in Aggressive “Transfer Pricing”?

1)  Federal income tax - to shift (a) income from the U.S., or (b) deductions into the United States.

2)  Customs duties - to reduce the inbound price for imports and, therefore, the amount of customs duties payable upon import is reduced.

3)  Corporate planning - reduce the amount of income of a particular subsidiary where employees may participate in profit sharing.

Code §482 Essentials -
Arm’s Length Pricing

1.  Commonly controlled entities (or parallel interests).

2.  Apportionment of gross income, deductions, etc., between parties.

3.  To “prevent evasion of taxes or clearly to reflect the income ...”

A tax accounting provision - to facilitate the determination of the true taxable income of a taxpayer.

Cf., result when Subpart F applies to transaction.

Challenge to the Pricing Adjustment by Taxpayer

An accounting adjustment - ordinarily more deference to Service's position on this adjustment.

Query: Is the adjustment by IRS reasonable?

Taxpayer can succeed in challenge to an adjustment if that adjustment is found to be "arbitrary, capricious or unreasonable". 

Further:  A requirement for correlative allocations and deductions for the related parties (if possible); cf., tax treaty & foreign country.

Defining “Control” for Code §482 Purposes           p.715

No specific % ownership attribution rules.

What about a 50-50 joint venture, particularly where parallelism of interest exists between the two joint venturers?

Example: a joint purchasing arrangement for raw materials, each venturer obtaining product.

           X, Inc. (US) ____ Y,Inc. (US)

                50%                        JV, Inc.      50%

                                    (foreign country)


Secondary Consequences of Adjustments under §482

Rev. Rul. 78-83, p. 716.

Triangular dividend treatment (sub-to-sub).

Excessive amount transferred is treated as:

1) Dividend distribution (§301) upstream to the common parent corporation; this assumes the payor has “earnings and profits;” &

2) Capital contribution downstream by parent corporation to the other entity (including a foreign entity). §351.


Impact of Foreign Law Restrictions               p.718

Proctor & Gamble: (1) P&G-US owned (2) AG-Swiss which owned (3) Espana.  Increase by IRS of the royalty to be paid from Espana to AG.  

But, Spanish law applied a limitation on the permitted royalties.   (Note: This limitation is not permitted under current EU law).        

Held:  For taxpayer; no income allocation to AG was required (note:  the allocation would have produced Subpart F income - royalty - to P&G).


Regs. Concerning Foreign Law Restrictions       p.719

1)  Must be publicly promulgated and generally applied.

2)  Taxpayer must exhaust local country remedies in seeking a waiver of these rules.

3) The restrictions must prevent income receipt.

4) The related parties must not have circumvented these restrictions.

Reg. §1.482-1(h)(2).


Mechanisms to reduce double economic taxation

1) Correlative adjustments to be made - if all entities are subject to U.S. income taxation.

2) Competent Authority mechanism for use to challenge these adjustments where cross-border situations.

See 2016 U.S. Model Income Tax Treaty, Article 25 (concerning “Mutual Agreement Procedure”).


Concepts of Arm’s Length Pricing under Code §482

"Best method" rule.  Reg. §1.482-1(c)(1). Since a range of economic results can occur the parties must examine these important factors (p.722):

1. Functions.

2. Contractual terms between the parties.

3. Economic risks.

4. Economic conditions.

5. The nature of the property or services.


Arm’s Length Pricing & Special Circumstances

Factors which may impact on having alternative pricing strategies in different transactional situations:

1) Market share strategy.

2) Differences in geographic markets.

3) Location savings.


Use the “best method.”  P.723  Reg. §1.482-1(c).


Interest on Debt Between Related Parties         p.723

Use a “safe haven” rate based on the "applicable federal rate“ - if the U.S. taxpayer is not in the “business” of making loans.

Range of not less than 100% of the AFR nor more than 130% of the applicable AFR.

Reg. §1.482-2(a)(2) (revised 2009).

What about short term debt for receivables?

What treatment of foreign currency loans?

Rental of Tangible Property                     p.724

Establish an arm's length rental amount based on:

1) The period and the location of the use.

2) The owner's investment in the property.

3) Expenses of maintaining the property.

4) The type of property involved.

Reg. §1.482-2(c).



Providing Services to a Related Party         p.724

Code §482 - determine that amount which would be charged for similar services in independent transactions between unrelated parties under similar circumstances. 

Reg. §1.482-2(b) & Reg. §1.482-9 (2009) which identify various potential methods to apply.


U.S. Steel Corp. T.C. case  
p.725     Services situation

Delaware mining company (activities in Venezuela) & Liberian shipping co. (Navios). 

Excessive charge for the shipping services?

One planning objective was to limit Venezuelan taxes & another to reduce U.S. tax.

