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CHAPTER 12
INTERNATIONAL TRANSFER PRICING
Chapter Outline
I. Two factors heavily influence the manner in which international transfer prices are
determined: (a) corporate objectives, and (b) national tax laws. There are a variety of
cost, especially tax, minimization objectives that MNCs might attempt to achieve through
international transfer pricing. However, MNCs must be careful to comply with national tax
laws in setting international transfer prices.
II. The three bases commonly used for establishing transfer prices, both for domestic and
international transactions, are: (1) cost-based transfer prices, (2) market-based transfer
prices, and (3) negotiated prices. Theory suggests that different pricing methods are
appropriate in different situations.
III. There are two types of objectives to consider in determining international transfer prices:
(a) performance evaluation and (b) cost minimization.
A. Transfer prices affect the reported profit of both parties to an intercompany transaction;
revenue for the seller and an expense for the buyer. To fairly evaluate performance,
transfer prices should be acceptable to both the buyer and the seller, otherwise
dysfunctional behavior can occur.
B. Cost minimization objectives can be achieved by top management using discretionary
transfer pricing. Possible objectives include minimization of worldwide income tax,
minimization of import duties, circumvention of repatriation restrictions, and improving
the competitive position of foreign subsidiaries.
C. The objectives of establishing transfer prices to form a basis for fair evaluation of
performance and at the same time minimize one or more types of cost through
discretionary transfer pricing often conflict with one another.
IV. National tax authorities have guidelines regarding what is an acceptable transfer price for
tax purposes. These national laws often are based on OECD guidelines. The basic rule is
that intercompany transactions should be made at an “arm’s length price.”
V. Section 482 of the U.S. Internal Revenue Code requires intercompany transactions to be
carried out at arm’s length prices.
A. Section 482 gives the IRS the power to audit and adjust taxpayers’ international
transfer prices if they are not found to be in compliance with Treasury department
regulations.
B. The IRS also may impose a penalty of up to 40% of the underpayment in the case of a
gross valuation misstatement.
VI. U.S. Treasury Regulations establish specific guidelines for determining an arm’s length
price for sales of tangible property, licenses of intangible property, intercompany loans,
and intercompany services.
A. The “best method rule” requires taxpayers to use the method that under the facts and
circumstances provides the most reliable measure of an arm’s length price. The two
primary factors to be considered in determining the best method are (a) the degree of
comparability between the intercompany transaction and any comparable uncontrolled
transactions and (b) the quality of the data and assumptions used in the analysis.
B. One of five specific methods must be used to determine the arm’s length price in a
sale of tangible property. These are: (1) comparable uncontrolled price method, (2)
resale price method, (3) cost plus method, (4) comparable profits method, and (5)
profit split method. The comparable uncontrolled price method is generally considered
to provide the most reliable measure of an arm’s length price when a comparable
uncontrolled transaction exists.
C. Four methods are available for determining an arm’s length price for the license of
intangible property: (1) comparable uncontrolled transaction method, (2) comparable
profits method, (3) profit split method, and (4) unspecified methods.
D. Intercompany loans must be made at an arm’s length rate of interest, taking into
consideration the principal and term of the loan, the security involved, the credit rating
of the borrower, and the prevailing interest rate. A safe harbor range exists equal to
100%-130% of the applicable Federal rate.
E. If the services provided are incidental to the business activities of the service provider,
the arm’s length price for intercompany services is equal to the direct and indirect
costs incurred in providing the service. An appropriate amount of profit must be
included in the transfer price if the service is an integral part of the business operations
of the service provider.
VII. Application of a particular transfer pricing method can result in an “arm’s length range” of
acceptable prices. Companies can try to achieve cost minimization objectives by selecting
prices at the extremes of the relevant range.
VIII. If the tax authority in one country adjusts a transfer price used by a company, the company
will seek correlative relief from the tax authority in the other country involved in the
intercompany transaction. Tax treaties generally require correlative relief if the tax
authority in the other country agrees with the adjustment, otherwise the treaty requires the
two tax authorities to attempt to reach a compromise.
IX. An advance pricing agreement (APA) is an agreement between a company and a national
tax authority on what is an acceptable transfer pricing method for specified transactions.
The tax authority agrees not to seek any transfer pricing adjustments if the agreed upon
method is used.
A. APAs negotiated with the U.S. IRS most frequently covers the sale of tangible property
and the comparable profits method is the method most commonly agreed upon.
B. A majority of APAs negotiated by the U.S. IRS have been with foreign parent
companies with U.S. operations, rather than U.S. parent companies with foreign
operations.
X. Countries have been stepping up their enforcement of transfer pricing regulations.
Transfer pricing is the most important international tax issue faced by MNCs
internationally. The United States is especially concerned with foreign MNCs not paying
their fair share of taxes in the U.S.
