Report to The Congress on 

Earnings Stripping, 

Transfer Pricing and 

U.S. Income Tax Treaties
 

Department of the Treasury 

November 2007 
The Honorable Max Baucus 

Chainnan 

Committee on Finance 

United States Senate 

Washington, DC 20510 

Dear Mr. Chainnan: 

Sections 424 and 806 ofP.L. 108-357, the American Jobs Creation Act of2004 

(AJCA), directed the Secretary of the Treasury to conduct studies of certain issues 

regarding earnings stripping, transfer pricing, and U.S. income tax treaties and to provide 

specific recommendations in those areas. AJCA directed the Secretary to submit a report 

of such studies to the Congress. Pursuant to that directive, we hereby submit the "Report 

to the Congress on Earnings Stripping, Transfer Pricing and U.s. Income Tax Treaties." 

Sectiorl 806 of AJCA also directed the Secretary of the Treasury to conduct a 

study of the effectiveness of the provisions inAJCA on corporate expatriation. Because 

the provisions on corporate expatriation are relatively new and there is a need for further 

published guidance on them, more time is needed to assess their impact. Consequently, 

the study relating to the impact of AJCA's corporate expatriation provisions will be 

presented in a separate report at a later date. 

I am sending a similar letter to Representative Charles Rangel, Chainnan of the 

Committee on Ways and Means, Senator Charles Grassley, and Representative Jim 

McCrery. 

Sincerely, 

Eric Solomon 

Assistant Secretary 

Tax Policy 

Enclosure 
The Honorable Charles B. Rangel 

Chairman 

Committee on Ways and Means 

U.S. House ofRepresentatives 

Washington, DC 20515 

Dear Mr. Chairman: 

Sections 424 and 806 ofP.L. 108-357, the American Jobs Creation Act of2004 

(AJCA), directed the Secretary of the Treasury to conduct studies of certain issues 

regarding earnings stripping, transfer pricing, and U.S. income tax treaties and to provide 

specific recommendations in those areas. AJCA directed the Secretary to submit a report 

of such studies to the Congress. Pursuant to that directive, we hereby submit the "Report 

to the Congress on Earnings Stripping, Transfer Pricing and U.S. Income Tax Treaties." 

Section 806 ofAJCA also directed the Secretary of the Treasury to conduct a 

study of the effectiveness of the provisions in AJCA on corporate expatriation. Because 

the provisions on corporate expatriation are relatively new and there is a need for further 

published gllidance on them, more time is needed to assess their impact. Conseqllently, 

the study relating to the impact of AJCA's corporate expatriation provisions will be 

presented in a separate report at a later date. 

I am sending a similar letter to Senator Max Baucus, Chairman of the Committee 

on Finance, Senator Charles Grassley, and Representative Jim McCrery. 

Sincerely, 

Eric Solomon 

Assistant Secretary 

Tax Policy 

Enclosure 
TABLE OF CONTENTS 

 Page

I. INTRODUCTION AND SUMMARY............................................................................ 1 

A. Introduction .............................................................................................................. 1 

B. Background .............................................................................................................. 1 

C. Summary .................................................................................................................. 3 

II. STUDY OF EARNINGS STRIPPING.......................................................................... 7 

A. Introduction .............................................................................................................. 7 

B. Executive Summary.................................................................................................. 8 

C. Background .............................................................................................................. 9 

D. Evidence for the Existence and Extent of Earnings Stripping ............................... 11 

E. The Effectiveness of Section 163(j) in Preventing Income Shifting ...................... 23 

F. The Effect of Deficiencies of Earnings Stripping Provisions on the 

Competitiveness of U.S.-Based Businesses........................................................... 23 

G. The Impact of Earnings Stripping Activities on the U.S. Tax Base ...................... 23 

H. The Effect of Foreign Laws on Stripping of Earnings Out of the United States ... 23 

I. The Effect of Changes to the Earning Stripping Rules on Jobs in the United 

States ...................................................................................................................... 24 

J. Conclusions ............................................................................................................. 25 

K. Recommendations to Improve Earnings Stripping Provisions .............................. 27 

III. STUDY OF TRANSFER PRICING.......................................................................... 33 

A. Introduction ............................................................................................................ 33 

B. Executive Summary................................................................................................ 34 

C. Background ............................................................................................................ 38 

D. Effectiveness of Current Transfer Pricing Rules and Compliance Efforts ............ 46 

E. Income Shifting from Transfer Pricing: Evidence from Tax Return Data ............ 55 

F. Improving Transfer Pricing: Recent Regulatory Efforts ....................................... 61 

G. Conclusions ............................................................................................................ 70 

H. Recommendations .................................................................................................. 70 

IV. STUDY OF INCOME TAX TREATIES.................................................................. 73 

A. Introduction ............................................................................................................ 73 

B. Executive Summary................................................................................................ 73 

C. Development of the Anti-Abuse Provisions of U.S. Tax Treaties ......................... 74 

D. Identification of Inappropriate Reductions in U.S. Withholding Taxes That 

Provide Opportunities for Shifting Income Out of the United States, and 

Evaluation of Whether Existing Anti-Abuse Mechanisms Are Operating 

Properly.................................................................................................................. 82 

E. Conclusions ............................................................................................................ 87 

F. The Treasury Department’s Most Recent Efforts to Combat Abuse of Tax 

Treaties................................................................................................................... 88 

G. Appendices............................................................................................................. 89 

V. REFERENCES........................................................................................................... 103 
 

LIST OF TABLES AND FIGURES 

Tables Page

2.1 The Ratio of Net Income to Total Receipts and Number of Corporate Tax Returns 

by Ownership Category and Sector: 2004 ................................................................13 

2.2 Net Income Adjusted to Operating Income in the Nonfinancial Sector and 

Manufacturing by Ownership Category: 2004 .........................................................15 

2.3 Distribution of the Ratio of Interest Paid to Cash Flow: 2004 .................................18 

4.1 Interest Payments from Foreign-Controlled U.S. Corporations to Foreign Related 

Parties, Ranked by Country of Residence of Foreign Related Party, 1996 ..............84 

4.2 Interest Paid to Related Parties in Iceland and Hungary: 1996-2004 .......................85 

4.3 Interest Payments from Foreign-Controlled U.S. Corporations to Foreign Related 

Parties, Ranked by Country of Residence of Foreign Related Party, 2004 ..............86 

Figures 

2.1 Ratio of Net Income to Total Receipts for Large Domestic Corporations by Control 

Status and Industry: 1995-2003 ................................................................................12 

3.1 CFC Profitability by Statutory Tax Rates: Non-financial CFCs ..............................58 
1

I. INTRODUCTION AND SUMMARY 

A. Introduction 

This report was prepared in response to sections 424 and 806 of the American 

Jobs Creation Act of 2004 (“AJCA”). In AJCA, Congress directed the Secretary of the 

Treasury to conduct studies regarding (1) the earnings stripping rules, including a study 

of the effectiveness of these rules in preventing the shifting of income outside the United 

States; (2) the effectiveness of the transfer pricing rules of section 482, with an emphasis 

on transactions involving intangible property; (3) income tax treaties to which the United 

States is a party, with a view toward identifying any inappropriate reductions in 

withholding tax or opportunities for abuse that may exist; and (4) the impact of AJCA’s 

corporate expatriation provisions on inversion transactions (i.e., where a U.S. parent 

corporation of a U.S. multinational group is replaced with a new foreign parent 

corporation). 

This integrated report provides the results of the Treasury Department’s analysis 

of the first three studies. Chapter II of this report is the study on earnings stripping. 

Chapter III of this report is the study on transfer pricing. Finally, chapter IV of this 

report is the study on U.S. income tax treaties. The first three studies are presented 

together in this integrated report, rather than issued separately, because of the common 

thread, which links them together – the potential for exploitation of inappropriate 

income-shifting opportunities to erode the U.S. corporate tax base. Since that theme 

underlies all three study areas, it seemed most appropriate to present results as part of a 

unified overall report. 

This Treasury Department report does not address at this time the fourth study 

area – the impact of the expatriation provisions on inversion transactions. Section 7874, 

enacted as part of AJCA, is a relatively new provision and more time is needed to assess 

the impact of the provision in this area. Since its enactment, the Treasury Department 

has issued two sets of temporary and proposed regulations interpreting section 7874 and 

is in the process of revising and finalizing the regulations. In addition, there is an 

ongoing need for further published guidance under section 7874. These steps must be 

taken before a thorough study of the effectiveness of this section can be completed. 

Consequently, the results of the fourth study relating to the impact of AJCA’s 

expatriation provisions on inversion transactions will be presented in a separate report at 

a later date. 

B. Background 

On May 17, 2002, the Treasury Department issued a preliminary report on 

corporate inversions (Treasury Department inversion report). An inversion is a 

transaction through which the corporate structure of a U.S.-based multinational 

corporation is altered so that a new foreign corporation, typically located in a low- or notax country, replaces the existing U.S. parent corporation as the parent of the corporate 

group. These transactions involve little or no immediate operational change in the 

corporate group. However, the transactions produce at least two major areas of tax 

benefit. First, they facilitate “stripping” of the U.S. tax base attributable to the foreign 

operations of the corporate group. Second, the transactions facilitate the stripping of the 
U.S. tax base attributable to the U.S. operations of the corporate group. The first major 

tax benefit is achieved by migrating ownership of the former U.S. parent corporation’s 

existing foreign subsidiaries outside the United States. This migration is coupled with 

having the group’s new foreign operations held outside the United States upon their 

formation or acquisition. Consequently, when all the transaction steps are completed, the 

foreign operations of the corporation are generally outside U.S. taxing jurisdiction, 

reducing or even eliminating the U.S. tax on foreign operations. The second major tax 

benefit is achieved by leveraging the U.S. parent corporation and the U.S. group as part 

of the inversion transaction. The leveraging of the U.S. operations of the group is 

accomplished through intercompany loans from related foreign entities. The result is a 

major reduction in the level of U.S. tax on domestic operations of the group through 

deductible interest payments to foreign members of the overall group that are subject to 

little or no U.S. tax. In the SEC filings seeking shareholder approval of these 

transactions, significant reductions in U.S. corporate taxes are listed as a key reason that 

the former U.S. parent corporations undertook these transactions. 

 In its study of inversion transactions, the Treasury Department pinpointed the tax 

benefits critical to the operation of these transactions, namely shifting earnings out of 

U.S. taxing jurisdiction through a variety of techniques. These techniques included the 

migration of foreign subsidiaries and the introduction of leverage in the U.S. group as 

described above, as well as transfer pricing and U.S. income tax treaty-based techniques. 

The Treasury Department concluded, however, that the manner that the provisions of the 

Internal Revenue Code (the “Code”) and our income tax treaties are exploited in these 

transactions is not necessarily unique to corporations that had undergone an inversion 

transaction. For example, these techniques are available to any foreign-controlled 

corporate group, regardless of whether the corporation undergoes an inversion transaction 

to become such a group. Consequently, the conclusion of the Treasury Department 

inversion report was that inversion transactions simply exposed areas of weakness in the 

Code and U.S. income tax treaties. Accordingly, the Treasury Department inversion 

report concluded that further study of the rules that facilitate earnings stripping through 

the payment of interest on intercompany loans (i.e., section 163(j) and reductions of 

withholding taxes through income tax treaties) and the rules related to stripping the U.S. 

corporate tax base through transfer pricing (i.e., section 482) are necessary. 

 While the Treasury Department studied inversion transactions and issued its 

report, members of Congress introduced a variety of legislative proposals to deal with 

corporate inversion transactions. Some of these legislative proposals related to the tax 

treatment of the inversion transaction itself. Others proposals related to what some 

perceived as the root causes of the transactions, such as weakness in the earnings 

stripping and transfer pricing rules. Other proposals combined these approaches. At the 

same time, a variety of proposals were being considered to update and reform the U.S. 

international tax rules more generally in order to make U.S.-based multinationals more 

competitive with foreign-based multinationals in the global marketplace. 

 AJCA, enacted on October 22, 2004, made significant changes to tax rules that 

apply to cross-border investment and transactions. The provisions in AJCA included 

repeal of the Extraterritorial Income Exclusion and tax changes for U.S. business 

operating abroad, particularly regarding the foreign tax credit. AJCA also included a 

2
one-time incentive to reinvest foreign earnings in the United States. In addition, AJCA 

contained provisions to reduce tax avoidance through individual and corporate 

expatriation. In particular, AJCA enacted section 7874, which directly addresses the 

structural results and certain tax consequences of a wide range of inversion transactions. 

AJCA did not, however, specifically alter other provisions relevant to the dynamics of 

inversion transactions, namely the earnings stripping provisions, the transfer pricing 

provisions of section 482, or provisions relating to treaty abuse (e.g., section 894). 

However, Congress did request in sections 424 and 806 of AJCA that the Treasury 

Department conduct studies of these three inversion-related provisions, as well as the 

effectiveness of section 7874 of the Code. 

Section 7874 appears to have been successful in curtailing inversion transactions 

by large, publicly traded corporations. Temporary and proposed regulations were issued 

under that section in December 2005 and May 2006. The Treasury Department believes 

these regulations are an effective implementation of Congressional intent. Nonetheless, 

there is currently a need for further published guidance under section 7874, and the 

existing temporary and proposed regulations must be finalized. These efforts are in 

process. Because the guidance process and our study of the effectiveness of this 

provision are ongoing, the fourth report requested by AJCA will be issued separately. 

C. Summary 

As indicated above, this report addresses three areas of study requested by AJCA. 

The studies in this report are with respect to earnings stripping, transfer pricing, and tax 

treaties. Brief summaries of these studies follow. 

1. Earnings-Stripping Study 

The focus of the earnings-stripping study is on earnings stripping by foreigncontrolled domestic corporations. As discussed below, it is not possible to quantify with 

precision the extent of earnings stripping by foreign-controlled domestic corporations 

generally. However, there is strong evidence of earnings stripping by the subset of 

foreign-controlled domestic corporations consisting of inverted corporations (i.e., former 

U.S.-based multinationals that have undergone inversion transactions). 

 The overall effect of income stripping on U.S. employment is unclear. The 

theoretical effect of income shifting on cross-border investment in the United States is 

ambiguous, because income shifting may either increase or decrease investment in a 

high-tax country. Empirical studies show that foreign direct investment depends 

negatively on a country’s corporate tax rate. Relatively high U.S. corporate tax rates, 

thus, likely decrease foreign investment in the United States. However, existing studies 

do not address the question of how income shifting affects cross-border investment. The 

level of investment by multinationals is unlikely to affect total employment in the United 

States significantly unless there is unemployment in the markets for labor whose skills 

foreign investors demand. 

The study on earnings stripping concludes by analyzing a number of proposals 

aimed at restricting the ability of foreign-controlled domestic corporations to strip income 

out of the United States -- some of which have been suggested by others and some of 

which have been developed within the Treasury Department. The earnings stripping 

3
study did not find conclusive evidence of earnings stripping from foreign-controlled 

domestic corporations that had not inverted. However, there is strong evidence that 

inverted corporations have engaged in earnings stripping. The corporate-inversion 

provisions in AJCA do not affect taxpayers who inverted before March 5, 2003, but 

recent Administration Budget proposals would. These Administration Budget proposals 

would also affect taxpayers other than inverted corporations. 

The earnings-stripping study in this report concludes that additional information is 

needed to determine how the Administration’s Budget proposal would affect foreigncontrolled domestic corporations that have not inverted and whether modifications to the 

proposal would be appropriate. In order to obtain this additional information and further 

the administration of section 163(j), a new tax form has been created, Form 8926, 

Disqualified Corporate Interest Expense Disallowed Under Section 163(j) and Related 

Information. 

2. Transfer Pricing Study

The transfer pricing study focuses on issues in the transfer pricing area relating to 

shifting income from the United States (both in the context of inversion transactions and 

more generally). Specifically, the study reviews Treasury regulatory guidance under 

section 482 and the effectiveness of current transfer pricing rules and compliance efforts 

to ensure that related-party transactions cannot be used to shift income out of the United 

States improperly. In addition, the study reviews the administration of the section 482 

rules. In that regard, the study indicates that the transfer pricing rules must be continually 

monitored to ensure their relevance to changing business conditions and to prevent 

income shifting from non-arm’s length transfer pricing. The empirical evidence available 

from tax return data is consistent with (although not proof of) ongoing non-arm’s length 

pricing or income shifting among related parties. As discussed below, a key outcome of 

this conclusion is the need for the Treasury Department to complete the process of 

finalizing and modernizing its transfer pricing guidance. 

In this regard, three areas of particular concern stand out among related-party 

transactions generally. First, proposed revisions to the existing cost sharing rules must be 

completed regarding the type and valuation of external contributions (i.e., “buy-in” 

payments) for which arm’s length consideration must be provided as a condition to 

entering into a cost sharing arrangement. The cost sharing area is a crucial one regarding 

the shifting of income out of the United States. An important first step in this regard was 

proposed regulations issued in 2005. The Treasury Department is currently working to 

finalize the proposed regulations. 

Second, proposed revisions to the related-party services regulations must be 

completed to reflect legal, business, and economic developments since the regulations 

were issued in 1968. Updated guidance on the transfer pricing methods to be used to 

determine the arm’s length price in a services transaction needs to be completed, and it 

should be consistent with current regulations applicable to transfers of tangible and 

intangible property. Changes to the existing cost safe harbor for low-margin, back-office 

services must be completed, and guidance is needed to coordinate and harmonize the 

rules applicable to services related to intangibles with the transfer pricing rules applicable 

4
to transfers of intangible property generally. Temporary and proposed regulations have 

been issued addressing these issues and are undergoing revision before they are finalized. 

Third, new rules are needed to allow taxpayers to determine the amount of income 

from a global dealing operation that is subject to tax in the United States, as well as the 

source of such income and the circumstances under which such income is effectively 

connected with a U.S. trade or business. Proposed regulations in this regard are being 

drafted and will be issued soon. After comments are received and analyzed, the Treasury 

Department will finalize these regulations. 

 The transfer pricing study of this integrated report concludes that high priority 

should be given to prompt finalization and implementation of the three transfer pricing 

regulatory projects described above. These regulations will address known gaps in 

transfer pricing administration, and will alleviate common avenues for income shifting 

from non-arm’s length transfer pricing available to multinational corporations. Once 

these regulations are issued in final form, further study and consideration may be 

appropriate. However, given the current disclosure requirements already in place (as well 

as the additional disclosure requirements that are part of the proposed regulations), the 

generally high audit rates of affected taxpayers, and the enhanced ability of the competent 

authority to exchange information with other tax jurisdictions, the Treasury Department 

does not recommend additional disclosure requirements at this time. 

3. U.S. Income Tax Treaties Study

The study on U.S. income tax treaties in this integrated report focuses on 

combating abuses of treaty-based withholding rate reductions, particularly with respect to 

payments of dividends, interest, and insurance premiums. In addition, the tax-treaty 

study focuses on the need to prevent third-country residents from inappropriately 

obtaining the benefits of U.S. income tax treaties, in particular by achieving inappropriate 

reductions in U.S. withholding taxes. Especially important in this regard are limitation 

on benefits (“LOB”) provisions that deny treaty benefits to corporations with insufficient 

business and economic connection to their claimed country of residence. 

 The LOB provisions are the critical area of consideration for purposes of this 

study. Empirical evidence from U.S. corporate tax returns reveals that in recent years the 

total interest payments from foreign-controlled U.S. corporations to related parties in 

countries that are a party to a U.S. tax treaty with no LOB provisions and significant 

reductions in withholding rates (Iceland and Hungary) have surged. Many of the 

Icelandic and Hungarian corporations claiming treaty benefits are ultimately owned by 

persons from third countries (i.e., they would not be entitled to treaty benefits generally 

under most LOB provisions). The data are consistent with ongoing abuse of these 

treaties. A similar concern exists with respect to the U.S.-Poland tax treaty, which also 

lacks an LOB provision and provides significant reductions in withholding rates, 

although the data do not indicate that third-country investors are exploiting the U.S.-

Poland treaty as heavily as the U.S.-Iceland and U.S.-Hungary treaties. 

 Evidence of such exploitation of treaties without anti-treaty shopping protections 

leads to two conclusions. First, the LOB provisions in other U.S. agreements appear to 

provide significant deterrence against this sort of abuse. Second, the evidence 

underscores the importance of the Treasury Department’s ongoing efforts to revise the 

5
treaties with no or inadequate LOB provisions. These efforts are consistent with the 

emerging international consensus regarding the need to prevent third-country residents 

from inappropriately obtaining the benefits of bilateral income tax treaties, and serve to 

safeguard the U.S. tax-treaty network against possible abuse in the future. The Treasury 

Department has made significant progress in this regard. The most noteworthy 

development to date is the signing of a new income tax treaty with Iceland in October 

2007. The new treaty conforms closely to the current tax treaty policies of both the 

United States and Iceland and contains a comprehensive LOB provision which will 

ensure that only residents of the United States and Iceland will enjoy the benefits of the 

agreement. 

6
II. STUDY OF EARNINGS STRIPPING 

A. Introduction 

 Section 424(a) of AJCA included the following mandate for a study of earnings 

stripping provisions:

(a) IN GENERAL- The Secretary of the Treasury or the Secretary’s delegate shall 

conduct a study of the effectiveness of the provisions of the Internal Revenue Code of 

1986 applicable to earnings stripping, including a study of— 

(1) the effectiveness of section 163(j) of such Code in preventing the shifting of 

income outside the United States, 

(2) whether any deficiencies of such provisions place United States-based businesses 

at a competitive disadvantage relative to foreign-based businesses, 

(3) the impact of earnings stripping activities on the United States tax base, 

(4) whether laws of foreign countries facilitate stripping of earnings out of the United 

States, and 

(5) whether changes to the earning stripping rules would affect jobs in the United 

States. 

The report should also include specific recommendations as to how to improve the 

provisions of the Code applicable to earnings stripping. 

 Earnings stripping usually refers to the payment of excessive deductible interest 

by a U.S. corporation to a related person when such interest is tax exempt (or partially tax 

exempt) in the hands of the related person. Consequently, the Treasury Department has 

interpreted section 424 of AJCA to be a mandate primarily to study the shifting of 

income of domestic corporations offshore through related-party debt and associated 

interest payments. Although payments of other deductible amounts by a U.S. corporation 

to tax-exempt or partially exempt related parties also provide an opportunity to shift 

income out of a U.S. corporation, the use of related-party debt arguably is the most 

readily available method of shifting income out of U.S. corporations.1

 Income shifting 

through interest payments is certainly the most recognizable manner of shifting income in 

this context. It should be noted that chapter III of this integrated report discusses the 

shifting of income out of the United States through transfer pricing. 

 Due to the focus on the use of earnings stripping to shift income outside the 

United States, this study in chapter II concentrates on earnings stripping by foreign-

 

1

The U.S. tax on U.S. operations is easily reduced through deductions for interest payments on 

intercompany debt. A U.S. subsidiary can be loaded up with a disproportionate amount of debt for 

earnings-stripping purposes through the issuance of an intercompany note. This does not require any real 

movement of assets or a change in the business operations of the corporation. In contrast, the use of 

royalties or other deductible payments may result in a change in tax position but also may require a real 

change in business operations. 

7
controlled domestic corporations (“FCDCs”).2

 In this context, a foreign-controlled 

domestic corporation is a U.S. corporation in which one foreign person owns, directly or 

indirectly, more than 50 percent of (a) the total voting power of all classes of stock of the 

corporation entitled to vote, or (b) the total value of all classes of stock of the 

corporation.3 U.S. corporations that are not foreign-controlled domestic corporations are 

referred to as “domestically controlled corporations” (“DCCs”). In part, the focus on 

FCDCs is due to concerns about the possibility of shifting income and jobs outside the 

United States. In addition, earnings stripping may be more difficult in the case of DCCs. 

For example, the subpart F provisions of the Code limit the ability of DCCs to shift 

income offshore by means of interest payments to foreign subsidiaries.4 

B. Executive Summary 

FCDCs have opportunities to reduce their U.S. taxable income by leveraging their 

U.S. operations with debt, the interest on which is not subject to U.S. tax in whole or in 

part. 

 Historically, FCDCs have been relatively less profitable compared to DCCs, 

which, at first blush, might suggest the possibility that FCDCs may be improperly 

reducing their U.S. taxable income. However, analysis of tax return data for 2004 did not 

find conclusive evidence of a higher ratio of interest expense to cash flow for FCDCs 

compared with DCCs in the nonfinancial sector and in the manufacturing industry (which 

is part of the nonfinancial sector), although the ratio appears to be higher for FCDCs in 

securities dealing and investment banking. The data are not conclusive that the reason 

for this low profitability of FCDCs relative to DCCs is a result of earnings stripping. 

 The data gathered with respect to inverted corporations (“ICs”), however, strongly 

suggest that these corporations are stripping substantially all of their income out of the 

United States, primarily through interest payments. Consequently, these corporations’ 

U.S. operations are very unprofitable. Evidence of earnings stripping by ICs suggests 

that in this context the current rules of section 163(j) are not effective at preventing the 

shifting of income inappropriately outside the United States. 

The overall effect of income stripping on U.S. employment is unclear. The 

theoretical effect of income shifting on cross-border investment in the U.S. is ambiguous, 

because income shifting may either increase or decrease investment in a high-tax country. 

Empirical studies show that foreign direct investment depends negatively on a country’s 

corporate tax rate. Relatively high U.S. corporate tax rates, thus, likely decrease foreign 

investment in the United States. However, existing studies do not address the question of 

how income shifting affects cross-border investment. The level of investment by 

multinationals is unlikely to affect total employment significantly in the United States, 

 

2

 Although partnerships, limited liability companies (LLCs), and other non-corporate entities may be 

involved in earnings stripping as well, corporations are frequently the most important parties either directly 

or indirectly using such entities. 

3

 This information is reported on the Corporate Income Tax Return, Form 1120, Schedule K. 

4

 Multinational DCCs can and typically do allocate a disproportionate share of the debt from their global 

operations to the United States, however. Data in the Bureau of Economic Analysis Benchmark Surveys of 

Direct Investment Abroad have indicated that U.S. parents have more debt in relation to assets than their 

foreign affiliates. There is also evidence in Grubert and Altshuler (2003) that U.S. companies allocate 

much more of their debt abroad to high-tax countries compared to low-tax countries.

8
unless there is unemployment in the markets for labor whose skills foreign investors 

demand. 

 The earnings-stripping study did not find conclusive evidence of earnings 

stripping from FCDCs that had not inverted. However, there is strong evidence that ICs 

have engaged in earnings stripping. The study concludes that additional information is 

needed to determine how the Administration’s Budget proposal would affect FCDCs that 

have not inverted and whether modifications to the proposal would be appropriate. In 

order to obtain this additional information and further the administration of section 

163(j), a new tax form has been created, Form 8926, Disqualified Corporate Interest 

Expense Disallowed Under Section 163(j) and Related Information. 

C. Background 

 Section 163(j) was added to the Code by the Omnibus Budget Reconciliation Act 

of 1989 (P.L. 101-239) to prevent erosion of the U.S. tax base by means of excessive 

deductions for interest paid by a taxable corporation to a tax-exempt (or partially taxexempt) related person.5 Section 163(j) applies where a corporation’s debt-to-equity 

ratio exceeds 1.5 to 1 and its net interest expense exceeds 50 percent of its adjusted 

taxable income (generally computed by adding back net interest expense, deprec

amortization, depletion, and the net operating loss deduction). If the corporation exceeds 

the thresholds, no deduction is allowed for interest in excess of the 50-percent limit that is 

paid to a related party and that is not subject to U.S. income tax. Interest is treated as not 

subject to U.S. income tax to the extent an applicable income tax treaty reduces the U.S. 

income tax on such interest. Disallowed interest amounts may be carried forward 

indefinitely. In addition, the excess of the 50-percent limit over a corporation’s net 

interest expense for the year (if any) may be carried forward three years. Special rules 

also apply in the case of interest paid or accrued to a partnership. For purposes of these 

rules, all members of the same affiliated group of corporations are treated as one 

taxpayer. 

iation, 

 

 The Omnibus Budget Reconciliation Act of 1993 (P.L. 103-66) broadened the 

scope of section 163(j) to apply to interest paid with respect to certain loans between 

unrelated parties. Section 163(j) applies where a corporate borrower pays or accrues 

interest to an unrelated party if the interest is not subject to a gross basis income tax and 

the guarantor is a foreign person or a tax-exempt entity. 

 In 1991, the Treasury Department and the Internal Revenue Service (IRS) issued 

proposed regulations implementing section 163(j) of the Code. These regulations have 

not been finalized. 

 The efficacy of the current rules of section 163(j) has been questioned in the 

course of public discussion and legislative activity regarding corporate-inversion 

transactions. A feature common to many inversions is the presence of substantial 

indebtedness of the U.S. group to the new foreign parent or one of its foreign 

subsidiaries. The indebtedness can arise through the former U.S. parent’s issuance of a 

note to the foreign corporation prior to the consummation of the inversion transaction. 

5

 For purposes of section 163(j), a related person is any person who is related as defined in section 267(b) 

or section 707(b)(1). 

9
Alternatively, it can arise after the inversion transaction through a distribution of a note to 

the new foreign parent. While the steps through which the debt is put in place vary, the 

result can be interest payments that effectively shift income out of the U.S. taxing 

jurisdiction. Where the foreign parent is not taxed by its country of residence and a 

comprehensive income tax treaty with the United States is applicable that provides for 

little or no withholding tax on interest, the tax-reduction benefit of this technique is 

maximized, as there is no offsetting increase in foreign taxes. However, even where the 

foreign parent is located in a country that generally imposes tax on it, the interest income 

earned may be subject to little foreign tax if, for example, the country specifically reduces 

taxation on financing structures. In any case, there is a net tax benefit whenever the 

foreign tax imposed on the interest income is less than the value of the U.S. tax deduction 

for the interest expense. 

 Inversion transactions provide evidence that the earnings stripping rules are not 

fully achieving their intended purposes and have led some to conclude that these rules 

need to be strengthened. The Treasury Department inversion report proposed that the 

rules regarding earnings stripping through related-party debt (i.e., section 163(j)), and 

reduced withholding rates in U.S. income tax treaties, be examined.6

 Moreover, the 

Treasury Department articulated in that report that because the opportunities for earnings 

stripping are not limited to inversion transactions but are present in cases where a U.S. 

business is structured from the outset with a foreign parent and in cases where a foreign 

corporation acquires a U.S. operating group, reconsideration of these rules should not be 

limited in application to inverted corporations. In addition, the President’s Budget has 

included a proposal to amend section 163(j) in this regard since the FY 2004 Budget. 

 A number of congressional proposals have been introduced since 2002 to amend 

section 163(j) in response to an increase in the number of inversions. However, it should 

be noted that while amendments to section 163(j) were considered in the context of 

AJCA, AJCA as enacted did not contain an earnings stripping provision. Instead, AJCA 

required a study of the area. AJCA addressed key aspects of the inversion problem by 

adding section 7874 to the Code. 

 Section 7874 generally provides for certain tax consequences for inversion 

transactions where there has been significant continuity of ownership before and after the 

transaction. If there is at least 60 percent continuity of ownership between the old U.S. 

parent corporation and the new foreign parent corporation, section 7874 limits the ability 

to use tax attributes to offset any benefits resulting from the transaction. If there is at 

least 80 percent continuity of ownership between the old U.S. parent corporation and the 

new foreign parent corporation, section 7874 treats the new foreign parent corporation as 

a domestic corporation for income tax purposes. Section 7874 only applies to 

transactions after March 4, 2003, and so corporations that inverted before that time are 

unaffected. 

The United States’ major trading partners have thin capitalization rules similar to 

section 163(j), but the details of those rules differ among countries. A debt-to-equity 

ratio is often used, but sometimes it is a strict limit (e.g., interest on any debt that exceeds 

 

6

The study in chapter IV of this report examines any inappropriate reductions in U.S. withholding tax that 

provide opportunities for shifting income out of the United States. 

10
the ratio is disallowed) rather than only a safe harbor as it is in the United States. Safe 

harbors employed by other countries include the worldwide group average debt-to-equity 

ratio, or a level that taxpayers can show would be acceptable to a third-party lender. 

Interest-coverage-ratio limits are also commonly employed.7

 

D. Evidence for the Existence and Extent of Earnings Stripping 

1. Foreign-Controlled Domestic Corporations

FCDCs have the opportunity to reduce their U.S. taxable income by leveraging 

their U.S. operations. As noted above, section 163(j) may limit the deductibility of 

“excess interest expense” on loans from related parties in certain circumstances. 

However, there may be continuing opportunities to strip earnings notwithstanding section 

163(j). 

This section examines the evidence for the existence of earnings stripping by 

FCDCs by comparing their profitability and their use of debt to that of DCCs. 

Profitability of FCDCs 

Given that FCDCs have historically been relatively less profitable when compared 

to DCCs, some have suggested the possibility that FCDCs might be improperly reducing 

their U.S. taxable income. The persistence of this lower relative profitability of FCDCs 

is shown on Figure 2.1, which is derived from data from corporate income tax returns for 

large corporations for 1995 through 2003 and that are published in annual articles in the 

Statistics of Income Bulletin.8

 The profitability measure used in the comparison is the 

ratio of net income to total receipts.9

 These data show that, over this period, large 

FCDCs in the nonfinancial sector generally (which includes the manufacturing industry), 

and in the manufacturing industry specifically, were consistently less profitable than large 

DCCs. For most of these years, FCDCs in the financial sector were also less profitable 

than their domestic counterparts. 

