1. Why transfer pricing matters ^6/

One phenomenon of internationalized economic activities is the development of multinational enterprises. A multinational enterprise is a group of associated companies operating across national frontiers. ^7/ While the individual members of the group are more or less directed by a parent company at headquarters, they are legally autonomous and operate under different national laws. Within a multinational enterprise, many transactions take place between members of the group, such as the sales of goods, provision of services, licensing of patents and know-how, and granting of loans. The prices charged for these transfers do not necessarily represent a result of the free play of market forces, but may diverge from the prices which would have been agreed upon in an open market. ^8/ Multinational enterprises may adopt higher or lower transfer prices to minimize tax (e.g., by selling goods to an associated company in a low-tax country at lower prices), or they may adopt them for other reasons, such as minimizing customs duty liability, lowering exchange rate risks, circumventing restrictions on remittance of profits, or achieving other business objectives (e.g., motivating member companies, penetrating a new market, or improving the financial appearance of certain member companies)—even with the result that total tax liability for the whole group may become higher. ^9/ However, whatever the reason, the higher or lower price can result in shifting profits from one company to another within the group and consequently the tax liability of the relevant companies would be distorted. Since national tax authorities need to determine a proper level of taxable profits of the associated companies operating within their respective jurisdictions, transfer pricing policies of multinationals are of great importance. ^10/

Transfer pricing is an issue, as far as the separate accounting rule applies to the associated persons. Separate accounting is the normal practice for distinct legal entities (the exception is when unitary apportionment is applied, cf. Ch. VI: 3 below). It is also the general rule for the computation of foreign branch profits (cf. Art. 7:2 of the OECD model treaty). Taxation of these profits, therefore, raises the same transfer pricing problems as the taxation of foreign subsidiaries. ^11/

While multinational enterprises can bring substantial benefits to home and host countries by contributing to the efficient utilization of capital, technology, and human resources among the countries, their operations may lead to abuse of economic power and to conflicts with national policy objectives. In view of this, the 1976 OECD Guidelines for Multinational Enterprises lay down standards for the activities of multinational enterprises. ^12/ The guidelines state that enterprises should refrain from making use of the particular facilities available to them, such as transfer pricing, for modifying in ways contrary to national laws the tax base on which members of the group are assessed. They also state that enterprises should publish, on a regular basis, the policies followed in respect of intragroup pricing.

Apart from such matters of conduct, appropriate pricing and accounting practices would also help multinational enterprises improve their efficiency in the allocation of resources and management of member companies.

2. Tax avoidance and evasion through the use of tax havens

One of the most important types of international tax avoidance and evasion occurs through the use of tax havens. Large differences in tax burdens between high-tax countries and tax havens, together with some tax haven features such as strict secrecy and refusal to cooperate with foreign tax administrations, can induce transfer pricing manipulation or, at least, open up opportunities for it. ^13/ To the extent that harmonization of corporate tax systems among high-tax countries can be achieved and corporate tax rates can converge internationally, taxpayers will have fewer incentives to allocate income fictitiously to avoid or evade taxes. Nevertheless, the above-mentioned problems caused by tax havens will remain.

Tax authorities have taken many types of measures to curb tax avoidance and evasion through the use of tax havens. ^14/ In cases where multinational enterprises establish in tax havens “conduit companies” that have no real activities and are solely aimed at income channelling objectives, some juridical rules usually exist so that tax laws can be applied in light of the economic reality of transactions. Some countries have further enacted special legislation that treats most income accrued by controlled affiliates incorporated in tax havens as current income of the parents and makes it taxable in the home country even if the income is not remitted. This legislation was first adopted in the United States, then in Germany, Canada, Japan, France, and the United Kingdom.

Although transfer pricing legislation is not focused on transactions with tax havens, It is also an important instrument in preventing the artificial shifting of income to related companies established in tax havens or low-tax countries. The above-mentioned White Paper reveals the U.S. authorities’ concerns about inappropriate pricing practices for transactions with entities in tax havens and about the administrative difficulty of obtaining access to information located in tax havens. The 1986 legislation and the subsequent measures taken in the United States for strengthening transfer pricing rules and their implementation were motivated by these problems, but eventually covered not only transactions related to tax havens but also transactions related to any other countries. The tax authorities in many high-tax countries have expressed their concern about these measures, as indicated below. However, stricter rules and implementation applied only to tax haven cases would be accepted internationally with less difficulty.

3. Elimination of economic double taxation

Apart from the cases related to tax havens, when an adjustment is made by the tax authorities of a country to transfer prices for tax purposes, the adjustment (usually called an “initial adjustment”), if it increases the taxable profits in that country, may result in economic double taxation, in the sense that the same profits have already been reported to another country by an associated company. ^15/ To eliminate economic double taxation, it is necessary for the tax authorities in the latter country to make an appropriate adjustment to the transfer prices (usually called a “corresponding adjustment”) in response to the initial adjustment. The procedures for corresponding adjustments depend on the mechanism for double taxation relief provided by the tax treaty between the two countries, though in some cases domestic rules may provide unilateral relief for economic double taxation without involving the tax authorities of other countries.

As tax authorities are intensifying transfer pricing adjustment practices, the need for a more efficient system of eliminating double taxation is increasing. Under existing international tax treaty provisions, the elimination of double taxation depends on how successfully the relevant competent authorities can reach an agreement on an appropriate transfer price through their negotiations. If the taxing approaches of national tax authorities differ, the problem of double taxation could remain unsolved. This is why international coordination among tax authorities as well as international dialogues between tax authorities and taxpayers are frequently advocated in this area.

The Appendix deals with the issues regarding elimination of double taxation arising from transfer price adjustments.

