Transfer Pricing: Perspectives of Economists and Accountants (Part 1) (Portfolio 6908)

Tax Management Portfolio, Transfer Pricing: Perspectives of Economists and Accountants (Part 1), No. 6908, analyzes the economics of transfer pricing, considers the viability of the arm's-length approach, and discusses the use of a company's internal data to assist in establishing and defending transfer prices. To view this Portfolio, visit Bloomberg Tax for a free trial.

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Tax Management Portfolio, Transfer Pricing: Perspectives of Economists and Accountants (Part 1), No. 6908, analyzes the economics of transfer pricing, considers the viability of the arm's-length approach, and discusses the use of a company's internal data to assist in establishing and defending transfer prices.

Chapter 1, “The Economics of Transfer Pricing,” analyzes transfer pricing from an economist's perspective, explaining the economic principles underlying intercompany pricing of tangible property, intangible property, services, and financial transactions. With respect to the latter, the Chapter discusses the economic principles underlying the pricing of intercompany loans, guarantees, accounts receivable factoring, and cash pooling. This Chapter also explores the key roles played by profits and rates of return in economic theory and addresses issues of economic measurement in the context of transfer pricing practice in general. While it explores the economic foundations of transfer pricing, the § 482 regulations are also described in the context of transfer pricing practice. This Chapter thus represents a synthesis of perspectives, including economic theory, the relevant law and corresponding regulations, and practical considerations regarding the practice of transfer pricing in general.

Chapter 2, “Multinational Group Theory and the Limitations of the Arm's-Length Approach,” discusses multinational group theory and the arm's-length and formulary apportionment approaches to transfer pricing. The Chapter examines the attempts in the §482 regulations to address some of the inherent limitations of the arm's-length approach and discusses the emphasis of those regulations on profit split methods in situations involving valuable intangibles.

Chapter 3, “The Use of Financial Accounting Data for Transfer Pricing Purposes,” demonstrates how to analyze a company's accounting and managerial data for transfer pricing purposes. The Chapter uses a case study to show how to utilize that data in implementing and updating the company's transfer pricing system, as well as in seeking an advance pricing agreement or Competent Authority assistance.

This Portfolio may be cited as Axelsen, Plotkin, Stone, Langbein, Morgan, Meyer, and Clowery, 6908 T.M., Transfer Pricing: Perspectives of Economists and Accountants (Part 1).


Dr. Dan Axelsen

Dan Axelsen, Central Washington University, B.S. in economics (mathematics minor); Washington State University, Ph.D. in economics. Dr. Axelsen is a Director in the Atlanta transfer pricing practice of PricewaterhouseCoopers. Dr. Axelsen specializes in the design and implementation of complex economic models used in the context of transfer pricing practice with particular focus on financial transactions, including guarantees, interest rates, cash pooling arrangements, and pricing associated with internal risk management functions. He assists clients with transfer pricing planning and structuring, documentation, and dispute resolution, including in the financial services and insurance industries. Dr. Axelsen has published extensively in economics.

Dr. Irving Plotkin

Irving H. Plotkin, Wharton School, University of Pennsylvania, B.S.; Massachusetts Institute of Technology, Ph.D. in mathematical economics. Dr. Plotkin, who works out of PricewaterhouseCoopers' Boston office, is Managing Director of its National Tax Service and Global Dispute Resolution practices; previously, for many years, he was Vice-President for Forensic Economics at Arthur D. Little, Inc. Dr. Plotkin has designed and conducted research studies on various topics, including the effects of government regulation, self-regulation, and taxation on industry efficiency and risk-taking. Dr. Plotkin, whose work is widely cited, lectures frequently on economic and regulatory issues, has presented expert testimony in the Tax, Claims, U.S. District, and State Courts on behalf of taxpayers and the IRS in a number of high-profile tax disputes (including Du Pont, Xilinx, UPS, DHL, ACM, Bausch and Lomb, The Limited, Dow, The Limited [NYS], Toys R Us [NYC], and the captive cases), has testified before U.S. congressional committees and federal and state commissions, and assisted in the drafting of tax legislation and regulations.

Dr. Garry Stone

Garry Stone, Bowling Green State University, B.S. in economics; The Ohio State University, M.A. in economics; The Ohio State University, Ph.D. in economics (finance minor). Dr. Stone is the global and U.S. leader of PricewaterhouseCoopers' transfer pricing practice. Dr. Stone has directed and performed numerous analyses of intercompany pricing and economic valuation issues for Fortune 500 companies. He has performed projects in the automotive, banking, chemical, computer hardware and software, cosmetics, distribution, electrical controls and equipment, financial markets, food processing, heavy and industrial equipment, medical supplies, mining, pharmaceuticals, plastics, retailing, semiconductor, and telecommunications industries. Dr. Stone has also written extensively on transfer pricing issues.