 

7

 For more details, see, e.g., IBFD (2006) and Morris (2006). 

8

 http://www.irs.gov/taxstats/bustaxstats/article/0,,id=96311,00.html#2 9

 Profitability is expressed relative to total receipts rather than total assets or equity because of the problems 

associated with assets reported on corporate tax returns. For example, assets are valued at historical book 

value (i.e., the value at the time of acquisition). Newly acquired assets generally have a higher book value 

than the assets they replaced. Comparisons using book-value measures may be misleading if either FCDCs 

or DCCs contain a larger share of corporations with newly acquired assets, such as new corporations. In 

addition, the balance sheet also includes foreign assets and liabilities, and corporations apparently vary on 

how these are stated (e.g., sometimes the foreign assets are on a gross basis and sometimes on a net equity 

basis). Also, corporations that file consolidated tax returns frequently do not net out intercompany assets 

and liabilities. 

Net income is taxable income (total income less total deductions) before special deductions and the net 

operating loss deduction as reported on the corporate tax return (Form 1120, line 28). Total receipts 

include all of the income received by a corporation and reported on its tax return, including gross receipts 

before the deduction for cost of goods sold and business expenses, and interest on tax-exempt obligations. 

Large corporations are those with assets of $250 million or more and/or business receipts of $50 million or 

more. In Figure 2.1, FCDCs are those with 50 percent or more foreign ownership. The data exclude real 

estate investment trusts (REITs), regulated investment companies (RICs), S corporations, and corporations 

with foreign ownership between 25 percent and 50 percent. 

11
Figure 2.1

 Ratio of Net Income to Total Receipts for Large Domestic Corporations by

Control Status and Industry: 1995-2003

Source: SOI Bulletin Articles (http://www.irs.gov/taxstats/bustaxstats/article/0,,id=96311,00.html#2)

Nonfinancial

0

1

2

3

4

5

6

1995 1997 1999 2001 2003

Percent

Financial

-2

0

2

4

6

8

10

12

14

16

1995 1997 1999 2001 2003

Percent

domestically-controlled corporations

foreign-controlled domestic corporations

Manufacturing

0

1

2

3

4

5

6

7

8

1995 1997 1999 2001 2003

Percent

A more detailed examination of the profitability difference in 2004 (the most 

recent y

or, 

 

ear for which tax return information is available) is presented in Table 2.1. It 

compares the ratio of net income to total receipts in all industries, the nonfinancial sect

manufacturing, and the financial sector by ownership category.10 The three categories of 

U.S. corporations displayed are those that are more than 50 percent owned by foreigners, 

10 Table 2.1 is based on tabulations of data from Form 1120, the corporate income tax return. They differ 

somewhat from the tabulations published by the Statistics of Income Division, which were used to 

construct Figure 2.1. Unlike Figure 2.1, Table 2.1 is not restricted to large corporations. Also, Table 2.1 

defines FCDCs as corporations with greater than 50 percent foreign ownership, whereas Figure 2.1 uses 50 

percent or more foreign ownership. 

12
those with 25 percent to 50 percent foreign ownership, and all other corporations 

(referred to here as domestically controlled). The estimated lower profitability of 

compared with DCCs is evident in all groupings. For example, in manufacturing the ratio 

of net income to total receipts is about one-third lower for FCDCs (3.3 percent) than for 

DCCs (4.9 percent). The ratio of net income to total receipts is also substantially lower 

for FCDCs than for DCCs in the nonfinancial and financial sectors. 

FCDCs 

All

Industries Nonfinancial Manufacturing Financial

Ownership Category

Foreign Ownership > 50% 2.9 2.8 3.3 3.9

Foreign Ownership 25 - 50% 3.0 2.9 4.9 6.1

Domestically Controlled 4.3 3.8 4.9 6.6

Foreign Ownership > 50% 10,202 8,243 2,671 1,959

Foreign Ownership 25 - 50% 832 724 238 108

Domestically Controlled 65,550 52,638 10,197 12,912

Table 2.1

The Ratio of Net Income to Total Receipts and Number of Corporate Tax Returns

by Ownership Category and Sector: 2004

Ratio of Net Income to Total Receipts (%)

Number of Corporate Returns in Sample

Notes: These estimates are based on data from corporate income tax returns for 2004. They exclude 

REITs, RICs, S corporations, and branches of foreign corporations filing on Form 1120F. Number of 

returns is unweighted.

The analysis in this section of the study explores the sources of this profitability 

differential. Several explanations for the difference in profitability are possible, such as 

different structure of assets and income, a greater reliance on debt, and the manipulation 

of prices in intercompany transactions. It is also possible that foreign investors 

systematically tend to acquire less promising corporations.

a 

ty of 

93) 

itability of FCDCs is which corporations 

should 

l” 

vesting 

 

11 The low profitabili

FCDCs in the United States has been studied by Grubert, Goodspeed and Swensen (19

and Grubert (1997).12 This section updates the results in some of these earlier studies 

and extends the analysis to the financial sector. 

A basic question in studying the prof

be used as a basis of comparison. Figure 2.1 compares FCDCs to domestic 

corporations that are not foreign controlled, implicitly using the latter as the “contro

group. A similar approach is adopted in this chapter, which uses DCCs as the focus of 

the comparisons with FCDCs. It is possible that multinational corporations (“MNCs”) 

based in the United States (i.e., DCCs with foreign subsidiaries) shift income out of the 

United States. However, excluding U.S. MNCs from the comparison group would leave

purely domestic corporations that may have special characteristics, such as lower 

profitability and fewer intangible assets, which may limit their opportunities for in

abroad. Corporations in the 25 percent to 50 percent foreign ownership category might 

11Most foreign-controlled corporations in the United States were the product of acquisitions and were not 

start-ups. 

12See also Blouin, Collins, and Shackelford (2001).

13
be a potentially suitable control group because minority ownership probably offers fewer

opportunities for income shifting. However, the small size of the 25 percent to 50 

percent foreign ownership category is problematic especially at the level of specific

industries and makes it difficult to use in drawing reliable conclusions. 

Grubert (1997) indicated that one of the asymmetries between FCDCs and DCCs 

is that D

ely 

a

al sector 

d 

e 

d 

 amortization deductions as a share of 

total re

 

CCs receive a substantial amount of income in the form of dividends and 

royalties, mainly from subsidiaries abroad. Therefore, net income does not accurat

reflect the profitability of DCC domestic operations alone. In order to isolate domestic 

operations and some of the more relevant factors that may explain the differences in 

profitability of DCCs and FCDCs, “operating income” is calculated from amounts 

reported on corporate tax returns. Operating income is defined as net income (taxab

income before special deductions and the net operating loss deduction) plus interest 

expense, depreciation, amortization, and depletion and minus interest, dividends, and

royalties received. Thus, operating income is total income with all purely financial 

receipts and deductions eliminated.

le 

 it 

 with the ratio of net income to total receipts shown in Table 2.1 

nd disp

13 It is a better measure than net income, because

focuses on corporations’ U.S. domestic operations (i.e., it adjusts for the relatively large

amount of foreign investment income received by DCCs that is largely unrelated to their 

domestic operations). 

Table 2.2 starts

lays the components of the adjustment from net income to operating income. 

The last row in each section of Table 2.2 shows the ratio of operating income to total 

receipts for FCDCs and DCCs in the nonfinancial sector and in manufacturing, 

respectively.14 Whereas FCDCs are less profitable than DCCs in the nonfinanci

and in manufacturing when the ratio of net income to total receipts is used as the measure

of profitability, that profitability difference disappears when profitability is measured on 

the basis of operating income. In the nonfinancial sector, FCDCs are slightly more 

profitable than DCCs in terms of operating income (6.3 percent for FCDCs compare

with 5.5 percent for DCCs). In manufacturing, FCDCs are significantly more profitabl

than DCCs in terms of operating income (7.9 percent for FCDCs compared with 5.9 

percent for DCCs). An important reason for these differences is that DCCs receive a 

greater amount of dividends and royalties relative to total receipts (which are subtracte

from net income in computing operating income), particularly in manufacturing where 

corporations have significant foreign operations. 

Table 2.2 also shows that depreciation and

ceipts are roughly the same for DCCs and FCDCs. Both interest paid and received

are higher for DCCs than for FCDCs in the nonfinancial sector as well as manufacturing. 

This difference may reflect greater financial activities of DCCs compared with FCDCs, 

and perhaps the difficulties and arbitrariness of classifying corporations that have both 

significant financial and manufacturing aspects of their business. 

13Interest expense, the main subject of this section, is explored separately below. 

14Table 2.2 excludes financial corporations because interest income and expense are an intrinsic part of 

their business operations.

14
Foreign

Control

Foreign

Ownership

25 - 50%

Domestic

Control

Net Income / Total Receipts 2.8 2.9 3.8

Plus:

 Interest Paid / Total Receipts 3.1 1.8 3.8

 Depreciation & Amortization / Total Receipts 4.2 3.9 4.4

 Depletion / Total Receipts 0.1 0.1 0.1

Minus:

 Dividends Received / Total Receipts 0.5 0.5 1.2

 Interest Received / Total Receipts 2.9 0.7 4.4

 Royalties Received / Total Receipts 0.5 1.2 1.0

Operating Income / Total Receipts 6.3 6.3 5.5

Foreign

Control

Foreign

Ownership

25 - 50%

Domestic

Control

Net Income / Total Receipts 3.3 4.9 4.9

Plus:

 Interest Paid / Total Receipts 2.4 2.3 3.2

 Depreciation & Amortization / Total Receipts 4.3 5.0 4.0

 Depletion / Total Receipts 0.1 0.0 0.1

Minus:

 Dividends Received / Total Receipts 0.4 0.7 2.1

 Interest Received / Total Receipts 1.3 0.8 2.4

 Royalties Received / Total Receipts 0.5 1.4 1.8

Operating Income / Total Receipts 7.9 9.3 5.9

Table 2.2

Net Income Adjusted to Operating Income

in the Nonfinancial Sector and Manufacturing

by Ownership Category: 2004

Nonfinancial

Manufacturing

Notes: Shares reported as percentages. Operating Income = Net Income + Interest Paid + 

Depreciation + Depletion - Dividends - Royalties - Interest Received. The estimates are 

based on data from corporate income tax returns for 2004. They exclude RICs, REITs, and 

S corporations.

As noted earlier, the higher profitability of FCDCs compared to DCCs when 

operating income is used as the profitability measure does not mean that FCDCs are not 

shifting income out of the United States. The comparison is at an aggregate level and 

may not account for systematic differences between FCDCs and DCCs at the level of the 

firm that may affect profitability.15 Further, the domestic-corporation control group also 

may be shifting income out of the United States. For example, Figure 2.1 shows that the 

ratio of net income to receipts of U.S. corporations in manufacturing declined 

 

15The statistical analysis summarized below attempts to control for other factors that may affect 

profitability. 

15
substantially from 1995 to 2003, based on the net income (including repatriated foreign 

income) that is reported on corporate tax returns.16,17 

The relationship between net income and operating income is also examined 

using statistical regression methods that can control for other factors that contribute to 

profitability, such as the age of the corporation (based on its date of incorporation) and its 

reliance on outside purchases.18 The age of the corporation is used to test the possibility 

that some of the net income difference between FCDCs and DCCs is attributable to startup costs by relatively immature FCDCs.19 A greater reliance on outside suppliers would 

be associated with a lower ratio of net income to receipts because the corporation would 

require less of its own capital per unit of receipts. For example, wholesalers tend to have 

lower margins on profits on sales than manufacturers because they contribute a smaller 

share of the total value added in the final product. The results based on firm-level data 

from the 2004 corporate tax returns were consistent with the aggregate tabulations in 

Tables 2.1 and 2.2, which were also based on 2004 data. Before the addition of the other 

explanatory variables, the difference in the ratio of net income to total receipts in the 

firm-level analysis was large and about the same magnitude as in Table 2.1. The addition 

of the additional age and purchases explanatory variables to the firm-level analysis 

reduced the initial estimated difference by more than half. The addition of the reliance on 

purchases was particularly significant. When using operating income as the profitability 

measure in the regressions, FCDCs had a substantially higher ratio of operating income to 

receipts than DCCs in both the nonfinancial sector and in manufacturing (consistent with 

Table 2.2). Thus, based on operating income, FCDCs were found to be at least as 

profitable as DCCs. 

Debt and Earnings Stripping 

Section 163(j) is directed at taxpayers that have very high interest expense relative 

to cash flow. Whereas Table 2.2 provided information on average interest expense 

relative to total receipts, this subsection analyzes the distribution of interest paid relative 

to cash flow by FCDCs and DCCs. The distributions are presented for all industries and 

separately for the nonfinancial sector, manufacturing, and the financial sector (excluding 

 

16Grubert (1997) found that the profitability of FCDCs was more clustered near zero than DCCs and were 

more likely to revert to that pattern than DCCs. That result was sensitive to whether profitability was 

expressed relative to sales or assets; the difference was much smaller with sales. The analysis in this 

section does not use assets, because of the measurement problems noted above, such as the problems 

associated with historical book values. 

17Some have also suggested that data showing that the rate of earnings on foreign-owned U.S. assets is less 

than the rate of earnings on U.S-owned foreign assets provide evidence of earnings stripping by foreign 

entities out of the United States. (See, e.g., The Economist (2006) for a general discussion.) However, 

there are other possible explanations. A much greater share of U.S. foreign direct investment abroad is 

start-up rather than acquisitions, whereas most foreign direct investment in the United States is through 

acquisitions. Further, U.S. companies have relatively more intangible assets. In addition, U.S. companies 

may shift income out of the United States, which would raise the measured rate of return on U.S.-owned 

foreign assets above the true rate of return. 

18These results are described in detail in Grubert (2007). In the regression analyses, DCCs include 

corporations in the 25 percent to 50 percent foreign ownership category. 

19The age of a corporation is determined based upon the date of incorporation reported on its tax return. A 

recent incorporation date may indicate a new start-up corporation, but it may also reflect a new 

incorporation as a result of a recent acquisition or merger of previously existing corporations. 

16
insurance and real estate). The extent to which FCDCs and DCCs rely on debt also was 

examined using regression and other statistical methods that attempt to control for firmspecific factors that may affect a firm’s ability to borrow and thus its interest expense. 

The Nonfinancial Sector

Table 2.3 presents the percentage of FCDC and DCC total receipts and total cash 

flow accounted for by corporations in selected intervals of the ratio of interest paid to 

cash flow.20 Cash flow is defined as net income (before net operating loss deductions) 

plus interest paid, depreciation, depletion, and amortization. Therefore, cash flow is total 

receipts less current direct expenses, such as wages and the cost of materials. The ratio of 

interest paid to cash flow is similar to the ratio of net interest expense to adjusted taxable 

income used to calculate disallowed interest in section 163(j). The difference in the two 

ratios is that for purposes of section 163(j) net interest expense is calculated by 

subtracting interest income from gross interest paid to determine net interest expense and 

adjusted taxable income. The ratio of interest paid to cash flow used in this analysis does 

not deduct interest income from gross interest expense in determining interest paid or 

cash flow. 

The ratio of interest paid to cash flow is computed for each corporation. Based on 

the result of that calculation, each corporation is assigned to the appropriate interval of 

the ratio of interest paid to cash flow. The frequency distribution is determined using two 

sets of weights — receipts and cash flow.21 

Table 2.3 indicates that, in the nonfinancial sector and in the manufacturing 

industry, it is very difficult to identify major differences in the frequency of high interest 

expense (i.e., a ratio of interest expense to cash flow of 50 percent or more). In the 

nonfinancial sector, the comparison of FCDCs and DCCs with interest expense equal to 

50 percent or more of cash flow provides mixed results, depending on whether receipts or 

cash flow are used as weights. The share of total receipts is 16.2 percent for FCDCs 

(12.6 percent plus 3.6 percent) and 13.4 percent for DCCs (8.4 percent plus 5.0 percent). 

However, the share of total cash flow is approximately the same for both FCDCs and 

DCCs: 20.4 percent for FCDCs (18.0 plus 2.4 percent) compared to 20.3 percent for 

DCCs (17.5 percent plus 2.8 percent). On the other hand, DCCs with interest expense of 

75 percent or more of cash flow are more likely to have high interest expense than 

FCDCs using either receipts or cash flow as weights. 

In the manufacturing industry, DCCs are somewhat more likely than FCDCs to 

have high interest expense in relation to cash flow. FCDCs with interest expense equal to 

50 percent or more of cash flow accounted for 10.4 percent of FCDC total receipts (6.6 

percent plus 3.8 percent) and 10.6 percent of FCDC total cash flow (7.9 percent plus 2.7 

percent). In contrast, DCCs with interest expense equal to 50 percent or more of cash 

flow accounted for 13.7 percent of DCC total receipts (8.8 percent plus 4.9 percent) and 

16.2 percent of DCC total cash flow (14.0 percent plus 2.2 percent). 

 

 

20Corporations with 25 percent to 50 percent foreign ownership are not included in Table 2.3. 

21These measures were used as weights in the frequency distribution because they take into account 

corporations’ varying size. A frequency distribution based on the number of corporations would be 

misleading because it would assign the same weight to small corporations as to large corporations. 

17
Foreign 

Control

Domestic 

Control

Foreign 

Control

Domestic 

Control

.00 ≤ ratio < .25 62.7 61.9 50.1 49.0

.25 ≤ ratio < .50 19.1 22.4 21.5 21.1

.50 ≤ ratio < .75 12.4 8.7 16.1 17.0

.75 or more 5.9 7.0 12.3 13.0

Total 100.0 100.0 100.0 100.0

Foreign 

Control

Domestic 

Control

Foreign 

Control

Domestic 

Control

.00 ≤ ratio < .25 64.4 63.8 55.6 56.5

.25 ≤ ratio < .50 19.4 22.7 24.1 23.1

.50 ≤ ratio < .75 12.6 8.4 18.0 17.5

.75 or more 3.6 5.0 2.4 2.8

Total 100.0 100.0 100.0 100.0

Foreign 

Control

Domestic 

Control

Foreign 

Control

Domestic 

Control

.00 ≤ ratio < .25 69.3 61.1 62.7 62.4

.25 ≤ ratio < .50 20.3 25.2 26.6 21.5

.50 ≤ ratio < .75 6.6 8.8 7.9 14.0

.75 or more 3.8 4.9 2.7 2.2

Total 100.0 100.0 100.0 100.0

Foreign 

Control

Domestic 

Control

Foreign 

Control

Domestic 

Control

.00 ≤ ratio < .25 16.7 18.5 16.7 9.5

.25 ≤ ratio < .50 9.1 16.4 6.5 10.8

.50 ≤ ratio < .75 5.0 15.2 5.2 14.5

.75 or more 69.1 49.9 71.6 65.3

i. .75 ≤ ratio < .90 18.8 25.6 17.9 27.9

ii. .90 ≤ ratio < .95 37.9 4.8 39.1 6.1

iii. .95 ≤ ratio < 1.0 1.4 18.0 2.5 29.7

iv. ratio ≥ 1 11.0 1.5 12.1 1.6

Total 100.0 100.0 100.0 100.0

Interest Paid/Cash Flow

Percentage of Percentage of

Percentage of Percentage of

Percentage of Percentage of

Percentage of Percentage of

Interest Paid/Cash Flow

Total Receipts

Note: These estimates are based on data from corporate income tax returns for 2004. They 

exclude REITs, RICs, S corporations, and branches of foreign corporations filing on Form 

1120F and corporations in the 25 percent to 50 percent ownership category. The financial 

sector excludes insurance and real estate.

 Total Receipts Total Cash Flow

Interest Paid/Cash Flow

Total Receipts Total Cash Flow

Financial

Total Cash Flow

Manufacturing

Table 2.3

Distribution of the Ratio of Interest Paid to Cash Flow: 2004

Nonfinancial

Interest Paid/Cash Flow

 Total Receipts Total Cash Flow

All Industries

18
The comparison of FCDCs and DCCs in manufacturing with interest expense 

equal to 75 or more of cash flow yields a somewhat more mixed picture, with the result 

depending on whether receipts or cash flow are used as weights. Corporations with 

interest expense equal to 75 percent or more of cash flow account for 3.8 percent of 

FCDC total receipts compared to 4.9 percent of DCC total receipts. However, 

corporations with interest expense equal to 75 percent or more of cash flow accounted for 

2.7 percent of FCDC total cash flow compared to 2.2 percent of DCC total cash flow. 

The extent to which FCDCs and DCCs rely on debt, including the frequency with 

which corporations have high interest expense, was also examined with regressions and 

other statistical methods using firm-level tax return data. These statistical analyses 

supplement the analysis in Table 2.3 by controlling for a number of factors that may 

increase a corporation’s ability to borrow, such as a liquid composition of assets and a 

large amount of interest income. Like Table 2.3, the indicator of interest expense used in 

the regression analysis is the ratio of interest expense to cash flow. In the numerator of 

that ratio, interest income is not deducted from interest expense. However, in the 

regression analysis, the ratio of interest income to total receipts (or alternatively cash 

flow) is included as an explanatory variable to reflect the possibility that corporations 

with greater interest income can be more highly leveraged.22

The statistical analysis indicated that on average FCDCs in the nonfinancial sector 

and in the manufacturing industry had interest expense relative to cash flow virtually the 

same as comparable DCCs.23 In addition, the firm-level statistical analysis examined 

whether FCDCs were more likely to have high levels of interest expense in relation to 

cash flow, using the section 163(j) threshold of 50 percent (without the 163(j) netting of 

interest income from interest expense). The results show that in 2004 FCDCs were less 

likely to be above the threshold than were comparable DCCs. They were also less likely 

to have a ratio of interest paid to cash flow greater than 75 percent. 

The Financial Sector

Corporations in the financial sector generally have much greater leverage than 

corporations in the nonfinancial sector. Because financial corporations are much more 

likely to be highly leveraged than nonfinancial corporations, a threshold ratio of interest 

expense to cash flow of 90 percent, rather than the 50 percent threshold discussed above, 

may be a more appropriate measure of high interest expense. Using the 90-percent 

threshold ratio of interest expense to cash flow, Table 2.3 shows that FCDCs in the 

financial sector24 do seem to be more likely to have high levels of interest expense 

relative to cash flow compared to DCCs, but the comparison is not completely 

unambiguous. Corporations with interest expense of 90 percent or more of cash flow 

 

22The regression analysis does not use debt measures based on the balance sheet that corporations submit as 

part of their corporate tax return. The balance sheet data are unreliable for this purpose for several reasons, 

including the historical book value and other measurement problems discussed above. Cash flow may be a 

better indicator of the true value of assets. 

23Utilities are excluded from the nonfinancial sector in the regressions because of the special features of 

rate regulated industries, such as the ability to issue a large amount of debt. 

24Insurance corporations and real estate corporations are excluded from the financial sector for this purpose 

because they are likely to have a much different relationship between interest expense and cash flow than 

other financial intermediaries. 

19
account for 50.3 percent of FCDC total receipts25 compared to 24.3 percent of DCC total 

receipts,26 and 53.7 percent of FCDC total cash flow27 compared to 37.4 percent of DCC 

total cash flow.28 In the financial sector, FCDCs are also much more likely than DCCs to 

have interest expense greater than or equal to cash flow, measured either in terms of the 

share of total receipts or total cash flow. However, a greater share of total receipts and 

total cash flow are above the 95-percent threshold for DCCs than for FCDCs. A 

significant share of DCC total receipts and total cash flow (18.0 percent and 29.7 percent, 

respectively) fall in the 95 percent to 100 percent category.29 

A more detailed examination of corporations in selected industries within the 

financial sector (commercial banks, securities dealers and investment banks, stock life 

and property and casualty insurance, and real estate) indicated that FCDCs in those 

industries exhibit a wide range of profitability. Commercial bank FCDCs had a slightly 

lower ratio of net income to receipts than domestically controlled banks, but any 

discrepancy seems largely attributable to the greater amount of dividends that domestic 

banks receive. Domestically controlled international banks receive dividends from their 

foreign affiliates, but in the case of banks that are FCDCs the comparable dividends go to 

the home country. However, the profitability differential between FCDCs and DCCs that 

are securities dealers and investment banks was substantial in 2004, with net income 

equal to 4.2 percent of receipts for FCDCs compared to 7.1 percent for DCCs, and a wide 

disparity was also notable in 2002 and 2003, the other years examined in detail. The ratio 

of net income to receipts was similar for stock life insurance FCDCs and their 

domestically controlled counterparts in 2004 (as well as in 2002 and 2003). However, 

stock property and casualty FCDCs were much less profitable than DCCs, net income 

being equal to 1.4 percent of receipts for the former versus 6.4 percent for the latter. The 

FCDCs in property and casualty insurance also had large losses in 2002 when DCCs were 

profitable and they had meager profits compared to DCCs in 2003. Finally, FCDCs in 

real estate had a higher ratio of net income to receipts than comparable DCCs in each of 

the three years and they also had much less debt. 

As in the case of nonfinancial industries above, firm-level analysis of the debt and 

interest expense in commercial banking and in securities dealing and investment banking 

was undertaken. This makes it possible to control for the type of assets a corporation 

holds and whether it receives substantial financial income, such as interest. The issue is 

whether FCDCs in these sectors are much more likely to have high interest expense 

relative to cash flow.30 

 

2550.3 percent is the sum of 37.9 percent, 1.4 percent and 11.0 percent. 

2624.3 percent is the sum of 4.8 percent, 18.0 percent and 1.5 percent. 

2753.7 percent is the sum of 39.1 percent, 2.5 percent and 12.1 percent.

2837.4 percent is the sum of 6.1 percent, 29.7 percent, and 1.6 percent. 

29Corporations in the financial sector tend not to be constrained by 163(j) because they can net interest 

income from interest paid. Because financial intermediaries earn an interest spread, they can frequently 

have negative net interest expense. 30As above in the case of nonfinancial corporations, cash flow is defined as the sum of net income, interest 

paid, depreciation expense, depletion, and amortization. Unlike section 163(j), interest income is not netted 

from interest expense in the numerator of the interest expense-to-cash-flow ratio in calculating which 

corporations are above the threshold.

20
 In the case of commercial banks, FCDCs were somewhat more likely to be above 

the 90-percent threshold than comparable DCCs. In securities dealing and investment 

banking FCDCs the difference was much larger. For example, the probability that a 

domestic corporation in securities dealing and investment banking paid more than 90 

percent of cash flow in interest was very low, but greater than 40 percent in the case of 

FCDCs. FCDCs were also much more likely to pay more than 95 percent of their cash 

flow in interest. 

Summary 

The analyses of corporate tax return data for 2004 did not find conclusive 

evidence that FCDCs have very high interest expense relative to cash flow compared to 

DCCs in the nonfinancial sector and in the manufacturing industry.31 In the financial 

sector, FCDCs in securities dealing and investment banking appear to have very high 

interest expense relative to cash flow. However, in general it is difficult to make precise 

estimates or to draw firm conclusions because of the possibility of alternative 

explanations and the problems with using DCCs as a comparison group. 

2. Inverted Corporations 

 In contrast to the data on all FCDCs, data on ICs strongly suggest that these 

corporations are shifting substantially all of their income out of the United States, 

primarily through interest payments. 

 Seida and Wempe (2004) compare pre-inversion taxes and post-inversion taxes 

paid by ICs.32 They find large reductions in effective tax rates and evidence of 

widespread income shifting out of the United States. (Because Seida and Wempe use 

accounting data from annual reports, “IC” in the context of their study refers to the 

consolidated worldwide group rather than simply the U.S. subsidiaries of the group.) 

 The authors examine the financial statements of 12 ICs and 24 similar control 

corporations (selected based in part on industry classification and level of sales) and find 

that ICs had a significantly larger increase in foreign income and profit margin and a 

significantly larger decrease in U.S. profit margin and effective tax rate than the control 

corporations. For the ICs, the foreign profit margin nearly doubles, the U.S. profit 

margin is driven negative, and the worldwide effective tax rate is reduced by one-third. 

 

31It should be noted that the number of ICs are so small in number relative to all other FCDCs that any 

earnings stripping or lack of earnings stripping activity by ICs would have a very negligible effect on the 

data relating to FCDCs. 

32Seida and Wempe select inverted corporations for their study by the following procedure. They searched 

SEC filings for corporations domiciled in one of the 41 countries identified as tax havens in the OECD 

2000 Progress Report. They made sure that corporations had at least one year of Compustat data available, 

moved their domicile from the United States, were not private corporations immediately before and after 

inversion, did not have a contemporaneous event (such as a spin-off) at the time of their inversion, went 

through with their proposed inversion, and were not insurance corporations (which the authors assert do not 

consistently disclose the geographic sources of pre-tax income). Seida and Wempe’s sample of 12 

corporations, thus, appears to exclude a number of corporations they would consider to be inverted but for 

which insufficient data are available for their study purposes, for which the effects of an inversion cannot 

be isolated easily, or are corporations that inverted from a country other than the United States. Seida and 

Wempe study only corporations, not other types of businesses. They also do not study tax-haven 

corporations generally. When we discuss inverted corporations in the context of Seida and Wempe’s study, 

the term “ICs” will have the meaning of an inverted corporation as they have selected.

21
The authors conclude that these data are consistent with the view that the primary 

motivation for U.S. inversions is to reduce U.S. taxation significantly. 

 The authors look more closely at four ICs that provide detailed information on the 

levels of intercompany debt and interest and fee expense. The authors show that the 

levels of these items increased significantly post-inversion. For three of the four 

corporations, the amounts of these items located in the U.S. operations of the corporation 

can be determined and, in each case, most of the long-term debt and interest and fee 

expense is attributable to the U.S. operations.33 These data are consistent with the view 

that the primary means of income shifting by these corporations is through related-party 

debt and interest payments, in other words earnings stripping. 

 The Treasury Department extended the analysis of earnings stripping by all 

FCDCs, described in section 1 above, by creating an indicator for ICs. Of the 12 ICs 

studied by Seida and Wempe, two had been acquired by U.S. corporations by 2002 and, 

thus, were no longer inverted. All the necessary data for three other corporations could 

not be obtained, probably because they were not large enough to be in the top 7,500 

corporations that comprise our sample of corporate tax returns. 

 For the remaining seven corporations, the primary U.S. taxpaying entity was 

determined by comparing subsidiaries listed in parent-corporation annual reports for 2002 

with those listed on the 2002 IRS Form 851 (which lists subsidiaries included in a 

consolidated filing) of the U.S. filing entity. These primary U.S. taxpaying corporations 

were extremely unprofitable. 

 The Treasury Department also examined the payments declared on Form 5472 for 

these seven corporations.34 These data suggest the majority of stripping is through 

interest, but some takes place through royalties. This is not surprising, because interest 

and royalties are the two major deductible income payments made between corporations, 

and treaty withholding-tax rates are often zero for interest and royalties. 

 This analysis differs somewhat from Seida and Wempe’s work in that it compares 

ICs to a large number of other FCDCs and domestic corporations that did not invert for a 

single year, while Seida and Wempe compare differences in profitability pre-inversion 

and post-inversion between ICs and their close competitors who did not invert for the 

three years immediately prior to and immediately after inversion. The inversions they 

analyze occurred in the time period from 1994 to 2002. The differences in methodology 

help provide independent confirmation of the conclusions. 

There do not appear to have been any high-profile inversions as defined by Seida 

and Wempe since 2002, which may be due to the enactment of section 7874. While 

section 7874 has likely prevented new inversions, those that occurred before the March 4, 

2003 effective date are grandfathered. These existing, grandfathered ICs are the 

corporations that Seida and Wempe studied and that have been analyzed in this study.

 

33Disclosure of data on intercompany debt and interest and fee expense are required by SEC regulations 

when a subsidiary issues debt guaranteed by its parent. 

34The Form 5472 is an information return of a 25 percent or more foreign-owned U.S. corporation or a 

foreign corporation engaged in a U.S. trade or business. It includes data on transactions between FCDCs 

and foreign related parties. 

22
E. The Effectiveness of Section 163(j) in Preventing Income Shifting 

Because we are unable to quantify accurately the extent of income shifting by 

FCDCs generally, it is not possible to determine with precision whether section 163(j) is 

effective in preventing it. Some have suggested that the absence of strong evidence of 

earnings stripping by FCDCs indicates that earnings-stripping rules of section 163(j) are 

serving their intended purpose. Others believe that the data are not certain enough to 

support this conclusion. 

 As discussed above, however, there is strong evidence that ICs are stripping. 

Seida and Wempe (2004) state that section 163(j) is ineffective in stopping the stripping 

of essentially 100 percent of their income out of the United States by the four ICs for 

which sufficiently detailed data are available. The authors state that all four corporations 

appear to be within the 1.5-to-1 debt-to-equity safe harbor of section 163(j). They do not 

discuss whether or not the 50 percent of adjusted taxable income limit is exceeded by the 

related-party interest payments of ICs. These data indicate that at the very least 

modifications to section 163(j) are needed to address the problems of earnings stripping 

by existing ICs. 

F. The Effect of Deficiencies of Earnings Stripping Provisions on the 

Competitiveness of U.S.-Based Businesses 

 Any deficiencies of the U.S. earnings-stripping provisions that allow foreignbased corporations to strip earnings out of the United States without allowing U.S. 

corporations to do so provide a tax advantage to foreign corporations that do business in 

the United States and, therefore, provide them with a competitive advantage. 