1. Arm’s length price principle and international guidelines for its application

It is internationally acknowledged that in calculating for tax purposes the profits of a company that engages in transactions with associated companies, the prices applied to these transactions should be arm’s length prices, that is, prices which would have been agreed upon between unrelated parties engaged in the same or similar transactions under the same or similar conditions. ^16/ This arm’s length price principle is the principle endorsed in the 1977 OECD Model Double Taxation Convention on Income and Capital and the 1979 United Nations (UN) Model Double Taxation Convention between Developed and Developing Countries, and included in modern bilateral tax treaties agreed upon by OECD or non-OECD countries. ^17/

Although there is thus an international agreement in principle, there can be much variation in practice regarding how this principle is applied to specific cases. If national tax authorities differ in their approach, a problem of double taxation may arise. To avoid this, efforts are being made to minimize national variations. The 1979 OECD Report on Multinationals and Transfer Pricing, the subsequent OECD work on transfer pricing issues, and the work done by the UN Group of Tax Experts represent the major international attempts to reconcile the national variations and to provide guidelines enabling national administrations to adopt harmonious approaches. ^18/

The 1979 OECD Report provides guidelines for determining arm’s length prices in specific cases, by endorsing the following specific methods:

• - The comparable uncontrolled price (CUP) method (direct reference to prices in comparable transactions between parties independent of each other);

• - The retail price (RP) method (the final selling price less an appropriate markup determined by reference to markups in comparable uncontrolled transactions);

• - The cost plus (CP) method (the cost of providing the goods or services plus an appropriate markup determined by reference to markups in comparable uncontrolled transactions).

All three methods rely on finding comparable transactions between unrelated parties and determine an appropriate price either directly or by reference to appropriate markups in the comparable uncontrolled transactions. When none of the methods can be applied in the absence of comparables, the 1979 OECD Report accepts that other reasonable methods (generally referred to as “fourth methods”) can be used, but provides little guidance on the methodology of fourth methods. In fact, tax authorities often devise and apply ad hoc methods to resolve these cases, ^19/ but main approaches would be the following:

• - The rate of return on assets or equity approach (the rate of return on assets or equity is compared between the taxpayer in question and other companies with similar functions);

• - The rate of return on operating costs approach (the rate of return on operating costs is compared between the taxpayer in question and other companies with similar functions);

• - The profit split approach (total profits are split between the related parties in a ratio deemed appropriate).

The above-mentioned methods are typically applied to transfers of tangible goods, and some special consideration may be necessary for other types of transactions. Regarding the transfer of intangible property (e.g., patents, know-how, and trademarks), provision of intragroup services, and loans, the 1979 OECD Report provides the following guidelines:

- Transfer of intangible property: In determining the amount of an arm’s length consideration, the standard applied is the amount that would have been paid by an unrelated party for the same intangible property under the same circumstances; where a sufficiently similar transaction involving an unrelated party cannot be found, or does not provide satisfactory evidence, other methods have to be used to test whether the price actually paid by the licensee is acceptable to the tax authorities. ^20/ The 1979 OECD Report, however, provides little guidance on other methods that can be applied to the transfer of intangible property.

Provision of services: To determine the amount of the consideration under the arm’s length price principle, the open market value of the services rendered would have to be established; where it is not possible to compare the service fee charged by an associated company with the price charged in a sufficiently similar open market transaction, a cost-oriented method may be helpful in providing an approximation to arm’s length prices. ^21/

Loans: The arm’s length interest rate is the rate of interest that is charged or would have been charged at the time the indebtedness arose between unrelated parties under similar circumstances; in deciding what is a comparable or similar loan, it is necessary to take into account amounts and maturities, the nature or purpose of the loan, the currencies involved, the exchange risks, the security involved, and the credit standing of the borrower. ^22/

2. National rules

Table 1 summarizes the outline of transfer pricing rules in six industrial countries (Canada, France, Germany, Japan, the United Kingdom, and the United States). ^23/ Although these rules have underlying similarities to the OECD guidelines, they also have some variations.

Table 1.

Comparison of Transfer Pricing Rules ^1/

^1/Originally taken from Simon (1991) and revised by the author. For details on each country’s rules, see International Bureau of Fiscal Documentation (1987- ).

Table 1.

Comparison of Transfer Pricing Rules ^1/

	Canada	France	Germany	Japan	United Kingdom	United States
Statutes providing for the arm’s length price principle	Income Tax Act §69 (1)-(3)	Code Général des Impôts (CGI) §57	Aussensteuergesetz (AStG) §1	Special Taxation Measures Law (STML) §66(5)	Income and Corporation Taxes Act (ICTA) §§770-773	Internal Revenue Code (IRC) §482 broadly grants Income allocation
Pricing guidance or rules from tax authority	Information Circular No.87-2	Administrative Commentary (Doc, Adm. FEAA 1210 et seq).	Letter of the Federal Minister of Finance (IVC5-S1341-4/83)	STML; further details provided by Enforcement Order §39(12) under STML.	Little formal guidance, except a brief note by Inland Revenue	Regulations under IRC §482
Existence of well-developed body of case law	Very little case law of late	Yes	Yes	Not current	Yes	Yes
Are rules applied to domestic relationships?	Yes for sales of tangibles and intangibles, but not for services	No	No, but rules on constructive profit or capital distributions are applied.	No, but excess payments are deductible as contributions only within a ceiling.	Yes	Yes
Control (a) Share percentage rules (b) Does it include “de facto” control?	Not defined in the statute. (a) More than 501 from case law. (b) Yes from case law.	(a) Majority (b) Yes	(a) 25X or more (b) Yes	(a) 50X or more (b) Yes	(a) Not specified (b) Yes	(a) Not specified (b) Yes
Pricing methods specified in national rules (numbering shows the sequence of application)	1)Primary method (CUP) 2)Secondary methods (RP&CP) 3)Other methods	Not specified. The 1979 OECD Report is in practice taken Into account.	1)Standard methods (CUP&RP&CP) 2)Other methods	1)CUP&RP&CP 2)Other methods	Not specified. inland Revenue is guided by the considerations set out in the 1979 OECD Report.	1)CUP 2)RP 3)CP 4)Other methods
Types of transactions for which special considerations are set out in national rules	Management or administrative services; R&D; use of intangibles	Payment of royalty; loan and waiver of claims; division of commercial expenses	Transfer of services; interest and similar remuneration; transfer of intangibles	None	None	Loans and advances; performance of services; use of tangibles; transfer or use of Intangibles

