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transfer price is being determined. If such information is not available from the same buyer, markup percentages may derived from comparable buyers if such comparability can be established. The regulations emphasize that in order to apply this method, the buyer of the intermediate product generally should not have contributed more than an insubstantial amount of value to the product. However, the regulations permit this method to be used in certain other circumstances, in particular where the adjustments that would be required under this method are less extensive and easier to evaluate than the adjustments under the cost plus method. 66a

The cost plus method requires data on costs to the seller of producing the intermediate product sold to a related party and determination of a gross profit margin, determined as a percentage of costs.67 As in the case of determining the markup percentage, a gross profit percentage requires determination of gross profits of similarly situated firms. It is worth noting that the resale price method, which depends on information provided by the reseller, may be more administrable for determination of transfer prices of inbound sales from a foreign entity to a U.S. affiliate.

The difficulties of identifying comparable transactions has been a problem in applying the arm's length standard. In 1986, Congress modified section 482 in the case of transfers of certain intangibles to require the use of a standard under which the income with respect to such transfers would be "commensurate with the income attributable to the intangible." 68 The legislative history expressed a concern that the relationship between related parties is different from that of unrelated parties, and that comparable unrelated party transactions often cannot be found. The legislative history indicated particular concern about the absence of comparables in the case of transfers of intangibles. 69

D. Proxy Measures of Rates of Return Calculated under the Fourth Method

In general

Return on equity.-Besides the three methods specified in the regulations, which attempt to determine transfer prices between related parties directly, there is an alternative set of approaches which attempt to infer the existence of inappropriate transfer prices by measuring aberrations in various measures and proxy measures of rates of return.70 For example, if it could be deter

66 See Part I.C., supra.

67 This method entails the additional issue of measuring and allocating costs. Even if, as discussed below, comparable gross profit percentages can be established, the method may not be applicable unless significant problems of adequately determining and allocating costs can be overcome. Because of the relative ease, in general, of determining resale profit margins as compared to the correct allocation of manufacturing costs, one author has suggested that the resale price method is "probably, though not always' more accurate that the cost plus method. See Charles H. Berry, "Economics and the Section 482 Regulations," Tax Notes, May 9, 1989, p. 473. 68 Section 1231(e)(1) of the Tax Reform Act of 1986.

69 H.R. Rept. No. 99-426, 99th Cong., 1st Sess., pp. 423-427.

70 Economic accounting rules, which generally would include accrual of unrealized gains (i.e., mark-to-market accounting), often do not coincide with standard financial accounting rules. For purposes of measuring and comparing rates of return, unadjusted financial accounting data could be misleading. In general, proxy measures of rates of return are employed in an attempt to avoid biases that would result from using rates of return measured from standard accounting

data.

mined that a U.S. company, which is a subsidiary of a foreign parent from which it purchases intermediate goods, has an abnormally low rate of return, it might be inferred that this low rate of return is attributable to inappropriately high prices from the foreign parent to the controlled subsidiary in the United States. Underlying these comparisons of rates of return is the principle, widely recognized among economists, that in the long run after-tax rates of return measured under economic accounting rules will be equalized. Therefore, the presence of persistent abnormal accounting rates of return for individual members of a controlled group might be indicative of transfer prices that do not reflect the real value of goods transferred between related parties.

If it can be assumed that rates of return can be equalized across industries, use of a rate of return method may not necessarily be restricted to comparison of the rate of return of the firm in question to comparable firms performing the same function in the same industry. However, if it is believed that rates of return among industries may vary (for example, because of differences in risk) or that measured rates of return among industries may vary due to systematic errors in the measurement of income and assets, analyses utilizing comparisons of rates of return would be improved by restricting comparison of rates of return to firms within industries. The main problem with this general approach is that it is difficult in practice to measure rates of return accurately. Since a rate of return is the ratio of income to equity, this calculation requires acceptable measurements of income and equity, both of which may be subject to a variety of estimation methodologies. In application to transfer pricing problems, some of these measurement issues have largely been avoided by development of alternative ratios analogous in various degrees to rates of return on equity.