 Among the FCDCs, the ICs provide the clearest evidence of earnings stripping 

out of their U.S. operations. Earnings stripping by ICs puts U.S.-based businesses at a 

competitive disadvantage. 

G. The Impact of Earnings Stripping Activities on the U.S. Tax Base 

 As discussed above, the Treasury Department cannot accurately quantify earnings 

stripping by FCDCs. Thus, the effect on the U.S. tax base is unclear. However, Seida 

and Wempe (2004) calculate the reduction in tax revenue to the U.S. Treasury for the 

four ICs for which they have sufficient data to be in excess of $700 million for the twoyear period from 2002 to 2003. As these four corporations are a subset of the total 

number of ICs, the revenue loss for all ICs would be considerably larger. 

H. The Effect of Foreign Laws on Stripping of Earnings Out of the United 

 States 

 Foreign country tax laws may facilitate the stripping of income out of the United 

States. For example, foreign corporations based in no-tax or low-tax countries gain from 

stripping income from the United States to those countries by the differential in tax rates 

multiplied by the amount of stripped income. Other corporations may be based in hightax countries that exempt or allow deferral of tax on income earned offshore, so that 

corporations resident in those countries can strip income from the United States to a third, 

no-tax or low-tax country without incurring either U.S. tax or tax in their home countries. 

23
 There are many no-tax or low-tax countries, many high-tax countries with special 

low-rate offshore regimes, and many high-tax countries that allow exemption or deferral 

of foreign source active income. On the other hand, many high-tax countries have rules 

(known as controlled foreign corporation (“CFC”) rules) designed to tax foreign earnings 

currently if earned in low-tax countries. These rules, thus, may discourage corporations 

resident in those countries from stripping earnings out of the United States. 

I. The Effect of Changes to the Earning-Stripping Rules on Jobs in the United 

States 

 The effect of cross-border income stripping on employment has two components: 

(1) the effect of income stripping on cross-border investment, and (2) the effect of crossborder investment on employment. This section reviews the economics literature 

evaluating both of these effects.35 

1. The Effect of Taxation and Income Stripping on Corporate Investment

 Multinational corporations (“MNCs”) can shift income out of high-tax countries 

and allocate it to low-tax countries by several means, including leverage, royalty 

payments, and transfer pricing. All of these techniques can be used to increase 

deductions on investment in high-tax countries, thereby lowering the effective tax rate 

and raising the after-tax return on that investment. The critical tax rate for income 

shifting is the differential between the nominal corporate tax rates in the home and host 

countries (or, where a MNC has multiple subsidiaries, the corporate tax rate differential 

between the high-tax and low-tax host countries). Because the United States has high 

statutory corporate tax rates relative to other member countries of the Organisation for 

Economic Cooperation and Development (OECD),36 it is likely that income shifting 

would be used to strip taxable income out of the United States. 

 The effect on investment of international tax differentials and the income shifting 

opportunities to which they give rise is ambiguous. By lowering the effective tax rate in 

high-tax jurisdictions, income shifting may support investment in those jurisdictions. 

However, the capacity to shift income may lead corporations to invest in low-tax 

jurisdictions in order to allocate taxable income to those jurisdictions. In general, income 

shifting lowers a corporation’s marginal cost of capital in both home and host countries.37

 How international corporate tax differentials affect corporate investment is 

ultimately an empirical question. The literature on the effect of international tax 

differentials on foreign direct investment is reviewed in de Mooij and Ederveen (2003). 

Analyzing the results of 25 different studies of the effect of international tax differentials 

on foreign direct investment (“FDI”), the authors find a median elasticity of foreign 

investment to the host-country tax rate of -3.3, indicating that a 1-percent decrease in the 

corporate tax rate will lead to a 3.3-percent increase in foreign direct investment. 

Relatively high U.S. corporate tax rates, thus, likely decrease foreign investment in the 

United States. However, existing empirical work does not address the question of 

whether income shifting raises or lowers the level of investment in high-tax countries. 

 

35The literature does not focus exclusively on earnings stripping through related party debt. Thus, the 

discussion in this section refers to income stripping. 

36CBO (2005). 

37Grubert (2003). 

24
2. The Effect of Foreign Investment on Employment

 As Baldwin (1995) points out, U.S. employment depends more on domestic 

factors such as labor and product-market flexibility and work-force composition than on 

the level of foreign investment or trade. In equilibrium, any increase (decrease) in 

foreign investment is likely to be at least partially offset by a decrease (increase) in 

domestic investment because the capital inflow (outflow) will alter domestic factor prices 

as well as the exchange rate, if it is flexible. 

 For example, an increase in inbound foreign investment creates higher demand for 

U.S. factors such as labor, thereby reducing unemployment and/or raising wages. To the 

extent that it increases wages, it will crowd out some domestic investment and labor 

demand, dampening the expansionary effects of the capital inflow. Higher real wages 

also result in increased import demand and reduced export demand. The initial capital 

inflow may appreciate the U.S. dollar, which will also tend to lower the trade balance.38 

J. Conclusions 

The focus of this chapter is on earnings stripping by FCDCs. FCDCs have 

opportunities to reduce their U.S. taxable income by leveraging their U.S. operations with 

debt, the interest on which is tax exempt or partially tax exempt for the recipient. The 

possibility that FCDCs may be reducing their taxable income is suggested by the fact that 

historically they have been relatively unprofitable compared to the DCCs. However, an 

analysis of corporate tax return data for 2004 did not find conclusive evidence that the 

reason for the low profitability of FCDCs compared to DCCs is a result of earnings 

stripping. 

 In 2004, FCDCs in the nonfinancial sector did not have higher average levels of 

interest expense relative to cash flow than DCCs. Further, an analysis of the ratio of 

interest expense relative to cash flow found that FCDCs also are not more likely to have 

high interest expense (e.g., interest expense equal to 50 percent or more of cash flow) 

than DCCs. Although FCDCs in the nonfinancial sector historically have earned lower 

net income as a percentage of receipts than DCCs, for 2004 the difference in relative net 

income was largely attributable to the larger amount of dividends and royalties relative to 

receipts for DCCs, particularly in the manufacturing industry where corporations have 

significant foreign operations. Nevertheless, the absence of conclusive evidence does not 

imply that FCDCs in the nonfinancial sector are not engaging in earnings stripping. The 

 

38Although foreign investment may have little effect on long-run total employment, it may nonetheless alter 

the composition of employment, thereby affecting wages for different segments of the labor force. For 

example, an OECD (1994) employment study shows that foreign investment by industrialized countries in 

developing countries may erode employment in labor-intensive industries in industrialized countries. Riker 

and Brainard (1997) corroborate this finding, showing that MNCs tend to allocate jobs according to 

national skill levels, with skilled employment concentrated in industrialized countries and unskilled 

employment concentrated in developing countries. Thus, foreign investment both into and out of the 

United States may decrease demand for unskilled U.S. labor but increase demand for skilled U.S. labor. 

25
comparison group includes DCCs with foreign subsidiaries that also may be earnings 

stripping by locating debt from their global operations in the United States. 

In the financial sector, FCDCs in different industries exhibited widely different 

profitability. For example, FCDCs in real estate were more profitable than DCCs, 

FCDCs and DCCs in the stock life insurance industry were similarly profitable, but 

FCDCs in property and casualty insurance were much less profitable than DCCs. FCDCs 

in securities dealing and investment banking were much less profitable than DCCs in that 

industry and were much more likely to have very high interest expense relative to cash 

flow. 

 In view of those findings, it is difficult to make precise estimates or to draw firm 

conclusions. Because the Treasury Department is unable to quantify accurately the 

extent of earnings stripping by FCDCs generally, it is not possible to determine with 

precision whether section 163(j) is effective in preventing earnings stripping by FCDCs. 

 There is strong evidence that ICs are stripping a significant amount of earnings 

out of their U.S. operations and, consequently, it would appear that section 163(j) is 

ineffective in preventing them from engaging in earnings stripping. 

 The relative lack of evidence of earnings stripping by FCDCs generally relative to 

ICs might be seen to suggest that earnings stripping is less attractive to FCDCs than to 

ICs. This may be due in part to the fact that foreign parents of ICs are based in no-tax or 

low-tax countries, while many foreign parents of FCDCs are based in high-tax countries 

whose laws may cause reductions in U.S. taxes from interest payments to be partly or 

fully offset by increased foreign taxes on the interest income. Another possible 

explanation may be that it is easier to quantify income stripping by ICs because ICs can 

be compared to the same corporations pre-inversion. In contrast, our comparison group 

for FCDCs is DCCs, which differ in many more ways besides country of incorporation. 

 The effect of earnings stripping on the U.S. tax base is unclear, because we cannot 

accurately quantify earnings stripping by FCDCs generally. However, Seida and Wempe 

(2004) calculate the reduction in tax revenue to the U.S. Treasury for the four ICs for 

which they have sufficient data to be in excess of $700 million for the two-year period 

from 2002 to 2003. As these four corporations are a subset of the total universe of ICs, 

the revenue loss for all ICs would be considerably larger. 

 Any deficiencies of the U.S. earnings-stripping provisions that allow foreignbased corporations to strip earnings out of the United States without allowing U.S. 

corporations to do so provide a U.S. tax advantage to foreign corporations that do 

business in the United States. Foreign taxes may partially or fully offset this tax 

advantage, however. The tax laws of foreign countries encourage earnings stripping out 

of the United States to the extent that the interest income is subject to little or no foreign 

tax. 

 The overall effect of income stripping on U.S. employment is also unclear. The 

theoretical effect of income shifting on cross-border investment in the United States is 

ambiguous, because income shifting may either increase or decrease investment in a 

high-tax country. Empirical studies show that foreign direct investment depends 

negatively on a country’s corporate tax rate. Relatively high U.S. corporate tax rates, 

26
thus, likely decrease foreign investment in the United States. However, existing studies 

do not address the question of how income shifting affects cross-border investment. The 

level of investment by multinationals is unlikely to affect total employment significantly 

in the United States, unless there is unemployment in the markets for labor whose skills 

foreign investors demand. 

K. Recommendations to Improve Earnings Stripping Provisions 

 In the last five years, a number of proposals to tighten the rules of section 163(j) 

have been suggested. The findings of this study provide a fresh opportunity to examine 

these proposals. Consequently, in light of these findings and the Congressional request to 

provide recommendations based on our conclusions in this study, the Treasury 

Department analyzed a number of proposals aimed at restricting the ability of FCDCs and 

ICs to strip income out of the United States. These are discussed in more detail below. 

1. Certain Recent Earnings Stripping Proposals

There are three recent and significant legislative proposals regarding earnings 

stripping. The first of these proposals was included in S. 1637, the “Jumpstart our 

Business Strength Act” in 2004. This proposal would tighten the current earningsstripping rules, but only for corporations that entered into certain inversion transactions 

described in the proposal. With respect to these corporations, the proposal would 

eliminate the debt-to-equity safe harbor and would reduce the threshold for excess 

interest expense to 25 percent of adjusted taxable income. The excess limitation 

threshold would be modified so that 25 percent of adjusted taxable income over a 

corporation’s net interest expense for the year (if any) could be carried forward three 

years. 

After this proposal was made, AJCA enacted section 7874, which provides 

special rules regarding the taxation of inversion transactions. The adoption of a proposal 

such as the one proposed in S. 1637 would require some consideration of the need to 

coordinate the two provisions (e.g., effective dates and the inversion transactions subject 

to the two rules). 

The second recent legislative proposal was S. 1475, the “Promote Growth and 

Jobs in the USA Act of 2003.” The proposal would provide a special exception for any 

corporation that could be subject to section 163(j) as a result of a related-party guarantee 

if the taxpayer could establish to the satisfaction of the Secretary of the Treasury that it 

could borrow a substantially similar amount of money without the guarantee. 

The third recent legislative proposal regarding section 163(j) was included in H.R. 

5095, the “American Competitiveness Act of 2002.” This proposal would strengthen the 

rules of section 163(j) in several ways, regardless of whether the corporation entered into 

an inversion transaction. With respect to the interest-disallowance rule, the proposal 

would eliminate the debt-to-equity safe harbor and would reduce the threshold for excess 

interest expense from 50 percent to 35 percent of adjusted taxable income. Disallowed 

interest could be carried over for five years, but excess limitation could not be carried 

over. 

 The proposal would also add an additional interest-disallowance rule that would 

generally disallow related-party interest expense to the extent that the U.S. subsidiaries of 

27
a foreign parent are more highly leveraged than the overall worldwide corporate group. 

Disallowed interest and excess limitation could not be carried forward. Financial 

corporations would be treated as a separate sub-group for purpose of the test. The 

amount of total interest expense disallowed would be the greater of the current-law 

disallowance rule, as modified, or the additional interest-disallowance rule. 

2. President’s Budget Proposals

 The President’s Budget proposal for FY 2004 also contained a proposal to amend 

section 163(j) in several ways. First, the proposal would replace the existing debt-toequity safe harbor with a safe harbor based on a series of debt-to-asset ratios in order to 

make the safe harbor more sensitive to the ability of different types of assets to support 

debt. Interest would be disallowed only if a corporation’s debt exceeds the safe harbor 

amount so computed. Second, the proposal would reduce the threshold for excess 

interest expense to 35 percent of adjusted taxable income. Similar to the proposal in H.R. 

5095, this proposal would add a new disallowance provision based on a comparison of 

domestic and worldwide indebtedness, and the amount of interest disallowed would be 

the greater of the amounts disallowed under the present-law rule, as modified, or the new 

disallowance rule. Third, the proposal would limit the carryover of any disallowed 

interest to five years and would allow no carryover of interest disallowed under the 

domestic-worldwide indebtedness test. The proposal would eliminate the carryover of 

excess limitation. 

 Each of the President’s Budget proposals for FY 2005 through FY 2008 contained 

the same modified section 163(j) proposal. The debt-to-equity safe harbor would be 

eliminated. The adjusted taxable income threshold for the limitation would be reduced 

from 50 percent to 25 percent of adjusted taxable income (as opposed to the 35 percent 

limit in the 2004 proposal) with respect to disqualified interest other than interest paid to 

unrelated parties on debt that is subject to a related-party guarantee. Interest on 

guaranteed debt generally would be subject to the current law 50 percent of adjusted 

taxable income threshold. The carryforward for disallowed interest would be limited to 

10 years, and the carryforward of excess limitation would be eliminated. 

3. Additional Proposals

 The Staff of the Joint Committee on Taxation in its report entitled “Additional 

Options to Improve Tax Compliance” proposed a change to the reporting required with 

respect to section 163(j).39 The proposal would require a taxpayer to report to the IRS 

whether any portion of its interest deduction is disallowed for the taxable year under 

section 163(j). If any part of the taxpayer’s deduction is disallowed, the taxpayer would 

also be required to report its computation of how much disqualified interest was paid or 

accrued during the taxable year, the payees of such interest, and the amount of 

disqualified interest carried forward. 

 

39Joint Committee on Taxation (2006). 

28
4. Analysis and Recommendation

Proposals Limited to ICs 

 The proposals described above generally would limit corporations’ ability to 

engage in earnings stripping through related-party debt by tightening the rules of section 

163(j). Most of them would apply to all FCDCs. One of these proposals, S. 1637, 

would tighten the rules of section 163(j) only with respect to ICs as described in the 

provision. 

 Proponents of rules like those found in S. 1637 often argue that there is no 

evidence of earnings stripping outside the context of ICs and, consequently, if there is 

any need to strengthen the rules of section 163(j), these amendments should apply only to 

corporations that have engaged in inversion transactions. In fact, this study was unable to 

quantify accurately the extent of earnings stripping by FCDCs, but did find strong 

evidence that ICs are stripping a significant amount of earnings out of their U.S. 

operations. Proponents of such a proposal may assert that this study supports their view. 

 It should be kept in mind that this study does not determine that FCDCs were not 

stripping. It simply could not be determined that they were, and that may be explained, 

in part, by the additional difficulty of showing stripping by FCDCs relative to ICs. With 

respect to ICs, there is an event study comparing an IC’s earnings in the United States 

before and after the event of inverting. Consequently, it is far easier to determine that 

these ICs are stripping. In contrast, with respect to FCDCs there is no single event for 

which the comparison of the earnings of the U.S. operations before and after is 

instructive. Thus, it is only possible to examine the earnings of FCDCs over time in the 

United States and relative to DCCs. These earnings have declined over time and are 

lower than the earnings of DCCs. However, this is not conclusive evidence of earnings 

stripping. 

 In addition, to the extent that section 163(j) provides opportunities for earnings 

stripping, these opportunities are not limited to inversion transactions. These 

opportunities are present in cases where a U.S. business is structured from the outset with 

a foreign parent and in cases where a foreign corporation acquires a U.S. operating group. 

In fact, there does not appear to be any mention of a difference in the ability to satisfy the 

requirements of section 163(j) by ICs relative to FCDCs in the literature or articulated by 

proponents of a proposal such as S. 1637. 

Debt to Equity Safe Harbor 

 Many of the proposals would eliminate the debt-to-equity safe harbor. Seida and 

Wempe (2004) state that all four ICs they studied in detail appeared to be within the debtto-equity safe harbor. It is not clear how this is accomplished. Commentators have 

noted, however, that many U.S. corporations have debt-to-equity ratios that exceed 1.5 to 

1. For example, the capital structure of multinational businesses may vary based on their 

lines of business and what the market will bear with respect to such a business. 

Consequently, some commentators have argued that the debt-to-equity safe harbor should 

not be eliminated but should be modified to reflect this reality. 

 The President’s Budget proposal for FY 2004 was an effort to be responsive to 

such arguments and would replace the existing debt-to-equity safe harbor with a safe 

29
harbor based on a series of debt-to-asset ratios in order to make the safe harbor more 

sensitive to the ability of different types of assets to support debt. However, some 

commentators argued that even this proposal was insufficiently sensitive to differences in 

certain assets’ ability to support debt. Other commentators argued that this proposal was 

unduly complex in its attempt at greater precision. 

 The President’s Budget proposals for FY 2005 through FY 2008 take a simpler 

approach and eliminate the debt-to-equity safe harbor. The Treasury Department found 

that modifying the debt-to-equity safe harbor to take into account different levels of 

leverage supportable by different assets was too complex and that almost any 

generalization regarding the ability of the assets of a corporation to support debt, even 

within limited classes of assets, meant that at least some taxpayers would believe the test 

was insufficiently precise. Given this concern, the Treasury Department determined in 

this case that the policy goal of simplicity was paramount. 

Additional Disallowance Rule 

 Both H.R. 5095 and the President’s Budget proposal for FY 2004 would add an 

additional interest-disallowance rule that would generally disallow related-party interest 

expense to the extent that the U.S. subsidiaries of a foreign parent are more highly 

leveraged than the overall worldwide corporate group. Interest disallowed under this rule 

could not be carried forward and excess limitation also could not be carried forward. 

Financial corporations would be treated as a separate sub-group. The amount of total 

interest expense disallowed under this provision would be the greater of the current-law 

disallowance rule, as modified, or the new disallowance rule. 

 Commentators noted that the additional disallowance rule would add additional 

complexity to section 163(j). The tracking of foreign assets and debt required in the 

domestic-to-foreign debt comparison was seen as burdensome and difficult to apply. 

Given these comments, the Treasury Department determined that the policy goal of 

simplicity was better served by having only one disallowance rule. 

Guaranteed Debt 

 One of the proposals (the President’s Budget proposal for FY 2005 through FY 

2008) would apply a different excess-interest-expense threshold for guaranteed debt and 

one of the proposals (S. 1475) would loosen the rules related to guaranteed debt. Some 

have argued that guaranteed debt does not increase the likelihood of base erosion as 

compared with non-guaranteed debt because borrowers typically obtain guarantees to 

reduce the interest rate on a loan and such interest is paid to an unrelated party. In fact, 

these commentators, like the proponents of S. 1475, argue that the rules relating to 

guaranteed debt should be relaxed or eliminated altogether. However, others argue that 

third-party debt guaranteed by a foreign related party is a close substitute for direct 

borrowing from that foreign related party, so if the former is restricted less than the latter, 

the former can be used to circumvent restrictions on the latter. In this view, the rules for 

guaranteed debt serve as a backstop to the general rules of section 163(j).40 The Treasury 

Department believes that guaranteed debt does not raise the same level of concern that 

 

40Parent guarantees may enable FCDCs to have a higher level of debt than would normally be possible for a 

comparable DCC. 

30
related-party debt raises under section 163(j) and, consequently, there is no need to lower 

the excess-interest-expense threshold for guaranteed debt. However, the Treasury 

Department continues to study the rules relating to guaranteed debt. 

Recommendation 

 The earnings-stripping study did not find conclusive evidence of earnings 

stripping from FCDCs that had not inverted. However, there is strong evidence that ICs 

have engaged in earnings stripping. 

The Treasury Department believes that additional information is needed to 

determine how the Administration’s Budget proposal would affect FCDCs that have not 

inverted and whether modification to the proposal would be appropriate. In order to 

obtain this additional information and further the administration of section 163(j), a new 

tax form has been created, Form 8926, Disqualified Corporate Interest Expense 

Disallowed Under Section 163(j) and Related Information. Form 8926 solicits 

information relating to the determination and computation of a corporate taxpayer’s 

section 163(j) limitation, including the determination of the taxpayer’s debt-to-equity 

ratio, net interest expense, adjusted taxable income, excess interest expense, total 

disqualified interest for the tax year and the amount of interest deduction disallowed 

under section 163(j), as well as certain information with respect to the related persons 

receiving disqualified interest. 

 

31
III. STUDY OF TRANSFER PRICING 

A. Introduction 

Section 806 of AJCA included the following mandate for a study of current transfer 

pricing rules: 

The Secretary of the Treasury or the Secretary’s delegate shall conduct a 

study regarding the effectiveness of current transfer pricing rules and 

compliance efforts in ensuring that cross-border transfers and other related 

party transactions, particularly transactions involving intangible assets, 

service contracts, or leases cannot be used improperly to shift income out of 

the United States. The study shall include a review of the contemporaneous 

documentation and penalty rules under section 6662 of the Internal Revenue 

Code of 1986, a review of the regulatory and administrative guidance 

implementing the principles of section 482 of such Code to transactions 

involving intangible property and services and to cost sharing arrangements, 

and an examination of whether increased disclosure of cross-border 

transactions should be required. The study shall set forth specific 

recommendations to address all abuses identified in the study. 

To address the issues raised in the statute, this study is comprised of seven 

sections. Section B contains an executive summary. Section C provides background on 

transfer pricing compliance under the current regulatory regime. Section D analyzes the 

adequacy of current rules in providing sufficient, clear, and administrable guidance to 

taxpayers and the IRS to ensure arm’s length results, with particular emphasis on cost 

sharing arrangements (“CSAs”), services, marketing intangibles, and global dealing 

transactions.41 Section E provides an analysis of potential income shifting from nonarm’s length transfer pricing under the current regulatory regime, based on tax return 

data. With Sections C through E as background, Section F provides an overview of 

recent regulatory guidance by the Treasury Department and the IRS on cost sharing 

arrangements (proposed), the provision of intercompany services and transfers of 

intangibles (temporary and proposed), and global dealing transactions (soon to be 

 

41“Current regulatory regime,” “current rules,” “existing rules,” and similar references in this study refer 

primarily to the existing final regulations under Section 482 as of December 31, 2006. These include the 

1968 regulations with respect to the intercompany provisions of services under Treas. Reg. § 1.482-2(b), 

the 1994 transfer pricing regulations under Treas. Reg. § 1.482, the 1996 cost sharing regulations under 

Treas. Reg. § 1.482-7, and the stock-option regulations under Treas. Reg. §§ 1.482-5 and 1.482-7. For 

these purposes, the 1998 proposed global dealing regulations are also considered as part of the current 

regulatory regime. Although these regulations are not in final form, taxpayers and the IRS have significant 

experience in applying the guidance from the proposed regulations over the past eight years. 

33
reproposed).42 The study concludes in Section G, and provides recommendations in 

Section H. 

B. Executive Summary 

The IRS previously submitted to Congress two major studies, each containing 

detailed analyses of issues bearing on the administration of section 482 and the applicable 

regulations, including the transfer pricing penalty provisions. The first of these studies 

was completed in 1999,43 and the more recent in 2001.44 These reports provided the 

history of section 482 and a description of the regulations under sections 482 and 6662, 

as well as a review of the administration of those regulations. In the time since those 

reports were issued, final regulations have been promulgated under §1.482-5 and §1.482-

7. The regulations clarify that participants in cost sharing arrangements are required to 

include compensatory employee stock options within the pool of costs to be shared.45 

The regulations further clarify the appropriate treatment of compensatory employee stock 

options consistent with the reliability and comparability standards.46

With respect to administration of section 482, the fundamental components of the 

five-part strategy to improve the administration of section 482 described in the 1999 

report have remained largely unchanged, although they have been adapted by the IRS to 

reflect the increased amount and complexity of cross-border activity since that time. The 

IRS has undertaken several examination initiatives, including emphasizing identification 

and explanation of book-tax differences, reducing examination cycle time, expanding 

opportunities for pre-filing compliance, and emphasizing early issue identification and 

risk assessment. In addition, the IRS has established cross-functional Issue Management 

Teams (“IMTs”), which provide executive oversight and ensure that resources are 

allocated to specific cases and issues that pose the highest compliance risk. Also, the IRS 

Office of Chief Counsel continues to provide support for the initiatives to improve 

compliance with section 482. 

With respect to transfer pricing litigation, the only recent transfer pricing case 

designated by the IRS Office of Chief Counsel as involving issues of broad significance 

to the administration of the tax law (that is, a case not to be settled or compromised prior 

to a final adjudication by the Tax Court) was Xilinx, Inc. v. Commissioner. Xilinx is 

currently on appeal to the Ninth Circuit, and the case involves the issue of whether 

participants in a qualified cost sharing arrangement are required to include compensatory 

employee stock options within the pool of costs to be shared.47

Additionally, the IRS recently resolved a major transfer pricing dispute with 

Glaxo SmithKline Holdings (Americas) Inc. (“Glaxo”). Glaxo’s $3.4 billion payment is 

the largest single payment ever made to the IRS to resolve a tax dispute. 

 

42Unless expressly differentiated, references to the Treasury Department in chapter III incorporate the IRS. 43“Report on the Application and Administration of Section 482,” issued on April 21, 1999. 

44 “Effectiveness of Internal Revenue Code Section 6662(e),” issued on December 28, 2001. 45Treas. Reg. § 1.482-7. 

46Treas. Reg. §§ 1.482-5 and 1.482-1. 

47Xilinx involves taxable years prior to the final regulations under Treas. Reg. § 1.482-7 that clarify that 

participants in cost sharing arrangements must include compensatory employee stock options within the 

pool of costs to be shared.

34
Notwithstanding the marked improvement of the current transfer pricing rules and 

compliance efforts since 1986, there are certain aspects of the final regulations that may 

not be sufficiently clear, complete, or effective. These include the rules for cost sharing 

arrangements, intercompany services, marketing intangibles, and global financial 

dealings. 

Experience in the administration of cost sharing arrangements under Treas. Reg. 

§ 1.482-7 has demonstrated the need for additional regulatory guidance to improve 

compliance with, and administration of, the cost sharing rules. In particular, there is a 

need for additional guidance regarding the external contributions for which arm’s length 

consideration must be provided as a condition to entering into a cost sharing arrangement 

(i.e., what the existing regulations refer to as the “buy-in” payment). Under the current 

regulations, taxpayers have undertaken valuations that purport to be consistent with the 

transfer pricing regulations but that the IRS believes to result in systematic 

undervaluation of buy-in payments. For example, some applications of the “residual 

profit split method” effectively treat future cost sharing payments as intangible 

contributions, which allows pure financing participants to earn anticipated returns from 

the cost sharing arrangement that are in excess of what a similarly situated participant 

could anticipate earning at arm’s length.48 Not surprisingly, the buy-in provisions have 

led to many significant high-dollar disputes between taxpayers and the IRS. Additional 

guidance is necessary to value buy-in payments appropriately, to define more clearly 

what constitutes a cost sharing arrangement, and to specify more clearly how the 

commensurate with income standard applies to such arrangements. 

The transfer pricing regulations applicable to services were originally 

promulgated in 1968 and have remained in force, essentially unchanged, for almost 40 

years. These regulations have proven to be inadequate to handle the increased volume 

and complexity of multinational operations and transactions that have occurred since that 

time. Prior to 2007, the absence of updated services regulations led to discontinuities 

between transfer pricing for services and transfer pricing for tangible and intangible 

property. Transfer pricing for tangible and intangible property is addressed in the 

otherwise comprehensive regulations under section 482 that were promulgated in 1994. 

With respect to the development of an affiliate’s intangible property, such as 

marketing services provided by a licensee of a trademark that enhance the value of that 

trademark, the existing final regulations in certain cases deem the service provider to be 

the owner of the intangible property for purposes of section 482 and determine the 

appropriate return to the service provider based on its ownership of such property. This 

rule may be misapplied to reach “all or nothing” results based on a binary determination 

of ownership. Instead, as a matter of policy, the income attributable to an intangible 

should be allocated among controlled taxpayers under the arm’s length standard, in 

accordance with each party’s contributions to the development or enhancement of that 

intangible and its ownership interests. 

The proposed global dealing regulations are almost 10 years old and have not yet 

been finalized. Current law generally provides that securities dealing income and 

associated expense of a global securities dealing operation are allocated and sourced on 

 

48Treas. Reg. § 1.482-6. 

35
an all-or-nothing basis and treated as effectively or non-effectively connected income, 

depending upon whether a taxpayer is engaged in the conduct of a trade or business in the 

United States, and whether a securities dealing asset is held in connection with such trade 

or business or the trade or business is a material factor in the realization of the 

income. Furthermore, technological advances, increased globalization, and increased 

interconnection of economic activities have highlighted the need for updated guidance in 

this area. The 1998 global dealing rules do not yet take account of arm’s length interest 

expense allocations that have since been addressed in some of the United States’ more 

recent treaty agreements. Accordingly, revised regulations are needed to refine the 

treatments for arm’s length sourcing and allocations of income and expenses among 

participants in a global dealing enterprise.

Based on the Treasury Department’s experience administering the current transfer 

pricing regulations discussed above, this study concludes that there remains some 

potential for income shifting from non-arm’s length transfer pricing. This potential is 

perhaps most acute with respect to cost sharing arrangements, but is also possible with 

respect to the provision of intercompany services and other transactions. 

The economics literature has historically found empirical evidence that is 

consistent with income-shifting behavior of multinational groups. The literature shows, 

for example, that pre-tax profitability of CFCs has been negatively correlated with local 

country statutory tax rates, taking into account real economic factors such as financial 

structure, capital employed, and other non-transfer pricing operational aspects of 

multinational groups. While the data and analyses do not provide direct evidence of 

specific transfer pricing manipulation (since the data are at a more aggregated level than 

the necessarily detailed transactional level required to isolate specific transfer pricing 

effects), they generally do not allay the concerns about potential non-arm’s length income 

shifting derived from a critical assessment of the current transfer pricing regulations. A 

recent working paper by the Treasury Department’s Office of Tax Analysis has attempted 

to isolate further specific effects of transfer pricing by removing the effects of possible 

“income stripping” through intercompany debt and by incorporating proprietary data on 

cost sharing arrangements. Although substantial caution is required in interpreting the 

specific implications with respect to transfer pricing from the analysis, it shows that the 

data are consistent with (although not proof of) the existence of potential income shifting 

from non-arm’s length transfer pricing. In addition, the results suggest that CFCs whose 

parents engage in cost sharing arrangements tend to show more evidence of potential 

income shifting, but it is unclear the extent to which this may be due to cost sharing 

arrangements themselves or to other factors. 

In response to these developments, a number of regulatory projects have been 

undertaken: proposed cost sharing regulations (2005); regulations addressing crossborder services (proposed 2003, temporary and proposed 2006); and reproposed global 

dealing regulations expected to be issued shortly. 

Cost sharing represents an area that provides substantial opportunities to shift 

significant amounts of income out of the United States. The 2005 proposed cost sharing 

regulations provide a comprehensive revision of the 1996 regulations, and clarify how the 

arm’s length principle is properly applied to these arrangements. The proposed 

regulations adopt as a fundamental concept an “investor model” for addressing the 

36
relationships and contributions of controlled participants in a cost sharing arrangement. 

Specific methods for determining the arm’s length compensation for external 

contributions (i.e., the buy-in) are derived from the investor model. The proposed 

regulations also identify general principles governing all methods, specified and 

unspecified. The proposed regulations further provide greater clarity on how the 

“commensurate with income” standard is to be applied to cost sharing arrangements. The 

proposed regulations provide significantly stronger documentation requirements than 

those under the existing final regulations. Finally, the proposed regulations provide 

enhanced definitional clarity to the structure and parameters of cost sharing 

arrangements. Taken together, the guidance provided by the proposed regulations helps 

to address the serious problems, particularly relating to buy-in valuations, identified by 

the Treasury Department. 

