Recent Issues in Transfer Pricing' 

Barbara L. Rollinson 

U.S,Treasury Department 

and 

Daniel J. Frisch 

U .S. Treasury Department

OTA Paper 61 November 1988 

OTA Papers and Briefs are circulated so that the preliminary findings of tax research conducted 

by staff members and others associated with the Office of Tax Analysis may reach a wider 

audience. The views expressed are those of the author(s). and do not reflect Treasury policy. 

Comments are invited. but OTA Papers and Briefs should not be quoted without permission from 

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Technical lnformation Service. 5285 Port Royal Rd., Springfield. Virginia 22 I6 I. Phone: (703) 

487-4660. 

Ofice of Tax Analysis 

U.S. Treasury Department. Room 4040 

Washington, D.C. 20220 

* 

This paper is based on the authors' work on the joint Treasury/IRS Study of Intercompany 

Pricing. It presents supplemental theoretical issues that reinforce the approaches that the 

study has advanced. The authors would like to thank Harry Grubert. Eugene Steuerle. Mark 

Beams. Michael Patton. and participants in OTA's Work in Progress seminar for comments on 

earlier drafts of this paper; and Vicky Conway for preparing the manuscript. The views 

presented in this paper are those of the authors and do not necessarily reflect those of the 

Treasury Department. 
Table of Contents 

.) 

r 

I. Introduction 

11, The Market-Based Approach . 

111. An Alternative Application of the Arm's Length Standard in the 

Presence of Firm Specific Economies 

IV. Theoretical Aspects of Issues Raised During Tax Reform 

A. Multinationals Operating As If Their Parts Were Unrelated 

B. Commensurate with Income 

C. Uncertainty 

D. Tangibles vs. Intangibles 

V. Conclusion 

Endnotes 

References 

Page 

1 

2 

4 

10 

11 

13 

15 
RECENT ISSUES IN TRANSFER PRICING 

I. Introduction 

The goal of section 482 of the Internal Revenue Code is to allocate gross income and 

deductions between related parties in order to "clearly...reflect the income of any such 

organization." It is left to regulations to implement this goal. The need for such a section 

arises when a taxpayer has operations in more than one tax jurisdiction and transfers goods and 

services between the different locations. For tax purposes, the taxpayer must charge itself a 

price when it makes a transfer. Depending on the relative tax rates and other components of 

the tax systems in the two countries. the taxpayer may hay an incentive to manipulate the 

price the company charges itself when transferring the good. 

A market based approach is presentlx adopted by the income tax regulations for the purpose 

of allocating income under section 482. The goal of this approach is to attribute income in 

the same way that the market would distribute the income. That is, related parties are to earn 

the same returns that unrelated parties would earn under similar circumstances. This approach. 

often referred to as the arm's length standard. is implemente? through separate accounting. An 

individual transfer price is determined for each transaction. 

Recently. the arm's length standard has been attacked on both practical and theoretical 

grounds. Opponents with practical concems argue that pistortions arise when one attempts to 

apply rigid rules in order to implement the standard. Theoretical opponents argue that 

multinational firms are able to take advantage of economies of scale which lead these firms to 

employ technologies that differ from those employed by other producers. Therefore. the 

argument continues, one will get skewed results if a transfer price for a multinational is 

based on what non-multinational parties would do. During the development of the Tax Reform 

Act of 1986. a related issue arose as Congress was concerned that taxpayers had made use of 

inappropriate arm's length prices as comparables. 

From the perspective of economic theory, one is interested in the way that a set of rules 

implementing section 482 affects a firm's economic behavior. Distortions may arise if the 

rules lead to changes in the relative benefits and costs of producing in different locations. 

Changes in after tax prices might lead the firm to change its location of production or to 

change the factors employed in different locations. Similarly, the rules could affect a firm's 

decision when choosing between the following alternatives: ( 1) establishing a manufacturing 

subsidiary in another country or (2) licensing the technology necessary to produce the final 

product to an unrelated firm in the other country. Rules which distort a firm's activities 

would not meet the goal of clearly reflecting income and would cause needless economic 

inefficiencies in the marketplace. 
This paper evaluates the arm's length standard from the perspecthe deconomic theory in 

order to address these concerns and to show that the standard can hc qp@kJ in such a way that 

it will not distort decisions about the choice of affiliation. Tbe pqp also argues that 

attempts to depart from the arm's length approach in order to use t"dkrpricing policy to 

ameliorate the distortions created by differential tax rates wadh3 lead to aclditional 

distortions that would discriminate between imports and exports d sthat would affect 

affiliation choices. 

