Transfer Pricing Abuse

The term “transfer pricing”, standing alone, describes prices charged by related entities for goods or services sold within the same corporate family. From a tax point of view, this practice is vulnerable to abuse where, and to the extent, an enterprise with subsidiaries and affiliates in different countries manipulates the prices charged to and by its various subsidiaries and affiliates to shift income away from the United States and into tax-favored jurisdictions.

Because related parties—i.e., members of a single corporate entity—generally care more about their global profit than where profit is reported, it is in their interest as a group to report more profit in jurisdictions with comparatively low tax rates, thereby raising the profits of the group overall.

This manipulation is typically accomplished by causing the corporate subsidiary in the United States (or other “high tax” jurisdiction) to sell goods to the foreign subsidiary at below market rates, or to buy goods from that foreign subsidiary at above market rates, so that any profit from the ultimate sale of those goods to a third party is attributed to the foreign subsidiary.

Section 482 of the Internal Revenue Code (26 U.S.C. § 482) is designed to prevent this sort of transfer pricing abuse. The IRS Code and enforcing regulations provide taxpayers with substantial flexibility in setting their transfer prices, and a range of options as to how to calculate these prices. However, transfer prices “arranged solely to avoid taxes and without a valid business purpose” are plainly impermissible. Merck & Co., Inc. v. The United States, 24 Cl. Ct. 73, 80 (1991).

Under IRS Code Section 482,generally provides that the IRS may re-allocate income between related entities if necessary to prevent tax evasion or to reflect the true income of the relevant businesses. Under section 482’s enforcing regulations, the “true income” of a taxpayer is “the taxable income that would have resulted had it dealt with the [related party] at arm’s length.”  26 C.F.R. § 1.482-1(i)(9). The regulations allow taxpayers to attempt to simulate an “arms-length” transaction through various economic models. No particular method is mandated, but the method chosen must be one which “under the facts and circumstances provides the most reliable measure of an arm’s length result.”  26 C.F.R. § 1.482-1(c).

IRS leadership, on numerous occasions, has commented on the importance of transfer pricing abuse as an international taxation issue. The IRS has also collected significant sums from multi-national corporations based on allegations of transfer pricing abuse. For example, in 2006, the IRS resolved a transfer pricing dispute with pharmaceutical manufacturer Glaxo SmithKline for a total value to the Treasury of $5.2 billion. In 2011, Western Union entered into a settlement agreement with the IRS under which it agreed to make $1.18 billion in adjustments to settle allegations of transfer pricing abuse.

To find out more about whether particular conduct is actionable or whether you have a whistleblower claim, contact us today.