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Transfer Pricing and Tax Consequences

The United States has the highest corporate tax rate in the developed world. 1  Hence it is no surprise that corporations may try to avoid recognizing income in order to avoid paying taxes on that income.  One of the ways a multinational corporation can achieve this result is by manipulating their transfer prices with foreign affiliated companies.  In fact, many multinational companies have a “huge incentive to pretend that their American operations pay too much or charge too little to their foreign operations for goods and services (for tax purposes only), thereby minimizing their U.S. taxable income.”2

As an example, assume that an American parent company pays interest to its Mexican subsidiary.  Because the Mexican corporate tax rate is lower than the American corporate tax rate, the corporation would be foolish not to maximize the interest the American parent pays to the Mexican subsidiary.  3  In addition to shifting income to an affiliate in a country with lower corporate taxes, a corporation would also be wise to shift expenses to an affiliate in a country with higher corporate taxes to achieve a greater tax deduction.  4

To prevent these games from being played, the IRS has imposed lengthy and complex regulations governing transfer pricing. 5  The most notable of these regulations requires transfer prices to be set at “arm’s length” prices.  6  If transfer prices fall outside the arm’s length range, the IRS may adjust the prices for tax purposes to within the range, which is usually set to the median of the interquartile range.7

In some cases, determining the proper arm’s length price can be relatively easy:  If Company A sells corn (the fair market price of which is easily identifiable) to its foreign subsidiary, the transfer price should be approximately the open-market value.  However, determining the arm’s length price for more unique items can present special problems.  For example, if the parent company sells goods to its subsidiary and only to its subsidiary (such as transmissions that are put in the subsidiary’s automobiles), there is no easy reference to determine if the prices being paid are the “arms length” prices.

A major consequence of transfer pricing rules is its impact on mergers and acquisitions.  As the tax risk related to strict transfer pricing increases, the less likely mergers and acquisitions are to occur. 8  Even worse news for corporations is that the IRS has ramped up its focus on transfer pricing to combat potential tax revenue loss. 9

  1. U.S. Corporate Tax Rate Are the Highest in the Developed World, The Heritage Found., (last updated 2014). 

  2. The Hidden Entitlements, Citizens For Tax Just., (last visited Nov. 12, 2014). 

  3. See The Real Story On Apple’s Tax Avoidance: How Ordinary It Is, Forbes (May 21, 2013, 4:58 PM), (“For a company like Apple, nearly all the value of its products is in its patents and other intellectual property.  By charging a relative pittance to a foreign subsidiary for use of that IP, it can maximize that affiliate’s profit and minimize its IP income in the U.S.”). 

  4. See The Hidden Entitlements, supra note 2 (“In its 1987 annual report to stockholders . . . IBM treated so much of its R&D expenses as U.S.-related that it reported almost no U.S. earnings–despite $25 billion in U.S. sales that year. As a result, IBM’s federal income taxes for 1987 were virtually wiped out.”). 

  5. 26 C.F.R. §§ 1.482-0–9 (2014). 

  6. Id. at § 1428-1(b). 

  7. Id. at § 1.482-1(e)(3). 

  8. Kenneth Klassen, Petro Lisowsky & Devan Mescall, Transfer Pricing: Strategies, Practices, and Tax Minimization, Internal Revenue Serv. 92, (last visited Oct. 29, 2014). 

  9. Id.