The remainder of the paper is divided into four sections. SectiCm 11 presents the market 

based approach and addresses the concern that the arm's length st"d leads to economic 

distortions. Section 111 provides an alternative means of impl- the arm's length 

standard in response to the challenge that an arm's length stamid is inappropriate for 

intra-firm transfers in situations where economies of scale exist. seelriarn IV addresses issues 

raised during the creation of the Tax Reform Act of 1986. Sectiom V provides concluding 

remarks e 

11. The Market-Based Approach 

The market based alternative for the allocation of income is articulately promoted by 

Surrey (1978). Surrey starts by discussing unrelated parties and the way that they are taxed: 

Tax administrators do not question transactions that are governed by the marketplace. If Company A sells goods to unrelated Company B at a certain price or 

furnishes services at a particular price. the income of both companies is 

determined by using that price. One company may be large and the other small: 

one may be a monopoly; one may be financially strong and the other in a weak 

condition. But these and other factors which may affect the pcce at which the 

transaction occurs are not the concern of the tax administrator. 

Having established the tax system's acceptance of the market- place. he concludes: 

Presumably, most transactions are governed by the general framework of the 

marketplace and hence it is appropriate to seek to put intra-group transactions 

under that general framework. Thus, a use of the standard of arm's length. both 

to test the actual allocation of income and expense resulting under controlled 

intra-group arrangements and to adjust that alloc~tionif it does not meet such 

standard, appears in theory to be a proper course. 

The goal of a market approach is to ensure that the return to an economic activity is 

allocated according to the location of the economic activity. By determining the amount of 

income earned in each location with reference to an arm's length standard, this approach 

neutralizes tax motivated reasons to affiliate or to disaffiliate (at least with respect to 

transfer pricing). 
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Up to this point a market based means of allocating income seems theoretically sound. 

However. it is necessary to be more specific about how the arm’s length price is determined in 

order to examine what distortions might be created. Various authors have addressed this 

question. Horst (1971) argues that multinationals view potential transfer prices as being 

bounded at the low end by the marginal cost of producing the good and at the high end by the 

final price for which the good is sold. He shows that firms will have an incentive to choose 

one of the two bounds given different tax rates in the different countries. It is this type of 

distortion that the regulations for arm’s length transfer pricing must confront. If the 

regulations are carefully crafted, the firm will not legally be able to manipulate, to any 

great degree. where it claims profits are earned. 

Samueison (1982) also considers the effects that arm‘s length pricing has in a world in 

which tax rates differ. He shows that firms with some monopoly power will not only find it 

profitable to choose one of the bounds. *but they will also find it profitable to manipulate 

production in order to change the bounds. Halperin and Srinidhi (1 987) examine the existing

U.S. regulations on transfer pricing and find that, given differential tax rates, the present 

rules leadgfirms to distort their use of resources relative to that which would prevailldn a no 

tax world. In essence the firm shifts production in response to differential tax rates. 

Transfer price policy. whether based on arm‘s length or some other principle. cannot 

correct for this distortion and still remain neutral with respect to inbound and outbound 

transfers, An example illustrates this point. Suppose all countries start with the same 

effective tax rate. If one country lowers its statutory tax rate. thereby lowering its 

effective tax rate relative to other countries. there will be a change in the pattern of 

production as production moves from the high tax countries to the low tax country. To the 

extent that this movement occurs within multinationals. countries could arrest the movement by 

means of their transfer pricing policies. Since the transfer price will affect the amount of 

income in one country and the size of the deduction in the other country, a transfer pricing 

policy could be constructed that would re-equalize effective tax rates. However. the policy 

would have to treat identical inbound and outbound products differently. The decreased flow of 

products outbound to the low tax country would be required to have a higher transfer price. 

Conversely, the increased flow of identical products inbound from the low tax country would be 

required to have a lower transfer price. These opposing actions would re-equalize the 

effective tax rates in all countries at the expense of discriminating between inbound and 

outbound transfers. 

In addition to discriminating between inbound and outbound transfers. any attempt to 

equalize effective tax rates by changing traysfer pricing policy will lead to discrimination 

between related parties and unrelated parties. Using the scenario described in the previous 

paragraph. multinationals will have an incentive to deal with unrelated parties in order to 

avoid thy2transfer pricing rules and obtain the benefits of the new lower tax rate in the one 

country. Therefore, the relevant issue is whether, given differential tax rates. the 

application of the arm’s length standard leads multinationals which transfer goods among 

entities to respond in the same way as firms that do not transfer goods among entities. 
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Consider a world in which there are no multinationals, capital is internationally mobile. 

and all tax rates are equal. If one country raises its tax on opiird. capital will flow out 

of the high-tax country and into the other countries with lower taxes m capital. This flow of 

capital will lead to a change in the capital/labor ratio in each "try and therefore to a 

change in the relative pre-tax returns to each factor. The changing msls of the factors will 

lead to distortions in the amounts of capital and labor employed per unit of production 

relative to the pre-tax-increase position. The flow of capital will continue until the after 

tax rate of retum on capital is re-equalized across countries. This example illustrates a 

non-transfer price situation in which differential tax rates would lead to distortions. 