The 2006 temporary and proposed services regulations generally provide that the 

“arm’s length charge in a services” transaction must be determined by using one of the 

transfer pricing methods authorized in the regulations. The guidance on methods is 

generally consistent with the 1994 final regulations (applicable to transfers of tangible 

and intangible property), and is consistent with international standards with respect to 

services transactions. The temporary and proposed regulations provide new transfer 

pricing rules for low-value services, such as routine back-office services. This “Services 

Cost Method” (SCM) preserves the constructive aspects of the cost safe harbor under 

Treas. Reg. § 1.482-2(b) (which provides reduced compliance burdens for low-margin 

services), while eliminating various problematic features. The temporary and proposed 

regulations also provide guidance intended to coordinate and harmonize the rules 

applicable to services related to intangibles with the rules applicable to transfers of 

intangible property. One purpose of the regulations is to ensure that transfer pricing 

rules, when applied to economically similar transactions, reach substantially similar 

results. Finally, the temporary and proposed regulations also provide rules and examples 

regarding the treatment of services performed in connection with the development or 

enhancement of an affiliate’s intangible property, particularly in the context of the 

development of marketing intangibles. These rules provide for the appropriate economic 

compensation for such services without the need to impute shifts of ownership of 

intangible property to service providers, as is done under the current regulations. 

The new reproposed global dealing regulations will respond to technological 

advances, increased globalization, and increased interconnection of economic activities 

since the global dealing regulations were first proposed in 1998. The reproposed global 

dealing regulations will be consistent with the approach increasingly adopted by other 

countries on profit attribution for global dealing operations.49 The reproposed 

regulations will also provide rules for determining the source of income earned in a 

global dealing operation and the circumstances under which such income is effectively 

connected to a foreign corporation’s U.S. trade or business. 

 

Based on this assessment of the effectiveness of current transfer pricing rules and 

compliance efforts, this study concludes that top priority in this area should be given to 

the prompt finalization and implementation of the three transfer pricing regulatory 

49See, e.g., the 2006 OECD Report on the Attribution of Profits to Permanent Establishments. 

37
projects discussed above. Substantial and continuous efforts are underway by the 

Treasury Department to conclude this regulatory process in the near term. When fully 

effective, these regulations will address known gaps in transfer pricing administration, 

and will eliminate some of the known avenues for non-arm’s length income shifting 

available to multinational groups. 

While enhanced disclosure is generally helpful from a tax administration 

standpoint, the Treasury Department is cognizant of the burden already faced by 

companies in complying with admittedly complex transfer pricing rules. In fact, an 

important part of each of the regulatory projects has been specifying documentation and 

information requirements that allow for proper administration of the regulations with the 

least possible burden to taxpayers. Given the current disclosure requirements already in 

place (as well as the additional disclosure requirements in the various temporary and 

proposed regulations discussed above), the generally high audit rates of affected 

taxpayers, and the enhanced ability of the U.S. Competent Authority to exchange 

information with other tax jurisdictions, we do not recommend additional disclosure 

requirements at this time. 

C. Background 

1. Introduction

The IRS previously submitted to Congress two major studies, each containing 

detailed analysis of issues bearing on the administration of section 482 and the applicable 

regulations, including the transfer pricing penalty provisions. The first of these studies 

was completed in 1999, the more recent in 2001. This section briefly summarizes these 

studies. It then provides an update concerning recent developments and new initiatives 

that the IRS has adopted to deal with the rapidly evolving compliance environment 

applicable to multinational groups, with emphasis on developments and initiatives 

relevant to transfer pricing. 

 2. Review of Recent IRS Studies on Transfer Pricing Compliance

1999 Report on the Administration of Section 482 

On April 21, 1999, the IRS issued its “Report on the Application and 

Administration of Section 482” (the “1999 Report”).50 This report was prepared in 

accordance with a directive in the Conference Report to H.R. 4328, the Omnibus 

Consolidated and Emergency Supplemental Appropriations Act of 1999.51 This directive 

called for the IRS to review and report to Congress concerning the administration of 

section 482. 

The 1999 Report observed that, historically, the primary obstacle to effective 

administration of section 482 had been the failure of taxpayers to make efforts to comply 

with the arm’s length standard under section 482 prior to or contemporaneously with the 

filing of the income tax return for the year in question. Moreover, even when taxpayers 

undertook to comply on a contemporaneous basis, they seldom prepared documentation 

describing the controlled transactions or the transfer pricing methodology used to 

 

50IRS Publication 3218 (4-1999). Cat. Number 26802E. 

51Pub. L. 105-277, 105th Cong., 2d Sess. 1486 (1998). 

38
determine taxable income. As a result of the lack of even basic information, IRS 

examiners were often required to analyze the taxpayer’s transfer pricing without the 

knowledge of any underlying facts. Because transfer pricing involves detailed factual 

analysis, even an examination that involved relatively straightforward transfer pricing 

issues could take several years to complete. 

Against this historical backdrop, the 1999 Report described several statutory and 

regulatory amendments and other initiatives that had been adopted to address these 

fundamental problems. The aim of these initiatives was to redirect the primary focus of 

transfer pricing compliance away from after-the-fact examination and litigation of 

transfer pricing controversies (as described in the preceding paragraph), in the direction 

of upfront taxpayer compliance, including, to the extent possible, advance resolution of 

transfer pricing issues. The 1999 Report noted that the IRS intended to follow a five-part 

strategy to improve the administration of section 482. This strategy consisted of issuing 

additional guidance under section 482, encouraging upfront compliance on the part of 

taxpayers, building international consensus concerning transfer pricing issues, resolving 

contentious transfer pricing cases by means of Advance Pricing Agreements (“APAs”), 

and, where appropriate, pursuing strategic section 482 litigation. To a large degree, many 

elements of the strategy were seen as mutually reinforcing. For example, the IRS 

indicated its willingness to negotiate in good faith to resolve disputed transfer pricing 

cases, either in the APA program or by other avenues of alternate dispute resolution, such 

as IRS Appeals. However, where it is not possible to resolve transfer pricing cases in 

such a manner, it is necessary for the IRS to be prepared to defend its position by means 

of litigation. 

2001 Report on the Effectiveness of Section 6662(e) 

On December 28, 2001, the IRS Director, International52 issued a report entitled 

“Effectiveness of Internal Revenue Code Section 6662(e)” (the “2001 Report”).53 This 

report responded to concerns raised by the Senate Committee on Appropriations 

regarding the effectiveness of certain statutory provisions intended to facilitate 

administration of section 482, in particular section 6662(e).54 The Committee directed 

the IRS to analyze the impact of section 6662(e) on transfer pricing compliance, and 

sought information on three specific areas: (1) whether taxpayers are preparing 

contemporaneous transfer pricing documentation, as anticipated by section 6662(e); (2) 

the quality of the documentation; and (3) the utility of such documentation to the IRS in 

enforcing section 482. 

The 2001 Report concluded that IRS administration of section 482 was facilitated 

when IRS examiners had access to contemporaneous documentation that described the 

methodology used by the taxpayer to apply the arm’s length standard. When 

documentation was generated by taxpayers and analyzed by the IRS, it tended to increase 

the overall efficiency of the examination, because it was possible to identify key transfer 

 

52Under the IRS’ current organizational structure, the position of Director, International corresponds to the 

Deputy Commissioner, Large and Midsize Business (International). 

53Fiscal Years 2000-2001 IRS Study: Effectiveness of Internal Revenue Code Section 6662(e) (December 

28, 2001). 

54See Report No. 106-87 to the Treasury and General Government Appropriation Bill, 2000 (S. 1298, 106th

Congress, 1st Sess.). 

39
pricing issues early in the process. Early identification of issues allowed the IRS to 

concentrate examination resources on those controlled transactions that raised the most 

substantial issues. The report also noted that the quality of this documentation varied 

widely from one taxpayer to another. 

Recent Developments 

The fundamental components of the five-part strategy to improve the 

administration of section 482 described in the 1999 Report have remained largely 

unchanged, although they have been adapted by the IRS to a new compliance 

environment. Specifically, the IRS continues to (1) issue additional guidance under 

section 482, (2) encourage upfront compliance on the part of taxpayers, (3) build 

international consensus concerning transfer pricing issues, (4) resolve contentious 

transfer pricing cases by means of APAs, and (5) where appropriate, pursue strategic 

section 482 litigation. This subsection addresses recent developments relevant to the 

administration of section 482 by the IRS. 

Section 482 Guidance

 A major focus of activity in this area is publication of guidance concerning 

application of the arm’s length standard under section 482. The goal is to continue to 

refine the transfer pricing regulations and to provide guidance that supplies direction to 

taxpayers and IRS personnel concerning the arm’s length standard. 

Since the release of the 1999 Report and the 2001 Report, final regulations have 

been issued with respect to the comparable profits method and on cost sharing 

arrangements and the treatment of compensatory stock options.55 With respect to the 

comparable-profits method, the regulations clarify that comparability may be affected by, 

and should be adjusted for, material differences in the utilization of or accounting for 

stock options between the tested party and comparable parties. With respect to cost 

sharing arrangements, the regulations address the treatment of stock-based compensation 

under a qualified cost sharing arrangement (“QCSA”) and the interaction between the 

rules applicable to QCSAs and the arm’s length standard. The regulations provide that 

stock-based compensation related to the covered intangible development area must be 

taken into account in determining the costs to be shared by participants in a QCSA. For 

stock-based compensation in the form of options on publicly traded stock, the controlled 

participants may elect to have the valuation and timing reflect the charge against income 

in audited financial statements or footnotes. In other cases, the expense attributable to 

stock-based compensation is the amount allowable as a federal income tax deduction on 

exercise. This amount generally is the “spread” between the option price and the fair 

market value of the underlying stock at the date of exercise. 

The Treasury Department has recently issued or is in the process of issuing 

several major items of substantive guidance in the section 482 area. These items are 

described in detail in Section F of this study. 

 

55Treas. Reg. §§ 1.482-5 and 1.482-7. 

40
Examination Initiatives and Programs

 Major initiatives recently undertaken by the IRS include emphasizing 

identification and explanation of book-tax differences, reducing IRS examination cycle 

time, expanding opportunities for pre-filing compliance, and emphasizing early issue 

identification and risk assessment. In addition, the IRS has established cross-functional 

Issue Management Teams (“IMTs”), which provide executive oversight and ensure that 

resources are allocated to specific cases and issues that pose the highest compliance risk. 

The Compliance Assurance Process (“CAP”) is a compliance review approach that 

allows the IRS to determine tax return accuracy before the tax return is filed. Under this 

process, the IRS engages the taxpayer during the tax year to facilitate the identification, 

review, analysis, and resolution of material tax issues involving completed transactions. 

The IRS then seeks the filing of compliant returns for the year in question, and ensures 

that appropriate IRS enforcement actions are taken, including traditional examination 

processes, as appropriate. The process is intended to build on corporate-governance 

requirements and on the financial-accounting model of real-time resolution of material 

issues. As compared to traditional post-filing examination processes, CAP can provide a 

taxpayer more certainty concerning its tax liability for a given year within months, rather 

than years, of filing a tax return. This program should reduce taxpayers’ compliance 

burden and the need to book income tax reserves, while also reducing cycle time for IRS 

examinations and allowing for more efficient use of IRS resources. Similar initiatives 

involve the Limited Issue Focused Examination (“LIFE”) program, which focuses 

resources on a limited number of critical issues that are identified at the outset of the 

examination, and the Prefiling Agreement (“PFA”) program, which allows taxpayers to 

obtain advance agreement on matters likely to be disputed in connection with returns for 

one or more taxable years. 

 The first IMT in the transfer pricing area concerns cost sharing, but also applies to 

transfers and licenses of intangibles more broadly. This IMT is intended to improve the 

IRS’ ability to identify, develop, and resolve issues in this key compliance area. Under 

the auspices of the IMT, a Cost Sharing Audit Checklist was issued in 2005 to provide 

guidance to IRS examiners. In 2007, the IMT released a coordinated issue paper (“CIP”) 

that will increase the uniformity of IRS examinations of cost sharing issues. The CIP 

provides guidance to IRS personnel concerning the methods that may be applied to 

evaluate the arm’s length charge for pre-existing intangible property that is made 

available, for purposes of research, to a QSCA. 

 The second transfer pricing IMT involves section 936 termination cases. 

Concerns in this area arise from actions taken by taxpayers in response to the elimination, 

at the end of 2006, of tax benefits under section 936 for qualifying Puerto Rican 

operations. Certain claimants of section 936 benefits have transferred U.S.-owned 

intangibles, which were previously used in Puerto Rican operations, to a new subsidiary, 

often domiciled in a low-tax jurisdiction. The taxpayer then enters into a series of 

controlled transactions with the new subsidiary (often including a license of intangibles), 

the effect of which is that the new subsidiary earns very substantial profits. These cases 

raise substantial issues concerning the appropriateness of transfer pricing between the 

U.S. corporation and the new subsidiary, as well as the amounts that may be due under 

41
section 367(d), a provision that applies to outbound transfers of intangibles in what 

otherwise qualifies as a tax-free reorganization. 

 With respect to documentation efforts, in January 2003, the Commissioner, Large 

and Midsize Business (“LMSB”), issued a Compliance Memorandum restating the 

importance of issuing requests for section 6662(e) transfer pricing documentation. In 

2005, the LMSB Commissioner issued another memorandum that requires IRS examiners 

to request and review taxpayer transfer pricing studies in all cases that involve crossborder controlled transactions that are material in amount or volume. This effort should 

allow IRS examiners and their managers to determine whether in-depth examination of 

transfer pricing issues is warranted, thereby allowing material section 482 issues to be 

pursued as appropriate. 

 Another initiative is the Outside Expert Program (“OEP”), which complements 

the in-house expertise of IRS transfer pricing economists. Under the OEP, the IRS has 

retained several independent economic experts to serve on an ad hoc basis as consultants 

on cost sharing cases. These experts provide technical assistance as requested to a 

specific IRS examination team, in support of IRS economists. 

 A final initiative involves training of agents and managers concerning proper use 

of the LIFE model (described above), as well as a new risk assessment tool that is in 

development. The LIFE model, combined with refined examination standards and 

quality criteria, allows IRS examiners and managers to focus on the most significant 

issues in a particular examination. It is anticipated that training on the use of the risk 

assessment tool will include, among other items, consideration of transfer pricing issues. 

Activities by the Office of Chief Counsel

 The Office of Chief Counsel provides support for the initiatives to improve 

compliance with section 482. Within the Office of Chief Counsel, the Associate Chief 

Counsel (International) has primary responsibility for issues involving section 482 in the 

cross-border context. Branch 6 in the Office of the Associate Chief Counsel 

(International) (“ACC(I)”) has subject-matter jurisdiction over technical issues under 

section 482. The APA Program, which is also located within ACC(I), negotiates and 

executes Advance Pricing Agreements with taxpayers. ACC(I) attorneys participate in 

drafting published guidance within their subject-matter jurisdiction and provide a full 

range of technical assistance to IRS functions, including Examination, Appeals, and 

Competent Authority.56 ACC(I) attorneys also provide technical assistance to attorneys 

in LMSB Counsel and Small Business/Self Employed (“SBSE”) Counsel who are 

engaged in transfer pricing litigation in the U.S. Tax Court. 

 In providing assistance on section 482 issues, ACC(I) and LMSB Counsel follow 

a “team” approach, based on requests for assistance, primarily from LMSB examiners. 

Although the examiners are responsible for factual development in connection with these 

issues, one or both Counsel may provide ongoing assistance over the course of an 

examination. Counsel may also advise examiners on interacting with other IRS 

 

56The term “Competent Authority” refers to the government official designated to enter into binding 

agreements on behalf of a revenue authority concerning the application of one or more provisions of an 

income tax treaty. Under U.S. practice, the Competent Authority is the Deputy Commissioner, Large and 

Midsize Business (International). 

42
functions, including the International Technical Advisors for section 482 or IRS 

economists. 

APA Program

 The APA Program continues to constitute a critical component of the effective 

enforcement of section 482. The APA program provides an alternative means of 

resolving difficult transfer pricing issues without resort to litigation. Under the APA 

program, the IRS and the taxpayer come together in a voluntary, cooperative effort to 

reach a binding agreement concerning prospective application of section 482 to one or 

more specified controlled transactions, referred to as “covered transactions.” In some 

circumstances, the methodology agreed to in the APA may also be “rolled back,” for 

purposes of resolving one or more taxable years for which the statute of limitations 

remains open. 

Multilateral Efforts

 The Treasury Department has worked through the OECD to build a consensus on 

the application of the arm’s length principle. The most notable product of this effort was 

the 1995 OECD Transfer Pricing Guidelines for Multinational Enterprises (“1995 

Transfer Pricing Guidelines”).57 Working Party No. 6 of the OECD Committee on Fiscal 

Affairs considers a wide range of issues related to transfer pricing, including both 

technical and policy issues. Pending items on the agenda of the Working Party include a 

comprehensive review of comparability and a review of the status of the so-called profit 

methods (the “transactional net margin” method and the “residual profit split” method) 

under the 1995 Transfer Pricing Guidelines. When completed, these projects may lead to 

proposed amendments or supplements to the 1995 Transfer Pricing Guidelines. The 

Working Party is also nearing finalization of a major, multi-year project that involves 

applying the 1995 Transfer Pricing Guidelines, by analogy, to attribute profits to a 

permanent establishment, under Article 7 of the OECD Model Tax Convention on 

Income and on Capital.58 When finally adopted by the Committee on Fiscal Affairs, the 

conclusions of this work program may be implemented by changes to the text of Article 

7, the associated Commentary on Article 7, and potentially other provisions of the OECD 

Model Tax Convention and Commentary as well. 

 The Treasury Department also seeks to develop consensus in multilateral 

organizations other than the OECD. For example, in March 2003, the IRS announced 

that it had reached an agreement with other members of the Pacific Association of Tax 

Administrators (“PATA”). The agreement set forth principles allowing taxpayers to 

prepare a single set of transfer pricing documentation that would satisfy the provisions of 

each PATA member country. The PATA Documentation Package was negotiated in 

response to complaints by business groups that by adopting non-uniform documentation 

provisions, major trading nations had greatly increased compliance costs. 

 

57Organisation for Economic Co-Operation and Development, Transfer Pricing Guidelines for 

Multinational Enterprises and Tax Administrations; July 1995. 58Organisation for Economic Co-Operation and Development, “Report on the Attribution of Profits to 

Permanent Establishments: Parts I (General Considerations), II (Banks), and III (Global Trading)”. Centre 

for Tax Policy and Administration; December 2006. 

43
IRS Office of Appeals

 Appeals is an independent function within the IRS that attempts to resolve cases 

that would otherwise be litigated. A significant portion of cases involving section 482 

adjustments are successfully resolved in the course of the examination. However, many 

cases involving section 482 adjustments are referred to Appeals. When taxpayers do not 

agree with an audit adjustment, they may file a protest with Appeals regarding the 

adjustment. An Appeals Officer or an Appeals Team will evaluate the facts and 

circumstances surrounding the tax issues and attempt to resolve the case. Except where 

an Appeals Settlement Guideline or other provision applies, the Appeals Officer has 

plenary authority to resolve the dispute in the manner he or she deems appropriate. 

Mutual Agreement Procedures

 The procedures by which U.S. taxpayers may request assistance from the U.S. 

Competent Authority were revised and updated in 2006.59 Taxpayers may request the 

assistance of the U.S. Competent Authority for relief from double taxation by means of a 

dispute-resolution process called the Mutual Agreement Procedure (“MAP”). In a MAP, 

the competent authorities of the United States and the treaty partner meet to seek mutual 

agreement concerning difficulties or doubts concerning the interpretation or application 

of a tax treaty. In the case of transfer pricing issues, the MAP generally concerns the 

application of the arm’s length principle, as reflected in Article 9 of most U.S. tax 

treaties, by the United States or the treaty partner. 

 Because a MAP involves a negotiation between treaty partners, the final outcome 

is uncertain. One country may agree that the other country’s application of the arm’s 

length principle is acceptable, in which case it may cede jurisdiction to tax the income in 

question. In that case, double taxation is avoided. A partial agreement is also possible, in 

which case double taxation may be reduced but not eliminated. Finally, the treaty 

partners may be unable to reach agreement, in which case partial or complete double 

taxation may result. As part of the MAP, the treaty partners often consider other matters 

ancillary to the final resolution, such as the effect of refund of taxes on foreign tax 

credits, conforming adjustments required on account of the agreed transfer pricing 

adjustments, repatriation of funds, and other matters. 

 A substantial portion of the inventory of the U.S. Competent Authority consists of 

cases that involve transfer pricing adjustments. In recent years, as foreign revenue 

authorities have devoted additional resources to transfer pricing matters, the number of 

foreign-initiated adjustments to foreign affiliates of U.S. taxpayers has increased 

substantially. The U.S. Competent Authority has pursued with U.S. treaty partners 

various means to reduce the overall backlog of cases and the number of cases that cannot 

be resolved in a manner that eliminates double taxation. For example, in 2004, the U.S. 

Competent Authority entered into a Memorandum of Understanding with the Canadian 

Competent Authority to resolve factual disputes that prevent resolution of pending MAPs 

between the two countries. 

 If a section 482 adjustment by the IRS creates a potential for double taxation (i.e., 

taxation of the same item of income by both the United States and another country), 

 

59Rev. Proc. 2006-54, 2006-49 I.R.B. 1035. 

44
taxpayers may seek competent authority relief in addition to consideration by the IRS 

Office of Appeals (“Appeals”). Taxpayers may request either simultaneous or sequential 

review on the part of Appeals and the U.S. Competent Authority.60 Under the 

simultaneous procedure, Appeals participates in the competent authority process, 

although the Competent Authority has responsibility for preparing and presenting the 

negotiating position to the treaty partner. Under the sequential procedure, taxpayers may 

request initial consideration of the case by Appeals. If a taxpayer reaches a settlement on 

the issue with Appeals, the U.S. Competent Authority will seek only to obtain correlative 

relief from the treaty partner; it will not engage in substantive negotiations with the treaty 

partner, which could have the effect of reconsidering the merits of the Appeals resolution. 

Litigation of Transfer Pricing Controversies

 The final significant component of transfer pricing administration is litigation. 

Because the majority of section 482 disputes are resolved in the course of the IRS 

examination, or based on consideration by Appeals, relatively few disputes involving 

transfer pricing result in issuance of a statutory notice of deficiency, which is the legal 

demand for payment of additional tax. The issuance of such a notice gives rise to 

jurisdiction for filing by the taxpayer of a petition in U.S. Tax Court, or for payment of tax 

and filing of a claim for refund in U.S. District Court or the U.S. Court of Federal Claims. 

In the case of petitions in Tax Court, the IRS Counsel from the specific division that 

issued the notice generally defends the case in Tax Court. District Court and Court of 

Federal Claims refund actions are defended by attorneys of the Department of Justice, Tax 

Division. 

 Transfer pricing litigation is often very resource-intensive, given that it usually 

involves a large factual record, submission of expert testimony on specialized matters, 

and economic and other analysis needed to support the IRS adjustment under the 

applicable standard of review. Substantial work generally must be performed in addition 

to the development and analysis done in the IRS examination. The precedential value of 

a decision involving section 482 may be quite limited, due to the highly factual nature of 

most disputes. Nonetheless, the IRS devotes substantial resources to litigation in this 

area. 

 The 1999 Report contained a comprehensive review of litigation involving 

transfer pricing cases. In the years since the issuance of that report, the IRS has 

continued to litigate a number of similar cases, as a component of its overall strategy with 

respect to the enforcement of section 482. Cases defended by the IRS Office of Chief 

Counsel fall into three basic categories: (1) general litigation, (2) notice cases, and (3) 

designated cases. All of these cases involve similar resources on the part of LMSB 

Counsel, but notice cases and designated cases involve coordinated issues or other 

matters and call for more extensive involvement by Associate Offices of IRS Chief 

Counsel, generally ACC(I). 

 Notice cases involve an issue of substantial or widespread importance, on which 

coordination with subject-matter experts in the relevant Associate Office of the IRS Chief 

Counsel is deemed advisable. Designated cases are “designated” for litigation because 

 

60See Rev. Proc. 2006-54, 2006-49 I.R.B. 1035, §§ 7, 8. 

45
they involve issues of broad significance to the administration of the tax law, which may 

not be settled or compromised prior to a final adjudication by the Tax Court. To date, the 

only transfer pricing case to be designated is Xilinx, Inc. v. Commissioner, which 

involves the issue of whether participants in a qualified cost sharing arrangement are 

required to include compensatory employee stock options within the pool of costs to be 

shared. 

 The following matters involve significant issues under section 482 that have been 

resolved in, or are pending in, U.S. Tax Court: 

H Group Holding, Inc. v. Commissioner, T.C. Memo. 1999-334; 

Adaptec, Inc. v. Commissioner, Docket Nos. 10077-00, 3480-01 ; 

BIB USA, Inc. v. Commissioner, Docket No. 4434-03; 

BMC Software v. Commissioner, Docket No. 2671-00; 

Compaq Computer Corp. v. Commissioner, T.C. Memo 1999-220; 

Dart Container Corp. v. Commissioner, Docket No. 10526-01; 

Glaxo SmithKline Holdings (Americas), Inc. v. Commissioner, Docket No. 5740-04; 

Mary Kay Corp. v. Commissioner, Docket No. 18150-02; 

Schneider Electric Holdings, Inc. v. Commissioner, Docket No. 12225-02; 

United Parcel Service of America, Inc. v. Commissioner, T.C. Memo. 1999-268, 

reversed and remanded, 254 F.3d 1014 (11th Cir. 2001), dismissed per stipulation, 

order entered January 22, 2003; 

Veritas Software Corp. v. Commissioner, Docket No. 12075-06; 

Xilinx, Inc. v. Commissioner, 125 T.C. 37 (2005), appeals docketed, Nos. 06-74246 

and 06-74269 (9th Cir. Sept. 29, 2006). 

 The IRS recently resolved a major transfer pricing dispute with Glaxo. This case 

represents the largest single settlement, by dollar value, in the history of the IRS. Under 

the settlement agreement, Glaxo will pay approximately $3.4 billion to resolve a longrunning transfer pricing dispute for the tax years 1989 through 2005. 

D. Effectiveness of Current Transfer Pricing Rules and Compliance Efforts 

1. Introduction

There have been successes both in providing transfer pricing guidance and in 

effectively administering transfer pricing rules since the modification to section 482 in 

1986. The theoretical underpinnings of the 1988 Treasury White Paper provided the 

basis for comprehensive revision of the transfer pricing regulations over the succeeding 

eight years. Each major regulatory endeavor, including the 1994 section 482 regulations 

and the 1996 cost sharing regulations, was undertaken with significant input by taxpayers 

and practitioners. Further, the section 482 regulations were helpful to the work of the 

OECD in its development of the 1995 Transfer Pricing Guidelines. 

The section 482 regulations provide a basis for undertaking transfer pricing 

analyses that are flexible enough to take into account the facts and circumstances 

46
surrounding particular intercompany transactions, while providing a rigorous and 

consistent means of assessing arm’s length outcomes. The best method rule,61 based on 

the functional analysis62 and applied under the comparability63 and reliability64

standards, provides an overall framework under which specific methods can be evalua

The acceptance of a range, rather than a point, of potential arm’s length outcomes 

recognition of the inexact nature of transfer pricing and provides relief to taxpayers 

facing legitimate uncertainty. Finally, the guidance on specific methods for transfers of 

tangible and intangible assets and services transactions provides practical guidance that 

allows taxpayers to apply the arm’s length standard. Taken together, the section 482 

guidance generally allows for effective self-compliance and effective IRS administration 

of this critical aspect of tax computations. 

ted. 

is a 

2. Inadequate Guidance and Potential Scope for Abuse Under the Current 

Regulations

Notwithstanding the general effectiveness of the current transfer pricing rules and 

compliance efforts, there are certain aspects of the existing final regulations that may not 

be sufficiently clear or complete. These include the treatment of cost sharing 

arrangements, the treatment of intercompany services, certain rules pertaining to 

marketing intangibles, and the treatment of global financial dealings. 

Cost Sharing Arrangements

The Treasury Department believes that the 1996 cost sharing regulations,65 when 

properly applied, place cost sharing arrangements within the arm’s length standard, and 

are consistent with the rest of the section 482 regulations, notably Treas. Reg. § 1.482-1. 

Nevertheless, experience in the administration of CSAs under the 1996 regulations has 

demonstrated the need for additional regulatory guidance to improve compliance with, 

and administration of, the cost sharing rules. In particular, there is a need for additional 

guidance regarding the scope of the external contributions for which arm’s length 

consideration must be provided as a condition to entering into a CSA. The consideration 

for this type of external contribution is referred to in the existing regulations as the “buyin.” Furthermore, additional guidance is needed on valuation of buy-in payments. 

Finally, other technical and procedural issues have arisen in the course of the 

administration of the cost sharing rules that should be clarified.66 

 

61Every transaction reviewed under section 482 must be evaluated “under the method that, under the facts 

and circumstances, provides the most reliable measure of an arm’s length result.” Treas. Reg. § 1.482-

1(c)(1). 

62The comparability of controlled and uncontrolled transactions “is based on a functional analysis that 

identifies and compares the economically significant activities undertaken ... by the taxpayers in both 

controlled and uncontrolled transactions.” Treas. Reg. § 1.482-1(d)(3)(i). 

63“Whether a controlled transaction produces an arm’s length result is generally evaluated by comparing the 

results of that transaction to results realized by uncontrolled taxpayers engaged in comparable transactions 

under comparable circumstances.” Treas. Reg. § 1.482-1(d)(1). 64Whether a method gives the most reliable measure of an arm’s length result depends in part upon the 

reliability of the assumptions made. Treas. Reg. § 1.482-1(c)(2)(ii). 65Treas. Reg. § 1.482-7. 

66For example, because of the interaction of the rules pertaining to the research credit under section 41 and 

the cost sharing rules under Treas. Reg. § 1.482-7, a U.S. CSA participant performing research is entitled to 

47
The importance of buy-in payments was recognized in the legislative history of 

the Tax Reform Act of 1986: 

In order for cost sharing arrangements to produce results consistent 

with the changes made by the Act to royalty arrangements, it is envisioned 

that the allocation of R&D cost sharing arrangements generally should be 

proportionate to profit as determined before deduction for research and 

development. In addition, to the extent, if any, that one party is actually 

contributing funds toward research and development at a significantly 

earlier point in time than the other, or is otherwise effectively putting its 

funds at risk to a greater extent than the other, it would be expected that 

an appropriate return would be provided to such party to reflect its 

investment.67

Under the 1996 cost sharing regulations, the provisions on buy-in payments apply 

whenever a controlled participant to a CSA makes available for purposes of research its 

pre-existing intangible property to the other controlled participants. In such a case, the 

transferring controlled participant of that pre-existing intangible property is treated as 

having transferred interests in such property to the other controlled participants. 

Accordingly, the other controlled participants must make buy-in payments to the 

transferring controlled participant. The cost sharing regulations provide no special 

valuation guidance on these payments, only that “the buy-in payment by each such other 

controlled participant is the arm’s length charge for the use of the intangible under the 

rules of Treas. Reg. §§ 1.482-1 and 1.482-4 through 482-6.”68

The issues that arise under the buy-in provisions generally relate to the nature and 

scope (and thus the value) of the intangible property rights transferred to a CSA, and the 

form, structure, and timing of the buy-in payments in exchange for those rights. 

Although the general nature of rights transferred in a buy-in transaction may be inferred 

from the regulation language, disputes with taxpayers have arisen concerning which 

intangibles (or the various rights thereto) are subject to the buy-in, and how they should 

be valued. 

The particularly complex valuation issues that arise under CSAs may indicate that 

the existing guidance is inadequate. For example, the general section 482 guidance on 

valuing intangible property typically applies to existing (and thus currently exploitable) 

technology. In contrast, CSAs typically involve two different types of intangible 

property. The first type of intangible property is the envisioned (that is, not currently 

existing and, therefore, not currently exploitable) technology that is the very subject of 

the cost sharing arrangement. The second type of intangible property, the subject of the 

buy-in payment, is the existing intangible that is contributed by one or more of the cost 

sharing participants, whose value derives from the intangible’s contribution to the 

development of the envisioned intangible, rather than, for example, to the contributed 

intangible’s exploitation in its own right. Further, the second type of intangible property 

 a research credit on its total research expenditures, notwithstanding that the U.S. participant is receiving 

cost sharing ‘reimbursement’ from foreign CSA participants. 

67H.R. Conf. Rep. No. 99-841 at II-638 (1986). (Emphasis added). 

68Treas. Reg. § 1.482-7(g)(2). 

48
is often an “in-process” intangible that is not currently exploitable and, therefore, 

particularly difficult to value. 

 In this complex and uncertain environment, taxpayers have undertaken valuations 

that purport to be consistent with Treas. Reg. § 1.482-4 through § 1.482-6, but that may 

result in systematic undervaluation of the buy-in payment, and, thus, produce income 

shifting from non-arm’s length transfer pricing. For example, some applications of the 

residual profit split method effectively treat future cost sharing payments as intangible 

contributions, allowing pure financing participants to earn anticipated returns from the 

CSA that are in excess of what a similarly situated participant could expect to earn at 

arm’s length. In other cases, the buy-in amount is determined by reference to a 

contingent royalty based on sales of the cost-shared intangible. The stream of contingent 

royalties is usually due only over what the taxpayer asserts to be the “useful economic 

life” of the specific intangible property rights acquired in a buy-in transaction. 

Consequently, that useful life assumption has a significant effect on the buy-in 

calculation. In some cases, taxpayers have argued that the useful economic life of the 

contributed intangibles expires before the sales associated with the CSA occur, 

supporting a result that no buy-in payment is ever payable. Such arguments are 

indicative of potentially systematic non-arm’s length pricing of buy-in payments. 