^1/Originally taken from Simon (1991) and revised by the author. For details on each country’s rules, see International Bureau of Fiscal Documentation (1987- ).

View Table

Table 1.

Comparison of Transfer Pricing Rules ^1/

	Canada	France	Germany	Japan	United Kingdom	United States
Statutes providing for the arm’s length price principle	Income Tax Act §69 (1)-(3)	Code Général des Impôts (CGI) §57	Aussensteuergesetz (AStG) §1	Special Taxation Measures Law (STML) §66(5)	Income and Corporation Taxes Act (ICTA) §§770-773	Internal Revenue Code (IRC) §482 broadly grants Income allocation
Pricing guidance or rules from tax authority	Information Circular No.87-2	Administrative Commentary (Doc, Adm. FEAA 1210 et seq).	Letter of the Federal Minister of Finance (IVC5-S1341-4/83)	STML; further details provided by Enforcement Order §39(12) under STML.	Little formal guidance, except a brief note by Inland Revenue	Regulations under IRC §482
Existence of well-developed body of case law	Very little case law of late	Yes	Yes	Not current	Yes	Yes
Are rules applied to domestic relationships?	Yes for sales of tangibles and intangibles, but not for services	No	No, but rules on constructive profit or capital distributions are applied.	No, but excess payments are deductible as contributions only within a ceiling.	Yes	Yes
Control (a) Share percentage rules (b) Does it include “de facto” control?	Not defined in the statute. (a) More than 501 from case law. (b) Yes from case law.	(a) Majority (b) Yes	(a) 25X or more (b) Yes	(a) 50X or more (b) Yes	(a) Not specified (b) Yes	(a) Not specified (b) Yes
Pricing methods specified in national rules (numbering shows the sequence of application)	1)Primary method (CUP) 2)Secondary methods (RP&CP) 3)Other methods	Not specified. The 1979 OECD Report is in practice taken Into account.	1)Standard methods (CUP&RP&CP) 2)Other methods	1)CUP&RP&CP 2)Other methods	Not specified. inland Revenue is guided by the considerations set out in the 1979 OECD Report.	1)CUP 2)RP 3)CP 4)Other methods
Types of transactions for which special considerations are set out in national rules	Management or administrative services; R&D; use of intangibles	Payment of royalty; loan and waiver of claims; division of commercial expenses	Transfer of services; interest and similar remuneration; transfer of intangibles	None	None	Loans and advances; performance of services; use of tangibles; transfer or use of Intangibles

^1/Originally taken from Simon (1991) and revised by the author. For details on each country’s rules, see International Bureau of Fiscal Documentation (1987- ).

3. Remaining issues

As pointed out above, there are two major issues concerning the methods for establishing transfer prices, on which little clear guidance is provided internationally: (a) under what circumstances and how fourth methods should be used, and (b) how intangible property should be valued. These issues are closely related, because, in a typical transaction within a multinational enterprise, unique intangible property is transferred simultaneously with the tangible goods and services that are sold or provided. In this case, finding comparable transactions with the transfer of the same intangible property is most difficult due to the uniqueness of the intangible property. To apply the standard methods, starting from prices in some comparable transactions without the transfer of the same intangible property, appropriate price adjustments must be made reflecting the value of the intangible property. Whether the standard methods can be applied to this case or not, therefore, greatly depends on how successfully the intangible property can be valued.

The recent discussions on these issues are reviewed in Section VI. 1.

1. Centralized administrative system

In some countries, administrative systems for international examinations in general or for examination of transfer pricing in particular have become more centralized in recent years.

In the United States, to place all international activities under a single executive in its national office, the IRS established the Office of the Assistant Commissioner (International) in 1986. This office was intended to provide centralized program direction and control, as well as high level executive attention to international tax matters. ^34/ Early that year, in the Office of Chief Counsel of the IRS, which deals with legal issues, the Office of Associate Chief Counsel (International) was created. The Counsel also created a network of attorneys at the regional level to assist international examiners in developing significant international tax cases, including transfer pricing cases, and to litigate these cases. These efforts represent a far greater concentration of expertise on international issues by the Office of Chief Counsel. ^35/

In Canada, the International Audits Division was created at the head office in 1988 to develop audit guidelines for international transactions, review the tax administration’s positions on tax reassessments, train international audit specialists, litigate international cases, resolve competent authority cases, and exchange information with treaty partners. ^36/ Concurrently, international audit groups were established in major district offices under the functional direction of this division. ^37/ Thus, much coordination has been cultivated between the head office and district offices (and assessors) in developing programs and approaches to identifying transfer pricing issues. ^38/

In Japan, where transfer pricing legislation was enacted in 1986, new divisions exclusively in charge of the examination of transfer pricing have been set up at National Tax Administration headquarters and at regional taxation bureaus, and a close monitoring system at headquarters has been adopted. Under the system, the new division at headquarters selects transfer pricing cases, analyzes them, and determines tax assessments. During this process, field audits are conducted by regional taxation bureau examiners under the headquarters’ supervision. The reasons why Japan adopted this close monitoring system are as follows: ^39/

- Since transfer pricing examinations are a new type of examination, examiners will need time to gain experience;

- Headquarters’ involvement will ensure consistency in transfer pricing examinations;

- Transfer pricing examinations will probably require competent authority procedures which are handled only at headquarters.