Transfer price policy cannot eliminate these distortions because it cannot affect the behavior 

of firms that are not under common control. 

In the real world. some groupings of capital are commonly controlled and therefore are 

affected by section 482 while others are not. However, all capital owners will attempt to 

respond to changing after tax returns on the use of their capital. Therefore. if transfer 

price policy is used to eliminate the distortions for the subset of cases within its purview 

new distortions will be created which will affect the choice of the form of organization. 

The fact that an arm's length price will not eliminate the economic distortions caused by 

unequal tax rates in various countries should not be viewed as a flaw in a market based 

transfer-pricing system. It is an inevitable reaction to the different tax rates. Similarly. 

firms that shift their production locations in response to the incentives created by 

differential rates should not automatically be viewed as if they are trying to manipulate 

transfer prices. 

111. An Alternative Applicationof the Arm's Length Standard in the Presence of Firm Specific 

Economies 

The previous section assumes that multinational firms are similar enough to firms located 

in only one country so that meaningful comparisons are possible. Recent critiques by McLure 

(1984) and Langbein (1986) question this assumption and question whether it is possible 

isolate the income earned in each country in order to apply the arm's length standard. 

McLure (1984) claims that economies of scale may lead firms to integrate and that the resulting 

industry may be populated with a few firmslfarning "extraordinary profits" which would be 

"difficult" to allocate between affiliates. McLure also perceives difficulties with 

horizontal integration. 1'5" particular he is concerned with inputs that have some of the 

aspects of a public good. Langbein claims that the flaw in an arm's length approach is that 

it does not allow a return to the form of organization. That is, because an integrated 

enterprise is presumably more efficient it will be able to execute an integrated economic 

activity at a lower cost than a series of independent firms whose joint efforts are necessary 

to execute the same series of transactions. The omission creates what he calls a continuum 

price problem, a situation in which the sum of the returns for individual services rendered by 

independent parties would be less than the actual retum of the combined group. 
-5-

McLure and Langbein's arguments grow out of the literature on the existence of 

multinationals. Caves (1982) explains that many multinationals exist because of a failure in 

the market for intangibles. In essence, intra-firm transactions can be more protitable than 

inter-firm transactions because of the expense of negotiating complete contracts or the 

inability of a firm to capture the full value of a piece of knowledge without fully explaining 

the knowledge and thus eliminating its value. Horstmann and Markusen ( 1985)develop a model 

which predicts that multinational enterprises will come into existence when these intra-firm 

savings exist and when transportation costs are high relative to plant scale economies. In 

other words. if transportation costs from the existing plant to the potential market are high 

and if a new plant in the potential market could produce the product at about the same cost as 

could be obtained by expanding existing production. then it is more likely that a new plant 

will be opened. Therefore. the product will be produced in both countries. Relatively high 

benefits from having production within one company imply that multinational enterprises are 

more likely to come into existence. so that the plants in different countries wilI be under 

common control. 

Support for the contention that multinationals exist because of firm specific economies 

does not automatically imply a rejection of the am's length principle. Grubert (1987) 

explains that one can approach the arm's-length problem by asking what unrelated parties would 

do if they had the opportunities available to related parties. The goal would be to distribute 

income in the way that unrelated parties would distribute the income if they were considering 

affiliation. As Grubert explains, the decision to affiliate could take the form of a joint 

venture. an acquisition, a merger or a decision to hire necessary labor and capital within a 

subsidiary. Such an approach effectively accounts for the benefit of the firm's choice afs 

organization and ensures that the distribution of income is based on the relevant technology. 

Another way of expressing the arm's length agreements that have to be considered in this 

situation is to say that they are the arrangements that would be made between unrelated parties 

if they could choose to have the costs of related parties. i.e. to use the related party 

technology. Recall the fundamental objective of tax policy in the area of transfer pricing: 

In general. tax rules should distort business decisions as little as possible because rules 

that minimize such distortions will lead to the greatest possible production efficiency. 

Transfer pricing rules will allow the most efficient production technology to come to the fore 

if. holding the cost functions constant, they result in the same tax burdens whether or not the 

parties are related. In other words, if unrelated parties somehow had access to the integrated 

technology, their operations should not result in more or less total taxes than would be paid 

by a multinational using this technology. If this goal can be met. transfer pricing policy 

will refrain from distorting,the optimal mix of unrelated- party versus within-multinational 

transactions in the market. The only difficulty would seem to be the practical application 

of this alternative interpretation of the arm's length standard. 