 The buy-in provisions in the 1996 regulations have led to many significant highdollar disputes between taxpayers and the IRS. Beyond the valuation issues illustrated 

above, these disputes involve definitional issues relating to which intangibles are subject 

to the buy-in provisions, the nature of the interests in the “deemed transfers” that give rise 

to the buy-in requirement, and many other technical issues. The result has been a 

significant drain on the resources of taxpayers and the IRS. 

The IRS’ experience in administering the cost sharing regulations has 

consequently led the Treasury Department to conclude that additional guidance is 

necessary to value buy-in payments appropriately, to define more clearly what constitutes 

a CSA, and to specify more clearly how the commensurate with income standard applies 

to such arrangements. 

With respect to buy-in payments, such guidance should take into account the 

characteristics of CSAs particularly relevant to buy-in valuations. First, CSAs are, by 

their very nature, forward looking. As with joint-venture agreements between unrelated 

parties who agree to pool resources to develop products or markets for mutual future 

benefit, contractual terms relating to the rights, contributions, and responsibilities of the 

parties should be established at the outset of the arrangement. Second, CSAs involve real 

risks relating to whether and the extent to which the envisioned intangible will be 

successfully developed and exploited. The nature of these risks is different from the risks 

associated with currently exploitable intangible property that is more typically the subject 

of Treas. Reg. § 1.482-4. Third, after-the-fact valuations of currently exploitable 

intangibles – typical in valuations outside of CSAs – are a dubious means of valuing 

contributed intangibles in a CSA. Finally, the research and other rights associated with 

intangibles contributed to CSAs must be clearly defined and sufficiently broad to 

measure realistically the full value of the contributed intangibles in developing the 

envisioned intangibles. 

49
Technically, the “commensurate with income” standard applies to CSAs through 

the reference in Treas. Reg. § 1.482-7(g) to the general guidance relating to the transfer 

of intangible property in Treas. Reg. § 1.482-4 through § 1.482-6, which includes the 

“periodic adjustment” guidance of Treas. Reg. § 1.482-4(f)(2). However, in light of the 

valuation difficulties discussed above, the regulations do not provide clear guidance on 

how the periodic adjustments should apply to CSAs. Further, some taxpayers have 

interpreted section 482 to mean that periodic adjustments are not the sole prerogative of 

the Commissioner, but instead may be used proactively by the taxpayer to make ex post

adjustments to buy-in payments (most notably when the CSA turns out to be 

unsuccessful). 

As discussed in Section F, these and other issues are addressed in the recently 

proposed cost sharing regulations (2005). 

Intercompany Services 

The existing final transfer pricing regulations applicable to services were issued in 

1968. In the interim, services have become an increasingly important component of the 

United States economy and the global economy. Large, integrated multinational groups 

are much more common now than they were in 1968, and services rendered within such 

groups constitute a growing proportion of intra-group transactions. The absence of 

updated services regulations has led to discontinuities between transfer pricing for 

services and transfer pricing for tangible and intangible property, which is addressed in 

the otherwise comprehensive 1994 section 482 regulations. 

The 1968 services regulations incorporate a so-called cost safe harbor, which 

permits certain intra-group services to be compensated at cost, with no profit element. In 

practice, the cost safe harbor applies to the majority of outbound intra-group services, 

including some services that may not be within the intent of the original rule. The 

determination of the arm’s length charge depends on whether the services transaction is 

an “integral part” of the business of the renderer or the recipient, and other subjective 

tests. Applying the rules has been problematic. In particular, the current final regulations 

in some cases have been interpreted or applied to reach inappropriate results from a 

policy perspective by allowing high-margin controlled services to be priced at cost. 

Further, the qualitative and subjective tests in the current final regulations for 

determining whether a controlled service may be priced at cost have been difficult to 

apply and have led to disputes. 

Because guidance on intercompany services transactions was not part of the 1994 

section 482 regulations, there has been a need to provide guidance concerning selection 

and application of the appropriate method for pricing intercompany services by more 

clearly incorporating the general rules in Treas. Reg. § 1.482-1 (including the best 

method rule of Treas. Reg. § 1.482-1(c), the comparability analysis of Treas. Reg. 

§ 1.482-1(d), and the arm’s length range of Treas. Reg. § 1.482-1(e)) of the existing 

regulations. In addition, there has been a need to coordinate better and harmonize the 

rules applicable to services transactions with the rules for other types of transactions 

under section 482, in particular transfers of intangible property. Such guidance is 

necessary to mitigate the extent to which the form or characterization of a transfer of 

intangibles as the rendering of services can lead to inappropriate results. In general, the 

50
transfer pricing rules should reach similar results in the case of economically similar 

transactions, regardless of the characterization or structuring of such transactions. 

As discussed in Section F, recent regulatory efforts ultimately resulting in the 

temporary and proposed services regulations (2006) have addressed these concerns. 

Marketing Intangibles 

Special rules may apply to services performed in connection with the 

development or enhancement of an affiliate’s intangible property, such as marketing 

services provided by a licensee of a trademark that enhance the value of that trademark. 

In certain cases, instead of determining the service provider’s income on the basis of an 

analysis of the service, the regulations deem the service provider to be the owner of the 

intangible property for section 482 purposes and determine the appropriate return to the 

service provider based on its ownership of such property. These rules also provide that 

intangible property may have multiple owners. These rules are illustrated by the socalled “cheese examples” in Treas. Reg. § 1.482-4(f)(3). 

Commentators have questioned the use of ownership for purposes of section 482, 

as distinct from legal ownership or ownership for tax purposes more generally, as an 

analytical tool for determining the appropriate allocation of income attributable to an 

intangible. Existing final regulations under Treas. Reg. § 1.482-4(f)(3), when properly 

applied, generally reach appropriate results in allocating income attributable to intangible 

property. However, the Treasury Department is concerned that the regulation may be 

misapplied to reach “all or nothing” results based on a determination of ownership in 

cases where an arm’s length analysis in accordance with the section 482 regulations 

would require that the income attributable to an intangible be divided among the 

controlled taxpayers that made significant contributions to develop or enhance that 

intangible, and that hold legal rights with respect to that intangible. 

As a policy matter, the rules for determining the ownership of an intangible 

generally should be distinct from the rules for determining the allocation of income from 

an intangible. The income attributable to an intangible should be allocated among 

controlled taxpayers under the arm’s length standard, in accordance with each party’s 

contributions to the development or enhancement of that intangible and its ownership 

interests (if any). This analysis generally would preclude “all or nothing” results. 

As discussed in Section F, these issues have been addressed in the temporary and 

proposed services regulations (2006). 

Global Dealing in Financial Products 

Financial institutions have traditionally acted as intermediaries between persons 

who want to invest capital, and those who need to acquire capital. In addition to 

brokering the basic capital needs of customers, financial institutions have developed 

innovative financial products that facilitate shifting varying types of risk, such as interest 

rate, currency, and credit risk. Institutions also manage their own risk for all jurisdictions 

and time zones where they conduct trading or dealer operations. Technological advances 

have enabled financial institutions to supply these products and implement riskmanagement practices on a 24-hour basis through offices around the world. This practice 

is commonly referred to as “global trading” or “global dealing.” 

51
Existing regulations governing taxation of financial products have not kept pace 

with the changes in the industry, and their continued application has been criticized as 

producing uneconomic results. The current final regulations for determining the source 

and effectively connected treatment of securities dealer income were intended to apply in 

situations where one location participated in the majority of the earnings process. As a 

result, current rules do not produce appropriate results in a situation where offices in 

multiple jurisdictions ordinarily and regularly participate in the earnings process of 

particular transactions. Accordingly, each jurisdiction’s tax laws seek to capture its 

economic share of income produced. The lack of harmonized rules between jurisdictions 

increases the likelihood of double taxation. 

In 1990, the IRS issued Announcement 90-106, requesting comments on how the 

regulations under sections 482, 864 and other sections of the Code could be improved to 

address the taxation issues raised by global trading of financial instruments. Because 

final regulations were not issued in response to the comments that were received, there 

remained a number of uncertainties regarding the manner in which the existing 

regulations apply to financial institutions that deal in financial instruments through one or 

more entities or trading locations. Many financial institutions sought to resolve these 

problems by negotiating APAs with the IRS. 

In 1994, the IRS published Notice 94-40, which provided a generic description of 

the IRS’ experience with global dealing operations conducted in a functionally fully 

integrated manner. Notice 94-40 specified that it was not intended to prescribe rules for 

future APAs or for taxpayers that did not enter into APAs. Moreover, Notice 94-40 

provided guidance only with respect to businesses conducted in a manner that financial 

institutions argue is fairly uncommon. 

In 1998, the IRS issued proposed regulations providing guidance regarding the 

allocation of income from global dealing in financial products. The proposed regulations 

also included rules regarding the source of income from global dealing, to the extent that 

such income is not otherwise sourced under the Code, and rules for determining when 

such income will be treated as effectively connected with a U.S. trade or business. 

Under the 1998 proposed regulations, taxpayers determine in three steps the 

amount of income from a global dealing operation over which the United States will 

claim taxing jurisdiction. In the first step, a global dealing operation allocates income to 

different legal entities. General principles of existing transfer pricing regulations would 

apply, with modifications necessary to reflect the different economic factors that affect 

pricing in a financial services business. Under the proposed regulations, marketing, 

pricing, and risk management are higher-value participant functions that must be 

compensated under the global dealing regulations. The determination of whether 

compensation for other functions is at arm’s length is made under other applicable 

transfer pricing regulations. For example, the legal, accounting, and clerical functions 

performed by the back office of a financial institution are all functions for which an arm’s 

length return may be determined under existing transfer pricing regulations. However, 

the proposed regulations were silent as to whether the provision of capital is a participant 

function and, thus, how it should be compensated, although examples demonstrated that 

acting as a counterparty to transactions constituted acting as a dealer in securities, which 

was identified as a participant function. 

52
The second step is the determination of the source of income allocated to each 

legal entity. The 1998 proposed regulations provided under section 863 special source 

rules only for items of income for which a source rule is not specifically provided under 

the Code. Thus, the special source rules applied to notional-principal contracts, but not to 

dividends or substitute dividends. 

For purposes of applying the source rules, each separate branch of a taxpayer is 

treated as a participant in the global dealing operation, with income being allocated to 

each participant under the transfer pricing rules described above. As a result, income 

from a single transaction may be sourced to more than one location, provided that the 

allocation methodology satisfies the arm’s length standard. 

In practice, the 1998 proposed regulations created uncertainty regarding the 

sourcing of global dealing income of U.S.-resident capital providers that did not maintain 

separate profit and loss accountings for each location where participant functions were 

performed. As a result, many U.S. taxpayers continued to treat their global dealing 

income entirely as U.S.-source income despite significant and sometimes exclusive 

participant contribution by foreign affiliates. Such treatment also resulted in interest 

expense allocations to domestic-source income under the asset method in Treas. Reg. 

§ 1.861-9T(g). Further uncertainty resulted from dealing operations conducted in 

separate tax jurisdictions through agents who exercised contractual authority on behalf of 

U.S.-resident capital providers. 

The final step, applicable only to foreign taxpayers engaged in a trade or business 

within the United States, is the determination of whether income is effectively connected 

to a U.S. trade or business (“ECI”) and, therefore, subject to tax on a net basis in the 

United States. The 1998 proposed regulations provide that only income treated as 

derived from U.S. sources will be treated as ECI. Although statutory sourcing rules 

generally prohibit changing or splitting the source of FDAP income such as interest and 

dividends, the 1998 proposed regulations provide that such amounts may be split as to 

whether they are ECI or non-ECI. As with sourcing, the existence, or not, of a permanent 

establishment (“PE”) is critical to the determination of whether, to what extent, and in 

what manner securities-dealer income (including certain foreign-source interest and 

dividends) of a foreign entity is subject to U.S. tax. Notably, ECI determinations under 

the Code are not contingent upon a finding of a PE. Accordingly, the activities of an 

agent could cause income to be effectively connected with a trade or business under the 

Code, but attribution for treaty purposes may depend upon the activities either of an 

office of the foreign person or a dependent agent. However, the ECI rules in the 1998 

proposed regulations did not always result in symmetry of allocation and source 

treatment of global dealing income since the allocation of FDAP income does not change 

its source under the Code. 

In addition to the rules regarding the allocation of income between taxing 

jurisdictions, the 1998 proposed regulations included rules under section 475 to deal with 

timing mismatches that can result if the separate existence of each desk is ignored. Under 

these rules, if certain threshold requirements are met, an interdesk agreement will be 

treated as if it were an agreement between separate taxable entities. Thus, each desk that 

is a party to the agreement will account for the agreement under the desk’s own method 

of accounting. In most cases, the dealer desk will mark to market its position in the 

53
agreement under section 475 while the sales or marketing desk will use hedge-accounting 

principles to match the recognition of income, expense, gain, or loss from its position in 

the interdesk agreement with the associated risk from its position with a customer. 

These rules reflect a policy judgment that for purposes of determining the income 

of separately managed business units of a single taxpayer, intradesk symmetry is more 

important than interdesk symmetry. In other words, it is more important to have each 

desk’s income determined consistently with its overall method of accounting applicable 

to all of its activities, than it is to ensure that the desks are accounting for interdesk 

transactions symmetrically. In addition, as a practical matter, it is virtually impossible to 

apply existing timing rules to global dealing operations without respecting interbranch 

transactions. For this reason, many global dealing operations have entered into APAs 

that allow them to account for interdesk and interbranch transactions in a manner 

consistent with the 1998 proposed regulations. 

As discussed in Section F, the Treasury intends to issue reproposed global dealing 

regulations addressing these issues. 

3. The Potential Scope for Income Shifting Under the Current Regulations

Based on the IRS’ experience, and in light of the critical assessment of the current 

transfer pricing regulations discussed above, the Treasury Department believes that there 

is some potential for income shifting from non-arm’s length transfer pricing under the 

current regulations. This potential is perhaps most acute with respect to CSAs, but is also 

possible with respect to the provision of intercompany services and other transactions. 

The opportunity to manipulate intercompany prices is a function of both the 

relative value of the transferred property to the taxpayer’s business, and the difficulty in 

reliably pricing the transaction (which tends to support a wider range of practically 

“acceptable” arm’s length prices). At one end of the spectrum, there is little risk of 

income shifting with respect to the intercompany transfers of commodities that are a 

relatively minor input to the production process: the value of the transferred property is 

small relative to the operations of the business, and there are likely to be readily available 

reliable comparable transactions that define the arm’s length price within a narrow, and 

not easily manipulable, range. On the other end of the spectrum, there is significant risk 

of income shifting from transfers of valuable intellectual property that are crucial to the 

core business of a taxpayer and that are difficult to value accurately. The risk of income 

shifting is further compounded by unclear transfer pricing valuation guidance and by the 

failure of some taxpayers to define the terms precisely under which intellectual property 

transfers take place. 

The Treasury Department believes that CSAs under the current regulations pose 

significant risk of income shifting from non-arm’s length transfer pricing. In addition to 

the valuation and definitional problems discussed above, CSAs often involve the key 

value-driving intangibles of a business. For example, it is not uncommon for CSAs to be 

for “future generations” of all products or licenses derived from the core technologies of 

a multinational group. Under the 1996 regulations, each participant “owns” the costshared intangibles that it exploits in its market. Thus, once a buy-in payment is 

undervalued, the IRS has little practical opportunity for redress. The IRS is effectively 

limited to making adjustments only to make each participant’s share of the intangible 

54
development costs incurred under the CSA equal to its share of the reasonable anticipated 

benefits from the CSA. In other words, only the relative shares of ongoing intangible 

development costs may be adjusted, and not the buy-in payments for contributed preexisting intangibles that are contributed to the CSA. In this way, companies may 

effectively achieve the transfer of valuable intangibles to offshore locations for less than 

the full value required by section 367(d) and section 482 of the Code. 

Compared to CSAs, intercompany-services transactions pose substantially less 

income-shifting risks. In practice, the vast majority of the services covered are lowmargin “back-office” services that currently may be priced at cost under an 

administrative safe harbor intended to reduce compliance burdens for taxpayers and the 

IRS. Nevertheless, intercompany services may “embed” valuable intangibles. Therefore, 

to the extent that the current regulations might allow different outcomes for economically 

identical transactions depending on whether such transactions are characterized as 

“services” or as “intangible transfers,” taxpayers could potentially exploit this asymmetry 

to shift income. 

E. Income Shifting from Transfer Pricing: Evidence from Tax Return Data 

1. Introduction

Transfer pricing analysis is intrinsically an analysis of specific facts and 

circumstances. Whether and the extent to which there may be income shifting from nonarm’s length pricing of intercompany transactions can only be definitively determined at 

the very detailed level of the particular transactions under review, or perhaps at a level of 

aggregation seldom higher than a single company within a multinational group. It is 

difficult to draw conclusive inferences from aggregated data (that is, company-level data 

from hundreds or thousands of companies) for two reasons. 

First, apparent income shifting in the aggregate data may in fact be fully 

supportable when specific transactions are analyzed. For example, it might be observed 

that the CFCs of U.S.-based multinational groups operating in low-tax jurisdictions have 

significantly higher profitability than the CFCs of these same U.S.-based multinational 

groups operating in high-tax jurisdictions. For a particular CFC, however, this result may 

not necessarily be indicative of non-arm’s length pricing of intercompany transactions. 

For example, a CFC operating in a low-tax jurisdiction may have developed a particular 

technology itself (for example through the independent efforts of its research activities) 

from which it earns above-normal returns, while a CFC in a high-tax jurisdiction may 

undertake only low-value routine activities that warrant relatively low profitability at 

arm’s length (e.g., a similar level of profitability as that of unrelated companies 

undertaking similar functions and risks). Or MNCs may simply invest more in low-tax 

jurisdictions. The differential in profitability may be related to such differences in 

investment levels, as profitability tends to be related to capital intensity, all else being 

equal. 

Second, transfer pricing transactional detail may be “buried” within the broader 

financial data that are typically used for empirical analyses. There is significant nontransfer pricing “noise” that hinders the ability to isolate transfer pricing effects, or to 

compare reliably the effects over time. For example, the “check-the-box” regulations 

issued in 1997 resulted in greater use of hybrid entities. One type of hybrid entity is an 

55
entity disregarded as separate from its owners according to U.S. tax rules, even though it 

may be a corporation under foreign law. Under U.S. rules, the hybrid “disappears” as its 

profit and loss results are rolled up into the return of its parent/affiliate. Importantly, 

what disappear are “zero sum” intercompany (which become interbranch) transactions. 

Thus, analysis of data that includes periods both before and after the issuance of the 

check-the-box rules would have to account for the fact that intercompany transactions of 

some companies may disappear from the data after an election is made to treat what had 

been a subsidiary corporation as a branch. This makes comparisons across such periods 

more difficult than they otherwise would be. 

The years examined in this study are 1996 (prior to the 1997 check-the-box rules), 

2000, and 2002.69 Although the impact of the check-the-box rules bears most notably on 

intercompany interest payments (which this analysis explicitly eliminates from 

consideration in order to isolate, to the extent possible, other transfer pricing effects), the 

use of disregarded entities may itself further encourage non-arm’s length pricing between 

foreign affiliates controlled by U.S. parents.70 Therefore, some caution is required in 

comparing 1996 and earlier years to 1997 and subsequent years. One reason is that under 

the rules for filing Form 5471, Information Return of U.S. Persons With Respect To 

Certain Foreign Corporations, a CFC that checks the box to become a branch of another 

CFC disappears from the tax file.71 The “remaining” CFC may be either in a low-tax or a 

high-tax jurisdiction. Another reason is that important transfer pricing regulatory 

developments also affected years subsequent to 1996, for example the 1996 cost sharing 

regulations. Attempting to disentangle the transfer pricing effects that may be due to the 

check-the-box regulations from those that may be due specifically to the cost sharing 

rules is difficult, although overall trends are still discernable. 

2. CFCs of U.S.-Based Multinational Groups – Profitability in High-Tax 

Versus Low-Tax Jurisdictions

Notwithstanding the shortcomings discussed above, an examination of tax return 

data may be useful in detecting and understanding patterns or relationships in the data 

that may point toward income shifting from non-arm’s length transfer pricing among 

related corporations. This section presents a preliminary empirical analysis of such 

potential income shifting. 

There are two initial considerations in undertaking and evaluating an analysis of 

tax data. First, the analysis should control, to the extent possible, for factors other than 

transfer pricing manipulation that may cause observed differences in the data. Second, 

given the transactional focus of transfer pricing, any aggregated data analysis would not 

in itself be determinative, but would be used most appropriately in conjunction with a 

more targeted analysis of explicit areas of transfer pricing that may be susceptible to 

income shifting from non-arm’s length transfer pricing, such as those areas discussed in 

Section D. 

 

69The years 2002 and 2000 are the two most recent for which data are available (components of the 

database are only compiled every other year). In addition, 1996 is included in order to benchmark the 

updated data to the period examined in a prior analysis discussed below (Grubert (2003)). 

70 See Altshuler and Grubert (2006) and Mutti and Grubert (2006). 

71This issue would be particularly troublesome if the empirical analysis employed a “panel” data analysis; 

that is, an analysis that tracked particular CFCs over time.

56
This transfer pricing analysis seeks to focus, to the extent possible, on related 

party transactions other than intercompany loans. A separate analysis of income 

stripping from the use of intercompany or interbranch debt is discussed in the study of 

earnings stripping in this report. 

The incentives and mechanisms to shift income are available to domestic 

corporations and their foreign affiliates, regardless of whether the transactions are 

between U.S. parents and their CFCs, or between foreign parents and their domestic 

corporations. The tax data that best facilitated the analysis of income shifting in this 

section relate to domestic corporations and their CFCs, but the results could be 

interpreted more broadly. 

A CFC is defined in the Code as a foreign company, more than 50 percent of 

which is owned by “U.S. shareholders” (defined as U.S. persons, including entities, that 

own at least 10 percent of the voting power of the company). If a multinational group is 

systematically engaging in non-arm’s length pricing of intercompany transactions in 

order to facilitate purely tax-advantaged outcomes, one would expect to observe higher 

CFC profitability in low-tax jurisdictions and lower CFC profitability in high-tax 

jurisdictions, assuming other factors that affect profitability are equal. This section 

undertakes an investigation of CFC profitability based on tax return data for the years 

1996, 2000, and 2002.72 

Figure 3.1 depicts the relationship between CFC profitability, measured by the 

ratio of operating profits to sales (or operating margin), and the statutory tax rate of the 

CFC jurisdiction.73 Operating profits are defined as pre-tax earnings excluding interest 

income and interest expense, but including royalty income and royalty expense. The 

measure is based on “earnings and profits” (E&P) and is intended to approximate “book” 

operating profits for tax purposes. This measure of pre-tax operating profits has the 

advantage of being defined consistently across the taxing jurisdictions in which the CFCs 

operate. By excluding interest flows, the measure captures real (“above the line”) 

activity related to, for example, the flows of tangible and intangible assets, and services 

transactions between related and unrelated parties. This operating-margin measure has 

the further advantage of being a common “profit level indicator” when applying the 

comparable profits method under Treas. Reg. § 1.482-5. Statutory tax rates are used 

 

72Specifically, the data used in this analysis are derived from the corporate income tax return (Form 1120) 

for each of the years, merged with information from Form 5471 (an information return filed for each of the 

domestic parent’s CFCs), and Form 1118 (by which a parent calculates the foreign tax credit for foreign 

taxes paid by its CFCs and branches). These tax return data were further matched, where possible, to 

financial data reported in public filings (e.g., SEC filings) of the parent. The sample is derived from the 

data for the largest CFCs where detailed information was available. The sample is further restricted by 

excluding financial CFCs and CFCs with losses. This latter restriction was imposed because firms with 

losses may face different income-shifting incentives than CFCs with net income. 73The term “operating profits” (and the associated term “operating margin”) has a particular meaning to 

transfer pricing practitioners, and so is used here. However, the term differs slightly from “operating 

income” as used in the earning-stripping literature (for example in Grubert (1997)) and discussed in the 

Earnings Stripping Study in this report. Compared to definition of operating income in the study of 

earnings stripping, operating profits discussed in this section include depreciation deductions and royalties 

paid and received. 

57
rather than other measures (for example, effective tax rates) because the shift of an 

additional dollar of income from one taxing jurisdiction to another would result in a 

change in tax equal to the difference in the marginal tax rates of the jurisdictions. The 

marginal tax rate is best measured by the jurisdiction’s statutory tax rate. 

Figure 3.1 depicts the relationship between operating margin and tax rates for all 

non-financial CFCs for each of the tax years analyzed. In general, the curves slope 

downward (although certainly not monotonically, notably in 1996), indicating an inverse 

relationship between pre-tax profitability and tax rates. For example, in 2002 the 

weighted average pre-tax operating margins were over 20 percent for CFCs operating in 

tax jurisdictions with a zero-percent statutory tax rate, while the pre-tax operating 

margins were under 8 percent for CFCs operating in tax jurisdictions with statutory tax 

rates over 35 percent. 

Figure 3.1

 CFC Profitability by Statutory Tax Rates: Non-financial CFCs

0

5

10

15

20

25

0 10 20 30 40 50 60

Local country statutory tax rate (%)

Operating Margin (%)

1996 2000 2002

Although the data depicted in Figure 3.1 generally show that pre-tax operating 

margins are higher in low-tax countries and lower in high-tax countries, they do not 

provide information on the factors that might be contributing to those differences. In 

particular, many factors that affect profitability are not necessarily related to 

inappropriate income shifting (whether achieved through transfer pricing or through other 

means). For example, CFCs in low-tax jurisdictions may have more asset-intensive 

operations, which tend to be associated with higher profit margins. CFC start-ups in a 

given year may happen to be more prevalent in high-tax jurisdictions. CFCs in more 

research-intensive industries may operate in lower tax jurisdictions, and in fact may 

develop their own intangibles to exploit. These non-transfer pricing factors could also be 

consistent with the observed inverse relationship between CFC profitability and statutory 

58
tax rates. Finally, the data depict single year snap-shots of CFC activities. Cyclical 

effects or other non-transfer pricing aberrations could also affect profit differences. 

In order to examine more carefully the relationship between CFC profitability and 

local country tax rates – in particular to capture as many of the non-transfer pricing 

factors as possible – a more refined empirical analysis is required. 

A number of studies have undertaken empirical investigations of income 

shifting.74 These can be categorized based on the data sources used: (1) aggregated, 

country-specific data; (2) firm-level data based on public (non-tax) filings of publicly 

traded companies; and (3) firm-level data based on tax and non-tax filings of U.S.-based 

MNCs and their CFCs. 

In the first category, Grubert and Mutti (1991) use aggregated country-level 

National Income and Products Account (NIPA) data on U.S-based MNCs’ affiliates to 

examine the relationship between profit rates and local country statutory tax rates, while 

controlling for GDP growth, and conclude that the pattern of profitability in high-tax and 

low-tax jurisdictions is consistent with income-shifting behavior. Hines and Rice (1994) 

use country-level aggregated data of non-bank CFCs (i.e., treating all foreign affiliates in 

a country as if owned by representative domestic parent firms), and find evidence of 

sensitivity of profitability to local country effective tax rates, adjusting for financial 

structure and capital employed. Clausing (2001) uses aggregated country-level data on 

intra-firm trade flows from the Bureau of Economic Analysis and shows that the intrafirm trade balance between the U.S.-based MNC and its foreign affiliates, as well as 

intra-firm sales between foreign affiliates of U.S.-based MNCs, are related to effective 

tax rates in a manner consistent with, although not necessarily entirely explained by,

income shifting. 

In the second category, Harris et al. (1993) use cross-sectional firm-level panel 

data from the public filings of 200 domestic manufacturing corporations to investigate 

how differences in U.S. taxes as a percentage of U.S. sales or assets relates to subsidiary 

operations in foreign tax jurisdictions. Taking into account company characteristics (e.g., 

research and development and advertising as proxies for intangible assets, interest 

expense, and number of employees), and using indicators on the presence of an affiliate 

in a particular low-tax or high-tax jurisdiction, they show evidence of income shifting out 

of or into the United States consistent with (that is, negatively correlated with) tax-rate 

differentials between the United States and foreign jurisdictions. Harris (1993) uses firmlevel data from public filings of domestic and foreign corporations to investigate the 

effects from major capital cost provisions in the Tax Reform Act of 1986 whose 

theoretical effect would unambiguously increase the incentive to shift income and/or 

capital to the United States from foreign affiliates independent of relative tax rates. 

Taking into account company characteristics pertaining to the level of “flexible” 

expenses (e.g., research and development, advertising, and interest expense), and 

investigating separately from the U.S. and foreign perspective, he shows evidence that 

 

74These studies refer to “income shifting” rather than the narrower concept of “income shifting from nonarm’s length transfer pricing.” “Income shifting” in these studies might more appropriately be termed 

“potential income shifting,” and often refers to an inverse relationship between profitability and tax rates 

after accounting for non-tax economic factors. This could incorporate, for example, not only non-arm’s 

length transfer pricing but also the aggressive use of inter-corporate debt. 

59
multinational groups shifted more income into the United States after the Tax Reform 

Act of 1986, and that they did so quickly. Jacob (1996) uses similar data to extend Harris 

(1993) by accounting for the volume of intercompany transactions between firms. His 

analysis provides evidence that transfer pricing, rather than other factors, may explain the 

income shifting. 

In the third category, Grubert and Slemrod (1998) use firm-level tax panel data of 

U.S.-based MNCs with subsidiaries in a particular low-tax jurisdiction (Puerto Rico), 

supplemented by data from public filings of the U.S.-based MNCs. They investigate the 

joint-investment and income-shifting choices available to multinational firms, and find 

evidence that a large proportion of U.S. investment in Puerto Rico is due to the incomeshifting opportunities (uniquely) available there. Grubert (2003) seeks, in part, to address 

the somewhat limited applicability of Grubert and Slemrod (1998) by extending the 

analysis across a more comprehensive spectrum of low-tax and high-tax foreign 

jurisdictions. He uses firm-level tax data of CFCs, each matched to domestic parent-level 

tax return data, and further supplemented with data from public filings of the domestic 

parent. The paper evaluates the correlation between pre-tax profitability and local 

country statutory tax rates, controlling for parent and CFC characteristics unrelated to tax 

(e.g., CFC asset intensity, parent size, start-ups, and in particular the presence of 

intangible assets), and finds evidence of income shifting, primarily associated with 

industrial (rather than marketing) intangibles. The analysis is further extended to 

investigate and quantify the extent to which tax incentives to shift income increase the 

volume of related-party transactions. 

A recent analysis (McDonald, 2007) examines potential income shifting from 

non-arm’s length transfer pricing by updating the analysis in Grubert (2003). The 

analysis was undertaken in two sections. In the first part, the analysis modifies the model 

in Grubert (2003) by excluding effects from intercompany debt, and extends the analysis 

through 2002. The second part further extends Grubert (2003) by incorporating 

proprietary transfer pricing-specific data. 

The first section of the analysis examines the relationship between a CFC’s pretax profitability (measured as the ratio of CFC operating profits to CFC sales (i.e., the 

operating margin depicted in Figure 3.1) and the local country’s statutory tax rate. As in 

Grubert (2003), the analysis shows that, even when important non-tax (and statistically 

significant) factors are taken into account, higher local country statutory tax rates had a 

negative and statistically significant correlation with the operating margin of CFCs. The 

correlation increases significantly between 1996 and 2002, indicating a widening of the 

profitability disparities between high-tax and low-tax jurisdictions over that time 

(although these results should be interpreted with some caution in light of the post-1996 

check-the-box regime). As in Grubert (2003), the results of the analysis do not in 

themselves necessarily point to specific inappropriately priced intercompany transactions 

as the underlying cause of the inverse relationship between tax rates and profitability. 

The data are aggregated beyond the transactional level necessary for such a determination 

and, in addition, the data used in this section did not allow for accounting for transfer 

pricing-specific factors, such as participation in CSAs. Nevertheless, because the 

analysis takes into account many non-transfer pricing economic factors that could affect 

profitability, the hypothesis that multinational groups engage in non-arm’s length pricing 

60
of intercompany transactions in order to facilitate purely tax-advantaged outcomes cannot 

be rejected by the available data, in both the pre-check-the-box and post-check-the-box 

years. These results are consistent with the existing economics literature. 

The second section of the analysis supplements the tax return data with survey 

data on CSAs to determine whether CSA status influenced the results. The data are 

derived from a survey undertaken by the IRS of its international examiners and 

economists in order to identify those MNCs that have in the past engaged in CSAs or are 

currently engaged in CSAs with any of their CFCs. The survey information includes the 

names of domestic parent companies that have at least one CSA, the starting year of the 

CSAs identified, the names of the CFCs participating in the CSAs, and some information 

on audit activity of the CSAs. This survey information was appended to the data used in 

the first section of the paper. While the survey data cannot be considered comprehensive, 

the information was used to assess the distribution of profitability across taxing 

jurisdictions for CFCs of this particular group of MNCs, and to compare these CFCs with 

CFCs of MNCs not engaging in CSAs. The analyses provide two notable results. First, 

CFCs whose parents engage in CSAs tend to be more profitable overall than other CFCs. 