An objective was to cause transportation costs to be increased to equalize costs for domestic and foreign ore when sold in the United States. 

§482 allocation was partially approved.

Reversed on appeal (for taxpayer).  P.731.

UPS case note 

UPS with OPL “subsidiary”? in Bermuda. Received income from “excess value charges” deflected from U.S. to Bermuda (with intermediary National Union (independent) & reinsurance with OPL.  Tax Court says “sham.”

Court of Appeals held arrangement not a sham transaction and remanded.  But, subsequently, a §482 analysis. 

Did “control” of OPL exist for §482 purposes?

Regs. §1.482-9 (2009)               Re:  Services         P.733

1.  Services cost method, no mark-up

2.  Comparable uncontrolled services price method (“CUP”).

3.  Gross services margin method

4.  Cost of service plus method

5.  Comparable profits method (“CPM”).

6.  Profit split method

7.  Unspecified methods

Safe Haven for Costs of Performing Services  p.733

IRS will not adjust a charge that is equal to the costs of performing services.

See Reg. § 1.482-9(b) (2009).

Both direct and indirect costs are to be included.  Former Reg. § 1.482-2(b)(4)(iii).

See Rev. Proc. 2007-13 – re no-mark-up transactions – use of a “services cost method.”

See exclusions from eligibility for this approach, p. 734, e.g., manufacturing & production.

Supervisory Expense

Cf., the cost for management services provided for the benefit of the related/parent corporation.

Young & Rubicam case – p. 734.

No § 482 allocation required, since for the benefit of the parent corporation, i.e., “stewardship expenses.” These expenses are incurred in protecting the interests of the shareholders/owners.

Sales of Tangible Personal Property                     p.735

Historic (prior) methods for arm’s length standards for sale of tangible property:

1)  Comparable uncontrolled price method (CUP)

2)  Resale price method

3)  Cost plus method

4)  Other “appropriate” method

But, remember the requirement to use the “best method.”

Rev. Rul. 87-71               p.736
Compare in the Same Market

Foreign sub sells product to both (i) Parent corporation and (ii) unrelated purchasers.

1) Sub can sell product to unrelated purchasers at a higher price because of market conditions (Market B) in one jurisdiction as contrasted with another jurisdiction.

2)  Higher price to parent corporation than to unrelated purchasers in the same jurisdiction (Market A) - not an arm’s length price.

Bausch & Lomb              p.738
Irish Mfg. Sub.

Irish sub was organized to manufacture and sell contact lenses (i.e., as contract manufacturer?).

Product sold to Parent (or affiliates) for $7.50 but the manufacturing cost was only $1.50.

Sub also paid royalty to Parent of 5 percent of sales to use “spin cast” manufacturing process.

IRS says use “cost plus”?

Held: OK to use the Irish subsidiary and $7.50 was an acceptable market price (using CUP).

Current Pricing Rules for Tangible Personal Property

“Best method” rule (Reg. §1.482-8 (2009)).

Reg. §1.482-3 choices (p. 746):

1) Comparable uncontrolled price method (CUP);

2) Resale price method (for a reseller operation);

3) Cost plus method (production cost &mark-up);

4) Comparable profits method (or CPM);  based on “profit level indicators” – see financial data;

5) Profit split method (profit divided based on relative values of contributions by parties).

Speakerhouse problem 

Basic tax planning issue:  Best pricing method when taxpayer wants lowest possible price that can withstand examination by the IRS?

1)  Comparable uncontrolled price?  Are the systems the same?  Are foreign & U.S. markets the same? Same % mark-up? U.S. sale @ $150; foreign sale @ $200; Sany sale @$300.

2)  Resale price method? Limited contribution by the seller? Same percentage of mark-ups for all the products sold?

Speakerhouse problem 
p.749, cont.

3)  Cost-plus method – for manufacturers.   I.e.,

cost of production, plus a gross profit mark-up. 

Relevant to U.S. production but not Eur. sales?

4)  Comparable profits?  If resources used and risks assumed are similar. No data here?

5)  Profit split?  What contributions by each?  See 50-50 split between competitors (Soundsgood & RadioGeneva).  But, is Soundsgood discounting to get into the market?


Problem 2                       p.750

USM sells gizmos:   (1) Delivered price to foreign

subs and (2) FOB factory to unrelated parties. 

Same price.

Applicability of comparable sales method?

Query: Do transportation and insurance costs

have a reasonably ascertainable impact on price

so as to enable appropriate adjustments between

the two transactions?

Problem 3                       p.750
Impact of Trademark?

USM sells gizmos:  Trademark on the gizmos sold

to USM subsidiaries, but not when sold to

unrelated distributors.

Is the effect on price of the trademark probably

material and, therefore, not reasonably

estimated?  Yes.