This practical problem can be analyzed more concretely using certain tools of microeconomic 

theory. Restated in these terms, the "continuum price problem" arises in the situation in 

which a vertically or horizontally integrated production technology. which is available to 

multinational corporations, leads to lower costs than a non-vertically or horizontally 
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integrated technology, which unrelated parties would have to use. The goal is then to 

determine if an examination of unrelated-party transactions can lead to a satisfactory 

resolution of the transfer pricing problem. 

It is helpful to step back at this point, and consider an indrrsttq in which there is no 

difference in costs between related-party and unrelated-party ddiwgs; there is only one 

production technology. and it is available to the parties in both types danangements. There 

is thus no "continuum problem", and the arm's length standard. as traditionally interpreted. 

can be applied. It is likely that both unrelated-party and related- party transactions will 

actually occur in the marketplace, and it should be possible to observe prices from the former 

and use them to determine the incomes of each party in the latter. This procedure satisfies 

the objective outlined above. The related parties that sell intermediate goods will be given 

the same gross revenues as the corresponding unrelated parties; related parties that purchase 

them will be given the same cost-of-goods-sold as corresponding unrelated parties. Further. it 

has already been assumed that the two sets of parties operate in the same market and have the 

same cost structure: therefore. the external prices and intemal costs will be equal. Thus. 

the related parties will have the same net taxable incomes as the corresponding unrelated 

parties. They should therefore pay the same taxes. Thus, the multinational will face the same 

total tax burden as the unrelated parties with which it is competing. 

Now return to the situation in which a vertically or horizontally-integrated technology. 

which is available only to multinational companies, is dominant. (Even though multinational 

corporations have an advantage, relative to smaller companies. it does not follow that 

monopolistic practices must be a problem. because there might be many competing 

multinationals.) If multinational corporations are able to produce at a lower cost. then. in 

the long run. it should be difficult for the smaller companies to continue in existence. 

Therefore. arm's length prices may be unavailable. 

An appropriate result will be achieved if each related party is assigned the income that 

the corresponding unrelated party would earn. if the latter were using the efficient cost 

structure. Microeconomic theory leads to an unambiguous and natural statement of what the 

income of unrelated parties should be taken to be in these circumstances. Specifically. as 

long as the industry under analysis is competitive and the factors of production are 

homogeneousand mobile between sectors. we may employ the familiar concept that "economic" or 

"excess" or "above-normal" profits will be zero in the long run. This concept states that each 

firm will eam just enough to be able to pay fy; the land, labor. capital. and other factors of 

production that it uses to produce its outputs, If owners of the firm have supplied it with 

capital or other inputs. then the firm should earn enough to be able to reward the shareholders 

for these factors: otherwise. the shareholders would be wise to find a better use for them. 

Algebraically: 

N 

(1) P*Q - E r,* Xn = 0, 

n=l 
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where P and Q are the price and quantity of the firm's output. Xn are the amounts of the 

factors of production used to produce Q. and r,, are the market retums to these factors. Xn 

includes factors that are internal to the enterprise and those that are hired or rented from 

the outside. Let X, through XI be internally owned inputs. and let through % be the 

inputs hired from the outside. Then: 

N I 

(2) P*Q - E rj * X, = E ri * Xi 

j=I+1 i= 1 

This formulation is useful because the left-hand side can be taken as the simplest possible 

representation of taxable income. If the enterprise is an affiliate of a larger firm. the 

left-hand side also displays the simplest possible version of the arm's- length approach to the 

transfer pricing problem. Presumably, one can observe Q and the amounts that the enterprise 

pays to outside suppliers of factors of production. Thus, if one can measure P. one can 

calculate the proper tax base of the affiliate. 

The new element is the right-hand side. It suggests an alternative way of approaching the 

problem of measuring the taxable income of an affiliate. In words. the right-hand side of 

equation (2) is the normal retum to the factors of production that are intemal to the 

enterprise. the factors that it is entitled to use to produce the goods and services that it 

sells but that it doesn't have to pay someone for (at least before determining the proper 

measure of taxable profits). Examples include plant and equipment and other assets owned by 

the enterprise. and perhaps. labor and other factors provided for "free" by an owner. Equation 

(2) states that the sum of the returns to these factors equals the tax base as conventionally 

measured. 

The traditional approach looks for the prices that the firm's outputs would command in the 

marketplace, whereas the alternative approach seeks to determine the returns that the firm's 

factors would earn in the marketplace. Therefore. both approaches are equally consistent with 

the basic goal of the arm's length principle. which is to use information about unrelated 

parties operating at arm's length to determine the allocation of income in a related-party 

setting. 