2. Use of economists

In the United States, tax examiners engaged in larger transfer pricing cases are assisted by economic specialists (economists) in obtaining the relevant facts and determining transfer prices sustained on appropriate economic analysis. Within the last several years, the IRS has substantially increased the number of economists who assist the examiners. While there is criticism that the use of economists is time-consuming and costly (e.g., many taxpayers also have to hire their own economists to defend their pricing against the IRS economists), the IRS responds that the early use of economists can prevent erroneous adjustments and thus save both the taxpayers and the Government time and money. ^40/

3. Industrywide pricing program

In the United States, in an effort to ensure uniform and consistent application of Section 482 of the IRC among companies within the same industry, the IRS has initiated industrywide pricing programs in certain key industries. ^41/ For example, the Petroleum Industry Program in the Southwest Region is charged with the responsibility of resolving transfer pricing issues associated with foreign-produced crude oil and refined products, and the Electronic Component Industry Program in the Western Region is studying marketing and distributing activities associated with electronic components imported into the United States.

During the course of these studies, taxpayers may be requested to provide information on an industrywide basis, and analysts working within these programs may liaise with other governmental agencies for purposes of securing and analyzing statistical information. In addition, industrywide exchanges of information are occasionally conducted with foreign administrations to secure comprehensive data on worldwide industry practices and operating patterns. The IRS points out that these programs provide benefits through the development of expertise within the IRS. ^42/

4. Time limitations

In general, examinations of transfer pricing cases are more time-consuming than other tax cases. Examiners have to spend more time gathering pricing information (in many cases, the information is located abroad), making economic analysis, and discussing cases with taxpayers. Some tax authorities in the countries with shorter time limitations for tax audits feel that their time is too short for transfer pricing cases, or that their time limitations place them at a disadvantage internationally. In the United States, the limitation is three years (six years if income is understated by 25 percent or more), but a system by which the time can be extended with the consent of the taxpayer is often used. In Canada, the 1988 tax reform extended the three-year general time limitation to six years for multinational intercompany transactions. Similarly, in Japan, where the general limitation is three years, the 1991 tax law revision extended the limitation to six years for audits of transfer pricing cases. ^43/

5. Information requirements

In determining appropriate transfer prices, it is essential that the tax authorities have access to the relevant information. The 1988 U.S. White Paper points out that the failure of taxpayers to document the methodology for establishing transfer prices and their delays in supplying (or failure to supply) information significantly hamper the administration of Section 482 of the IRC; ^44/ the White Paper proposes stricter rules on the taxpayer’s obligation to provide pricing information and imposition of penalties if necessary. ^45/ The issue of information requirements is also vital to taxpayers, not only because inappropriate information burdens can create excessive business costs but also because pricing information is usually highly confidential for their business purposes.

6. Burden of proof

In relation to the information requirements for the examination of transfer pricing, account should be taken of the rules on the burden of proof, that is, whether taxpayers have to prove that the tax authorities’ assessment is incorrect or the tax authorities have to prove that their assessment is correct. In Canada, the United Kingdom, and the United States, the authorities’ assessment is presumed to be correct, and taxpayers have the burden to disprove it. The 1988 U.S. White Paper explains that taxpayers are almost always familiar with—and in exclusive possession of—the relevant facts, and that to place the burden of proof on the Government would be unworkable. ^55/ In France and Japan, on the other hand, tax authorities have to prove that the prices used by taxpayers are not arm’s length prices. ^56/ In Germany, under general rules of the burden of proof, taxpayers claiming deductions have to establish that the expenditure corresponds to an arm’s length price, and the administration adjusting their income has to establish that their receipts were below the arm’s length consideration. ^57/

7. Penalty

Although, in principle, general rules on penalty or additional tax in each country would be applicable to tax deficiencies resulting from inappropriate intercompany pricing, some tax authorities have been cautious about applying them to transfer pricing cases. In the United States, for example, the IRS only infrequently imposed penalties in connection with transfer pricing adjustments, though the 25 percent penalty for substantial understatement of tax (Section 6661 of the IRC) could have been applied to them. ^58/ The 1990 U.S. legislation that includes a comprehensive reform of the civil penalty system has adopted a 20 percent (sometimes 40 percent) penalty for substantial valuation misstatement regarding Section 482 of the IRC, and has defined the cases to which the penalty is applied. However, it is uncertain at this stage how this new penalty will be applied in individual cases. ^59/

1. Safe harbor

One of the most common suggestions for solving the problem of uncertainty is to adopt safe harbor rules, which indicate that prices falling within certain ranges would be accepted without question. Instead of the absolute safe harbors that grant taxpayers total freedom from tax adjustments, conditional safe harbors that—in countries where taxpayers have the burden of proof—produce a rebuttable presumption or a shift in the burden of proof in the taxpayers’ favor may be proposed. In addition to providing certainty, if they work as intended, safe harbors could reduce costs of enforcing compliance by eliminating examination of insignificant cases and allowing the tax authorities to concentrate on cases that warrant closer scrutiny.