Stanley I. Langbein

Stanley I. Langbein, Yale College, A.B. (1970); Harvard Law School, J.D. (1973). Professor, University of Miami School of Law. Professor Langbein served as law clerk to Judge John Minor Wisdom of the U.S. Court of Appeals for the Fifth Circuit, as an associate attorney with law firms in Washington, D.C., and as attorney/advisor in the Office of International Tax Counsel of the United States Department of the Treasury. He also served as senior tax partner of a large law firm in Buffalo from 1985-1987.

R. William Morgan

R. William Morgan, Vanderbilt University, B.A.; University of Michigan, M.B.A.; Managing Director, Horst Frisch. Mr. Morgan specializes in assisting taxpayers and governments in analyzing intercompany prices and asset valuations in the contexts of litigation, audit, appeals, planning, and penalty documentation. Mr. Morgan served as the first Senior Economist in the Office of Transfer Pricing Operations, Large Business & International Division, Internal Revenue Service.

Thomas E. Meyer

Thomas E. Meyer, CFA, University of Vermont, B.A.; University of Michigan, M.B.A.; Managing Director, Horst Frisch. Mr. Meyer advises companies and the Internal Revenue Service on a range of transfer pricing issues, including tax planning, documentation, audits, intangible valuation, and advance pricing agreements.

Grant M. Clowery

Grant M. Clowery, C.A. (Canada), CPA (Illinois), Ph.D., Business, University of Chicago; J.D., George Mason University. Dr. Clowery has served as an expert witness and counselor for both the Internal Revenue Service and taxpayers on issues relating to transfer pricing, valuation, and financial accounting practice. He also serves as an adjunct professor at George Mason University School of Law.