Return on assets.—If it can be assumed that equity is proportional to assets, a good alternative or proxy measure of the rate of return would be the ratio of income to assets. Since the relationship between equity and assets varies widely across industries, this approach might be most useful in comparisons of a group of firms within an industry. Even then, it must still be assumed that there exists in the industry a fairly uniform relationship between assets and equity, and therefore there is reason to expect a fairly constant ratio of income to assets. Even within narrow industry classifications, differences in financial structure and methods of production could account for observed differences in the ratio of income to assets even where firms did not incorrectly price intra-group transactions and, as predicted by economic theory, earned equal rates of return.

Return on operating cost.-In addition, comparisons of returns on assets may suffer from large disparities in valuation of assets, especially between old and new firms.71 The problem of asset valuation

71 In the presence of inflation and methods of accounting for depreciation excess of economic depreciation, a firm with a relatively large proportion of old capital (i.e., a slow-growing firm) will have less capital reported on its balance sheets than a company with the same amount, but newer, capital. To the extent this is true, older, slower-growing companies will have larger measured rates of return than newer, faster-growing companies. See Berry, p. 748.

may be avoided by replacing equity or assets in the denominator of the proxy measure of rate of return with operating costs.72 This method fundamentally assumes operating costs are proportional to equity. Because these ratios do vary widely across industries, meaningful comparisons can only be made within industry groups.73 As similarly noted in the previous paragraph with regard to the ratio of income to assets, this approach might be used for comparisons of a group of firms within an industry which exhibits uniformity across firms in the relationship between operating costs and equity. Nevertheless, as noted above in the case of ratio of income to assets, even comparisons within industries can only be useful under certain assumptions about similarities across firms in financial structure and methods of production.

Difficulties in interpretation of ratios

In addition to these problems resulting from difficulties in measurement, comparisons of such ratios may be misleading if only one year's data is utilized. Any one firm in any year may have an aberration in its rate of return and still not violate the economic principle of long-run equalization of rates of return. It might be premature to suggest transfer pricing problems exist based solely on disparities in rate-of-return ratios calculated from a single year's data. A frequent use of measures of rates of return in practice has been not to determine transfer prices but to check the reasonableness of prices determined by alternative methods. An 1979 OECD report notes the following:

Levels of profit in an industry may for example conform to
a pattern and an exception to the pattern might indicate
that profits were being shifted by artificial transfer prices.
But comparisons of this sort would need to be made with
care. It does not necessarily follow that exceptional profits
or losses are artificial. . . . [T]he results of the comparison
could normally be regarded only as pointers to further in-
vestigation. 74

This approach was adopted in the Du Pont case, as the Court used return ratios as a guide to "reasonableness of the result" of the income reallocation determined by other methods.75

The rate of return method in the Treasury Department "White Paper"

The Treasury Department has suggested that under certain circumstances, the rate of return ratio methods may be used not only as a check on reasonableness of other methods, but to actually determine and set transfer prices. As discussed in the White Paper,

72 The ratio of gross income to operating costs is commonly referred to as the "Berry ratio," after Charles H. Berry, who employed this method for the IRS. See E.I. du Pont de Nemours & Co. v. United States, 608 F. 2d 445 (Ct. Cl. 1979).

73 In E.I. du Pont de Nemours & Co. v. United States, 608 F.2d 445 (Ct. Cl. 1979), the Court accepted the Commissioner's reallocation based on a comparison of the foreign subsidiary's rate of return compared to those of 1,100 companies in several industries and on a comparison of the foreign subsidiary's ratio of gross income to total operating costs of those 32 companies "functionally similar, in general" to the foreign subsidiary.