Second, CFCs whose parents engage in CSAs do tend to have higher profitability in lowtax jurisdictions and lower profitability in high-tax jurisdictions than their non-CSA 

cohorts, generally at statistically significant levels, when controlling for the other non-tax 

factors and the age of the CSA. The results suggest that CFCs whose parents engage in 

CSAs tend to show more evidence of potential income shifting, but again it is unclear the 

extent to which this may be due to CSAs themselves or to other factors. 

3. Conclusion

As discussed above, while the ability to draw transfer pricing-specific inferences 

from tax return and CSA data is limited to some extent, the analysis of the data does not 

allay the concerns about potential income shifting from non-arm’s length transfer pricing 

derived from the more detailed analysis of the administration of the existing transfer 

pricing regulations, especially CSAs, as discussed in Section D. 

F. Improving Transfer Pricing: Recent Regulatory Efforts 

Sections C and D discussed the progress made in developing and administering 

transfer pricing rules since 1986. Sections D and E discussed potential shortcomings of 

the current transfer pricing regulatory regime from a legal/administrative and empirical 

basis, respectively. This Section F discusses three projects undertaken to address these 

concerns: (1) the proposed cost sharing regulations (2005), (2) the temporary and 

proposed services regulations (2006) (preceded by proposed services regulations in 

2003); and (3) reproposed global dealing regulations (anticipated shortly). 

1. Proposed Cost Sharing Regulations (2005)

Proposed cost sharing regulations issued in 2005 adopt as a fundamental principle 

an “investor model” for addressing the relationships and contributions of controlled 

participants in a CSA. Under this model, each controlled participant may be viewed, at 

the outset of the CSA, as making an aggregate investment, attributable to both future cost 

contributions (ongoing share of intangible development costs) and current “external 

contributions” (the preexisting advantages that the parties bring into the arrangement), for 

61
purposes of achieving an anticipated return appropriate to the risks of the CSA over the 

term of the development and exploitation of the intangibles resulting from the 

arrangement. 

In evaluating the appropriate compensation for external contributions, it is 

necessary, under the investor model, to determine (1) what an investor would pay at the 

outset of a CSA for an opportunity to invest in that arrangement, and (2) what a 

participant with external contributions would require as compensation at the outset of a 

CSA to allow an investor to join in the investment. This is nothing more than a 

restatement of the familiar “willing buyer/willing seller” standard for determining fair 

market value generally. 

The appropriate “price” of undertaking a risky investment is typically determined 

at the time the investment is undertaken, based on the ex ante expectations of the 

investors. Given the uncertainty about whether and to what extent intangibles will be 

successfully developed under a CSA, ex post interpretations of ex ante expectations are 

inherently unreliable and susceptible to abuse. Accordingly, an important implication of 

determining the arm’s length result under the investor model, reflected in the methods set 

forth in the proposed regulations, is that compensation for external contributions is 

analyzed and valued ex ante. The ex ante perspective is fundamental to achieving arm’s 

length results. 

The proposed regulations provide supplemental guidance for determining the 

appropriate compensation for external contributions. The proposed regulations clarify 

the contractual terms under which external contributions are made. Specifically, the 

valuation of the rights associated with external contributions cannot be artificially limited 

by purported conditions or restrictions, as could arguably occur under the current 

regulations. Rather, the arm’s length compensation for external contributions must 

reflect the type of transaction and contractual terms of a “reference transaction” by which 

the benefit of exclusive and perpetual rights in the relevant resources or capabilities are 

provided. This compensation will be determined by a method that will yield a value for 

the obligation of any given controlled participant that is consistent with that participant’s 

share of the combined value of the external contribution to all controlled participants. 

The definition of external contribution does not require actual ex post use, but merely that 

the resource or capability is reasonably anticipated to contribute to developing costshared intangibles. In addition, external contributions are not limited to intangibles, but 

also include other resources or capabilities. 

The proposed regulations set forth new specified methods and provide rules for 

application of existing specified methods, for purposes of determining the arm’s length 

compensation due with respect to external contributions. The proposed regulations also 

enunciate general principles governing all methods, specified and unspecified, for these 

purposes. Taken together, the guidance provided by the proposed regulations helps to 

address the serious buy-in valuation problems identified in Section D. 

The proposed regulations require that compensation for external contributions be 

consistent with an investor model for cost sharing. Two key principles follow from the 

investor model regarding such compensation. The first is that, ex ante, the aggregate 

investment (external contributions plus subsequent cost sharing payments) would be 

62
expected to yield an anticipated rate of return (above and beyond the return relating to 

routine functions undertaken in exploiting the intangible) commensurate with the 

riskiness of the CSA (reflected in the appropriate discount rate). It should be noted, 

however, that the actual (or ex post) return to the cost sharing participants may be higher 

or lower than the anticipated return determined at the outset of the CSA, reflecting the 

legitimate return to risk-taking by the participants. Once cost sharing parameters (e.g., 

the buy-in contingent payment rate) are determined on an ex-ante basis, the cost sharing 

arrangement is allowed to play itself out. 

The second principle is that, ex ante, the appropriate return to the aggregate 

investment is measured over the entire period of development and exploitation of costshared intangibles. Included in this principle is the concept that no part of the investment 

should be viewed as separately earning a return over a more limited period. As a general 

matter, successful completion of each step in a research program is a necessary condition 

for the completion of the program as a whole and its contribution continues over the 

entire life of the project. For this reason, each aspect of the research program must be 

viewed as contributing to the success of the program as a whole (and not just its success 

for some limited period of time). 

The regulations specify methods for properly valuing external contributions 

(including the “comparable uncontrolled transactions” (CUT) method, the “acquisition 

price” method, the “market capitalization” method, the “income” method, and the 

“residual profit split” method) and also provide guidance on using unspecified methods. 

This guidance provides much needed clarification on applying the arm’s length standard 

under section 482 to the particularly complex valuation issues that arise under CSAs, and 

also more clearly addresses particular fact patterns that are commonly encountered by the 

IRS. In particular, the income method specifically addresses the situation where only one 

controlled participant brings non-routine external contributions into the CSA. In such 

circumstances, the other controlled participant or participants essentially only commit to 

bearing their respective share of ongoing costs and bring only routine contributions for 

purposes of exploiting cost-shared intangibles. As discussed in Section D, it is this 

situation that the Treasury Department believes is most susceptible to income shifting 

from non-arm’s length transfer pricing. 

The proposed regulations provide greater clarity on how the “commensurate with 

income” standard is to be applied to CSAs. Building on the investor model, the proposed 

regulations provide guidance on the periodic adjustments that the IRS Commissioner may 

make in situations where the actual results of a controlled participant’s investment 

attributable to cost contributions and external contributions are widely divergent from 

reasonable expectations at the time of the investment (typically the outset of the CSA). 

Exceptions are provided, including one under which the taxpayer may establish that the 

differential is due to events beyond its control that are extraordinary and not reasonably 

anticipated at the outset of the CSA. 

The disadvantages the IRS faces in examining, necessarily after-the-fact, the 

profit potential reasonably expected by taxpayers at the time of a transfer of intangible 

property between related parties justifies the ex post perspective necessarily inherent in 

63
the commensurate with income standard.75 This “information asymmetry” between the 

taxpayer and the IRS is, thus, the rationale for, and foundation of, the periodic-adjustment 

rules. The IRS Commissioner’s ability to evaluate controlled participants’ deals with 

regard to high-profit potential intangibles is hampered, not only by the absence of 

comparables, but by an asymmetry of information vis-à-vis the taxpayer. The taxpayer is 

in the best position to know its business and prospects. The IRS Commissioner faces real 

challenges in ascertaining the reliability of the ex ante expectations of the taxpayer’s 

arrangements in light of significantly different ex post outcomes. While risk and 

uncertain outcomes are typically the hallmarks of high-profit potential intangibles, results 

that are significantly more favorable to the taxpayer than the purported ex ante

expectations raise concerns whether the terms of the initial arrangement reflect a 

conscientious upfront valuation. These concerns are particularly problematic given the 

information asymmetry between taxpayers and the IRS. Periodic adjustments effectively 

permit the IRS to impute an arm’s length arrangement that appropriately reflects the 

profit potential of transferred intangibles where the taxpayer’s pricing fails to reflect a 

conscientious upfront valuation effort. Because the guidance on periodic adjustments is 

intended to address the problem of information asymmetry, and because it is extremely 

unlikely that a taxpayer would use information asymmetry for anything other than a taxadvantaged result, periodic adjustments of this type may only be exercised by the 

Commissioner. However, the periodic-adjustment rules are not intended to provide a 

basis for the IRS to make adjustments to buy-in payments simply because the actual 

return to the buy-in payor may have exceeded the anticipated return. 

Finally, the proposed regulations provide stronger documentation requirements 

than those under the existing final regulations. Taxpayers must comply with up-front 

contractual requirements, accounting requirements, reporting requirements, and other 

documentation requirements that ensure fair and timely assessment of the CSA by the 

IRS. The Treasury Department believes that the proposed cost sharing regulations 

provide a marked improvement over the current regulations (Treas. Reg. § 1.482-7), and 

will help ensure that key cost sharing financial parameters, most notably compensation 

for external contributions, are determined in accordance with the arm’s length standard. 

To the extent that income shifting from non-arm’s length transfer pricing has resulted 

from the misapplication of the current cost sharing regulations, expeditious finalization of 

the proposed regulations should be a high priority. The Treasury Department is currently 

reviewing taxpayer comments on the proposed regulations. 

 

75 The legislative history to the 1986 addition of the commensurate with income standard to section 482 

indicates that this ex post evaluation of ex ante taxpayer expectations was clearly intentional: 

The committee does not intend, however, that the inquiry as to the appropriate 

compensation for the intangible be limited to the question of whether it was appropriate 

considering only the facts in existence at the time of the transfer. The committee intends 

that consideration also be given the actual profit experience realized as a consequence of 

the transfer. 

H.R. Rep. No. 99-426, 99th Cong., 1st Sess., 1986-3 C.B. Vol. 2 420,425. 

64
2. Temporary and Proposed Services Regulations (2006)

Background: Proposed Services Regulations (2003) 

The predecessor to, and intellectual foundation of, the 2006 temporary and 

proposed services regulations was the proposed services regulations published in 2003. 

The 2003 proposed regulations provided generally that the arm’s length charge in a 

services transaction must be determined by using one of the transfer pricing methods 

provided or referenced in the regulations. The guidance on methods was generally 

consistent with the 1994 regulations applicable to transfers of tangible and intangible 

property, and was consistent with international standards with respect to services 

transactions. The methods provided or referenced include the “comparable uncontrolled 

services price” method, the “gross services margin” method, the “cost of services plus” 

method, the existing comparable-profits method, as adapted to services, the existing 

residual profit split method, and unspecified methods, to the extent such methods provide 

the most reliable measure of an arm’s length result under the best method rule. The 

provisions in the subsequent 2006 temporary and proposed regulations, described below, 

are substantially similar to the corresponding provisions in the 2003 proposed 

regulations. 

The proposed regulations provided a new transfer pricing method for low-value 

services such as routine back-office services. This “simplified cost based method” 

(SCBM) was intended to replace the current cost safe harbor with a simplified method 

based on comparability principles that would be more consistent with the arm’s length 

standard and yet require a less robust analysis than under the general transfer pricing 

rules. 

The SCBM would have limited the ability of the IRS to make allocations it could 

otherwise make under the general rules. Generally, the IRS would have been able to 

make an allocation under the SCBM only if it determined that the arm’s length markup 

on “total services costs” exceeded the markup charged by the taxpayer by at least the 

“applicable number of percentage points.” 

The applicable number of percentage points would be six if the amount charged 

by the taxpayer is equal to total services costs, and declines ratably to zero by one 

percentage point for every increase of two percentage points in the markup on total 

services costs charged by the taxpayer. For example, if the amount charged by the 

taxpayer is equal to total services costs (that is, if the taxpayer charges no markup), then 

the IRS could only make an allocation if it determined that the “true” arm’s length 

markup on total services costs exceeds 6 percent. If the amount charged by the taxpayer 

is 4 percent above total services costs, the arm’s length markup necessary before the IRS 

can make an adjustment is 8 percent. Consequently, as the taxpayer's transfer price 

increases, the safe harbor ”ceiling” over the taxpayer’s transfer price declines. The safe 

harbor is eliminated when the arm’s length markup exceeds 10 percent. 

In addition to the 10-percent upper bound, several quantitative and qualitative 

tests would have applied to filter out services that should be subject to a more robust 

arm’s length analysis, including a list of categories of transactions such as manufacturing, 

production, extraction, construction, distribution, research, and financial transactions. No 

inference was intended regarding either the arm’s length markup on total services costs 

65
with respect to any of the excluded categories or types of transactions or the appropriate 

transfer pricing method for analyzing any particular transaction. In particular, no 

inference was intended that the arm’s length markup for such transactions in a particular 

case would exceed 10 percent of total costs. Rather, these transactions are ineligible for 

the SCBM because the Treasury Department concluded that a full transfer pricing 

analysis is appropriate. 

The 2003 proposed regulations also provided guidance intended to coordinate and 

harmonize the rules applicable to services related to intangibles with the rules applicable 

to transfers of intangible property. The purpose of this guidance was to ensure that 

transfer pricing rules, when applied to economically similar transactions, reach 

substantially similar results. For example, the proposed regulations provided that the 

arm’s length result for a services transaction that results in, or has an effect similar to, the 

transfer of intangible property must be determined or corroborated by an analysis under 

the transfer pricing rules for transfers of intangible property. The proposed regulations 

also included provisions regarding the use or imputation of contingent-payment 

arrangements in services transactions and amendments to make the residual profit split 

method more suitable to services transactions, each of which was intended to contribute 

to better coordination and harmonization of the rules applicable to services with those 

applicable to transfers of intangible property. 

The 2003 proposed regulations also provided rules and examples regarding the 

treatment of services performed in connection with the development or enhancement of 

an affiliate’s intangible property, particularly in the context of the development of 

marketing intangibles. In general, these rules provided that such services must be 

compensated either through a separate charge or by being taken into account as a 

comparability factor in a larger integrated transaction, such as a license. Because of 

safeguards in the SCBM and the rules coordinating the pricing of services and transfers 

of intangibles, it would no longer be necessary to allocate income by imputing shifts of 

ownership of intangible property to service providers, as under the current regulations. 

Additionally, rather than allowing for the possibility of multiple owners of intangible 

property, the proposed regulations recognized that, based on intellectual-property law or 

contractual or other legal provisions, there are distinct owners of distinct intangibles. For 

example, the licensor of a trademark may be the owner of the trademark under 

intellectual-property law, while the licensee is the owner of the license pursuant to its 

contractual terms. The trademark and the license are distinct intangibles with distinct 

owners, rather than a single intangible with multiple owners. 

Temporary and Proposed Services Regulations (2006) 

The Treasury Department received a substantial volume of comments on a wide 

range of issues addressed in the 2003 proposed regulations. Substantial changes were 

made in response to those comments. In order to achieve the goal of updating the 1968 

regulations, while facilitating consideration of further public input in refining final rules, 

66
regulations were issued in temporary and proposed form with a delayed effective date for 

taxable years beginning after December 31, 2006.76 

As described in the 2003 proposed services regulations, the SCBM was intended 

to preserve aspects of the cost safe harbor (under Treas. Reg. § 1.482-2(b)) that provide 

appropriately reduced administrative and compliance burdens for low-margin services. 

At the same time, the existing rules would be brought more in line with the arm’s length 

standard, and various problematic features of those rules would be eliminated. However, 

a number of commentators argued that the SCBM was actually counterproductive to its 

stated goals. These commentators contended that to apply the SCBM, taxpayers would 

potentially need to expend substantial sums to prepare comparability studies, perhaps 

separately for each of the numerous categories of back-office services. They contended 

that, although taxpayers have in-depth knowledge concerning their businesses and the 

relative value added by their back offices, the SCBM called for quantitative judgments 

that business people are not qualified to make by themselves, especially in the prevailing 

compliance environment. As a matter of proper accountability, taxpayers would be 

effectively required to devote significant compliance resources to enlist outside 

consultants or otherwise to develop support for those judgments. 

Based on these comments, the 2006 temporary and proposed regulations 

eliminated the SCBM and replaced it with the “services cost method” (SCM). 

Specifically, the SCM provides for two categories of covered services that are eligible to 

be priced at cost (at the taxpayer’s election) if certain conditions are met. The first 

category consists of specified covered services identified in a revenue procedure 

published by the IRS. Such services are identified in a revenue procedure based upon the 

determination of the Treasury Department that they constitute support services of a type 

common across industry sectors and generally do not involve a significant arm’s length 

markup on total services costs. Because the government performs the analysis necessary 

to determine the eligibility of specified covered services, the compliance burden that 

might have been imposed by the SCBM is eliminated for a broad class of commonly 

provided services. The second category of covered services is certain low-margin 

covered services. Low-margin covered services consist of services for which the median 

comparable arm’s length markup on total services costs, as determined under the general 

rules of Treas. Reg. § 1.482, is less than or equal to 7 percent. 

Under the SCM, specified covered services or low-margin covered services 

otherwise eligible for the SCM will qualify for the method if the taxpayer reasonably 

concludes in its business judgment that the services do not contribute significantly to key 

competitive advantages, core capabilities, or fundamental chances of success or failure in 

one or more trades or businesses of the renderer, the recipient, or both. Unlike the 

quantitative judgment called for under the SCBM, this is a business judgment 

preeminently within the businessperson’s own expertise. This test is intended to focus 

transfer pricing compliance resources of both taxpayers and the IRS principally on 

significant valuation issues. The test allows the IRS to reject any attempt to claim that a 

core competency of the taxpayer’s business qualifies as a mere back-office service. This 

 

76A subsequent Notice and Revenue Procedure further delayed the effective date, so that the temporary 

regulations will apply for taxable years after December 31, 2007, for provisions relating to the cost method 

provided in the regulations. 

67
provision avoids the need to exclude from the categories of covered services certain 

back-office services that as a general matter and across a range of industry sectors are 

low-margin, but that in the context of a particular business, nonetheless, constitute highmargin services. That is, it permits the Treasury Department to include a greater range of 

service categories under the SCM, even though in specific circumstances an otherwise 

covered service of a particular taxpayer will be ineligible. 

Finally, the SCM preserves the same list of categories of controlled services as the 

SCBM did that are not eligible to be priced under this method. The Treasury Department 

continues to believe that these are high-margin services for which total services costs 

constitute an inappropriate reference point, or other types of services that should be 

subject to a more robust arm’s length analysis under the general section 482 rules. 

The preamble to the 2003 proposed regulations indicated that in certain cases, the 

allocation or sharing among group members of expenses or charges relating to corporate 

headquarters or other centralized service activities may be consistent with the proposed 

regulations, but no further guidance was provided on such service-sharing arrangements. 

The 2006 temporary regulations explicitly provide this guidance through “shared services 

arrangements” (SSAs). SSAs provide a means for aggregating services and for allocating 

the total charge for services among more than one beneficiary. 

Commentators observed that the definition of ”total services costs” in the 2003 

proposed regulations did not address situations in which the costs of a controlled service 

provider included significant charges from uncontrolled parties. Commentators claimed 

that such third-party costs should be treated as ”pass through” items that, in most cases, 

should not be subject to the markup (if any) applicable to costs incurred by the renderer 

in its capacity as service provider. This comment was potentially relevant to all costbased methods in the 2003 proposed regulations (i.e., Treas. Reg. § 1.482-9). The 2006 

temporary regulations provide specific guidance to deal with this situation by allowing 

taxpayers, in certain circumstances, to evaluate controlled services transactions that 

involve third-party costs on a disaggregated basis. That is, where the costs of a 

controlled service provider included significant charges from uncontrolled parties, the 

controlled-services transaction may be analyzed either as a single transaction or as two 

separate transactions (i.e., the third-party costs are broken out separately), depending on 

which approach provides the most reliable measure of the arm’s length result. 

The provisions in the 2006 temporary and proposed regulations with respect to the 

coordination and harmonization of the rules applicable to services related to intangibles 

are substantially similar to the corresponding provisions in the 2003 proposed 

regulations, although a substantial number of clarifications and other modifications were 

made in response to taxpayer comments. 

Notice and Revenue Procedure (2006) 

In December 2006, the Treasury Department issued a Notice and Revenue 

Procedure relating to the temporary and proposed services regulations.77 

 

77Notice 2007-5, 2007-3 I.R.B. 269 (Jan. 16, 2007) and Revenue Procedure 2007-13, 2007-3 I.R.B. 295 

(Jan. 16, 2007). 

68
The Notice provided a partial modification to the effective date, so that the 

temporary regulations will apply to taxable years after December 31, 2007, for all 

provisions relating to the SCM except the business-judgment rule. The modification was 

made in response to numerous taxpayer requests to allow sufficient time to modify 

accounting systems and to take other steps in order to comply fully with the temporary 

regulations. The Notice also clarified that that the application of the SCM is elective by 

taxpayers, and that taxpayers may use SSAs to make allocations of arm’s length charges 

for services ineligible for the SCM that yield a benefit to multiple members of a 

controlled group. 

Finally, in response to taxpayer requests, the list of specified covered services 

under the SCM was significantly broadened. The Revenue Procedure provides the 

updated list of specified covered services reflecting the modifications. 

3. Reproposed Global Dealing Regulations

It has been almost 10 years since the global dealing regulations were proposed, 

and those regulations have not been finalized. During this time, global dealing in 

financial products has changed significantly, as a result of technological advances, 

globalization and interconnection of economic activity, and other factors. Accordingly, 

the Treasury Department has placed a high priority on reproposing global dealing 

regulations to reflect these changes. 

The vast majority of dealing activity takes place within a handful of countries. As 

a result, treaties apply to most, but not all locations where global dealing operations are 

conducted. In order to avoid double taxation and to minimize disputes that may result 

among Competent Authorities, the reproposed global dealing regulations will comport 

with emerging income tax treaty principles as much as possible. 

Older U.S. tax treaties generally do not adopt the arm’s length standard provided 

for in Article 7 of the OECD Model Income Tax Treaty. However, several recent U.S. 

income tax treaties provide that the arm’s length standard will be used to allocate profits 

within a single enterprise based on a functional analysis of assets used, risks assumed, 

and functions performed. These recent treaties cover the main financial centers in the 

world and represent the most common jurisdictions where the majority of global 

securities dealing operation are conducted. These agreements follow the work of the 

OECD project on attribution of profits to PEs and apply the OECD Transfer Pricing 

Guidelines to PEs by analogy. The OECD project represents the principal effort by 

member countries to reach agreement on the common principles to apply in determining 

business-profit attribution to a PE for business in general and for global dealing 

operations in particular. Importantly, the OECD attribution project vastly narrows the 

differences between its member countries on the attribution of financial income and the 

allocation of debt financing and equity capital. Resolution of these issues significantly 

eliminates double taxation in many cases or reduces the differences to levels where the 

competent authorities should often be able to reach agreements. The Treasury 

Department intends to issue reproposed global dealing regulations, consistent with this 

emerging agreement, which provide guidance to allow taxpayers to determine the amount 

of income from a global dealing operation that will be subject to tax in the United States. 

These regulations will also provide rules for determining the allocation and source of 

69
income earned in a global dealing operation and the circumstances under which such 

income is effectively connected to a foreign corporation’s U.S. trade or business. 

G. Conclusions 

The Treasury Department believes that the existing transfer pricing rules and 

compliance efforts must be continually monitored in order to ensure their effectiveness. 

There are certain aspects of the final regulations that may not be sufficiently complete 

and that may not function as intended. These include the rules for cost sharing 

arrangements, intercompany services, certain rules pertaining to marketing intangibles, 

and global financial dealings. 

 The cost sharing regulations must be revised to provide additional guidance to 

ensure arm’s length compensation is paid for the external contributions each party may 

bring to a cost sharing arrangement. Many taxpayers have misinterpreted the current 

regulations, resulting in systematic undervaluation of buy-in payments. Additional 

guidance is necessary to value buy-in payments appropriately, to define more clearly 

what constitutes a cost sharing arrangement, and to specify more clearly how the 

commensurate with income standard applies to such arrangements. 

The existing final services regulations have become outdated by the passage of 

time and are inadequate in handling the complexities of current multinational operations 

and transactions. The absence of updated services regulations has led to discontinuities 

between transfer pricing for services and transfer pricing for tangible and intangible 

property. The rules applicable to the development of intangible property, such as 

marketing intangibles, have been misapplied in practice and need to be revised. 

Similarly, the current regulations provide insufficient guidance for the highly complex 

intercompany transactions of financial-services companies undertaking global dealing 

operations, as well as for other financial transactions, such as the provision of financial 

guarantees. 

Experience in administering the current transfer pricing regulations reveals that 

there is some potential for income shifting by taxpayers. This potential is perhaps most 

acute with respect to cost sharing arrangements, but is also possible with respect to the 

provision of intercompany services and financial transactions. 

The economics literature has historically found empirical evidence that is 

consistent with income shifting from non-arm’s length transfer pricing by multinational 

groups. The literature shows, for example, that pre-tax profitability of CFCs has been 

negatively correlated with local country statutory tax rates, taking into account real 

economic factors such as financial structure, capital employed, and other non-transfer 

pricing operational aspects of multinational groups. While the data and analyses do not 

provide direct evidence of specific transfer pricing manipulation, they do not allay the 

concerns about potential income shifting from non-arm’s length transfer pricing derived 

from a critical assessment of the current transfer pricing regulations. 

H. Recommendations 

Based on this assessment of the effectiveness of current transfer pricing rules and 

compliance efforts, the Treasury Department believes, as reflected in the 2007-2008 

Priority Guidance Plan, that the highest priority should be given to the prompt 

70
finalization and implementation of the three transfer pricing regulation projects discussed 

in this study. These regulations will address known gaps in transfer pricing 

administration, and will eliminate common avenues for income shifting from non-arm’s 

length transfer pricing available to multinational groups. While enhanced disclosure is 

generally helpful, it is not always cost effective and the Treasury Department is cognizant 

of the administrative burden already faced by companies in complying with admittedly 

complex transfer pricing rules. In fact, an important part of each of the regulatory 

projects has been specifying documentation and information requirements that allow for 

proper administration of the regulations at the lowest possible burden to taxpayers. 

Given the current disclosure requirements already in place (as well as the additional 

disclosure requirements that are part of the proposed regulations), the generally high 

audit rates of affected taxpayers, and the enhanced ability of the Competent Authority to 

exchange information with other tax jurisdictions, additional disclosure requirements are 

not recommended at this time.

 

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IV. STUDY OF INCOME TAX TREATIES 

A. Introduction 

 Section 806 of AJCA included the following mandate for a study of income tax 

treaties: 

The Secretary of the Treasury or the Secretary’s delegate shall conduct a 

study of United States income tax treaties to identify any inappropriate 

reductions in United States withholding tax that provide opportunities for 

shifting income out of the United States, and to evaluate whether existing 

anti-abuse mechanisms are operating properly. The study shall include 

specific recommendations to address all inappropriate uses of tax treaties. 

B. Executive Summary 

The United States has a network of 58 income tax treaties that encompasses 66 

countries. Through this network the United States seeks to minimize tax-related 

impediments to inbound foreign investment by reducing, and in many cases waiving, its 

statutory taxing rights on U.S.-source income earned by residents of its treaty partners. 

An underlying principle of U.S. tax-treaty policy is that the benefits accorded in these 

bilateral agreements must be safeguarded from abuse. In particular, adequate rules must 

protect against unintended and inappropriate application of the benefits provided in tax 

treaties. 

The United States generally imposes a 30-percent gross-basis withholding tax on 

payments of dividends, royalties, and many types of interest earned by nonresidents who 

do not have a U.S. trade or business. U.S. tax treaties usually significantly reduce 

withholding taxes imposed by each treaty partner. Over the past several years the 

Treasury Department has developed, in consultation with the Congress, special rules for 

payments by U.S. Regulated Investment Companies (RICs), U.S. Real Estate Investment 

Trusts (REITs) and through other financial instruments, to combat abuse of treaty-based 

withholding rate reductions, particularly with respect to payments of dividends, interest, 

and insurance premiums. The Treasury Department is satisfied that these anti-abuse rules 

achieve the proper balance of preventing inappropriate reductions of withholding taxes 

while at the same time allowing cross-border economic activity to reach its full potential. 

In addition, the United States has been a longstanding world leader in the 

development of limitation on benefits rules to prevent the inappropriate use of a bilateral 

tax treaty by residents of third countries, known as “treaty shopping.” Analysis of data 

from U.S. corporate tax returns indicates that a small subset of U.S. tax treaties that have 

deficient anti-treaty-shopping protections is being exploited by third-country residents. 

Thus, these treaties present an unusual opportunity to observe taxpayer behavior in the 

absence of anti-abuse provisions, and indirectly provide evidence that the anti-treatyshopping provisions in the other U.S. agreements are an effective deterrent against abuse. 

The Treasury Department is actively taking steps to amend or replace the deficient 

agreements, and to fortify the limitation-on-benefits provisions where needed throughout 

the U.S. tax-treaty network. 

73
C. Development of the Anti-Abuse Provisions of U.S. Tax Treaties 

Through its network of 58 income tax treaties encompassing 66 countries, the 

United States seeks to minimize tax-related impediments to inbound foreign investment 

by reducing, and in many cases waiving, its statutory taxing rights on U.S.-source income 

earned by residents of its treaty partners. For a variety of reasons (such as irreconcilable 

policy differences, the absence of problems that require resolution through a tax treaty, or 

low levels of cross-border investment), the United States does not have tax treaties with 

many countries. Accordingly, residents of those third countries are subject to U.S. 

taxation as prescribed under the Code on income from their investments in the United 

States. For instance, absent a treaty providing otherwise, the United States generally 

imposes a 30-percent gross-basis withholding tax on payments of dividends, royalties, 

and many types of interest earned by nonresidents who do not have a U.S. trade or 

business. 

Because tax treaties are negotiated agreements between two countries, it is 

necessary to ensure that the benefits they provide, such as reductions in statutory 

withholding rates, are not abused. Curtailing inappropriate reductions in withholding 

rates is an underlying principle of many aspects of modern U.S. tax-treaty policy as 

formulated by the Treasury Department, and embodied in the United States Model 

Income Tax Convention of November 15, 2006 (“2006 U.S. Model”) and all of the 

income tax treaties recently concluded by the Treasury Department. Safeguards against 

inappropriate withholding reductions are perhaps most noteworthy in the context of the 

provisions regarding cross-border payments of dividends, interest, and insurance 

premiums, as discussed in detail in sections 1 through 3 below. Section 4 discusses the 

evolution of the Treasury Department’s efforts to combat “treaty shopping,” or the 

inappropriate exploitation of bilateral treaty benefits by a resident of a third country. 

1. U.S. Treaty Measures to Prevent Abuse of Dividend-Withholding 

Reductions

U.S. income tax treaties customarily provide two different withholding-rate 

reductions for cross-border payments of dividends. Withholding on dividends paid to 

portfolio investors (defined as shareholders owning less than 10 percent of the shares of 

the corporation paying the dividend) is typically limited to 15 percent of the gross 

amount of the dividend. Withholding on dividends paid to direct investors (defined as 

shareholders owning at least 10 percent of the shares of the corporation paying the 

dividend) is typically limited to 5 percent of the gross amount of the dividend. 

For a number of years, U.S. tax-treaty policy has provided special rules that deny 

the 5-percent reduced withholding rate on dividends paid by RICs and REITs and permit 

the 15-percent reduced withholding rate on dividends paid by REITs only in certain 

instances. These special rules, found in modern U.S. tax treaties, are intended to prevent 

the use of these entities to gain inappropriate U.S. tax benefits. For example, a 

corporation resident in the treaty partner that wishes to hold a diversified portfolio of 

U.S. corporate shares could hold the portfolio directly and would bear a U.S. 

withholding tax of 15 percent on all of the dividends that it receives. Alternatively, it 

could hold the same diversified portfolio by purchasing 10 percent or more of the 

interests in a RIC. Absent the special rule, a RIC could be used to transform portfolio 

74
dividends, taxable in the United States under the treaty at the 15 percent rate of 

withholding tax, into direct investment dividends taxable at the 5 percent rate of 

withholding tax. 

Similarly, a resident of the treaty partner directly holding U.S. real property 

would pay U.S. tax upon the sale of the property either at a 30-percent rate of 

withholding tax on the gross income or at graduated rates on the net income. By placing 

the real property in a REIT, the investor could, absent a special rule, transform income 

from the sale of real estate into dividend income from the REIT, taxable at the rates 

generally applicable to dividends, significantly reducing the U.S. tax that otherwise 

would be imposed on income from real property. The special rule prevents this result and 

thereby avoids a disparity between the taxation of direct real-estate investments and realestate investments made through REIT conduits. The special rule, however, permits 

portfolio investors in a REIT to be eligible for the 15-percent maximum rate of 

withholding tax on dividends from the REIT. 

A number of recent U.S. income tax treaties have provided for an exemption from 

source-country withholding for certain intercompany dividend payments at prescribed 

ownership thresholds. The Treasury Department agrees to eliminate withholding taxes on 

intercompany dividends only in appropriate circumstances. In all cases where such a 

provision has been included, accompanying safeguards are included to ensure that the 

provision will not be exploited by persons who were not intended to enjoy the benefit. 

For example, the benefit is extended only to corporations that satisfy particular tests of 

the limitation-on-benefits provision, the purpose of which, as is explained more fully 

below, is to ensure that persons who are not truly residents of the treaty partner do not 

enjoy the benefits of the treaty. 