While various safe harbor rules have been proposed on the taxpayer’s side, ^61/ the tax authorities in several countries have mixed views on them. While admitting their merit in providing certainty and in reducing disputes over appropriate prices, ^62/ the authorities point out some technical difficulties. The 1979 OECD Report, for example, states that safe harbors are likely to be arbitrary since they will rarely fit exactly the varying circumstances even of companies in the same trade or business; to minimize this arbitrariness, a considerable amount of skilled labor would have to be allocated to collect, collate, and continuously revise a pool of information on prices and pricing developments. ^63/ The Report also states that safe harbors in one country may create difficulties in others. A German authority explains that safe harbors are of little value if they are not coordinated internationally, and that the 1983 German Transfer Pricing Guidelines therefore do not make reference to safe harbors, though this is not to say that the German competent authority will not consider safe harbor approaches on a bilateral basis. ^64/ In the United States where only a safe harbor for interest rates (100 percent to 130 percent of the applicable federal rate) is regulated (Regulation 482-2(a)(2)(iii)), ^65/ the 1988 White Paper did not recommend any additional safe harbors though it did not reject the possibility that useful safe harbors could be developed. ^66/ The recently proposed regulations under Section 482 of the IRC did not include any additional safe harbors either, but, perhaps reflecting the authorities’ middle-of-the-road position, they invited specific comments on the feasibility of a safe harbor approach and its structure. The final regulations may well move further, depending on the nature of comments received. ^67/

2. Preconfirmation or advance pricing agreements

To give clear guidance to taxpayers in advance, a system of preconfirmation by tax authorities or advance agreements between tax authorities and taxpayers on appropriate prices has been proposed. Although many countries have a general system of advance rulings on tax issues, they think the issuance of advance rulings on factual matters related to intracompany pricing arrangements is difficult or that the rulings, even if issued, have only a limited value. However, some countries have set up a system that is designed solely to resolve transfer pricing issues.

Japan set up a preconfirmation system for transfer pricing when it introduced its transfer pricing legislation in 1986. Under that system, a taxpayer proposes in advance to the tax authorities the method for determining an arm’s length price that the taxpayer thinks is most reasonable. The tax authorities then study the proposed method by analyzing the relevant data and information including those provided by the taxpayer. If the authorities find the proposed method reasonable, they confirm it and are bound by the confirmation.

The United States began using a similar advance price agreement system for transfer pricing in 1991. ^68/ According to the Revenue Procedure 91-22, the system is designed to produce an understanding between the IRS and the taxpayer on three basic issues: (a) the factual nature of the intercompany transactions to which the advance price agreement applies; (b) an appropriate transfer pricing methodology to apply to the transactions; and (c) the expected results of applying the methodology to the transactions. Where an understanding is reached, the IRS will regard the results of applying the methodology as satisfying the arm’s length standard, and will not contest the application of the methodology to the subject matter of the advance price agreement. After an agreement is adopted, IRS examination will be limited to ascertaining whether the taxpayer has complied in good faith with the terms and conditions of the agreement, whether the representations made in the agreement remain valid and accurate, whether correct data and computations have been used in applying the pricing methodology, whether the assumptions underlying the agreement remain valid, and whether the pricing methodology established in the agreement has been consistently applied. One of the important features of the system is that in situations where the relevant transactions affect the tax liability of a related company in one or more foreign countries with which the United States has an income tax treaty, it contemplates involvement of the competent authority process in reaching an agreement. ^69/ It is also anticipated that when a foreign country has a similar system, the IRS will process foreign-initiated requests under the same procedures that apply to U.S.-initiated requests.

It is argued that these systems are not very practical or useful from taxpayers’ point of view. Taxpayers must submit their transfer pricing practices to the tax authorities’ scrutiny and provide voluminous sensitive information; the process may be cumbersome and time-consuming; the agreement will cease to bind the tax authorities if a critical assumption of the agreement has changed; and the systems do not help to successfully resolve cases if the stance of the tax authorities is not flexible enough to accept taxpayers’ methodologies. ^70/ However, these systems provide an important opportunity for taxpayers to resolve potential intercompany pricing controversies in advance, without the need for serious audit disagreement, appeals negotiations, or litigation. ^71/ If the relevant foreign tax authorities are successfully involved in the process, it would help avoiding double taxation in advance. From the viewpoint of the tax authorities, these systems could provide a more efficient means of resolving transfer pricing issues by reducing the number of appeals and litigations and saving time at the examination level. ^72/ As a practical matter, the tax authorities may be able to obtain information from taxpayers more smoothly than through audits. ^73/ In any event, time will tell if these systems are successful in resolving transfer pricing cases.

3. De minimis rule

The assessment of an arm’s length price often depends on careful judgment and the resolution of many, perhaps conflicting, considerations between the tax authorities and the company concerned. ^74/ Even after lengthy negotiations, it may be impossible to determine precisely an appropriate price. Consequently, it is argued that if the prices actually paid can be substantiated by acceptable evidence as being arm’s length prices, there would be no justification for making merely minor or marginal adjustments to them for tax purposes. ^75/ Furthermore, an explicit de minimis rule is often proposed under which the tax authorities refrain from making a transfer pricing adjustment if the tax amount adjusted or the difference between an actual price and an appropriate price is below a certain level. A bilateral de minimis agreement could also be reached between the competent authorities of two countries, under which they would not negotiate cases including small amounts and the authorities in the country where the initial tax adjustment was made would withdraw the adjustment. ^76/