Table of Contents

Detailed Analysis
Chapter 1: The Economics of Transfer Pricing
1:I. Introduction
A. The Economics of Transfer Pricing
B. The Arm's-Length Standard and Selection of the Best Method
1:II. Intercompany Pricing of Tangible Property
Introductory Material
A. Introduction to the Nature and Role of Tangible Property
B. Prescribed Methods for Analyzing Tangible Goods and the Comparable
1. Transactional Methods
a. The CUP Method: Product Comparables
b. Gross Margin Methods: The Resale Price and Cost Plus Approaches
c. The Resale Price Approach
d. Cost Plus Approach
e. Selection of Arm's-Length Comparables
2. Profit-Based Methods
a. Selection of the Tested Party
b. Identification of Third-Party Comparables
c. Selection of the Most Appropriate Profit Level Indicator (PLI)
3. Profit Splits
C. Miscellaneous Issues
1. Economic Adjustments: Differences in Working Capital Intensity
2. The Relationship Between Volume and Price
3. Adjustments for Differences in Operating Expenses Under the Resale Approach: The “Berry Ratio” and the Distributor
4. Implications of Inconsistent Accounting
D. The Use of Alternative Statistical Methods for Analyzing Intercompany Tangible Goods Transactions
1. Introduction to the Use of Statistical Analyses
2. Dependent t-Tests (Also Referred to as Paired t-Tests)
3. Independent t-Tests
4. Regression Analysis
1:III. Intercompany Pricing of Intangibles
Introductory Material
A. Introduction to the Nature and Role of Intangible Property
B. Evaluating Intercompany Intangible Property Transactions
1. Comparable Uncontrolled Transaction (CUT)
2. Profit Margin Methods
a. Income-Based Operating Margin Approach
b. Cost-Based Gross Margin Approach
3. Profit Split Methods
a. Comparable Profit Split Approach
b. Residual Profit Split Approach
4. Unspecified Methods
C. Cost Sharing and the Prescribed Methods for Evaluating PCT Payments
1. The Cost Sharing Regulations
a. CUT Approach
b. Income Method
c. Acquisition Price Method
d. MCM
(1) Stock Market Values
(2) Intrinsic Value of a Business Versus the Value of Its Assets
(3) Allocation Issues
(4) Economic Life of Intangible Property
(5) MCM and the Commensurate with Income Standard
(1) Should R&D Be Treated as a Depreciable Asset?
(2) Useful Economic Life of Technology
(3) Allocation of Residual Profits Based on Depreciated R&D Expenditures
2. The CWI Standard in the Context of Cost Sharing
D. Determination of Ownership
E. Bundling
1:IV. Intercompany Pricing of Services
Introductory Material
A. Introduction to the Nature and Role of Services
B. Description and Background of the Services Regulations
C. Benefit Provided by the Service Provider to the Service Recipient
D. Total Services Cost Pool and Allocation Among Service Recipients
E. Description of the Services Regulations' Prescribed Methods for Analyzing Controlled Services Transactions
1. Services Cost Method (SCM)
2. The Comparable Uncontrolled Services Price Method (CUSP)
3. The Gross Services Margin Method (GSMM)
4. The Cost of Services Plus Method (CSPM)
5. CPM
6. The Profit Split Method
7. Unspecified Methods
8. Contingent Fee Arrangements
F. Examples of the Types of Services Generally Performed Within Large Multinational Firms and Treatment of Such Services from a Transfer Pricing Perspective
1. Management Services
2. Technical Services
3. Procurement
4. R&D
5. Marketing Services
G. Examples of Core Versus Non-Core Services in a Transfer Pricing Setting
H. The Relationship Between Services and Tangible Goods in a Controlled Setting
I. The Relationship Between Prices and Costs in a Controlled Services Transaction
J. Conclusions
1:V. Intercompany Financial Transactions and Transfer Pricing Issues
A. Introduction
B. Intercompany Lending
1. AFR Safe Haven
2. Situs of the Borrower
3. Market-Based Pricing
C. Intercompany Guarantees
1. Background on Intercompany Guarantees
2. Methods Commonly Applied to Pricing Intercompany Loan Guarantees
a. The Market Approach
b. The Credit Enhancement (Yield/Spread) Approach
c. The Put Option Approach
d. The LGD Framework
e. Estimating LGD
f. Estimating the Arm's-Length Guarantee Fee
D. Intercompany Factoring
1. Introduction
2. Transfer Pricing Considerations with Regard to Intercompany Factoring
a. Estimating the Profit Element
b. Estimating the Factoring Discount
c. Estimating the Amount Advanced to the Assignor
E. Cash Pooling
1. Introduction
2. Transfer Pricing Analysis and Considerations
a. The Banking/Financial Intermediary Model
(1) Cash Deposits
(2) Cost of Borrowing
b. The Service Provider Model
1:VI. Profits, Rates of Return, and Economic Theory
Introductory Material
A. Relationship Between Rate of Return and Profit Margin Measures
B. Rate of Return Measures
C. Profit Margin Measures
D. The Role of Risk in Economic Theory
E. Risk-Adjusted Rates of Return
F. Alternative Measures of Financial Performance
1. Cash Flows, Present Values, and Discount Rates
2. Internal Rate of Return
3. Average Cost of Capital
1:VII. Economic Concepts: Measurement Issues
Introductory Material
A. Financial Statements
B. Opportunity Cost and the Cost of Capital
C. Summary
Chapter 2: Multinational Group Theory and the Limitations of the Arm's-Length Approach
2:I. Introduction
2:II. Evolution of Transfer Pricing Analysis
Introductory Material
A. Early Developments
B. Postwar Expansion of U.S. Multinationals
C. U.S. Developments in the 1960s
D. International Developments in Response to U.S. Developments
1. Trade and Transfer Pricing
2. 1979 OECD Report
3. Controversy Over the Unitary Method
a. Article 9(4) of the Proposed United States/United Kingdom Income Tax Convention
b. Proposed Statute Concerning Unitary Method
c. Constitutional Litigation Over the Unitary Method
