1992)

PREDATORY TRANSFER PRICING

BOX NO. 1

A TEN YEAR SNAPSHOT

The House Ways and Means Committee analyzed the federal income tax returns filed over a ten year period by 36 foreign owned U.S. distributors of automobiles, motorcycles and electronics equipment including televisions, stereos, FAX machines and VCR's. The study produced the following conclusions:

• One-half of the companies paid little or no federal
income tax;

The major tax issue for these companies before the
IRS is reduction in taxable income through transfer
pricing;

• Most of the 36 companies engaged in questionable
transfer pricing practices;

• The 18 electronics distributors reported $116 billion
in gross receipts and paid only $654 million, or one
half of 1 percent, in Federal income tax;

• Only nine electronics companies reported positive
taxable income;

• Eight of the automobile and motorcycle companies
paid no federal income tax and IRS has proposed
$2.5 billion in adjustments to income;

A foreign parent sold television sets to an unrelated
distributor for $150, while its subsidiary paid $250
for the same model;

One foreign automobile manufacturer sold cars to
its U.S. distributor at prices averaging $800 more
than identical cars shipped to its Canadian distribu-

tor.

Source: House Ways and Means Committee

Based on Internal Revenue Service data.

13

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VANDERBILT JOURNAL OF TRANSNATIONAL LAW

[Vol. 25:3 Japan, over fifty percent of which is in autos and auto parts." Furthermore, the problem is likely to worsen. The Office for the Study of Automotive Transportation at the University of Michigan predicts that the automobile and auto parts trade deficit with Japan will widen from 31.1 billion dollars in 1990 to 45.7 billion dollars in 1994 in current dollars.28 Japanese automotive companies have a clear predisposition towards importing parts from Japan for assembly in the United States. Edward M. Graham and Philip R. Krugman, fellows at the Institute for International Economics, have concluded that United States based Japanese manufacturing operations are three times as likely to import parts from Japanese suppliers for assembly in the United States than the average foreign-controlled affiliate does from its domestic suppliers." Reports published during President Bush's January 1992 trip to Japan indicated that corporate Japan will increase the output at its United States transplants by roughly fifty percent in the next two or three years." Economist Clyde Prestowitz of the Economic Strategy Institute calculates that the net impact of Japanese auto transplants has been a loss of about eighty-three thousand jobs and 6.3 billion dollars in gross national product."1

Available evidence suggests that either Japan Inc. is committing tax evasion on a massive scale or it does not know the value of the goods and services it produces. Japan Inc. has earned steadily increasing revenues in the United States during 1983 to 1987, yet produced an anomalous decrease in net income during the same period. (See Chart #3]. A congressional study of IRS tax return data concluded that foreign subsidiaries of United States companies operating abroad "generally earn at 8 to 10 percent pretax net operating profit on their business receipts," while United States subsidiaries of companies from Japan, Canada, United Kingdom and West Germany operating in the United States earned only 0.1 percent on receipts, hardly a reason to do business here."

27. SEAN P. MCÅLINDEN ET AL., THE UNIV. OF MICHIGAN Transp. RESEARCH INST., Report No. UMTRI 91-20, The U.S.-Japan Automotive Bilateral 1994 TRADE DEFICIT 2 (1991).

28. Id. at 72.

29. EDWARD M. Graham & PAUL R. Krugman, Inst. for InternaT'L ECONOMICS, FOREIGNn Direct InvestMENT IN THE UNITED STATES 78 (2d ed. 1991). 30. David E. Sanger, Trade Mission Ends in a Tense Meeting About Autos, N.Y. TIMES, Jan. 10, 1992, at A1, A11.

31. CLYDE PRESTOWITZ ET AL., Economic Strategy Inst., The Case for SavING THE BIG Three 2 (1992).

32. Tax Underpayments, supra note 14, at 96 (testimony of Charles S. Triplett, Deputy Assoc. Chief Counsel, IRS).

1992]

PREDATORY TRANSFER PRICING

15

A separate study of federal corporate income tax returns from 1980 to 1987 found various reasons for the low rate of return for foreign corporations in the United States. The authors of the study found, for example, that one-half of the difference in profitability could be explained by a maturation process that all foreign corporations undergo in the United States market, or by exchange rates having a significant effect on foreign corporations' profitability, or by asset revaluation distorting the ratio of taxable income to assets, or, finally, by the effect on profits of outside purchases and investment income. The authors, however, concluded that the other half of this profitability differential was unable to be explained "by forces other than transfer pricing." Whatever the actual tax revenue loss, transfer pricing appears to have effectively subsidized Japanese entry into United States markets at the expense of American business interests.

Lack of an effective IRS response to international transfer pricing abuses either represents a triumph of diplomatic nicety over evenhanded enforcement of the nation's revenue laws or, more likely, shows that IRS is seriously outgunned. As of February 1990, the IRS was handling 294 cases of transfer pricing abuses involving proposed income adjustments of over thirteen billion dollars." Congressional testimony refers to press accounts that seventeen Japanese companies-including the DaiichiKangyo Bank, NEC, Nissan, Sony America and Yamaha USA-have

33. The study, which used Treasury Department data, analyzed the federal corporate income tax returns (IRS form 1120) for the year 1987 of a cross section of 4000 domestically-controlled and 600 foreign-controlled corporations (excluding finance, insurance, and real estate corporations). In addition, the authors constructed a second data set, called a panel, using IRS Form 1120 data from 1980 to 1987 for firms with assets of $50 million or more. The panel data set included about 1300 domestically-controlled firms and 110 foreign-controlled firms. According to the authors, the panel was valuable in identifying the role of startup costs and exchange rates in evaluating the profits of foreign and domestic corporations. Measuring return on investment as the ratio of taxable income over assets, the ratio was only 0.58 for foreign-controlled companies compared with 2.14 for domestically-controlled companies in 1987. The authors of the study also analyzed the returns of 86 Japanese companies in a cross section of 528 foreign-controlled companies. According to the study, corporate Japan's 1987 profitability taxable income/ assets ratio is -0.025 and, the authors noted, its debt/assets ratio is 0.097 which is a full 10 percentage points higher than domestically-controlled companies. Timothy Goodspeed et al., Explaining the Low Taxable Income of Foreign Controlled Companies in the United States 1, 2, 4-6, Tables 1.1 and 2.4 presented at the Conference on the International Aspects of Taxation, Cambridge; National Bureau of Economic Research, Inc. (Sept. 28, 1991). ·

34. Tax Underpayments, supra note 14, at 53 (statement of Patrick G. Heck, Assistant Counsel, Subcomm. on Oversight, Comm. on Ways and Means).