There are two further issues which should be analyzed at this point. The first concems 

monopolistic. rather than competitive. situations. Consider a market in which only one or a 

few firms are able to enter. Then, the existence of "above-normal" profits cannot be ruled 

out. because potential competitors will not be able to compete them away. The equality 

discussed above. and the results derived from it. cannot then be assumed to hold. However. it 

may still be possible to apply the basic idea. For example, consider a situation in which a 

corporation has been granted worldwide patent rights to a unique product. The company can 

still choose between exploiting this patent through related- party or unrelated-party dealings. 

and it would be worthwhile for this decision to be made free of distortions caused by transfer 

pricing rules. To get an unrelated party to provide a good or service. the corporation would 

have to pay it the sum of the returns that would be earned by the factors it would employ. 
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Therefore, it would still be proper to use the alternative procedure twdlaltcanmne the income of 

the corporation's affiliates, because then the parent corpo~weukt19not have a 

tax-motivated reason for choosing between using them versus unrelaoeat pdes. 

The second issue is closely related. The starting point for the e application of 

the arm's length approach is to measure the factors of production enqphyed by the related 

parties. and to determine the returns that they would eam in the ndWp&m. This procedure 

can be implemented in a straight forward fashion only if the factom an be identified and 

measured. However, there is at least one type of factor of proddkm, intangible assets. to 

which it is often difficult to assign a precise value. These assets am^ &en unique and it is 

frequently difficult to decide what returns they would eam if sepm&eby employed in the 

marketplace. One should not conclude that the presence of any intangible asset will make the 

alternative procedure impossible to implement. It may be that only me of the related parties 

employs intangible assets to any significant degree. In this situaticnr it sfices to measure 

the factors of production employed by the other party or parties. 

To summarize. microeconomic theory would seem to lend support to transfer pricing rules 

based on the arm's length principle. properly interpreted. In certain shakions. production 

technologies may be such that unrelated parties operating at am's length can be expected to 

coexist with vertically or horizontally integrated muitinational corporations. In these cases. 

arm's length prices for related-party transactions should exist and their use will. in theory. 

lead to appropriate results. In other situations. vertically or horizontally integrated 

technologies available only in related-party dealings may dominate. Then. arm's length prices 

will be difficult to find and their use, if they exist. may be inappropriate. However. 

information may exist as to the arm's length retums attributable to the factors of production 

employed by the related parties. and it is appropriate. from a theoretical standpoint, to base 

the allocation of income among the related parties on this information. 

IV, Theoretical Aspects Of Issues Raised During Tax Reform 

The Tax Reform Act of 1986 made the first significant change in section 482 since its 

inception in the tax code. The change specifies that, "in the case of any transfer (or 

license) of intangible property ...the income with respect to such transfer or license shall be 

commensurate with the income attributable to the intangible.'"O The discussions leading up to 

this change raised a number of the theoretical issues discussed above. The section of the 

House Committee Report that discusses the commensurate with income provision is a useful 

summary. Specifically, it raises four major issues: Do multinational firms operate as if 

their parts were unrelated? Are there inappropriate comparable prices? How does one provide a 

framework that allows flexibility for real world uncertainty? And. are methods for determining 

transfer prices for intangibles fundamentally different than those for tangible goods? The 

folIowing section will address each of these concems in an effort to explore the theoretical 

basis of an am's length system more completely. 
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A. Multinationals Operating As If Their Parts Were Unrelated 

A fundamental problem is the fact that the relationship between related parties 

is different from that of unrelated parties. Observers have noted that 

multinational companies operate as an2wonomic unit and not "as if" they were 

unrelated to their foreign subsidiaries. 

This issue was discussed in detail above. It is obvious that firms will not, in general. 

operate exactly as if their parts are unrelated. However, the appropriate solution is to 

allocate income based on the way that unrelated parties would act if they could use the factors 

of production and technologies that the related parties do. 

B. Commensurate with Income 

There are extreme difficulties in determining whether the arm's length transfers 

between unrelated parties are comparable. The committee thus concludes that it 

is appropriate to require that the payment made on a transfer2pf intangibles.. .be 

commensurate with the income attributable to the intangible. 

This statement focuses on the attempt to comply with section 482 by using only information 

about am's length prices. The theoretical reason that a distortion might occur when the 

taxpayer was making a good faith effort to comply with the regulations has been explained 

above. The structure of multinationals may mean that they drive out other methods of 

production so that appropriate comparable prices are not available. Therefore. as the 

committee report suggests. it is necessary to determine the income that should be eamed by the 

factors of production employed by the different entities. The appropriate arm's length 

comparison is the returns eamed by unrelated parties for the factors they employ and the 

functions they perform. 

