Method Madness: Transfer Pricing Controversy

Are you choosing the best method for your transfer pricing? The US transfer pricing rules offer several methods to determine appropriate transfer pricing, but the rules also require that taxpayers use the method that yields the most reliable results. This is referred to as the “best method rule” and it’s an issue that has sparked significant debate and controversy in audits and recent cases. 

The Basics of Transfer Pricing 

Transfer pricing is the most contentious issue in international tax. Transfer pricing refers to the pricing of goods, services, intangibles, and financial transactions between related entities within a multinational enterprise (MNE).  

Taxpayers have been accused of attempting to manipulate their related-party transactions to avoid building up income in higher tax jurisdictions. To combat this type of alleged activity in the U.S., Congress granted the IRS broad authority to evaluate pricing of related-party transactions and to adjust if necessary to prevent the evasion of taxes. The U.S. transfer pricing regulations provide a comprehensive guide for determining appropriate transfer pricing.  

The transfer pricing rules require that transactions between related parties be priced as if they were between unrelated parties. This principle is known as the arm’s length standard. The U.S. transfer pricing regulations under IRC Sec. 482 provide several methods to determine arm’s length pricing for intercompany transactions. The methods vary based on the nature of the transaction, whether it involves tangible goods, intangibles, or the provision of services. The enumerated methods include, but are not limited to, the following methods:  

• Comparable Uncontrolled Price (CUP) Method: The CUP method compares the price charged in a related-party transaction to the price charged in comparable transactions between unrelated parties. While the CUP method is considered highly reliable, finding transactions that meet this method’s high comparability requirement is often difficult. 
• Resale Price Method (RPM): The RPM compares the gross profit margin earned in a related-party transaction with that earned in comparable transactions between unrelated parties. It’s usually applied to transactions involving tangible goods, especially in cases involving distributors. 
• Cost-Plus Method: The cost-plus method compares the gross profit markup earned in a related-party transaction with that earned in comparable transactions between unrelated parties. It’s ordinarily used in cases involving the manufacture or assembly of goods that are sold to related parties. 
• Comparable Profits Method (CPM): The CPM evaluates whether the amount charged between related parties is arm’s length based on the profitability of independent companies engaged in similar business activities under similar circumstances. This method is widely used due to its flexibility and applicability to a variety of transaction types. 

The regulations include additional methods not described here, and allow for non-specified methods to be applied if they produce more reliable results than the specified methods. 

Best Method Rule 

The taxpayer is required to choose the “best” transfer pricing method. Under the rules, the best method is the method that yields the most reliable measure of an arm’s length result. This means that taxpayers cannot choose a method based on convenience, ease, or what yields the best financial result.  

One and only one of the transfer pricing methods can be the best method. Identifying the best method is challenging, somewhat subjective, and can be contentious. The determination of the best method should be based on careful consideration of the facts and circumstances of each case. The rules require that taxpayers document why a particular method was chosen as the best method and why the other methods were rejected. In practice, this requires that all the specified transfer pricing methods be evaluated, and their applicability assessed before selection of the best method. 

Medtronic, Inc. v. Commissioner 

The controversy surrounding transfer pricing in the U.S. often centers on the selection and application of the best method. Unsurprisingly, the IRS favors methods that result in higher taxable income in the U.S. The controversy in this case over the selection of the best method highlights the inherent tension between taxpayers and tax authorities in ensuring compliance with the arm’s length standard.  

In 2010, the IRS issued Medtronic a notice of deficiency for the 2005-2006 tax years that increased its U.S. taxable income by a total of $1.25 million, to reflect reallocation of income for certain intercompany transactions between Medtronic’s U.S. entities and its Puerto Rico entity. Medtronic was not subject to tax in Puerto Rico. The transaction involved the use of intangibles, and Medtronic had applied the comparable uncontrolled transaction (CUT) method, which is analogous to the CUP method described above but for intangibles instead of tangible products. The IRS, however, argued that the CPM was the best method.  

The Tax Court determined that neither party’s analysis was reasonable and ultimately adopted a variation of Medtronic’s method. On appeal, the Eighth Circuit Court of Appeals remanded the case, questioning the reliability of both methods. During post-trial briefing, Medtronic proposed a new approach using an unspecified method that was hybrid in nature, adjusting its original method by incorporating aspects of the CPM proposed by the IRS. On remand, the Tax Court adopted Medtronic’s new unspecified method, making some adjustments. The IRS appealed again, and the Eighth Circuit reversed and remanded again, stating that the Tax Court’s decision conflicted with the regulations.  

The Right Approach to Transfer Pricing  

Medtronic underscores the complexities and challenges in reaching consensus on the best method. The best defense to a potential challenge is a rigorous analysis of the facts and circumstances to determine the best method, and comprehensive documentation that articulates the thoughtful deliberation behind that determination. To do this, the taxpayer or its service provider, must perform a thorough functional analysis to understand the functions performed, risks borne, and assets employed by each entity involved in the transactions under review. Taxpayers should consult with transfer pricing experts to assist and make sure that the chosen method of analysis and its application are sound and defensible. 

In This Issue:

• Full Court Press: IRS Targets Compliance in the Sports Industry
• Too Good to be True? Ensuring Capital Gains Treatment of Qualified Small Business Stock is Upheld
• Method Madness: Transfer Pricing Controversy
• IRS Provides Updates on Efforts to Combat ERC Fraud Via Various Programs