Reputational Risk: A New Dynamic in Transfer Pricing Compliance

By Craig A. Sharon, Bingham McCutchen LLP  

Craig A. Sharon, a partner with Bingham McCutchen LLP in Washington, D.C., was director of the IRS's Advance Pricing Agreement Program from April 2008 to February 2011. The views expressed are those of the author and not necessarily those of his firm.

No quotation about taxation is more famous than the following comment made in 1934 by Judge Learned Hand:

Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes.1  


As a matter of general principle, it has long been accepted that a taxpayer need not pay more tax than is required by the law. As a practical matter, however, it is sometimes difficult to distinguish between tax minimization, which is lawful, and tax evasion, which is improper--especially when the legal rules are vague or their application is based largely on a facts-and-circumstances analysis. The distinction is further complicated in the international context, where taxpayers must satisfy multiple tax authorities with competing interests and often conflicting views. No technical issue challenges the distinction more directly than transfer pricing, where previously accepted tax minimization strategies are now under attack, based in substantial part on aspirational arguments not founded specifically on past or current interpretations of the arm's-length standard.

The long arc of transfer pricing enforcement reflects the perceived inability and increasing frustration of tax authorities, individually and collectively, to police taxpayers' application of the arm's-length standard. Starting with the adoption of specified transfer pricing methods in the late 1960s, evolving to up-front documentation and penalty rules in the 1990s, and moving more recently toward increased taxpayer transparency and bilateral collaboration, tax authorities have sought continually to balance better the mix of policies designed to encourage greater up-front taxpayer compliance, reduce controversy, and punish overly aggressive planning.

Each new enforcement phase followed a round of “incriminating” disclosures about taxpayer efforts to minimize their global tax liabilities, indignant public reaction, and increased political scrutiny, leading tax authorities to implement new initiatives to combat the latest perceived abuses. Historically, these new initiatives have focused on improving the effectiveness of traditional tax enforcement processes, with only occasional changes in the underlying substantive rules (for example, the addition in the United States of the commensurate-with-income rule to Section 482 in 1986).

A New Call to Arms

Recent events make clear that the global enforcement environment is changing again, but this time with a new, extra-legal dynamic, accompanied by populist rhetoric and unprecedented political pressure. Whether this is the beginning of the end of the arm's-length standard, a preview of an emerging consensus among tax authorities about an application of the arm's-length standard that focuses on “people functions,” or short-term political expediency to manage voter frustration with ongoing fiscal austerity measures, the immediate effect is to create new compliance challenges for multinationals.

Recent headlines in this publication manifest a new call to arms against the tax minimization strategies of global companies:

• “As Anger Over Alleged Tax Avoidance Rises, British MPs Vow Action on Multinationals”2;

• “U.K. Vows Transfer Pricing Crackdown as Part of £77M Effort Against 'Tax Dodgers' ”3;

• “Senate Committee Says Reforms Needed to Stop Tax Avoidance by Multinationals”4;

• “India Assesses Google Nearly $14M in Tax, Blasts 'Double Irish' Maneuver”5

• “Allegations Google Underreported $307M Prompt Italy to Revise Transfer Pricing Rules”6


These articles on legislative hearings and executive branch pronouncements in the United States, the United Kingdom, Italy, and other countries quote legislators and government officials who single out specific companies for condemnation and describe transfer pricing in pejorative and provocative terms.

The great irony is that none of the offending conduct was or is alleged to be unlawful under applicable local laws or current mainstream transfer pricing practice. Indeed, most of the conduct was and is fully consistent with, and was in fact contemplated by, tax and economic policies enacted by one sovereign government or another. In some cases, there may be legitimate disputes about a transfer pricing valuation, but that is not exclusively driving the debate--and is not true in all cases.

Microsoft's Buy-In Payment

For example, lost in the criticism of Microsoft is the fact that three low-tax affiliates made $28 billion in total buy-in payments to the United States when they first joined the company's cost sharing arrangement. It was those purchases that entitled the affiliates to earn the IP-related income in their respective territories in the later years reviewed by the Senate Permanent Subcommittee on Investigations.