C. Uncertainty 

Uncertainty is a topic that has not yet been addressed. There are at least two major 

topics of concern: First, are all risks ultimately borne by the parent, and second, since 

future events are uncertain, will it be necessary to make adjustments over time to reflect 

changing circumstances? 

The House Committee Report addressed the issue of risk in the following way: 

. . .a parent corporation that transfers potentially valuable property to its 

subsidiary is not faced with the same risks as if it were dealing with an 

unrelated party. Its equity interest assures it of the ability ultimately to 

obtain the benefit ?[ future anticipated or unanticipated profits, without regard 

to the price it sets. 
- 10-

This statement is true. but not on point. All risks in an enterprise Bllllzt uftimately be bome 

by the shareholders of the parent corporation. regardless of what tr” - s are undertaken 

between a parent and its subsidiaries. This is indeed a relevant way d looking at the risk 

takers. but one must ask where the shareholders are taking the When a domestic 

corporation elects to earn income abroad. the United States gemdilly cedes primary taxing 

authority to the country which is hosting the corporation‘s activities. h eleeting to perform 

certain functions abroad. the shareholders are taking risks abroad. More. the retum on 

those risky activities should also accrue abroad. In other wmb, if a corporation is 

undertaking activities that earn a risk premium in the marketplace. the risk premium should be 

attributed to the entity that is performing the risky function. 

Potential adjustments over time are another means of addressing ameertahty: 

The committee intends that consideration also be given the actual profit 

experience realized as a consequence of the transfer. Thus the committee intends 

to require that the payments made for the intangible be a$sted over time to 

reflect changes in the income attributable to the intangible. 

Is the use of actual profit experience consistent with an arm’s length approach? There is 

no single answer to this question. because there are a variety of ways that actual profit 

experience could be used. Certain uses are clearly consistent with ann’s length principles. 

If relevant. actual performance data may be used consistently with arm‘s length as an 

indication of what the parties‘ expectations were at the time the transaction was entered into. 

Further. it is consistent with arm‘s length to require related parties to adjust transfer 

prices in the same way that unrelated parties would have adjusted them. For example. it may be 

determined that certain types of royalty arrangements between unrelated parties typically are 

limited in duration. say to five years. If so. related parties in similar circumstances ought 

to adjust their payments at least every five years. 

Alternatively. it may be that unrelated parties do not limit the duration of their 

agreement. but allow either party to terminate with notice. Simply requiring related-party 

agreements to include termination clauses would clearly be inadequate, because the related 

parties would choose not to exercise them in some circumstances when unrelated parties would. 

It would be consistent with arm‘s length to require related parties to adjust their agreement 

if unrelated parties would have exercised a termination clause. In some circumstances. these 

type of adjustments may closely approximate the results contemplated by the House Bill 

Committee Report. 

D. Tangibles vs. Intangibles 

The commensurate with income change singles out intangible property. A partial list of 

intangible property includes patents, inventions. designs. know-how. copyrights. trademarks. 

brand names and technical data. The production and exploitation of intangible property often 

falls into the category of cases for which claims are made that it is not possible to use 

separate accounting. It is undeniable that the application of a separate accounting approach 
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is more difficult in the case of intangibles. However, the present goal is to ask whether 

there is a theoretical difference between valuing tangible and intangible property which would 

preclude using an arm's length approach in order to determine transfer prices for intangibles. 

Under the am's length approach, the goal of transfer pricing rules with respect to any 

type of property is that the income should be allocated according to the location of the 

economic activity that went into producing and exploiting the property. Given this goal, there 

would seem to be no theoretical difference between tangible and intangible property. 

What might seem to make intangibles different as a matter of economic theory is that the 

marginal cost of using an existing intangible to produce another unit of a good or service is 

zero. (For example, once one knows the formula to make a product, it does not have to be 

reinvented each time the raw materials rolltmto the assembly line.) Any return to the 

intangible contained in the second through n units of the product means that the price is 

greater than the marginal cost of producing the last unit. This does not provide a distinction 

between tangible and intangible goods, however. since price can be greater than marginal cost 

for any type of good. 

Another distinction is that problems may arise in identifying the intangibles. Tangible 

property. by definition. has physical properties which make it easy to classify. Intangible 

property is more elusive. Wright (1984) discusses the identification of intangible property. 

the distinction between manufacturing tangibles and marketing intangibles. and the pattern of 

value over time for these two types of intangibles. The fact that there are different types of 

intangibles with different values at different points in time emphasizes the necessity of 

identifying all the intangibles. If an intangible is overlooked. one may not establish the 

correct transfer price. Therefore, it is important to emphasize intangibles. not because they 

should be treated differently from tangibles, but because they may be more easily overlooked. 

