Strategic choices for transfer-pricing controversies.

Summary

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Transfer pricing is a complex area of tax law which lacks substantive rules that allow taxpayers to avoid tax disputes. However, taxpayers can minimize their risks or at least make a cost-benefit analysis when choosing how to report their transfer prices through decision-tree methodology. A decision tree allows taxpayers to chart possible responses to transfer-pricing techniques such as advanced pricing agreements, cost-sharing agreements and section 6038A district director agreements. The responses to possible audits can also be analyzed for the best possible benefit.

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Strategic choices for transfer-pricing controversies.

Few tax topics combine as many strategic options with as little substantive law as transfer pricing. The inescapable need to set prices for goods and services transferred between related entities and the huge amounts involved make this a fertile source for tax disputes. Yet the substantive issues involved are so contourless (and at the same time so sophisticated) that they are difficult for taxpayers and the Internal Revenue Service (IRS) to manage. Transfer-pricing audits are becoming legendary for their length, depth, cost, and risk; cases are often settled for large sums simply to avoid the burden of protracted controversy.

Section 482 of the Internal Revenue Code is the source of the IRS's authority to wring tax dollars out of transfer pricing. Section 482 authorizes the IRS to allocate gross income and deductions between commonly controlled entities in order to prevent evasion of taxes or clearly reflect income. For this purpose the regulations utilize the standard of an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer and specify rules for its application to various categories of transactions.(1*) Recently proposed regulations(2) would reconfigure the substantive rules to focus on the operating income of uncontrolled taxpayers with comparable operations (the "comparable profit interval") and to take into account the 1986 amendment to section 482 that requires the transferor's income from transferred intangible property to be "commensurate with the income" attributable to the intangible. These concepts make transfer-pricing analysis the haunt of economists and the subject of endless debate on "correct" transfer pricing as both a legal and economic matter.

This article focuses on nonsubstantive aspects of transfer-pricing cases - the strategic and tactical opportunities that line the path. Transfer-pricing controversies present a wide spectrum of choices. With choices, of course, comes the need for decisions -...

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