4. Set-offs

Assume that a benefit provided to one company in country A in its transaction with a related company in country B is balanced to some degree by a different benefit provided by that one company to the related company. The companies may claim that the benefit received should be set off against the benefit provided as full or partial payment for it so that only the net gain or loss on the transaction need be taken into account in assessing their tax liability. ^77/ If the arm’s length price principle is applied strictly on a transaction-by-transaction basis, tax adjustments are made even in this case probably in both country A and country B. However, since this kind of set-off arrangement is sometimes encountered between unrelated parties, it could not be argued in principle that the arrangement is unacceptable between associated enterprises. ^78/

The issue is how far this sort of set-off could be accepted in practice by national tax authorities. Although guidelines in some countries (e.g., Canada) provide that the arm’s length price principle is applied on a transaction-by-transaction basis, it is not clear how this rule is applied to each case in terms of set-offs. The U.S. Regulation 482-1(d)(3), on the other hand, explicitly accepts intrayear set-offs. Under this regulation, however, set-offs are accepted only on a year-by-year basis, and multiyear set-offs against excessive related party income derived in other taxable years are not permitted. The system of multiyear set-offs could provide more flexibility of taxation, though. Even between unrelated parties, their trade relations can be longer-term. Unexpected losses incurred by one party this year could be taken into consideration in the negotiations for next year’s dealings with the consequence that their longer-term profits are eventually balanced. In Germany, multiyear set-offs of detriments suffered against benefits received within three consecutive years are accepted by the 1983 Transfer Pricing Guidelines.

1. The “commensurate-with-income” standard and methodologies proposed thereunder

There are vigorous discussions currently under way on methods for establishing transfer prices, initiated by the amendment of Section 482 of the U.S. IRC in 1986. The 1986 Tax Reform Act amended Section 482 to require that payments to a related party for a transfer or license of intangible property be “commensurate with the income” attributable to the intangible. Since then, there has been much speculation and anxiety about the meaning of this language. ^79/

The 1988 White Paper discusses in detail the “commensurate-with-income” standard. It describes the primary difficulty addressed by the legislation—the transfers of high profit intangibles that are unique and typically not licensed to unrelated parties. ^80/ In these situations, although it is difficult to find comparable third party transactions, taxpayers often try to justify their royalty rates by simply using comparisons with industry averages. In addition, they might look solely at the purportedly limited facts known at the time of the transfer, or do not consider the potential profitability of the transferred intangible (as demonstrated by post-agreement results). By confining the analysis of an appropriate transfer price to the time the transfer was made, taxpayers could transfer a high profit potential intangible at an early stage and attempt to justify use of an inappropriate royalty rate by claiming they did not know that the product would become successful.

The White Paper further explains that the application of the “commensurate-with-income” standard adopted in the legislation requires the following two practices to determine appropriate prices.

- Functional analysis: To determine taxable income of related parties in the absence of comparables, an approach traditionally called a “functional analysis” should be used. In this approach, the functions performed and the economic costs and risks assumed by each party to the transaction are analyzed, and the income from the use of the intangible is allocated in accordance with the relative economic contributions and risk taking of the parties.

- Periodic adjustments: To determine appropriate compensation for the intangible, actual profit experience should be focused, and therefore periodic adjustments should be made to the compensation to reflect substantial changes in profitability of intangibles, as well as changes in the economic activities performed and economic costs and risks borne by the related parties in exploiting the intangibles.

Based on this understanding of the 1986 Tax Reform Act, the White Paper further proposes a series of methodologies—the basic arm’s length return method (BALRM), often referred to as the “ballroom” method—to be used to evaluate transactions involving intangible property. Under the BALRM.

- Total income from the relevant line of businesses is first determined;

- The line of businesses is then broken down by activity or function, and the factors (e.g., assets and expenses) used by the party performing a set of simple functions are measured;

- Income attributable to those functions is determined by identifying rates of return on assets or expenses of unrelated entities performing similar economic activities and assuming similar economic risks, and applying the comparable rate of return to the assets or expenses of the related party;

- After assigning the income thus determined to the party performing the functions, any residual income is assigned to the other party which performs complex economic functions, such as developing significant intangibles and bearing significant economic risks;

- An appropriate royalty rate or other transfer price is set to achieve the income allocation thus derived, without valuing the intangibles themselves;

- The appropriate price thus determined is reviewed periodically.

When both parties perform complex functions (both parties have significant intangibles), the BALRM is applied to the measurable assets or expenses of the two parties and the remaining income is split between the two parties based upon the relative values of their unique intangibles (Profit Split Addition to the BALRM), In this case, it is necessary to determine the relative value of significant intangibles, but not the absolute value.

The White Paper’s proposal of the BALRM has stimulated worldwide discussions on the methodologies for establishing transfer prices. ^81/ In cases where unique intangibles are transferred together with tangibles, “exact comparable transactions” with the transfer of the same intangibles hardly exist. To apply the three standard methods to these cases, starting from prices in some comparable transactions with the transfer of similar intangibles (the White Paper calls them “inexact comparable transactions”), appropriate price adjustments must be made reflecting the difference in the value of the intangibles. However, the valuation of the intangibles is difficult, and, as mentioned earlier in Section III, the existing international guidelines and national rules provide little guidance on this. The White Paper’s position is that in cases where no “exact comparable transactions” exist, fourth methods summarized as BALRM or Profit Split Addition should be used more widely, rather than determining an appropriate price on the basis of “inexact comparable transactions.” ^82/ Here, focus is no longer on the arm’s length price of each transaction or product. An appropriate price is determined only indirectly by allocating the entire income of a line of businesses (but not income from each transaction or product) among related parties on the basis of some profit indicators. Many authors have expressed concern that such fourth methods will result in an arbitrary or judgmental allocation of income. The rate of return analysis under the BALRM would not be as easy as the White Paper assumes, since the rate of return varies among companies according to their efficiency, situation, strategy, type of product, and so on. If this method is used without fine analysis, the result could be inaccurate. Moreover, the profit split analysis under the BALRM could be very judgmental in the absence of any reasonable standard for determining an appropriate split ratio. ^83/