The possibility of overlooking certain intangibles. together with the difficulties in 

valuing the ones that can be identified. suggests that. if possible, one should seek to analyze 

a transfer pricing problem from the point of view that minimizes the necessity of looking at 

intangibles. In certain cases, one may feel confident both about the total income accruing to 

a group of related parties from a line of activities. and about the fact that one or more of 

the parties does not own or employ intangibles to any sizeable degree. The preceeding 

discussion of an approach based on arm's length returns implies that it is reasonable in this 

case to start by deciding on the income of the entities making the least use of intangibles. 

and to allow the income of the other parties to be determined as a residual. However. such 

suggestions involve practical considerations. The conclusion here is that there is no 

, theoretical reason to reject the use of an arm's length standard for intangible property. 

V. Conclusion 

From the standpoint of economic theory, there does not seem to be any reason to reject a 

market-based approach implemented via separate accounting as a means of allocating income 

between related parties. This is true regardless of whether the property under consideration 
-12-

is tangible or intangible. Application of the ann’s length a m wdl result in firms 

changing their production decisions relative to a no tax world. hut the sslift in resoiirces will 

be the same as that which would result if unrelated parties were fd with different tax rates 

in different countries. Use of the arm’s length standard does not art the decision to use 

affiliates versus unrelated parties. Although these points favor ap@btian of the standard. 

they do not imply that the standard as previously implemented is iIbmkss. As critics have 

suggested, and as discussion during the Tax Reform Act of 1986 points aut, there are problems 

with a practical application of an arm’s length standard that focuses mly on prices charged by 

unrelated parties for similar goods, services or intangibles. This paper has shown that it may 

be worthwhile to focus on incomes earned by unrelated parties instd of on price in order to 

appropriately compensate related parties for the functions they @arm and the inputs that 

they employ. 
-13-

ENDNOTES 

1

The United States allows deferral of taxation for the active business income of a foreign subsidiary until it is 

repatriated, Therefore, a U.S. corporation with a foreign subsidiary in a low tax count has an incentive to charge itself 

a relatively low price for the transfer of goods and services from the parent to the su7sidiary. If the subsidiary were 

located in a high tax country, the firm would have an incentive to charge a high transfer price. 

2 See Treas. Reg. 0 1.482, 

3 The leading alternative to thearm's length approach, implemented through separate accounting. is the unitary business 

approach. implemented through formulaapportionment. See McLure ( 1984)and works cited therein for a discussion ofthis 

approach. We intend to analyze this method, specifically the effective tax rates on capital that can arise under a simple

representation of it, in future research. 

4 For example. see Halperin and Srinidhi (1987). 

5 For example. see Langbein (1986) and McLure (1984). 

6 Surrey (1978), p. 414. 

7 id at 414. 

E Rollinson (I986) shows ways in which transfer pricingcan be used to provide incentives to change the input mix chosen 

by multinationals. 

9

The income tax regulations examined by Halperin and Srinidhi are found at section 1.482-2(e). These regulations

describe the methods to be used when determining a transfer price for tangible property. 

10As Halperin and Srinidhi are quick to point out. it is not solely the tax rate differential that causes this shift. 

Instead. it is the combination of tax rate differentials and an effective transfer price policy. Halperin and Srinidhi 

eniphasize that if a multinational firm could arrange its transfer price policy so that all of its profits were earned in the 

country with the lowest tax rate then differential tax rates would not lead multinational firms to shift their resources. 

Our paper assumes that high tax countries would find such a result untenable so that this type of manipulation is not 

considered as an option. 

11While this paper was in its final stages of preparation, this concern was voiced. in a remarkably similar fashion in an 

important judicial decision. Afcari AIuminum Lrd. v. Frcuichise Tux Board. No. 87-2239, (Seventh Circuit, 10119/88) concerns two foreign parents whose U.S. subsidiaries are subject to California's worldwide unitary system of taxation. The 

basic issue in the case is whether the parents suffer injuries that are "sufficiently direct and independent of the injuries 

to their subsidiaries to confer standing." A key element in the judges' decision is so similar to the concerns addressed in 

this paper, and is so cogently stated, that it bears quoting at length: 