d. Working Group
E. Reconsideration of “Arm's Length” in the United States
1. Doubts About the “Arm's Length Standard”
2. Tax Reform Act of 1986
3. 1988 Treasury White Paper
4. Transfer Pricing and the General Public
5. 1992 Proposed Regulations
6. 1992 Election and 1993 Temporary Regulations
F. OECD Task Force Reports
G. Revised Transfer Pricing Regime of the 1990s
2:III. Economic Analysis: “Equilibrium,” “Disequilibrium,” and Neutrality
A. Two Elements of Theory
B. “Equilibrium” Economics
C. “Disequilibrium” Economics
1. The Schumpeterean “Entrepreneur”
2. Coasean Theory of the Firm
3. Game Theory Diseconomies
D. Disequilibrium Economics and “Capital Export Neutrality”
1. Capital Export Neutrality
2. A “Disequilibrium” Critique of Capital Export Neutrality
3. Rediscovery of the “Original Intent” of International Taxation
2:IV. Economic Analysis and the “Transaction-Based” Arm's-Length System
A. The Regulations of the 1960s and “Equilibrium” Economics
1. Section 1.482-1 of the 1968 Regulations
2. Section 1.482-2 of the 1968 Regulations and the Five Categories of Transactions
a. Regulatory Provisions
b. Transaction Categories and the “Triad Schema”
c. “Embedded” Intangibles
3. 1968 Regulations and the Three “Transactional” Methods
B. Theoretical Critique of the “Transaction” Methods
1. Theoretical Basis of the Critique
a. Coasean Substitution
b. Information Impactedness
c. Multinational Corporation Theory
2. Application of Multinational Corporation Theory to Transfer Pricing
a. Two Prongs of Multinational Firm Theory
b. Substitution of Contract Forms and the Disutility of the CUP Method
c. The “Residual” and the RPM and Cost-Plus Methods
d. The “Continuum Price” Problem
3. Multinational Firm Theory and the Right to Tax of a “Source State”
C. The Profit Split/Modified Fractional Apportionment Structure
D. Transfer Pricing Reform and the “Globalization” Movement of the 1990s
1. Lack of Response to the Critique of “Arm's Length”
2. The OECD Task Force and the Definition of “Profit Methods”
3. Transfer Pricing and “Transparency”
4. Transfer Pricing, the Clinton Administration, and Globalization
2:V. Economic Analysis and the Current Regulations
A. Profit Split Structure and Allocation of the Residual Profit
B. The §1.482-1 Regulations and the Indefiniteness of the System
1. Basic Precepts
2. Arm's-Length Result
3. Best Method Rule
4. Comparability
a. Dual Function
b. Five-Factor Test
c. Functional Analysis
d. Contractual Terms, Risk, and Multinational Corporation Theory
e. Example 3
(1) Pre-2007 Example 3
(2) Post-2006 Regulations
f. Final Comparability Factors
5. Arm's-Length Range
a. Arm's-Length Range and the Problematical Continuum
b. “Exact” and “Inexact” Comparables
c. Interquartile Range and “Inexact” Comparables
d. The Range, the Continuum, and the Question of “Tested Parties”
C. Intangible Property
1. Single Component Methods and the Continuum Price Problem
2. Intangible Property and Disequilibrium Analysis
3. “Embedded Intangibles”
a. Regulatory Rule
b. Ambiguity of the Rule
4. Returns on Intangibles
a. Methods
b. High-Profit Intangibles
5. Ownership of Intangible Property
a. Revision of Regulations
b. Pre-2007 Intangible Ownership Regulations
(1) Legal Owner and Assistance
(2) Legally Protected Rights
(3) Rights Not Legally Protected
(4) Arm's-Length Consideration
(5) Fromage Frere
c. Post-2006 Regulations
6. Cost Sharing
D. Tangible Property
1. A Six-Step Process
2. Comparable Uncontrolled Prices
3. Single Component Methods — Presence of High-Profit Intangibles
a. Resale Price Method
b. Cost-Plus Method
c. Comparable Profits Method
4. Presence of Intangible Property Within a Single Component
5. Requirement of a Separate Allocation for the Intangible
6. Consideration for the Intangible
7. Internal Determination of Consideration for the Intangible
E. Services
1. Revision of Regulations
2. Pre-2007 Regulations
3. Post-2006 Regulations
a. Controlled Services Transactions
b. Embedded Services
c. Pricing Methods
F. The Profit Split Method
1. Pre-2007 Regulations
2. Post-2006 Regulations
G. The Primacy of the Profit Split
Chapter 3: The Use of Financial Accounting Data for Transfer Pricing Purposes
3:I. Introduction
Introductory Material
A. The Transfer Pricing Environment
B. Case Study: Part 1 — The Facts
3:II. Analysis of Financial Accounting Data
Introductory Material
A. Transaction-Based Approaches
1. Comparable Uncontrolled Price
2. Resale Price
3. Cost Plus
4. Summary
B. Case Study: Part 2 — The First Meeting
C. Entity-Based Approaches
1. Comparable Profits Method
2. Profit Split Methods
3. Summary
D. Case Study: Part 3 — The Second Meeting
E. Financial Accounting Issues and Data Sources
1. Analysis of Controlled Party Data
2. Analysis of Uncontrolled Party Data
3:III. Implementing and Updating Transfer Pricing Systems
Introductory Material
A. Establishing Transfer Prices
B. Maintaining and Modifying Transfer Prices
C. Case Study: Part 4 — The Third Meeting
3:IV. Other Issues
Introductory Material
A. Advance Pricing Agreements
B. Competent Authority
3:V. Summary

Working Papers

Table of Worksheets
Worksheet 1 Economic Calculations in Transfer Pricing
Worksheet 11 Excerpt from Joseph A. Schumpeter, A History of Economic Analysis
Worksheet 12 Excerpt from Ronald H. Coase, “The Nature of the Firm”
Worksheet 13 Excerpt from Richard E. Caves, Multinational Enterprise and Economic Analysis
Worksheet 14 Flowchart: Identification of the Best Method Under the Section 482 Regulations
Worksheet 21 Checklist of Potential Accounting Issues in Transfer Pricing Analysis
Worksheet 22 Illustration of Issues Involved in Financial Statement Analysis for Transfer Pricing Purposes