2. U.S. Treaty Measures to Prevent Abuse of Interest-Withholding 

Reductions 

 Over the past decade, financial intermediaries have developed a variety of new 

financial products that do not fit well within the traditional definitions and concepts of 

debt and equity upon which the tax-treaty framework has relied. Although taxpayers 

generally use these new financial instruments for legitimate business reasons, there is a 

growing concern that they also may be used for tax-avoidance purposes. For example, it 

is apparent that taxpayers can use derivative instruments to replicate an equity investment 

and to earn income that is virtually indistinguishable from a dividend. If withholding tax 

is not imposed on these payments, it would be a simple matter for nonresidents to receive 

a dividend-like return without being subject to the withholding tax that would apply to 

actual dividends. 

In view of the foregoing, the Treasury Department places importance on 

preserving maximum flexibility for the United States to deal with the evolving market of 

financial products and to treat the income they generate as dividends or as interest if that 

treatment is consistent with internal law. On the other hand, it also is important to ensure 

that withholding taxes do not hinder the use of those instruments for hedging or other 

legitimate business purposes. 

The 2006 U.S. Model includes a special rule in the interest article that preserves 

the right of the United States to tax interest payments that are contingent on the debtor’s 

75
(or a related person’s) income (e.g., receipts, sales or other cash flow, profits, or changes 

in the value of property) or payments (e.g., dividends or partnership distributions), socalled “contingent interest,” at a rate of 15 percent of the gross amount of the interest. 

Under U.S. tax law, instruments that are denominated as debt instruments but that 

participate in profits may be respected as indebtedness or may be recharacterized as 

equity, depending on the terms of the instrument. 

Even if an instrument is respected as indebtedness for U.S. tax purposes, 

contingent interest generally will not qualify for the exemption from U.S. withholding tax 

that applies to “portfolio interest” received by a foreign person. Most other types of U.S.-

source interest qualify as “portfolio interest,” unless the interest is beneficially owned by 

a person that is related to the payor or is beneficially owned by a foreign bank that has 

made a loan in the ordinary course of its trade or business. The contingent-interest rules 

were added to the Code in 1993 to deal with specific types of abuses in which foreign 

taxpayers could avoid the taxes imposed on investments in U.S. real property or could 

avoid the withholding taxes on dividends by making economically equivalent payments 

with respect to instruments that would otherwise qualify as debt. Modern U.S. tax 

treaties preserve these special tax rules for payments of contingent interest.78 

 The 2006 U.S. Model and recent U.S. tax treaties similarly preserve anti-abuse 

rules regarding holdings by foreign persons in U.S. Real Estate Mortgage Investment 

Conduits (REMICs). REMICs are a popular U.S. tax vehicle that hold a fixed pool of 

real estate loans and issue debt securities with serial maturities and differing seniority and 

rates of return (referred to as “regular interests”) backed by those loans. Through a 

REMIC, a financial institution can repackage and sell long-term mortgages to investors. 

A REMIC is not subject to U.S. income tax. Instead, holders of a REMIC’s 

“residual interests” include in income their share of the REMIC’s net taxable income or 

loss each year. Although cash flow from the REMIC’s mortgage assets is used almost 

exclusively to service payment obligations with respect to the regular interests it has 

issued, ordinarily there is a mismatch in the tax character of payments received and 

payments made. For example, in a REMIC’s early years, payments of taxable interest 

received with respect to mortgage assets might be used to make nondeductible payments 

of principal with respect to a shorter-maturity regular interest. In such a case, the holder 

of a residual interest could have “phantom income,” or taxable income without 

accompanying distributions of cash. This situation reverses in the REMIC’s later years, 

when cash received from mortgage assets consists largely of nontaxable repayments of 

principal but the payments with respect to outstanding regular interests consist primarily 

of deductible payments of interest. 

If the present value of expected cash flows from a REMIC residual interest 

exceeds the present value of the tax liability that is expected to arise as a result of 

“phantom income” (followed by “phantom deductions” in later years), the residual 

interest may be an economically valuable asset. However, if the present value of the 

expected cash flows is less than the present value of the tax liability, the REMIC residual 

interest has a net liability, and a potential holder would require a payment to compensate 

for the negative value. 

 

78See Article 11(2)(b) of the 2006 U.S. Model. 

76
Income with respect to a residual interest generally is treated as interest income 

under U.S. law. If a REMIC residual interest is owned by a nonresident, the share of 

REMIC income that is attributable to a normal return (120 percent of the long-term 

Treasury bond rate) on the nonresident’s cash investment in the REMIC is treated as 

“portfolio interest” and is exempt from U.S. withholding. The return in excess of this 

amount is known as an “excess inclusion.” 

The special nature of REMIC residual interests – phantom income in early years 

followed by phantom deductions in later years – creates incentives both to escape 

taxation of the excess inclusion and to use subsequent phantom deductions to offset U.S. 

taxable income. Congress recognized this potential and created rules designed to ensure 

that excess inclusions remain subject to U.S. tax, whether held by or otherwise 

transferred to entities not subject to U.S. tax. Absent a full tax at source, inappropriate 

reductions in U.S. withholding taxes could result with respect to mortgages held in a 

REMIC because of opportunities for tax avoidance created by differences in the timing of 

taxable and economic income produced by these interests. Accordingly, in order to 

prevent such abuses, modern U.S. tax treaties preserve the ability of the United States to 

apply its domestic law to REMIC residual interests.79

3. Measures to Ensure Against Abuses of Treaty-Imposed Waivers of the 

Federal Excise Tax on Insurance Premiums Paid to Foreign Insurers

The Treasury Department is commonly asked by countries, in the context of 

bilateral negotiations, to include the Federal excise tax on insurance premiums paid to 

foreign insurers as a “covered tax” for purposes of a treaty. The effect of including this 

tax as a covered tax is that the United States generally would not be allowed to impose 

the tax on premiums paid to an insurance company resident in the treaty partner, unless 

that corporation had a permanent establishment in the United States. 

The Senate Foreign Relations Committee has expressed concerns that the 

treatment of the federal insurance excise tax as a covered tax may put U.S. insurers at a 

competitive disadvantage with respect to foreign competitors in the U.S. market if 

substantial tax is not imposed by the treaty partner on the insurance income of the foreign 

insurer.80 Moreover, in cases where the foreign premium income bears little or no tax in 

the other country, treatment of the insurance excise tax as a covered tax would create 

instances of double non-taxation. 

In response to these concerns, if a country expresses interest in including the 

insurance excise tax as a covered tax in a treaty, the Treasury Department conducts a 

thorough review of the taxation of the insurance industry in the prospective treaty partner. 

The Treasury Department agrees to cover this tax, and thereby grant an exemption from 

this tax, only if satisfied that an insurance company resident in the treaty partner and 

insuring U.S. risks would face a level of taxation that is substantial relative to the level of 

taxation faced by U.S. insurers. For a number of years the Treasury Department has 

employed a particular methodology to analyze a prospective treaty partner’s taxation of 

its insurance companies. The central component of the analysis includes a number of 

effective tax rate calculations and comparisons to determine if insurance companies in the 

 

79See Article 11(2)(c) of the 2006 U.S. Model. 

80See, e.g., S. Exec. Rpt. 106-8, Italy: 1999 Income Tax Convention. 

77
prospective treaty partner face a tax burden comparable to their counterparts in the 

United States. 

4. Abuses of Bilateral Income Tax Treaties by Third-Country Residents and 

the Development of the Limitation-on-Benefits Concept

Through its tax-treaty network the United States seeks to minimize tax-related 

impediments to inbound foreign investment by reducing, and in many cases waiving, its 

statutory taxing rights on U.S.-source income earned by residents of its treaty partners. 

However, tax treaties are negotiated agreements between two countries and, 

consequently, it is necessary to ensure that the benefits tax treaties provide, such as 

reductions in statutory withholding rates, are not abused. Residents of non-treaty 

countries may seek ways of lowering the tax cost of their investments in the United 

States. This result could be achieved by routing the investment through an entity that has 

been established in a country that has an income tax treaty with the United States. By 

establishing such a structure, the third-country resident can obtain the benefits of the 

bilateral treaty. This abuse of a bilateral agreement by third-country residents is 

commonly referred to as “treaty shopping.” 

As stated in the United States Model Technical Explanation Accompanying the 

United States Model Income Tax Convention of November 15, 2006, it has been the 

long-held belief of the United States that the benefits of an income tax treaty should be 

conferred only to the residents of the two countries party to the agreement. As a policy 

matter, tax treaties are intended to provide benefits to residents of the United States and 

residents of the particular treaty partner on a reciprocal basis. The reductions in sourcecountry taxes in a particular treaty mean that U.S. persons pay less tax to the other 

country on income from their investments there and residents of that country pay less 

U.S. tax on income from their investments in the United States. Those reductions and 

benefits are not intended to flow to residents of a third country. If third-country residents 

are able to exploit a tax treaty to secure reductions in U.S. tax, the benefits would flow 

only in one direction as third-country residents would enjoy U.S. tax reductions for their 

U.S. investments, but U.S. residents would not enjoy reciprocal tax reductions for their 

investments in that third country. Moreover, such third-country residents may be 

securing benefits that are not appropriate in the context of the interaction between their 

home country’s tax systems and policies and those of the United States. Preventing this 

exploitation of U.S. tax treaties is critical to ensuring that the third country will negotiate 

with the United States on a reciprocal basis, so that U.S. persons can receive the benefits 

of reductions in source-country tax on their investments in that country. 

It should be noted that in some cases, third-country residents may establish 

entities in the treaty partner for legitimate business reasons. An effective anti-treaty 

shopping rule should separate those cases from the abusive situations in which the 

primary reason for establishing the entity is to obtain treaty benefits. It is difficult to 

prove that a particular structure or transaction was motivated by tax-avoidance reasons, 

thus making anti-abuse rules based on subjective determinations of the taxpayer’s 

motives difficult to administer.81

 

81Moreover, in 1999 the Senate Foreign Relations Committee expressed a preference for an objective 

approach in the context of its consideration of the tax treaties with Slovenia and Italy. 

78
Development of the Limitation-on-Benefits Concept

Recognizing the shortcomings of subjective anti-abuse rules, the United States 

has developed a series of objective tests, known as Limitation on Benefits (“LOB”) 

provisions, which are intended to determine whether a person is sufficiently connected 

economically to the treaty partner to warrant receiving treaty benefits. The United States 

has included LOB provisions in its income tax treaties dating back to 1970, although the 

provisions have evolved and become increasingly sophisticated over time. The earliest 

versions, called Investment Holding Company provisions (Egypt (1981), Korea (1979), 

Norway (1972), Morocco (1981), and Trinidad and Tobago (1970)), deny benefits to a 

corporation that is greater than 25-percent owned by individuals not resident in that state, 

and which by reason of special measures faces an effective tax rate substantially lower 

than the generally imposed tax rate.82

Later U.S. tax treaties included additional objective tests to determine a person’s 

level of economic nexus to its country of residence. A number of agreements (Cyprus 

(1985), Indonesia (1990), and Jamaica (1981)) supplemented the ownership test by also 

requiring that a corporation’s gross income not be used “in substantial part” to satisfy 

liabilities to nonresidents. This rule was a precursor to the modern “ownership/baseerosion” test in the 2006 U.S. Model LOB provision. The ownership/base-erosion test 

denies treaty benefits to corporations that are majority owned by third-country residents 

or that disburse more than half of their gross income in the form of certain deductible 

payments to third-country residents. 

In addition, because widely held corporations are not likely vehicles for treaty 

shopping, several U.S. tax treaties also granted benefits to corporations publicly traded on 

a recognized stock exchange, as prescribed in the particular treaty. This “publicly 

traded” test, which has evolved over time as discussed below, has become one of the 

fundamental components of modern LOB provisions. 

Another cornerstone of the 2006 U.S. Model LOB, the “active-conduct” test, 

grants benefits to a corporation that did not satisfy the publicly traded or ownership/baseerosion tests. Under the active-conduct test, a corporation will be eligible for treaty 

benefits if it satisfies two conditions: (1) it is engaged in the active conduct of a trade or 

business in its country of residence; and (2) the payment for which benefits are sought is 

related to the trade or business. In certain cases, an additional requirement that the trade 

or business be substantial in size relative to the activity in the source country generating 

the income must be met. 

Collectively, the publicly traded, active-conduct, and ownership/base-erosion tests 

form the core of today’s LOB provisions. Typically, the LOB also grants the competent 

authorities the discretion to grant treaty benefits in instances in which the competent 

authorities conclude that treaty benefits are appropriate. 

While the United States has been a leader in this aspect of tax-treaty policy, tax 

authorities around the globe have also increased their efforts to combat treaty shopping. 

 

82Subsequent LOB provisions further developed the concept of ownership while de-emphasizing the 

effective tax rate faced by the corporation, but where appropriate, U.S. tax treaties deny benefits to 

corporations that benefit from preferential tax treatment in the other country by virtue of special regimes 

(Barbados (2004)). 

79
For instance, the Commentaries to the Model Income Tax Convention of the 

Organisation for Economic Cooperation and Development were amended in 2003 to 

include a template LOB provision that countries could include in their bilateral 

agreements if they wished to do so. 

Refinements to LOB Rules in the 2006 U.S. Model – Corporate Expatriations and the 

Publicly Traded Test

Under the publicly traded test, certain public corporations satisfy the applicable 

LOB provision and, thus, qualify for treaty benefits. In two recent protocols, the 

Treasury Department has revised the publicly traded test in response to particular 

developments in cross-border activity between the United States and the treaty partner. 

In both cases, the changes represent a further refinement of this test to ensure that the 

underlying objectives of the LOB provision are achieved. 

In its original form, the publicly traded test focused on corporations that were 

regularly traded on the stock markets in their home country and reflected the view that 

such corporations likely would not be used by residents of third countries for treatyshopping purposes. The parameters of the test evolved with changes in the global 

financial markets. With the growth of regional markets, corporations that are listed on a 

stock exchange in their home country nevertheless may have a substantial portion of their 

trading volume occur on another exchange in their region. Moreover, the international 

prominence of the U.S. stock exchanges means that many foreign corporations are listed 

and substantially traded on U.S. exchanges. The publicly traded test has been structured 

to take into account both home-country trading and also U.S. and regional third-country 

trading to reflect the realities of modern global financial markets. However, it has 

become clear that, in some circumstances, additional nexus between the corporation and 

its country of residence is necessary to effect the underlying objective of the LOB 

provision. 

The U.S.-Barbados protocol (2004) was negotiated to prevent the potential for 

exploitation of the U.S.-Barbados treaty by U.S. corporations seeking inappropriate U.S. 

tax reductions. In the years prior to the conclusion of the protocol, a small number of 

U.S. corporations engaged in corporate-inversion transactions, which involve a 

complicated restructuring in which a new foreign corporation is interposed between the 

public shareholders and the existing U.S. parent corporation. This restructuring was used 

to take advantage of U.S. tax rules to reduce U.S. tax on income from the corporate 

group’s U.S. operations and also to reduce U.S. tax on income from any foreign 

operations of the corporate group. In some corporate-inversion transactions, the new 

foreign “parent” corporation claimed to be a resident of Barbados so that the provisions 

of the U.S.-Barbados treaty could be used to reduce U.S. tax on payments from the 

existing U.S. corporate group to the new Barbados parent corporation. The use of the 

treaty in connection with this sort of corporate-inversion transaction was neither intended 

nor appropriate. More generally, the treaty was not intended to be used by corporations 

that while technically resident in Barbados do not have sufficient nexus with Barbados. 

The protocol curtails this inappropriate exploitation of the treaty through 

modifications to the LOB provision. In particular, the protocol tightens the publicly 

traded test to ensure that a corporation resident in Barbados must have a real nexus with 

80
Barbados in order to be eligible for treaty benefits. This nexus is established through the 

requirement that the corporation’s stock not only be listed on the Barbados stock 

exchange but also be primarily traded on the Barbados stock exchange (or on the 

complementary exchanges in Jamaica or Trinidad and Tobago). As a result of the 

protocol’s changes to the LOB provision, a Barbados corporation that is largely traded on 

a U.S. stock exchange, which is the case for the corporations that have undertaken 

corporate-inversion transactions, will no longer qualify for benefits under the U.S.-

Barbados tax treaty. 

The U.S.-Netherlands protocol (2004) constitutes an overhaul of the LOB 

provision in the 1993 U.S.-Netherlands treaty. It is notable that the 1993 U.S.-

Netherlands treaty broke new ground in terms of comprehensive anti-treaty shopping 

rules and the inclusion of the LOB provision in that treaty was crucial to the Treasury 

Department’s success in negotiating such provisions with other countries. The 

refinements included in the new protocol reflect experience gained both through the 

administration of the LOB provision in the 1993 treaty and through the crafting of similar 

provisions in more recent treaties. 

The U.S.-Netherlands protocol also included a new approach for the publicly 

traded test, designed to ensure the intended nexus between a publicly traded corporation 

and its country of residence while recognizing the integration of the global financial 

markets. Under this formulation, a public corporation that does not have sufficient nexus 

to its residence country through trading on the stock exchanges in that country must 

establish nexus through primary management and control in its residence country to 

qualify for treaty benefits under the publicly traded test. Thus, for example, a 

Netherlands corporation that has more trading of its shares on U.S. stock exchanges than 

on exchanges in the Netherlands and its economic region or whose shares otherwise are 

overwhelmingly traded on exchanges outside the Netherlands will qualify for U.S. treaty 

benefits under this new test if the corporation’s center of management and control is in 

the Netherlands (which establishes a real link between the corporation and the 

Netherlands). Given developments in trading patterns, the new publicly traded test better 

serves the intended purpose of limiting treaty shopping by third-country residents. 

Moreover, the revisions to the test are intended to be forward looking, to prevent any 

potential for the U.S.-Netherlands treaty to be exploited by a U.S. corporation in possible 

future evolution of corporate-inversion type transactions. 

In negotiating publicly traded tests requiring listing and primary trading of a 

corporation’s principal class of shares on a recognized stock exchange located in the 

corporation’s state of residence, the Treasury Department has encountered concerns from 

many countries with small native stock exchanges that such a rule would be too 

restrictive. These countries argue that their corporations should not be penalized just 

because they do not have access to equity capital in their home country. In response to 

these concerns the Treasury Department further modified the publicly traded test, as is 

found in recent agreements with Belgium (2006), Bulgaria (2006), Denmark (2005), 

Finland (2005), Germany (2005), Sweden (2005), and the 2006 U.S. Model. The new 

formulation requires either that the corporation’s principal class of shares be primarily 

traded on a stock exchange in its country of residence, or that the corporation’s primary 

place of management and control be in its country of residence. The term “primary place 

81
of management and control” is defined as the country where the corporation’s executive 

officers and senior management employees exercise the most day-to-day responsibility 

for the strategic, financial, and operational decision making of the corporation, and where 

the most day-to-day activities necessary for preparing and making those decisions take 

place.

D. Identification of Inappropriate Reductions in U.S. Withholding Taxes that 

Provide Opportunities for Shifting Income Out of the United States, and 

Evaluation of Whether Existing Anti-Abuse Mechanisms Are Operating 

Properly 

In evaluating potential opportunities for treaty shopping and the effectiveness of 

the LOB anti-abuse measures, two categories of tax treaties within the U.S. network merit 

special attention: (1) those that do not have any type of LOB provision; and (2) those 

that provide a low or zero rate of tax on certain payments, in particular deductible 

payments such as interest. The U.S. treaties that fall into both of these categories are 

those through which treaty shopping would be the easiest and most profitable. The 

current U.S. treaties with no LOB protection are the agreements with Greece (1953), 

Hungary (1979), Iceland (1975), Pakistan (1959), the Philippines (1982), Poland (1976), 

Romania (1976) and the U.S.S.R. (1976)83. Of these, zero-rate withholding provisions 

on interest84 in the treaties with Iceland, Poland, and Hungary make those the most 

attractive treaty-shopping candidates.85 Accordingly, use of these three agreement

be valuable indicators of treaty-shopping behavior that could take place in the absence o

adequate anti-abuse measures. 

s may 

f 

1. Data from U.S. Corporate Tax Returns

 Transactional data compiled from Form 5472, “Information Return of a 25% 

Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a Trade or 

Business,” provide some suggestive evidence regarding the potential extent of abuse of 

these three agreements by third-country residents. U.S. corporations that are at least 25-

percent foreign-owned are required to report on Form 5472 all of their transactions with 

related parties in other countries.86 Table 4.1 presents data from Form 5472 on interest 

payments from U.S. corporations that are at least 25-percent foreign owned to related 

foreign parties for the top 20 countries of residence of the foreign party for 1996, the 

earliest year for which the IRS has readily accessible data. With a few exceptions, this 

 

83The U.S.-U.S.S.R. income tax treaty applies to the countries of Armenia, Azerbaijan, Belarus, Georgia, 

Kyrgyzstan, Moldova, Tajikistan, Turkmenistan, and Uzbekistan. 84Interest is a popular tool for treaty-shopping abuses for two reasons. First, the interest payment generates 

a deductible expense. Second, it is often easier to route interest through a corporation that has been set up 

in the treaty jurisdiction for the purpose of obtaining treaty benefits for the payment than it is to route many 

other types of payments. 

85While the tax treaty with Greece provides a zero rate of withholding on interest, restrictions apply that 

prevent, for instance, a Greek company receiving interest from a U.S. company from obtaining the zero rate 

if the Greek company controls, directly or indirectly, more than 50 percent of the U.S. company paying the 

interest. 

86For purposes of Form 5472, the term “related party” is defined as any direct or indirect foreign 

shareholder of the reporting corporation, any person who is related (within the meaning of section 267(b) or 

707(b)(1)) to a 25-percent foreign shareholder of the reporting corporation, or any other person who is 

related to the reporting corporation within the meaning of section 482 and the related regulations.

82
top stratum contains the most significant trade and investment partners of the United 

States. 

Table 4.2 presents data on interest payments made by U.S. corporations that are at 

least 25-percent foreign owned to related parties in Iceland and Hungary for 1996 

through 2004.87 Neither Iceland nor Hungary ranked within the top 20 recipient 

countries of related-party interest in 1996, but ranked seventh and eighth by 2004, hig

than major investment partners such as Canada and Japan, as is shown in Table 4.3 

below.

her 

om 

rest 

88 Payments of interest to related parties in Iceland increased exponentially, fr

$0.3 million in 1996 to $912.7 million in 2004. A similarly dramatic increase of inte

payments to related parties in Hungary occurred, from $197.5 million in 2000 to $1.24 

billion in 2004. The data indicate that Poland has not yet experienced such growth in 

interest payments from related U.S. corporations. Poland did not appear within the top 

50 recipient countries of related-party interest until 2004, when it ranked 35th, with $1.4 

million. 

2. Ultimate Parent Ownership 

The substantial increase in interest paid by U.S. corporations that are at least 25-

percent foreign owned to related Icelandic and Hungarian corporations in recent years, 

while noteworthy, is not by itself conclusive evidence of treaty-shopping abuse. 

However, information from publicly available corporate profiles reveals that many of the 

Icelandic and Hungarian related parties are owned by parent corporations from third 

countries. 

A third-country corporation may have an incentive to engage in treaty shopping if 

the tax treaty between the United States and its country of residence only reduces, but 

does not eliminate, withholding taxes on interest. Alternatively, the country of residence 

may simply not have a tax treaty in force with the United States, in which case a U.S.-

source payment to the third-country corporation may be subject to gross-basis 

withholding at 30 percent. Accordingly, it is advantageous from a tax perspective for the 

third-country corporation to structure a loan through an Icelandic or Hungarian entity for 

three reasons. First, no U.S. withholding tax is imposed on the interest by virtue of the 

U.S.-Iceland and U.S.-Hungary tax treaties. Second, taxation of the payments by Iceland 

or Hungary may be reduced or avoided through tax incentives, special regimes,89 or other 

arrangements. Finally, if the payment is not taxed currently by the third country, the 

interest will bear no tax in the source, conduit, or residence jurisdictions. 

 

89Presently, a number of special regimes such as Iceland’s International Trading Companies and Hungary’s 

offshore corporations have been repealed or are phasing out, although in Hungary 100-percent tax credits 

for certain investments will continue to be available until 2011. 

87Data from Form 5472 are only available for the even-numbered years shown. 

88Data on the stock of foreign direct investment in the United States, compiled by the Commerce 

Department’s Bureau of Economic Analysis (BEA) are consistent with the corporate tax return data. BEA 

defines “direct investment” as a holding of at least 10 percent of the shares of a corporation. Iceland and 

Hungary figure fairly prominently, ranking 17th and 13th, respectively, in terms of foreign direct 

investment in the United States.

83
Table 4.1 

Interest Payments from Foreign-Controlled U.S. Corporations to Foreign Related 

Parties, Ranked by Country of Residence of Foreign Related Party: 1996 

Country 

Interest Paid by 

U.S. Corporations 

to Related Foreign 

Persons 

($ millions) 

Number of Foreign 

Related Persons 

Rank (by Amount 

of Interest Paid) 

United Kingdom 3,009.8 1,282 1

Netherlands 1,092.4 516 2

France 742.8 636 3

Germany 699.6 757 4

Luxembourg 681.0 31 5

Ireland 567.7 107 6

Canada 433.3 602 7

Japan 421.9 616 8

Netherlands Antilles 417.9 35 9

Switzerland 186.7 310 10

Sweden 87.3 321 11

Finland 85.6 123 12

Singapore 78.1 279 13

Bermuda 67.2 74 14

Denmark 41.2 95 15

Hong Kong 39.4 277 16

Australia 34.3 385 17

Barbados 27.6 25 18

Puerto Rico 16.6 184 19

Belgium 15.8 241 20

84
Table 4.2 

Interest Paid to Related Parties in Iceland and Hungary: 1996 - 2004 

Interest Paid by U.S. Corporations to 

Related Parties in Iceland 

Interest Paid by U.S. Corporations to 

Related Parties in Hungary 

Year 

Amount 

($millions) 

Number of 

Foreign 

Related 

Persons 

Rank (by 

Amount of 

Interest 

Paid) 

Amount 

($ millions) 

Number 

of Foreign 

Related 

Persons 

Rank (by 

Amount 

of 

Interest 

Paid) 

1996 0 0 N/A 0 26 40

1998 0.3 2 37 50 45 5

2000 63.7 5 18 197.5 37 13

2002 643.6 12 9 1,179.8 111 7

2004 912.7 18 8 1,238.1 137 7

 A more definitive conclusion that treaty shopping has taken place would depend 

upon whether the Icelandic or Hungarian subsidiaries of third-country parent corporations 

would fail standard LOB tests. If they are wholly owned and controlled by the thirdcountry parent, the Icelandic or Hungarian corporations would not likely satisfy the 

requirements for subsidiaries of publicly traded corporations or the ownership/baseerosion test. In order to qualify under the “active conduct” test, the corporations would 

need to be engaged in a trade or business in Iceland or Hungary, respectively; the 

payment from the United States would have to be related to the Icelandic or Hungarian 

trade or business; and the Icelandic or Hungarian trade or business would have to be 

substantial in size relative to the U.S. activity generating the payment. 

85
Table 4.3 

Interest Payments from Foreign-Controlled U.S. Corporations to Foreign Related 

Parties, Ranked by Country of Residence of Foreign Related Party: 2004 

Country 

Interest Paid by 

U.S. Corporations 

to Related Foreign 

Persons 

($ millions) 

Number of Foreign 

Related Persons 

Rank (by Amount 

of Interest Paid) 

United Kingdom 6,745.7 1,608 1

Switzerland 6,421.3 438 2

Netherlands 3,068.4 619 3

Luxembourg 1,468.2 103 4

Germany 1,351.2 1,269 5

France 1,328.8 1,032 6

Hungary 1,238.1 137 7

Iceland 912.7 18 8

Belgium 591.5 326 9

Ireland 460.4 235 10

Canada 381.5 905 11

Sweden 328.2 430 12

Cayman Islands 325.5 69 13

Barbados 323.0 54 14

Bermuda 134.9 132 15

Japan 74.6 1,004 16

Austria 41.6 126 17

Finland 39.7 171 18

Hong Kong 36.6 336 19

Mexico 36.1 608 20

 

86
The number of related persons in Hungary (137) and Iceland (18) suggests that as 

of 2004, a limited number of taxpayers are engaged in treaty-shopping abuses of the 

Hungary and Iceland agreements (compare this to the number of related parties in 

Germany (1,269) and France (1,032)). Nevertheless, as Table 4.2 demonstrates, the size 

in dollar terms of the potential treaty abuse is significant.

E. Conclusions

1. Effectiveness of Measures to Avoid Abuses of Withholding Taxes on 

Dividends, Interest and Insurance Premiums

Through its network of bilateral income tax treaties, the United States seeks to 

minimize tax-related impediments to inbound foreign investment by reducing, and in 

many cases waiving, its statutory taxing rights on U.S.-source income earned by residents 

of its treaty partners. However, tax treaties are negotiated agreements between two 

countries and, consequently, it is necessary to ensure that the benefits they provide, such 

as reductions in statutory withholding rates, are not abused. The Treasury Department 

develops tax-treaty policy to ensure that inappropriate reductions of withholding taxes 

provided in treaties are avoided. In many instances, treaty policy was crafted in 

consultation with the Congress, as was the case with the special rules governing 

dividends paid by RICs and REITs, excess inclusions with respect to residual interests in 

REMICs, payments of contingent interest, and the methodology for analyzing potential 

waivers of the Federal excise tax on insurance premiums in bilateral agreements. The 

Treasury Department is confident that these anti-abuse rules achieve the appropriate 

balance of preventing inappropriate reductions of withholding taxes while at the same 

time allowing cross-border economic activity to reach its full potential. 

 2. Effectiveness of Measures to Combat Treaty Shopping

A growing consensus is developing among tax authorities worldwide about the 

need to prevent third-country residents from inappropriately obtaining the benefits of 

bilateral income tax treaties. The United States has been a leader in combating treaty 

shopping with objective LOB provisions intended to deny treaty benefits to persons with 

an insufficient business and economic nexus to the treaty partner. The evolutionary 

nature of tax planning and treaty shopping similarly requires that LOB provisions adapt 

with time to prevent abusive structures from developing. For instance, the rise of abusive 

corporate-inversion structures has necessitated fortifying the U.S. approach to combat 

treaty shopping. 

The contributing role of a few U.S. tax treaties in facilitating corporate 

expatriations from the United States prompted the Treasury Department to adjust some of 

the objective tests of standard LOB provisions, in particular the publicly traded test. 

Revised publicly traded tests were introduced in the 2004 protocols to the U.S.-Barbados 

and U.S.-Netherlands treaties. More recently, a revised test has been incorporated in the 

U.S. tax treaties with Belgium (2006), Bulgaria (2006), Denmark (2005), Finland (2005), 

Germany (2005), and Sweden (2005). 

It is difficult to measure the effect of anti-abuse provisions, and the LOB rules are 

no exception. However, a number of agreements in the U.S. tax-treaty network, namely 

87
those with Iceland, Hungary and Poland, are unique in that they provide significant 

source-country benefits (in particular a complete exemption of all interest payments) and 

also do not have any anti-treaty shopping protections. Thus, these treaties present the 

opportunity to observe taxpayer behavior in the absence of an LOB provision. 

Data compiled from U.S. corporate tax returns show that in recent years the 

amounts of interest payments from foreign-controlled U.S. corporations to related parties 

in Iceland and Hungary have increased dramatically. In 1996, no U.S.-source interest 

was reportedly paid by foreign-controlled U.S. companies to their related parties in 

Iceland, and insignificant amounts of interest was paid to related parties in Hungary. 

However, by 2004, those amounts had increased exponentially. Moreover, a 

preponderance of the Icelandic and Hungarian entities were ultimately owned by 

corporations from third countries. The evidence on treaty shopping through the Iceland 

and Hungary treaties suggests that the LOB provisions in the other U.S. agreements 

provide deterrence against abuse. 

F. The Treasury Department’s Most Recent Efforts to Combat Abuse of Tax 

Treaties 

A chief objective of the Treasury Department’s tax-treaty program is to protect 

the U.S. tax-treaty network from abuse. The Treasury Department has taken many steps 

towards achieving that goal. The 2006 U.S. Model contains an improved LOB provision 

that the Treasury Department developed over the course of its recent tax-treaty 

negotiations. A noteworthy enhancement of the new LOB provision is a publicly traded 

test reformulated to thwart corporate expatriations. This revised rule will form the 

starting point for future U.S. tax-treaty negotiations. 

The Treasury Department has also taken steps to revise those U.S. tax treaties that 

are most vulnerable to treaty shopping. In this regard, the signing of a new income tax 

treaty between the United States and Iceland in October 2007 is especially significant. 

The new agreement with Iceland reflects current tax treaty policies of both countries, and 

includes a comprehensive limitation on benefits provision intended to ensure that only 

residents of the United States and Iceland will enjoy the benefits of the agreement. 

Additionally, further treaty negotiations with Hungary are scheduled for the second half 

of 2007. As of 2004, it does not appear that the U.S.-Poland tax treaty has been 

extensively exploited by third-country residents. Nevertheless, the Treasury Department 

anticipates commencing negotiations with Poland in 2007 to conclude a new tax treaty to 

replace the 1976 agreement. The United States places a high priority on bringing the new 

Iceland tax treaty into force and on concluding as soon as possible the negotiations with 

Hungary and Poland. 