The idea of periodic adjustments is even more controversial. While the White Paper explains that the practice of periodic adjustments is consistent with what unrelated parties would do, there is a strong argument that it is not the practice engaged in by unrelated parties and that periodic adjustments are inconsistent with the arm’s length price principle. ^84/

Taking into account comments on the White Paper received from the public and foreign authorities, in January 1992 the U.S. Treasury and IRS proposed a revision of the regulations under Section 482 of the IRC which regulate the methodologies for establishing transfer prices. ^85/ The methodologies set forth by the proposed regulations have much in common with those proposed in the White Paper, in spite of differences in terminology. The proposed regulations have retained the concept of exact and inexact comparables, though they are now termed “matching transactions” and “comparable adjustable transactions.” ^86/ They also retained the concept of periodic adjustments. In the absence of comparable s., similarly to the BALRM (or its variation) proposed in the White Paper, the “comparable profit method” set forth in the proposed regulations tests the profitability of taxpayers by comparing their profit indicators (e.g., return on assets, margins, and profit splits) with those of uncontrolled parties. There is, however, an important difference between the two methods. While the BALRM (or its variation) specifies a single set of methodologies to be applied and estimates a single point of acceptable income, the comparable profit method constructs an interval of acceptable income on the basis of convergent results obtained by applying different profit indicators to a single uncontrolled party or by applying one or more profit indicators to different uncontrolled parties.

The proposed regulations are not final. Comments have been invited from the public and foreign authorities and will be considered before adoption of the final regulations. Further extensive discussions are therefore expected on this issue.

2. Some taxation techniques adopted to deal with the difficulty of applying the arm’s length price principle

The difficulty of applying transfer pricing rules to particular cases, which is experienced to some extent by every tax administration in advanced industrial countries, would be much more serious in developing countries whose administrations in most cases have only limited resources. Transfer pricing is, however, an important issue for developing as well as developed countries. Taxation of foreign-related businesses often represents such a substantial part of total tax revenue in developing countries that it is not just a matter of tax equity but one of economic necessity to be able to tap the tax potential of multinational enterprises. ^87/

To deal with this problem, some simpler taxation techniques are often used in developing as well as developed countries, ^88/ though their consistency with international tax rules, represented by the OECD and the UN Models and bilateral tax treaties, is sometimes questionable.

a. Notional prices. Notional or posted prices are occasionally fixed for intracompany transactions by a host country, with or without negotiation with multinationals, for the purpose of determining income subject to tax. The classic example, though no longer relevant, was the posted price for crude oil exported from Arab countries. ^89/ In Jamaica, to avoid a transfer pricing problem, income from bauxite mining is assessed on the basis of assumed net profits per ton of bauxite, which are derived from a transparent set of market price indicators.

b. Presumptive tax. Some countries have established presumptions of income for certain activities, usually on the basis of a percentage of gross receipts, where the use of the transfer pricing method is difficult. For example, in Argentina, net income is presumed to be 10 percent of gross receipts for international transportation, news agencies, and insurance companies; in Brazil, a 20 percent presumption is applied to import and export, mining, and transportation. In response to such taxing practices, some tax treaties include an article which provides that the amount of the profits so derived shall not exceed a certain percentage of the gross receipts. ^90/

c. Taxation of intercompany transfer payments. A substantial withholding tax on intercompany royalties, interest, and service fees imposed by a number of countries could be considered as a measure taken to deal with the problem that these intercompany payments offer an opportunity to shift profits. Some countries (e.g., Brazil and Colombia) have further disallowed or restricted the size of the deduction of intercompany royalties, commissions, and fees as a business expense, treating these payments as profits.

d. Unitary apportionment. In some countries (e.g., Chile), the tax authorities are allowed to discard the transfer pricing method when the result of applying it would be unrealistic or unsatisfactory, and to assess the income of a domestic entity in a multinational group by unitary apportionment, that is, by apportioning to the entity a fraction of the worldwide income of the multinational group according to certain objective factors, such as sales, payroll, property, or a combination of these.

3. Unitary apportionment for international income allocation

Because of the difficulty of applying the transfer pricing method, unitary apportionment is frequently proposed as an alternative general method for international income allocation. Bird (1988), pointing out that the present transfer pricing approach has by now received a fair test and has clearly failed that test, concludes-

“As every country which has seriously attempted to cope with its international tax problems has discovered, there is no effective way to deal with many intercountry allocation problems except through some type of formula apportionment of the tax base.”

Vann (1991) also mentions that formula apportionment “would be a more satisfactory procedure than the resolution of differing views of the appropriate arm’s length price by agreements between national tax authorities.”

Nevertheless, considerable criticism has been directed at the unitary method. ^91/ The method ignores differences in profitability among different parts of an enterprise. Establishing an internationally acceptable formula is not an easy task given the differences in development among countries. There are also a number of technical difficulties—how to define the coverage of the unitary business and how to measure factors in countries with different accounting practices and currencies.

