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This pamphlet,1 prepared by the staff of the Joint Committee on Taxation, provides a discussion of present-law tax rules and certain issues relating to transfer pricing under section 482 of the Code. The Subcommittee on Oversight of the House Committee on Ways and Means has scheduled a public hearing on certain section 482 transfer pricing issues on July 10 and 12, 1990. Due to the nature of the hearing for which the pamphlet is prepared, the pamphlet focuses largely on issues related to sales of tangible property to related party distributors. It is understood that the hearing is expected to focus principally on such sales by foreign corporations to controlled U.S. distributors.

The first part of the pamphlet describes present-law rules and background under section 482. The second part analyzes issues relating to transfer pricing under section 482.

1 This pamphlet may be cited as follows: Joint Committee on Taxation, Present Law and Certain Issues Relating to Transfer Pricing (Code sec. 482) (JCS-22-90), June 28, 1990.



A. Overview

The United States generally taxes all income of U.S. citizens, residents, and U.S. corporations, whether or not such income is derived in the United States. By contrast, the United States taxes nonresident alien individuals and foreign corporations only on income with a sufficient nexus to the United States. In the case of a multinational enterprise under common control that includes both a U.S. and a foreign corporation, the United States thus may tax all of the income of the U.S. corporation, but only so much of the income of the foreign corporation as satisfies the relevant rules for determining a U.S. nexus.2 The determination of the amount of income that properly is the income of the U.S. member of a multinational enterprise, and the amount that properly is the income of a foreign member of the same multinational enterprise thus is critical to determining the amount the United States may tax as well as the amount other countries may tax.

Due to the variance in tax rates (and tax systems) among countries, and possibly for other reasons, a multinational enterprise may have a strong incentive to shift income, deductions, or tax credits among commonly controlled entities to the entity in the most favorable tax jurisdiction in order to arrive at a reduced overall tax burden. Such a shifting of items between commonly controlled entities might be accomplished by setting artificial transfer prices for transactions between group members.

As a simple illustration of how transfer pricing might reduce taxes, assume a foreign corporation has a wholly owned U.S. subsidiary. The foreign corporation manufactures a product in its home country which it then sells to the U.S. subsidiary. The U.S. subsidiary, in turn, sells the product to unrelated third parties. Due to the foreign parent's control of its subsidiary, the price which is charged by the parent to the subsidiary could theoretically be set independently of ordinary market forces. If the foreign corporation is established in a jurisdiction that would subject its profits from the manufacture and sale of the product to an effective rate of tax lower than the effective U.S. tax rate (and assuming that the foreign corporation's presence in the United States apart from the subsidiary is sufficiently limited so that its profits would not be subject to U.S. tax), then the foreign corporation may be inclined to overcharge the U.S. subsidiary for the product. By doing

2 In different circumstances, the relevant nexus rules may depend on whether the income has its source in the United States, whether the income is effectively connected with a U.S. trade or business, or whether the income is connected with a business that operates through a permanent establishment located in the United States. In certain situations, special rules treat undistributed income of a foreign corporation owned by U.S. shareholders as the current income of the U.S. shareholders.

so, a portion of the combined profits of the group from the manufacture and sale of the product would be shifted out of a high-tax jurisdiction (the United States) and into a lower-tax jurisdiction (the foreign corporation's home country). The ultimate result of this process would be a reduced worldwide tax liability of the multinational enterprise.


Transfer pricing issues arise regardless of whether the parent corporation is a foreign or a U.S. corporation. The preceding example involves a transfer from a foreign parent corporation to a controlled U.S. entity. Such a transfer from a foreign entity to a controlled U.S. entity is commonly referred to as an "inbound" transfer. However, a U.S. parent corporation with a subsidiary in a country with a low effective tax rate compared to the U.S. effective tax rate would have an incentive to place a larger portion of profits in that subsidiary by artificially understating transfer prices paid to the U.S. corporation from its subsidiary. Such transfers by U.S. entities to their controlled foreign affiliates are often referred to as "outbound" transfers.

In general, as a practical matter, it is understood that many of the cases involving questions of "inbound" transfer prices to date have involved foreign corporations that manufacture tangible property (e.g., various consumer products) and sell such property to affiliates in the U.S. that distribute the property. It is understood that many of the cases involving questions of "outbound" transfer prices to date have involved U.S. corporations that transfer various manufacturing or other intangibles (for example, patents, know how or secret processes) to affiliates in jurisdictions with low effective tax rates which affiliates then manufacture and sell products using the transferred intangibles.

The relative statutory tax rates of different jurisdictions do not necessarily reflect their relative effective tax rates. Thus factors other than relative statutory tax rates may affect a multinational's incentive to place income or deductions in a particular tax jurisdiction. Factors that might reduce a high statutory rate to a low effective tax rate might include, for example, the ability to avoid a high statutory tax rate by timing rules permitting significant deferral; or by tax planning permitted under a country's combined internal and treaty tax rules (including for example, routing income to lowtax third country affiliates so that it is not taxed in the home country). The effectiveness of tax administration in a country may also be a factor. Other factors that can affect the level of tax borne by income reported in a particular jurisdiction include the availability of double tax relief (e.g., a foreign tax credit), and liability for customs or other duties.

Nontax factors, such as remittance or capital controls, or other actual or perceived advantages to be obtained by reporting a high or low level of income in a particular jurisdiction, might also influence the preference of a multinational enterprise regarding which member of the group retains income and thus the level at which transfer prices may be set in transactions with that member.

3 By contrast, foreign companies located in countries with effective tax rates in excess of the U.S. rates may have an incentive to undercharge for sales into the United States in order to shift profits, and the resulting tax, into the United States.

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