Whether or not the buy-ins were arm's-length--all presumably were subject to potential adjustment--their implications (and justification) for Google's post-buy-in results effectively have been ignored. Similarly, Google is under attack in various foreign countries because of a transfer pricing structure--the so-called double Irish, Dutch sandwich structure--that was and still is permitted under the local laws of the affected countries. The transaction followed an early-stage IP migration from the United States to Ireland that was blessed as arm's-length by the IRS in an advance pricing agreement, which was referred to as a “secret pact” in a 2010 article about Google.7

Have Microsoft and Google been engaging in acceptable tax minimization or improper tax evasion since their respective restructurings years ago? Under the emerging paradigm, it doesn't matter. According to critics, both are guilty of engaging in unacceptable (even if legal) tax minimization because the resulting local tax consequences are too favorable. This normative judgment appeals not to applicable legal rules, but instead invokes eye-of-the-beholder notions of fairness, social responsibility, and corporate ethics. As invoked, these concepts ignore and effectively reject the arm's-length legal standard--or any legal standard.

Should taxpayers not be allowed to take advantage of preferences made available to the public at large by tax jurisdictions trying to influence economic behavior? Should such taxpayers be publicly shamed into paying more tax than is legally required in one tax jurisdiction because they took advantage of preferences available in one jurisdiction or another? Shouldn't a changed legal standard be applied only after the change is made through normal, carefully crafted legislative and administrative processes?

U.K. Patent Box

In answering these questions, consistency apparently is not required, at least not in the United Kingdom. In describing its patent box regime, the government stated:

The Patent Box is part of the Government's growth agenda (as detailed in the Plan for Growth document published in March 2011). The aim of the Patent Box is to provide an additional incentive for companies to retain and commercialise existing patents and to develop new innovative patented products. This should encourage companies to locate the high-value jobs associated with the development, manufacture and exploitation of patents in the UK and maintain the UK's position as a world leader in patented technologies.8  


Why is the patent box acceptable to Parliament, but not the policy choices adopted by Ireland (or other jurisdictions) to attract similar economic activity there? Should the IRS go after U.S. companies that try to take advantage of the patent box? Is there a principle here, or is it only the tax results that critics find so objectionable?

Starbucks' Voluntary Tax

After being harshly criticized by Parliament and the U.K. Treasury, Starbucks agreed to pay about $16 million more in U.K. corporate taxes in 2012 by forgoing available tax deductions for royalties, coffee purchases, interest on intercompany loans, capital allowance deductions, and loss carryforwards. The company expects to make similar, negotiated “extra-legal” tax payments in 2013 and 2014.

The company's statement makes clear that it was acting primarily to protect its reputation: “Since Starbucks was founded in 1971, we've learned it is vital to listen closely to our customers--and that acting responsibly makes good business sense.”9

How this gesture will go over with the IRS and other tax authorities remains to be seen. Starbucks asserts that its payment does not represent an admission of improper transfer pricing, but other tax authorities may not take the same view. Before more companies decide to ante up additional revenue to satisfy public opinion, they may want to consider these questions:

• How much extra-legal tax represents a company's “fair share?”

• What are the criteria, if any, for determining the right amount?

• Whatever the amount, how should the payment be characterized--as additional income tax, a marketing expense, or a gift to the people of England?

• If HMRC characterizes the payment as an additional tax, will the amount be creditable in the United States for foreign tax credit purposes? A credit seems unlikely given the payment's non-compulsory nature.


The compliance road ahead is unmarked and may take surprising turns. To navigate, companies may need to broaden their thinking about tax compliance to encompass not only the technical tax rules but also public policy, public relations, and government relations. Following the current legal rules may not be enough when a multinational's reputation is increasingly at risk.

1 Helvering v. Gregory, 69 F.2d 809, 810-11 (2d Cir. 1934).

2 21 Transfer Pricing Report 741, 11/29/12.

3 21 Transfer Pricing Report 815, 12/13/12.

4 21 Transfer Pricing Report 552, 10/4/12.

5 21 Transfer Pricing Report 688, 11/15/12.

6 21 Transfer Pricing Report 816, 12/13/12.

7 “Google 2.4% Rate Shows How $60 billion Lost to Tax Loopholes,”, October 2010. Also see “Misrepresentation of Transfer Pricing in the Mainstream Media,” 19 Transfer Pricing Report 829, 11/18/10.

8 See

9 “Starbucks to Voluntarily Pay U.K. Tax After Criticism at Parliamentary Hearing,” 21 Transfer Pricing Report 816, 12/13/12.