Developing countries normally avoid the unitary apportionment system, except where it is included in a tax code as a warning to induce cooperation from multinationals in applying the transfer pricing method. The above-mentioned technical difficulties would be much more serious for less-equipped tax authorities in developing countries. Moreover, these countries would have difficulties in deciding on apportionment keys: the traditional keys—sales, payroll, and property—could be all unfavorable for developing countries; however, if they could work out other favorable keys, they would have difficulty making the rest of world accept them. ^92/

Examples of actual application of the unitary apportionment are found in some states in the United States. ^93/ The states that impose a corporate income tax use some type of formula (in most cases, the above-mentioned three-factor formula) to apportion business income among the states in which the corporation operates. While most states only apportion business income of the corporation doing business within the state, some states have adopted a worldwide combined reporting (WWCR). Under this system, the formula is applied not only to the income of the corporation doing business within the state, but also to the income of any related corporation whose activities outside the state contribute to or are dependent upon the activities within the state. ^94/ Here, the formula is applied to foreign as well as domestic operations.

The WWCR was used by a number of U.S. states, but under pressure from foreign governments, the international business community, and even the Federal Government, most of them have now modified their mandatory WWCR at least to allow taxpayers to limit the income base to that earned within the United States (a limitation which is referred to as the “water’s edge” limitation). ^95/ California, which has been applying the WWCR most conspicuously, has also allowed multinational taxpayers this option since 1988, but has required that the electing corporations pay a special election fee.

The constitutionality of the WWCR has been tested in some court cases. Most recently, the November 30, 1990 decision of an appellate court in California in the well-known Barclays Bank case held that the state’s WWCR method as applied to foreign-based unitary groups is unconstitutional because it not only implicates foreign policy issues, which must be left to the Federal Government, but also violates a clear federal directive. ^96/ This decision, however, was reversed on May 11, 1992 by the California Supreme Court, and the case has been remanded back to the appellate court for further consideration. ^97/ Much more time will elapse before this issue is concluded, most likely through a final judgment of the U.S. Supreme Court.

4. Cost-sharing arrangements

In transfers of intangible property, one income (cost) allocation practice used by multinationals is cost-sharing arrangements among associated companies, especially for research and development (R&D) expenditures. Cost-sharing arrangements are those under which members of the group agree to share the actual costs and risks of R&D undertaken for the benefit or expected benefit of each of them. ^98/ Each participant shares the costs and risks and in return is entitled to share any usable results of the R&D. Because each participant owns specified rights to the intangibles developed, no royalties are paid by the participants; thus, they may be able to avoid the issue of valuing intangibles. The 1979 OECD Report stated that although this method of recouping R&D costs was not very common, it had been used over recent years by several large multinational enterprises that had extensive and costly worldwide research activities. ^99/ Recent trends among tax authorities to strengthen their transfer pricing rules on intangible goods may make the use of cost-sharing arrangements more attractive to taxpayers in future, although this possibility, of course, depends on each country’s tax treatment of cost-sharing arrangements.

Cost-sharing payments by each member of a cost-sharing contract are deductible as an expense, or charged to a capital account and written off in later years—depending upon the tax laws of the countries concerned—but such tax treatments are allowed only when the cost-sharing contract is recognized for tax purposes. To date, tax authorities in many countries appear to have little experience with cost-sharing arrangements, but a few countries have specifically addressed cost-sharing arrangements in their transfer pricing regulations or guidelines.

An example of relatively detailed rules on cost-sharing arrangements is found in the 1983 German Transfer Pricing Guidelines. ^100/ The main rules of the guidelines are the following:

- The cost-sharing contract has to be concluded in advance in unambiguous terms and then actually carried out.

- The contract has to establish on the part of the taxpayer a specific right, definite in both nature and scope, to benefit from the R&D activities. The taxpayer has to actually use or be expected to use the results of the R&D in its commercial activities.

- The contract has to base the sharing arrangement on the costs (direct and indirect) that are attributable to the R&D activities and arise in the accounting year. The costs must be clearly distinguishable by reference to the contract.

- The contract has to include appropriate apportionment formulas corresponding to the extent to which the taxpayer actually benefits or can be expected to benefit from the results of the R&D. The ratio given by the respective turnovers of the group members can only be applied as a basis if this is a useful standard for determining the actual or expected benefits for these members.

- The costs borne by the taxpayer itself within the scope of the contract have to be included in the shared costs and credited against the shared portion.

A profit markup on shared costs cannot be recognized for tax purposes in view of the absence of entrepreneurial risk. However, this does not rule out the possibility that, within the framework of the full-cost computation, an appropriate amount for interest on capital invested as well as a contribution to executive and general administrative expenses can be included in the shared costs.

As shown in the German guidelines, the major concerns of tax authorities would be the reasonableness of coverage of the cost-sharing contract in terms of products or participating members, calculation of the R&D costs and basis for allocating the costs to the members, and entitlement to any profit markup on the activities of the member conducting the R&D function.

The proposed U.S. regulations under Section 482 of the IRC (see Section VI.1) detail the rules on cost-sharing arrangements, together with those on transfer pricing methodologies. In addition to the above-mentioned points, it shows the authorities’ concern about inclusion of fully developed intangibles in the contract and inappropriate treatment of new participation or withdrawal. It also shows the view that the cost-sharing contract is subject to the requirement of periodic adjustments discussed in Section VI.1 above.

The 1979 OECD Report contains some guidelines for cost-sharing arrangements, but not in great detail. As there is some concern that countries will differ regarding the acceptability of such arrangements, this would be an area which could usefully be kept under review by international bodies. ^101/

Another important issue regarding the tax treatment of cost-sharing arrangements is whether withholding tax on royalties can be applied to the cost-sharing payments. The 1979 OECD Report sets forth the view that the payments should not be taxed in the country of source; Germany, Canada, the United States, and Italy follow this rule. However, this view is not necessarily shared by everyone, notably the many developing countries that may wish to apply their withholding tax on royalties to the cost-sharing payments.