74 Transfer Pricing and Multinational Enterprises-Report of the OECD Committee on Fiscal Affairs, Organisation For Economic Co-operational Development, Paris, 1979, at para. 71. 75 E.I. du Pont de Nemours & Co. v. United States, 608 F. 2d 445 (Ct. Cl. 1979).

the Treasury Department would apply return ratio methods for the pricing of intangibles where no exact or inexact comparable exists. This method, known as the Basic Arm's Length Return Method (BALRM), could only be applied in situations where only one of the related parties has intangible assets without exact or inexact comparables. Furthermore, this method may only be applied after performing "functional analysis" to identify different components of the firm's business, assigning rates of return to each line of business, and subsequently computing the rate of return of the intangibles as the residual from the total. Since comparables are relatively rare for intangibles, the suggested application of the BALRM method would be applied in a significant portion of transfer pricing

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Net basis taxation of income from foreign inbound investment poses administrative issues that are in some ways different from those posed by the taxation of local U.S. investment. As a threshold matter, if a foreign person with U.S.-related income not subject to withholding determines that it has no U.S. trade or business (a determination calling for particularized analysis of facts and circumstances), and for that reason files no U.S. tax return, the IRS is foreclosed from challenging that determination in the ordinary return-examination process. Moreover, differing effective tax rates in different jurisdictions, or other factors, may create incentives to artificially shift income across borders. Accurate allocation and apportionment of worldwide expenses to U.S. income depends on data which may be subject to foreign business and accounting conventions that take little or no account of U.S. tax or accounting rules. The ability of the IRS to examine or obtain materials created abroad is limited by obstacles resulting from, among other things, language differences, geographical distance, and different levels of foreign judicial support available to compel compliance with U.S. tax laws. The substantive U.S. tax rules applicable to inbound foreign investment are supported by certain Code and treaty provisions that respond to these administrative issues.

Despite the regulatory detail, what does and does not constitute an arm's length arrangement remains fundamentally a question of fact, and is, of necessity, largely based on information available only from the taxpayer. The Treasury and IRS, in their 1988 White Paper on related-party pricing, reported on tax administration difficulties in determining arm's length prices: 77

A significant threshold problem in the examination of section 482 cases has been IRS access to relevant information to make pricing determinations. In some cases, relevant information is not furnished by the taxpayer to the examining agent. In other cases, long delays are experienced by agents in receiving information, in most cases without explanation for the delays. In many cases, delays in responding to [International Examiner] requests for in

76 White Paper n. 10, supra, Chapter 11.

77 White Paper n. 10, supra, pp. 13-15 (references omitted).

formation exceed one year. Because of the emphasis upon
timely closing of large cases in the recent past, section 482
cases have been closed without receiving necessary infor-
mation or without the opportunity for agents to follow up
on information that has been provided.

Because of the dramatic increase in recent years of direct foreign investment in the United States, the examination of transactions between foreign parents and their U.S. affiliates will become an increasingly more important part of the international examination program. A survey of rates of return on these companies based on IRS statistics of income ("SOI") data reveals a substantially lower than average profit in this country reported by these companies, which may involve transfer pricing policies.

In practice, examinations of United States subsidiaries of foreign parents have developed into some of the Service's most difficult examinations. A primary reason for the difficulty is that agents are unable to obtain timely access to necessary data, which is typically in the hands of the parent company. In many cases, foreign parent companies refuse to produce this information upon request. An additional difficulty encountered by agents is that foreign parent corporations may not be subject to information reporting requirements similar to U.S. requirements.

In addition to the procedural steps that can be taken in any domestic tax controversy, a section 482 case involving both foreign and domestic taxpayers can also be thrown into "competent authority" proceedings, bringing the tax administrators of two countries together for the purpose of resolving the income allocation dispute. Competent authority procedures add an additional set of administrative issues to what can already be a fairly lengthy and complex dispute resolution process. In addition to resolving substantive tax issues, the competent authorities may be called upon to coordinate the disparate procedural rules applicable in each country to audit adjustments, such as interest on refunds or deficiencies, and differing statutes of limitations on refunds or additional assessments.

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