Beyond focusing on renegotiating the three treaties described above, the Treasury 

Department reviews, on a continuing basis, the current U.S. tax-treaty network to identify 

deficiencies in existing agreements and areas where more beneficial terms for U.S. 

taxpayers could be negotiated. As part of this process, anti-treaty-shopping provisions 

are given special scrutiny to ensure that they are functioning appropriately. Those 

treaties with LOB provisions that are out of date or need strengthening are given higher 

priority in the Treasury Department’s plan for negotiations. 

88
G. Appendices

1. Limitation on Benefits Provision from 2006 U.S. Model 

Article 22

LIMITATION ON BENEFITS

1. Except as otherwise provided in this Article, a resident of a Contracting State 

shall not be entitled to the benefits of this Convention otherwise accorded to residents of 

a Contracting State unless such resident is a “qualified person” as defined in paragraph 2. 

2. A resident of a Contracting State shall be a qualified person for a taxable year if 

the resident is: 

a) an individual; 

b) a Contracting State, or a political subdivision or local authority thereof; 

c) a company, if: 

i) the principal class of its shares (and any disproportionate class of 

shares) is regularly traded on one or more recognized stock exchanges, 

and either: 

A) its principal class of shares is primarily traded on one or 

more recognized stock exchanges located in the Contracting State 

of which the company is a resident; or 

B) the company’s primary place of management and control is 

in the Contracting State of which it is a resident; or 

ii) at least 50 percent of the aggregate vote and value of the shares 

(and at least 50 percent of any disproportionate class of shares) in the 

company is owned directly or indirectly by five or fewer companies 

entitled to benefits under clause i) of this subparagraph, provided that, in 

the case of indirect ownership, each intermediate owner is a resident of 

either Contracting State; 

d) a person described in paragraph 2 of Article 4 of this Convention, 

provided that, in the case of a person described in subparagraph a) of that 

paragraph, more than 50 percent of the person’s beneficiaries, members or 

participants are individuals resident in either Contracting State; or 

 e) a person other than an individual, if: 

i) on at least half the days of the taxable year, persons who are 

residents of that Contracting State and that are entitled to the benefits of 

this Convention under subparagraph a), subparagraph b), clause i) of 

subparagraph c), or subparagraph d) of this paragraph own, directly or 

indirectly, shares or other beneficial interests representing at least 50 

percent of the aggregate voting power and value (and at least 50 percent of 

any disproportionate class of shares) of the person, provided that, in the 

case of indirect ownership, each intermediate owner is a resident of that 

Contracting State, and 

89
ii) less than 50 percent of the person’s gross income for the taxable 

year, as determined in the person’s State of residence, is paid or accrued, 

directly or indirectly, to persons who are not residents of either 

Contracting State entitled to the benefits of this Convention under 

subparagraph a), subparagraph b), clause i) of subparagraph c), or 

subparagraph d) of this paragraph in the form of payments that are 

deductible for purposes of the taxes covered by this Convention in the 

person’s State of residence (but not including arm’s length payments in 

the ordinary course of business for services or tangible property). 

3. a) A resident of a Contracting State will be entitled to benefits of the 

Convention with respect to an item of income derived from the other State, 

regardless of whether the resident is a qualified person, if the resident is engaged 

in the active conduct of a trade or business in the first-mentioned State (other than 

the business of making or managing investments for the resident’s own account, 

unless these activities are banking, insurance or securities activities carried on by 

a bank, insurance company or registered securities dealer), and the income 

derived from the other Contracting State is derived in connection with, or is 

incidental to, that trade or business. 

b) If a resident of a Contracting State derives an item of income from a trade 

or business activity conducted by that resident in the other Contracting State, or 

derives an item of income arising in the other Contracting State from a related 

person, the conditions described in subparagraph a) shall be considered to be 

satisfied with respect to such item only if the trade or business activity carried on 

by the resident in the first-mentioned Contracting State is substantial in relation to 

the trade or business activity carried on by the resident or such person in the other 

Contracting State. Whether a trade or business activity is substantial for the 

purposes of this paragraph will be determined based on all the facts and 

circumstances. 

c) For purposes of applying this paragraph, activities conducted by persons 

connected to a person shall be deemed to be conducted by such person. A person 

shall be connected to another if one possesses at least 50 percent of the beneficial 

interest in the other (or, in the case of a company, at least 50 percent of the 

aggregate vote and value of the company’s shares or of the beneficial equity 

interest in the company) or another person possesses at least 50 percent of the 

beneficial interest (or, in the case of a company, at least 50 percent of the 

aggregate vote and value of the company’s shares or of the beneficial equity 

interest in the company) in each person. In any case, a person shall be considered 

to be connected to another if, based on all the relevant facts and circumstances, 

one has control of the other or both are under the control of the same person or 

persons. 

4. If a resident of a Contracting State is neither a qualified person pursuant to the 

provisions of paragraph 2 nor entitled to benefits with respect to an item of income under 

paragraph 3 of this Article the competent authority of the other Contracting State may, 

nevertheless, grant the benefits of this Convention, or benefits with respect to a specific 

item of income, if it determines that the establishment, acquisition or maintenance of 

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such person and the conduct of its operations did not have as one of its principal purposes 

the obtaining of benefits under this Convention. 

5. For purposes of this Article: 

 a) the term “recognized stock exchange” means: 

i) the NASDAQ System owned by the National Association of 

Securities Dealers, Inc. and any stock exchange registered with the U.S. 

Securities and Exchange Commission as a national securities exchange -

under the U.S. Securities Exchange Act of 1934; 

 ii) stock exchanges of -------; and 

 iii) any other stock exchange agreed upon by the competent 

authorities; 

 b) the term “principal class of shares” means the ordinary or common shares 

of the company, provided that such class of shares represents the majority of the 

voting power and value of the company. If no single class of ordinary or common 

shares represents the majority of the aggregate voting power and value of the 

company, the “principal class of shares” are those classes that in the aggregate 

represent a majority of the aggregate voting power and value of the company; 

 c) the term “disproportionate class of shares” means any class of shares of a 

company resident in one of the Contracting States that entitles the shareholder to 

disproportionately higher participation, through dividends, redemption payments 

or otherwise, in the earnings generated in the other State by particular assets or 

activities of the company; and 

d) a company’s “primary place of management and control” will be in the 

Contracting State of which it is a resident only if executive officers and senior 

management employees exercise day-to-day responsibility for more of the 

strategic, financial and operational policy decision making for the company 

(including its direct and indirect subsidiaries) in that State than in any other state 

and the staff of such persons conduct more of the day-to-day activities necessary 

for preparing and making those decisions in that State than in any other state. 

 2. Technical Explanation to 2006 Model Article 22 (Limitation on 

Benefits) 

ARTICLE 22 (LIMITATION ON BENEFITS) 

Article 22 contains anti-treaty-shopping provisions that are intended to prevent 

residents of third countries from benefiting from what is intended to be a reciprocal 

agreement between two countries. In general, the provision does not rely on a 

determination of purpose or intention but instead sets forth a series of objective tests. A 

resident of a Contracting State that satisfies one of the tests will receive benefits 

regardless of its motivations in choosing its particular business structure. 

The structure of the Article is as follows: Paragraph 1 states the general rule that 

residents are entitled to benefits otherwise accorded to residents only to the extent 

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provided in the Article. Paragraph 2 lists a series of attributes of a resident of a 

Contracting State, the presence of any one of which will entitle that person to all the 

benefits of the Convention. Paragraph 3 provides that, regardless of whether a person 

qualifies for benefits under paragraph 2, benefits may be granted to that person with 

regard to certain income earned in the conduct of an active trade or business. Paragraph 

4 provides that benefits also may be granted if the competent authority of the State from 

which benefits are claimed determines that it is appropriate to provide benefits in that 

case. Paragraph 5 defines certain terms used in the Article. 

Paragraph 1

Paragraph 1 provides that a resident of a Contracting State will be entitled to the 

benefits otherwise accorded to residents of a Contracting State under the Convention only 

to the extent provided in the Article. The benefits otherwise accorded to residents under 

the Convention include all limitations on source-based taxation under Articles 6 through 

21, the treaty-based relief from double taxation provided by Article 23, and the protection 

afforded to residents of a Contracting State under Article 24. Some provisions do not 

require that a person be a resident in order to enjoy the benefits of those provisions. 

Article 25 is not limited to residents of the Contracting States, and Article 27 applies to 

diplomatic agents or consular officials regardless of residence. Article 22 accordingly 

does not limit the availability of treaty benefits under these provisions. 

Article 22 and the anti-abuse provisions of domestic law complement each other, 

as Article 22 effectively determines whether an entity has a sufficient nexus to the 

Contracting State to be treated as a resident for treaty purposes, while domestic antiabuse provisions (e.g., business purpose, substance-over-form, step transaction or conduit 

principles) determine whether a particular transaction should be recast in accordance with 

its substance. Thus, internal law principles of the source Contracting State may be 

applied to identify the beneficial owner of an item of income, and Article 22 then will be 

applied to the beneficial owner to determine if that person is entitled to the benefits of the 

Convention with respect to such income. 

Paragraph 2 

Paragraph 2 has six subparagraphs, each of which describes a category of 

residents that are entitled to all benefits of the Convention. 

It is intended that the provisions of paragraph 2 will be self executing. Unlike the 

provisions of paragraph 4, discussed below, claiming benefits under paragraph 2 does not 

require advance competent authority ruling or approval. The tax authorities may, of 

course, on review, determine that the taxpayer has improperly interpreted the paragraph 

and is not entitled to the benefits claimed. 

Individuals -- Subparagraph 2(a)

Subparagraph (a) provides that individual residents of a Contracting State will be 

entitled to all treaty benefits. If such an individual receives income as a nominee on 

behalf of a third country resident, benefits may be denied under the respective articles of 

the Convention by the requirement that the beneficial owner of the income be a resident 

of a Contracting State. 

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Governments -- Subparagraph 2(b) 

Subparagraph (b) provides that the Contracting States and any political 

subdivision or local authority thereof will be entitled to all benefits of the Convention. 

Publicly-Traded Corporations -- Subparagraph 2(c)(i) 

Subparagraph (c) applies to two categories of companies: publicly traded 

companies and subsidiaries of publicly traded companies. A company resident in a 

Contracting State is entitled to all the benefits of the Convention under clause (i) of 

subparagraph (c) if the principal class of its shares, and any disproportionate class of 

shares, is regularly traded on one or more recognized stock exchanges and the company 

satisfies at least one of the following additional requirements: first, the company’s 

principal class of shares is primarily traded on one or more recognized stock exchanges 

located in the Contracting State of which the company is a resident; or, second, the 

company’s primary place of management and control is in its State of residence. 

The term “recognized stock exchange” is defined in subparagraph (a) of 

paragraph 5. It includes (i) the NASDAQ System and any stock exchange registered with 

the Securities and Exchange Commission as a national securities exchange for purposes 

of the Securities Exchange Act of 1934; (ii) [certain exchanges located in the other 

Contracting State]; and (iii) any other stock exchange agreed upon by the competent 

authorities of the Contracting States. 

If a company has only one class of shares, it is only necessary to consider whether 

the shares of that class meet the relevant trading requirements. If the company has more 

than one class of shares, it is necessary as an initial matter to determine which class or 

classes constitute the “principal class of shares”. The term “principal class of shares” is 

defined in subparagraph (b) of paragraph 5 to mean the ordinary or common shares of the 

company representing the majority of the aggregate voting power and value of the 

company. If the company does not have a class of ordinary or common shares 

representing the majority of the aggregate voting power and value of the company, then 

the “principal class of shares” is that class or any combination of classes of shares that 

represents, in the aggregate, a majority of the voting power and value of the company. 

Although in a particular case involving a company with several classes of shares it is 

conceivable that more than one group of classes could be identified that account for more 

than 50% of the shares, it is only necessary for one such group to satisfy the requirements 

of this subparagraph in order for the company to be entitled to benefits. Benefits would 

not be denied to the company even if a second, non-qualifying, group of shares with more 

than half of the company’s voting power and value could be identified. 

A company whose principal class of shares is regularly traded on a recognized 

stock exchange will nevertheless not qualify for benefits under subparagraph (c) of 

paragraph 2 if it has a disproportionate class of shares that is not regularly traded on a 

recognized stock exchange. The term “disproportionate class of shares” is defined in 

subparagraph (c) of paragraph 5. A company has a disproportionate class of shares if it 

has outstanding a class of shares which is subject to terms or other arrangements that 

entitle the holder to a larger portion of the company’s income, profit, or gain in the other 

Contracting State than that to which the holder would be entitled in the absence of such 

terms or arrangements. Thus, for example, a company resident in the other Contracting 

93
State meets the test of subparagraph (c) of paragraph 5 if it has outstanding a class of 

“tracking stock” that pays dividends based upon a formula that approximates the 

company’s return on its assets employed in the United States. 

The following example illustrates this result. 

Example. OCo is a corporation resident in the other Contracting State. OCo has 

two classes of shares: Common and Preferred. The Common shares are listed and 

regularly traded on the principal stock exchange of the other Contracting State. The 

Preferred shares have no voting rights and are entitled to receive dividends equal in 

amount to interest payments that OCo receives from unrelated borrowers in the United 

States. The Preferred shares are owned entirely by a single investor that is a resident of a 

country with which the United States does not have a tax treaty. The Common shares 

account for more than 50 percent of the value of OCo and for 100 percent of the voting 

power. Because the owner of the Preferred shares is entitled to receive payments 

corresponding to the U.S. source interest income earned by OCo, the Preferred shares are 

a disproportionate class of shares. Because the Preferred shares are not regularly traded 

on a recognized stock exchange, OCo will not qualify for benefits under subparagraph (c) 

of paragraph 2. 

The term “regularly traded” is not defined in the Convention. In accordance with 

paragraph 2 of Article 3 (General Definitions), this term will be defined by reference to 

the domestic tax laws of the State from which treaty benefits are sought, generally the 

source State. In the case of the United States, this term is understood to have the 

meaning it has under Treas. Reg. section 1.884-5(d)(4)(i)(B), relating to the branch tax 

provisions of the Code. Under these regulations, a class of shares is considered to be 

“regularly traded” if two requirements are met: trades in the class of shares are made in 

more than de minimis quantities on at least 60 days during the taxable year, and the 

aggregate number of shares in the class traded during the year is at least 10 percent of the 

average number of shares outstanding during the year. Sections 1.884-5(d)(4)(i)(A), (ii) 

and (iii) will not be taken into account for purposes of defining the term “regularly 

traded” under the Convention. 

The regular trading requirement can be met by trading on any recognized 

exchange or exchanges located in either State. Trading on one or more recognized stock 

exchanges may be aggregated for purposes of this requirement. Thus, a U.S. company 

could satisfy the regularly traded requirement through trading, in whole or in part, on a 

recognized stock exchange located in the other Contracting State. Authorized but 

unissued shares are not considered for purposes of this test. 

The term “primarily traded” is not defined in the Convention. In accordance with 

paragraph 2 of Article 3 (General Definitions), this term will have the meaning it has 

under the laws of the State concerning the taxes to which the Convention applies, 

generally the source State. In the case of the United States, this term is understood to 

have the meaning it has under Treas. Reg. section 1.884-5(d)(3), relating to the branch 

tax provisions of the Code. Accordingly, stock of a corporation is “primarily traded” if 

the number of shares in the company’s principal class of shares that are traded during the 

taxable year on all recognized stock exchanges in the Contracting State of which the 

company is a resident exceeds the number of shares in the company’s principal class of 

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shares that are traded during that year on established securities markets in any other 

single foreign country. 

A company whose principal class of shares is regularly traded on a recognized 

exchange but cannot meet the primarily traded test may claim treaty benefits if its 

primary place of management and control is in its country of residence. This test should 

be distinguished from the “place of effective management” test which is used in the 

OECD Model and by many other countries to establish residence. In some cases, the 

place of effective management test has been interpreted to mean the place where the 

board of directors meets. By contrast, the primary place of management and control test 

looks to where day-to-day responsibility for the management of the company (and its 

subsidiaries) is exercised. The company’s primary place of management and control will 

be located in the State in which the company is a resident only if the executive officers 

and senior management employees exercise day-to-day responsibility for more of the 

strategic, financial and operational policy decision making for the company (including 

direct and indirect subsidiaries) in that State than in the other State or any third state, and 

the staff that support the management in making those decisions are also based in that 

State. Thus, the test looks to the overall activities of the relevant persons to see where 

those activities are conducted. In most cases, it will be a necessary, but not a sufficient, 

condition that the headquarters of the company (that is, the place at which the CEO and 

other top executives normally are based) be located in the Contracting State of which the 

company is a resident. 

To apply the test, it will be necessary to determine which persons are to be 

considered “executive officers and senior management employees”. In most cases, it will 

not be necessary to look beyond the executives who are members of the Board of 

Directors (the “inside directors”) in the case of a U.S. company or the members of the [ 

] in the case of the other Contracting State. That will not always be the case, however; in 

fact, the relevant persons may be employees of subsidiaries if those persons make the 

strategic, financial and operational policy decisions. Moreover, it would be necessary to 

take into account any special voting arrangements that result in certain board members 

making certain decisions without the participation of other board members. 

Subsidiaries of Publicly-Traded Corporations -- Subparagraph 2(c)(ii)

A company resident in a Contracting State is entitled to all the benefits of the 

Convention under clause (ii) of subparagraph (c) of paragraph 2 if five or fewer publicly 

traded companies described in clause (i) are the direct or indirect owners of at least 50 

percent of the aggregate vote and value of the company’s shares (and at least 50 percent 

of any disproportionate class of shares). If the publicly-traded companies are indirect 

owners, however, each of the intermediate companies must be a resident of one of the 

Contracting States. 

Thus, for example, a company that is a resident of the other Contracting State, 

all the shares of which are owned by another company that is a resident of that State, 

would qualify for benefits under the Convention if the principal class of shares (and any 

disproportionate classes of shares) of the parent company are regularly and primarily 

traded on a recognized stock exchange in that Contracting State. However, such a 

subsidiary would not qualify for benefits under clause (ii) if the publicly traded parent 

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company were a resident of a third state, for example, and not a resident of the United 

States or the other Contracting State. Furthermore, if a parent company in the other 

Contracting State indirectly owned the bottom-tier company through a chain of 

subsidiaries, each such subsidiary in the chain, as an intermediate owner, must be a 

resident of the United States or the other Contracting State in order for the subsidiary to 

meet the test in clause (ii). 

Tax Exempt Organizations -- Subparagraph 2(d)

Subparagraph 2(d) provides rules by which the tax exempt organizations 

described in paragraph 2 of Article 4 (Resident) will be entitled to all the benefits of the 

Convention. A pension fund will qualify for benefits if more than fifty percent of the 

beneficiaries, members or participants of the organization are individuals resident in 

either Contracting State. For purposes of this provision, the term “beneficiaries” should 

be understood to refer to the persons receiving benefits from the organization. On the 

other hand, a tax-exempt organization other than a pension fund automatically qualifies 

for benefits, without regard to the residence of its beneficiaries or members. Entities 

qualifying under this rule generally are those that are exempt from tax in their State of 

residence and that are organized and operated exclusively to fulfill religious, charitable, 

scientific, artistic, cultural, or educational purposes. 

Ownership/Base Erosion -- Subparagraph 2(e)

Subparagraph 2(e) provides an additional method to qualify for treaty benefits 

that applies to any form of legal entity that is a resident of a Contracting State. The test 

provided in subparagraph (e), the so-called ownership and base erosion test, is a two-part 

test. Both prongs of the test must be satisfied for the resident to be entitled to treaty 

benefits under subparagraph 2(e). 

The ownership prong of the test, under clause (i), requires that 50 percent or more 

of each class of shares or other beneficial interests in the person is owned, directly or 

indirectly, on at least half the days of the person’s taxable year by persons who are 

residents of the Contracting State of which that person is a resident and that are 

themselves entitled to treaty benefits under subparagraphs (a), (b), (d) or clause (i) of 

subparagraph (c) of paragraph 2. In the case of indirect owners, however, each of the 

intermediate owners must be a resident of that Contracting State. 

Trusts may be entitled to benefits under this provision if they are treated as 

residents under Article 4 (Residence) and they otherwise satisfy the requirements of this 

subparagraph. For purposes of this subparagraph, the beneficial interests in a trust will be 

considered to be owned by its beneficiaries in proportion to each beneficiary’s actuarial 

interest in the trust. The interest of a remainder beneficiary will be equal to 100 percent 

less the aggregate percentages held by income beneficiaries. A beneficiary’s interest in a 

trust will not be considered to be owned by a person entitled to benefits under the other 

provisions of paragraph 2 if it is not possible to determine the beneficiary’s actuarial 

interest. Consequently, if it is not possible to determine the actuarial interest of the 

beneficiaries in a trust, the ownership test under clause i) cannot be satisfied, unless all 

possible beneficiaries are persons entitled to benefits under the other subparagraphs of 

paragraph 2. 

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The base erosion prong of clause (ii) of subparagraph (e) is satisfied with respect 

to a person if less than 50 percent of the person’s gross income for the taxable year, as 

determined under the tax law in the person’s State of residence, is paid or accrued to 

persons who are not residents of either Contracting State entitled to benefits under 

subparagraphs (a), (b), (d) or clause (i) of subparagraph (c) of paragraph 2, in the form of 

payments deductible for tax purposes in the payer’s State of residence. These amounts do 

not include arm’s-length payments in the ordinary course of business for services or 

tangible property. To the extent they are deductible from the taxable base, trust 

distributions are deductible payments. However, depreciation and amortization 

deductions, which do not represent payments or accruals to other persons, are disregarded 

for this purpose. 

Paragraph 3

Paragraph 3 sets forth an alternative test under which a resident of a 

Contracting State may receive treaty benefits with respect to certain items of income 

that are connected to an active trade or business conducted in its State of residence. A 

resident of a Contracting State may qualify for benefits under paragraph 3 whether or 

not it also qualifies under paragraph 2. 

Subparagraph (a) sets forth the general rule that a resident of a Contracting State 

engaged in the active conduct of a trade or business in that State may obtain the benefits 

of the Convention with respect to an item of income derived in the other Contracting 

State. The item of income, however, must be derived in connection with or incidental to 

that trade or business. 

The term “trade or business” is not defined in the Convention. Pursuant to 

paragraph 2 of Article 3 (General Definitions), when determining whether a resident of 

the other Contracting State is entitled to the benefits of the Convention under paragraph 

3 of this Article with respect to an item of income derived from sources within the 

United States, the United States will ascribe to this term the meaning that it has under 

the law of the United States. Accordingly, the U.S. competent authority will refer to the 

regulations issued under section 367(a) for the definition of the term “trade or 

business.” In general, therefore, a trade or business will be considered to be a specific 

unified group of activities that constitute or could constitute an independent economic 

enterprise carried on for profit. Furthermore, a corporation generally will be considered 

to carry on a trade or business only if the officers and employees of the corporation 

conduct substantial managerial and operational activities. 

The business of making or managing investments for the resident’s own account 

will be considered to be a trade or business only when part of banking, insurance or 

securities activities conducted by a bank, an insurance company, or a registered securities 

dealer. Such activities conducted by a person other than a bank, insurance company or 

registered securities dealer will not be considered to be the conduct of an active trade or 

business, nor would they be considered to be the conduct of an active trade or business if 

conducted by a bank, insurance company or registered securities dealer but not as part of 

the company’s banking, insurance or dealer business. Because a headquarters operation 

is in the business of managing investments, a company that functions solely as a 

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headquarters company will not be considered to be engaged in an active trade or business 

for purposes of paragraph 3. 

An item of income is derived in connection with a trade or business if the incomeproducing activity in the State of source is a line of business that “forms a part of” or is 

“complementary” to the trade or business conducted in the State of residence by the 

income recipient. 

A business activity generally will be considered to form part of a business activity 

conducted in the State of source if the two activities involve the design, manufacture or 

sale of the same products or type of products, or the provision of similar services. The 

line of business in the State of residence may be upstream, downstream, or parallel to the 

activity conducted in the State of source. Thus, the line of business may provide inputs 

for a manufacturing process that occurs in the State of source, may sell the output of that 

manufacturing process, or simply may sell the same sorts of products that are being sold 

by the trade or business carried on in the State of source. 

Example 1. USCo is a corporation resident in the United States. USCo is 

engaged in an active manufacturing business in the United States. USCo owns 100 

percent of the shares of FCo, a corporation resident in the other Contracting State. FCo 

distributes USCo products in the other Contracting State. Since the business activities 

conducted by the two corporations involve the same products, FCo’s distribution business 

is considered to form a part of USCo’s manufacturing business. 

Example 2. The facts are the same as in Example 1, except that USCo does not 

manufacture. Rather, USCo operates a large research and development facility in the 

United States that licenses intellectual property to affiliates worldwide, including FCo. 

FCo and other USCo affiliates then manufacture and market the USCo-designed products 

in their respective markets. Since the activities conducted by FCo and USCo involve the 

same product lines, these activities are considered to form a part of the same trade or 

business. 

For two activities to be considered to be “complementary,” the activities need not 

relate to the same types of products or services, but they should be part of the same 

overall industry and be related in the sense that the success or failure of one activity will 

tend to result in success or failure for the other. Where more than one trade or business is 

conducted in the State of source and only one of the trades or businesses forms a part of 

or is complementary to a trade or business conducted in the State of residence, it is 

necessary to identify the trade or business to which an item of income is attributable. 

Royalties generally will be considered to be derived in connection with the trade or 

business to which the underlying intangible property is attributable. Dividends will be 

deemed to be derived first out of earnings and profits of the treaty-benefited trade or 

business, and then out of other earnings and profits. Interest income may be allocated 

under any reasonable method consistently applied. A method that conforms to U.S. 

principles for expense allocation will be considered a reasonable method. 

Example 3. Americair is a corporation resident in the United States that operates 

an international airline. FSub is a wholly-owned subsidiary of Americair resident in the 

other Contracting State. FSub operates a chain of hotels in the other Contracting State 

that are located near airports served by Americair flights. Americair frequently sells tour 

98
packages that include air travel to the other Contracting State and lodging at FSub hotels. 

Although both companies are engaged in the active conduct of a trade or business, the 

businesses of operating a chain of hotels and operating an airline are distinct trades or 

businesses. Therefore FSub’s business does not form a part of Americair’s business. 

However, FSub’s business is considered to be complementary to Americair’s business 

because they are part of the same overall industry (travel) and the links between their 

operations tend to make them interdependent. 

Example 4. The facts are the same as in Example 3, except that FSub owns an 

office building in the other Contracting State instead of a hotel chain. No part of 

Americair’s business is conducted through the office building. FSub’s business is not 

considered to form a part of or to be complementary to Americair’s business. They are 

engaged in distinct trades or businesses in separate industries, and there is no economic 

dependence between the two operations. 

Example 5. USFlower is a corporation resident in the United States. USFlower 

produces and sells flowers in the United States and other countries. USFlower owns all 

the shares of ForHolding, a corporation resident in the other Contracting State. 

ForHolding is a holding company that is not engaged in a trade or business. ForHolding 

owns all the shares of three corporations that are resident in the other Contracting State: 

ForFlower, ForLawn, and ForFish. ForFlower distributes USFlower flowers under the 

USFlower trademark in the other State. ForLawn markets a line of lawn care products in 

the other State under the USFlower trademark. In addition to being sold under the same 

trademark, ForLawn and ForFlower products are sold in the same stores and sales of each 

company’s products tend to generate increased sales of the other’s products. ForFish 

imports fish from the United States and distributes it to fish wholesalers in the other 

State. For purposes of paragraph 3, the business of ForFlower forms a part of the 

business of USFlower, the business of ForLawn is complementary to the business of 

USFlower, and the business of ForFish is neither part of nor complementary to that of 

USFlower. 

An item of income derived from the State of source is “incidental to” the trade or 

business carried on in the State of residence if production of the item facilitates the 

conduct of the trade or business in the State of residence. An example of incidental 

income is the temporary investment of working capital of a person in the State of 

residence in securities issued by persons in the State of source. 

Subparagraph (b) of paragraph 3 states a further condition to the general rule in 

subparagraph (a) in cases where the trade or business generating the item of income in 

question is carried on either by the person deriving the income or by any associated 

enterprises. Subparagraph (b) states that the trade or business carried on in the State of 

residence, under these circumstances, must be substantial in relation to the activity in the 

State of source. The substantiality requirement is intended to prevent a narrow case of 

treaty-shopping abuses in which a company attempts to qualify for benefits by engaging 

in de minimis connected business activities in the treaty country in which it is resident 

(i.e., activities that have little economic cost or effect with respect to the company 

business as a whole). 

99
The determination of substantiality is made based upon all the facts and 

circumstances and takes into account the comparative sizes of the trades or businesses in 

each Contracting State the nature of the activities performed in each Contracting State, 

and the relative contributions made to that trade or business in each Contracting State. In 

any case, in making each determination or comparison, due regard will be given to the 

relative sizes of the economies in the two Contracting States. 

The determination in subparagraph (b) also is made separately for each item of 

income derived from the State of source. It therefore is possible that a person would be 

entitled to the benefits of the Convention with respect to one item of income but not with 

respect to another. If a resident of a Contracting State is entitled to treaty benefits with 

respect to a particular item of income under paragraph 3, the resident is entitled to all 

benefits of the Convention insofar as they affect the taxation of that item of income in the 

State of source. 

The application of the substantiality requirement only to income from related 

parties focuses only on potential abuse cases, and does not hamper certain other kinds of 

non-abusive activities, even though the income recipient resident in a Contracting State 

may be very small in relation to the entity generating income in the other Contracting 

State. For example, if a small U.S. research firm develops a process that it licenses to a 

very large, unrelated, pharmaceutical manufacturer in the other Contracting State, the size 

of the U.S. research firm would not have to be tested against the size of the manufacturer. 

Similarly, a small U.S. bank that makes a loan to a very large unrelated company 

operating a business in the other Contracting State would not have to pass a substantiality 

test to receive treaty benefits under Paragraph 3. 

Subparagraph (c) of paragraph 3 provides special attribution rules for purposes of 

applying the substantive rules of subparagraphs (a) and (b). Thus, these rules apply for 

purposes of determining whether a person meets the requirement in subparagraph (a) 

that it be engaged in the active conduct of a trade or business and that the item of income 

is derived in connection with that active trade or business, and for making the 

comparison required by the “substantiality” requirement in subparagraph (b). 

Subparagraph (c) attributes to a person activities conducted by persons “connected” to 

such person. A person (“X”) is connected to another person (“Y”) if X possesses 50 

percent or more of the beneficial interest in Y (or if Y possesses 50 percent or more of 

the beneficial interest in X). For this purpose, X is connected to a company if X owns 

shares representing fifty percent or more of the aggregate voting power and value of the 

company or fifty percent or more of the beneficial equity interest in the company. X also 

is connected to Y if a third person possesses fifty percent or more of the beneficial 

interest in both X and Y. For this purpose, if X or Y is a company, the threshold 

relationship with respect to such company or companies is fifty percent or more of the 

aggregate voting power and value or fifty percent or more of the beneficial equity 

interest. Finally, X is connected to Y if, based upon all the facts and circumstances, X 

controls Y, Y controls X, or X and Y are controlled by the same person or persons. 

Paragraph 4

Paragraph 4 provides that a resident of one of the States that is not entitled to the 

benefits of the Convention as a result of paragraphs 1 through 3 still may be granted 

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benefits under the Convention at the discretion of the competent authority of the State 

from which benefits are claimed. In making determinations under paragraph 4, that 

competent authority will take into account as its guideline whether the establishment, 

acquisition, or maintenance of the person seeking benefits under the Convention, or the 

conduct of such person’s operations, has or had as one of its principal purposes the 

obtaining of benefits under the Convention. Benefits will not be granted, however, solely 

because a company was established prior to the effective date of a treaty or protocol. In 

that case a company would still be required to establish to the satisfaction of the 

Competent Authority clear non-tax business reasons for its formation in a Contracting 

State, or that the allowance of benefits would not otherwise be contrary to the purposes of 

the treaty. Thus, persons that establish operations in one of the States with a principal 

purpose of obtaining the benefits of the Convention ordinarily will not be granted relief 

under paragraph 4. 

The competent authority’s discretion is quite broad. It may grant all of the 

benefits of the Convention to the taxpayer making the request, or it may grant only 

certain benefits. For instance, it may grant benefits only with respect to a particular item 

of income in a manner similar to paragraph 3. Further, the competent authority may 

establish conditions, such as setting time limits on the duration of any relief granted. 

For purposes of implementing paragraph 4, a taxpayer will be permitted to present 

his case to the relevant competent authority for an advance determination based on the 

facts. In these circumstances, it is also expected that, if the competent authority 

determines that benefits are to be allowed, they will be allowed retroactively to the time 

of entry into force of the relevant treaty provision or the establishment of the structure in 

question, whichever is later. 

Finally, there may be cases in which a resident of a Contracting State may apply 

for discretionary relief to the competent authority of his State of residence. This would 

arise, for example, if the benefit it is claiming is provided by the residence country, and 

not by the source country. So, for example, if a company that is a resident of the United 

States would like to claim the benefit of the re-sourcing rule of paragraph 3 of Article 23, 

but it does not meet any of the objective tests of paragraphs 2 and 3, it may apply to the 

U.S. competent authority for discretionary relief. 

Paragraph 5

Paragraph 5 defines several key terms for purposes of Article 22. Each of the defined 

terms is discussed above in the context in which it is used. 

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