Basic Principles 

The operating units of a multinational corporation usually engage in a variety of intercompany transactions.  For example, a U.S. corporation may sell its manufactured products abroad through foreign subsidiaries.  The same U.S. corporation may also provide managerial, technical, and administrative services to its foreign subsidiaries.  Another common arrangement is for the U.S. corporation to license its manufacturing and marketing intangibles to its foreign subsidiaries for commercial exploitation abroad.   

The U.S. corporation and its foreign subsidiaries must determine a “transfer price” for the intercompany transactions in order to satisfy various financial reporting, tax, and other regulatory requirements.  Although transfer prices do not affect the combined profits of a control group of corporations, transfer prices do affect the allocation of profits for taxation among the countries where the corporations reside. 

The ideal allocation of profits between relevant jurisdictions would permit each country to tax an appropriate portion of the multinational’s total profit, while avoiding taxation of the same income by more than one country.  The mechanism for allocating a multinational’s worldwide profits between the U.S. and foreign affiliates is the transfer price used for intercompany transactions.  When tax rates vary across countries, transfer pricing can significantly impact the taxpayer’s total tax cost. 

To arrive at an arm’s length result, the taxpayer must select and apply the best method, which is the method that provides the most reliable estimate of an arm’s length price.  The primary focus in selecting a transfer pricing method is the reliability of the result, not its theoretical accuracy.  Related parties determine the reliability of a pricing method by the degree of comparability between the controlled and uncontrolled transactions and the quality of the data and the assumptions used in the analysis.   

The principal factors to consider in assessing the comparability of controlled and uncontrolled transactions include the following:  

• Functions performed:  The functional analysis identifies and compares the economically significant activities undertaken.  These activities would include, for example, research and development, manufacturing or production, marketing and distribution, warehousing and transportation, and administrative functions.  From an economic perspective, the related party performing more functions should receive more of the income.  

• Risks assumed:  This analysis requires a comparison of the significant risks that could affect the prices the parties charge.  For example, risks associated with the success or failure of research and development, finances (such as fluctuations in foreign currency and interest rates), credit and collection, product liability, and market fluctuation.  From an economic perspective, the related party assuming more risks should receive greater rewards.  

• Contractual terms:  Significant contractual terms could affect the economic analysis of two similarly priced transactions.  For example. The quantity of the items purchased or sold, the form of the consideration paid (U.S. dollars or foreign currency), the scope of warranties, the rights to any updates or modifications, the duration of the contract, the extent of any collateral transactions between the parties, and the extension of any credit or payment terms may have an economic effect on the transaction.  Comparable transactions are often uncomparable after considering contractual terms.  

• Economic conditions and market:  This comparability factor focuses on the economic conditions that could affect the prices charged.  This includes the similarity of geographic markets, the level of the market (e.g., wholesale or retail), the extent of competition in each market, the economic conditions of the particular industry, and the alternatives realistically available to either party (e.g., the choice to manufacture or purchase inventory).  As with evaluating contract terms, seemingly comparable transactions are uncomparable after analyzing economic conditions and markets.  

• Nature of property or services transferred in the transaction:  The comparability of property sold or services provided relate more to the transaction-based methods than the profit-based methods. 

The concept of an arm’s length range permits a taxpayer to use two or more comparable uncontrolled transactions (of similar comparability and reliability) to establish an arm’s length range of prices, which is the interquartile range of the companies.  If the taxpayer’s transfer prices lie outside the arm’s length range, then the IRS will make an adjustment, generally using the median of the range as the benchmark price. 

Taxpayers may also satisfy the arm’s length requirement by showing that the average result for a multiple-year period is comparable to that of uncontrolled transactions for the same period.  The use of multiple year data helps reduce the effects of short-term variations in prices, such as the effects of an industry business cycle that are unrelated to transfer pricing.  

Strategic Considerations for Multinational Companies 

All companies large and small that have operations in multiple jurisdictions should establish sound transferring pricing strategies.  The transfer pricing approach should be customized to each company taking into consideration their size, scope cross-border operations, degree of intercompany transactions, and countries involved.