However. theargumentsthatAlcan and Imperial incur nodirectand independent injury fronicosts 

plausibly viewed as burdens on their subsidiaries remains persuasive only so long as the 

relationship between parents and subsidiaries is viewed narrowly. focusing exclusively on the 

parents' status as shareholders. It is indisputable that. but for their ownership of stock in 

corporations that operate in California, Alcan and Imperial would have noconiplaint about their 

compliancecostsordoubletaxation.This lineofargument, however, ignoresasecond iniportant feature of the relationship between the forei n parents and their domestic subsidiaries: the 

subsidiaries are owned as instrumentalities oBthe foreign commerce of their parents. Foreign

companies seeking to sell or purchase products or services in California choose between 

conducting business through dealings with American subsidiaries or through contracts with 

unrelated companies. Plantiffs allege that for many enterprises subject to the unitary tax, the 

earnings ofoperations in California. computed tinder thearm's length transaction approach. are 

lower in relation to labor costs, capital assets and sales than are the similarly computed

earnings of related operations in countries other than the United States. These companies will 

show a higher taxable income in California under the unitary tax scheme than they would if they 

I 
- 14-

engaged in preciselythe sameforeign commerce through arm's lengthcontractawi&iliated

companies. From the perspective of the foreign parent, therefore. the unm taradkmhishes 

the attractiveness of owning American subsidiaries in comparison with entering i"mtmcts 

with independent companies as a means ofengaging in foreign commerce. TaatplnaenlPrkrthe unitary tax to penalize foreign owiiership of American assets distinguishes tkulribasptm from 

environmental or safety regulation that might cause comparable increases im tkamirddoing

business in California, but would presumably affect foreign and domesticallywdmns 

fairly equally. It is the incidence of the unitary tax, its potential to didiwcmr a p"lar mode of foreign participation in the American economy, rather than the magnW&&w& it 

iniposes that provides the strongest argument for standing. 

12Alternatively. if multinationals could set their own transfer pricing policy so alkaa dl rprofits were earned in the 

low tax country, then there would be a bias against unrelated-party tran"s ad in favor of multinational 

operations. 

13The genesis of the debate over the arm's length standard niay be attributed to H i(19.S6). Hirslileifer derives 

the appropriate internal transfer price for goods that are transferred between divisions &a firm. In this context the 

"appropriate" price means the price that will signal enough activity at each division satdbk ahe overall profit of the firm 

will be maximized. Hirshleifer finds that the market price is the correct internal tmdk price only when the product being transferred is produced in a competitive market. If the market for the product is hperktly competitive then the 

optimal transfer price will be lower than the market price. Since the arm's length stadkd mcs the market price. critics 

have pointed to Hirshleifer's article as an indication that the arm's length standard will ma always yield an appropriate price. Such arguments are misguided because Hirshleifer's transfer price is for intenid use $Ithe firm. The transfer 

price used for tax purposes does not put any restrictions on the internal prices used by a 6i".See Langbein (1 986) for a 

niore complete discussion of earlier critiques of the arm's length standard. 

14McLure (1984), p. 94. 

15An example is advertising for a particular product which promotes brand loyally mrd all of the firm's product lines. 

16A discussion by Steiierle (1982) of the efficient valuation of fringe benefits in the presence of taxes also addresses 

the distortions that are created if one applies a market price. which is derived from one lsrpe of technology. in situations 

where a different production function is appropriate. However, the solution to tfpe fringe benefit case is slightly

different because the market for a company's fringe benefits is potentially segregated from the market for the company's product so that both markets niay remain in existence. In the transfer pricing case. potentially different technologies are 

being used to supply identical consumers. If one technology is more efficient. the other will disappear in the long 

run. 

17Hines (1988) presents six criteria that transfer pricing rules should satisfy. It would be interesting to consider 

whether these criteria imply or are implied by the goal discussed in this paragraph: however, this issue is beyond the scope

of our paper. 

18Below we relax the assumption of homogeneous factors. 

19In more complicated situations. both the affiliated corporation and any potential unrelated-party participant may each 

possess monopoly rights that allow it to earn above-normal profits. In deciding whether to use such an unrelated party. a 

corporation would have to consider what would happen if it attempted to bargain with it. There are analyses. relating to 

economic game theory, that are able to predict what the outcomes would be in such a bilateral monopoly situation. If the 

outcome. specifically the income of the potential unrelated-party, can be predicted. then it would be proper to use it to 

determine the income of the corporation's affiliate. This is so. to repeat, because this procedure would allow the 

corporation's choice between using an affiliate versus an unrelated-party to be made free of tax distortions. To implement

this procedure, however, one would need to analyze the theoretical models of bargaining situations in detail. and this 

analysis is beyond the scope of this paper. 

20Sec. 1231(e)(l), Tax Reform Act of 1986, P.L.99-514-October 22, 1986. 100 Stat. 2085. 

21Committee on Ways and Means, H. Rep. No. 99-426, 99th Cong.. 1st Sess. at 424 (1985). 

22id at 425. 

a3 id at 424. 

24id at 425-426. 
-15-

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