Therefore the CUP method is probably not

reliable here.

Problem 4                       p.750
Different Area Markets

USM sells gizmos:  Subsidiaries sold gizmos to

European customers but unrelated distributors

sold gizmos in Asia.

If geographic differences have definitive and

reasonably ascertainable effects for which

adjustments can be made the CUP method may

be acceptable for pricing the transaction. 

Problem 5                       p.750
Foreign Sales Sub

US Corp sells items – $70 each to Singapore sub

to distribute item in Asia.  $2 shipment cost (&

net $68 to U.S. Corp).

Sales to unrelated distributors for distribution

elsewhere with terms of sale at $80 FOB factory.

Is the effect of arrangements to transfer ($12 per

unit) income to the foreign subsidiary – and,

therefore, an adjustment should be made?

Problem 6                      p. 750
Foreign Sub Pays Too Much?

US Corp sells items for $70 each to Singapore sub

to distribute item in Asia. $2 shipment cost (&

net $68). Sales to unrelated distributors for

distribution elsewhere with terms of sale at $60

FOB factory.

Taxpayers can not invoke §482 to make an

adjustment. File an amended income tax return

based on different prices?

Problem 7                      p. 751
Impact of Trademark

Trademark affixed to item sold in Asia, but not

when sold in the rest of the world.

Can the financial effect of the trademark in this

situation be quantified?

Intangible Property Transfers                   p.751

Definition: Patents, copyrights, trademarks, confidential know-how, trade secrets.

Transfer is accomplished either by (1) sale or (2) licensing.  

Licensing can be either (1) co-extensive with the life of the property or (2) for a shorter period. 

Obama 2017 Greenbook proposal: Intangible property also to include “workforce in place, goodwill and going concern value.”

Intangible Property Transfers – Regs        P.754

Best method rule for applicable methods:


   Profit split

   Comparable uncontrolled method (CUT)

   Unspecified methods.

Further consider the “super-royalty” provision in Code §482 – requiring periodic adjustments (post licensing) to the pricing arrangements when circumstances change. P.755.

Cost Sharing Arrangements            p.755

Reg. §1.482-7 (2013) (§1.482-7T in casebook).

Agreement to share the costs and the risks of research and development.

No royalties paid since each participant in the cost-sharing arrangement is an owner of the intangible as it is developed.

No Code §482 adjustments to be made if the arrangement is a "qualified cost sharing arrangement."  How to price the “buy-in” to the research by the foreign subsidiary?


Administration of Transfer Pricing Issues            p.757

1) Reporting and Documentation Requirements - §§6038A & 6038C.

2) Penalty Provisions - §6662(e).  P.759

Accuracy related penalty can be imposed. Exception applicable if documentation was developed establishing that the taxpayer reasonably used one of the methods.   §6662(e)(3)(B). 

Possible doubling of the penalty.  §6662(h).

APAs                          p.760
Rev. Proc. 2006-9

Factual items to be provided:  

1) Measurements of the profitability and the return on investment;                                  

2) Functional analysis of the economic contributions of each party;                        

3) Industry pricing studies;                           

4) Competitors and financial data;                 

5) Criteria concerning comparables.

Further: Identify the “critical assumptions”?


APAs, continued      P.760
Rev Proc. 2006-9

Use APA on a bilateral/trilateral basis.

Use APA to solve issues for prior years?

Annual report to be provided as to performance under the APA.

See APA Annual Report for the format for an Advance Pricing Agreement and assumed pricing methodology.

IRS APA Report for 2016, in IRS Announcement 2017-03, 2017-15 IRB ___, April 15, 2017.

Alternatives for Apportionment           p.761

1) Formulary approach:

state taxation - apportion income on the basis of three factors: (i) labor costs, (ii) asset values and (iii) sales receipts.

2) Production sharing arrangements in the natural resource context.  Each party is entitled to a quantity of the product produced.

3) Arbitrary formula – percentage of the local expenses (as documented).


Transfer Pricing Approach for “Global Trading”

Notice 94-40     p.762

Global trading of commodities and derivative financial products. Functionally fully integrated operations - concerning centralized management of risk and personnel.

Use profit split method to allocate income of related operations between taxing jurisdictions.

See allocation factors (p.764) to determine contribution: value, risk & activity.


Arbitration of Intercompany Pricing Disputes          p.768

1)  In the U.S. - between the IRS and the taxpayer.   Using “baseball arbitration” (defined?).  U.S. Tax Court Rule 124.

2) Between U.S. IRS and taxing authorities of other countries - e.g., Germany, Netherlands, Canada & Belgium income tax treaties, and other more recent U.S. income tax treaties. 

But, is this giving up U.S. sovereignty to an international body (like the United Nations!)?