A transfer price is the price charged by one company for a product or service supplied to a related company, such as the price a parent corporation charges its wholly-owned subsidiary. Any company that has a related company with which it transacts business establishes transfer prices for those intercompany transactions. Although often associated with the pricing of tangible goods, transfer pricing occurs whenever income and expenses are allocated among interrelated companies. For example, the payment of royalties, interest payments for debts, leasing expenses, and fees for other services between interrelated companies are transactions requiring transfer prices. Pricing of intercompany transactions affects the distribution of profits and, therefore, taxable income among the related companies and, sometimes, across tax jurisdictions. Abusive transfer pricing occurs when income and expenses are improperly allocated among interrelated companies for the purpose of reducing taxable income in a high-tax jurisdiction. Underpayment of U.S. income taxes can result from inappropriate transfer pricing between interrelated companies with operations in both the United States and in a country with a lower tax burden. Even when the U.S. corporate tax rate is lower than that of some other country, transfer pricing abuses can occur by shifting income through another related company that operates in a tax haven, that is, a country with low or no taxes. The following is an example of abusive cross-border transfer pricing. A foreign parent corporation with a subsidiary operating in the United States charges the subsidiary excessive prices for goods and services rendered (for example, $1,000 instead of the going rate of $600). This raises the subsidiary’s expenses (by $400), lowers its profits (by $400), and effectively shifts that income ($400) outside of the United States. At a 35-percent U.S. corporate income tax rate, the subsidiary will pay $140 less in U.S. taxes than it would if the $400 in profits were attributed to it. Section 482 of the Internal Revenue Code provides IRS authority to allocate income among related parties if IRS determines that the transfer prices used by the taxpayer are inappropriate. To evaluate transfer pricing, the IRS examiner considers what the price would have been if the parties had not been related to each other. Such a price between unrelated parties is called the “arm’s length” price. Finding a section 482 violation, that is, a difference between the price a related party charged and the arm’s length price, the IRS examiner can propose an adjustment to the taxpayer’s income. If the taxpayer does not agree with the proposed adjustment, it can appeal the dispute through IRS’ appeals process or take the case to court. In July 1994, IRS issued new regulations under section 482 that differed significantly from previous section 482 regulations. Under the new regulations, taxpayers have great latitude in establishing transfer prices. However, under 1993 legislation, taxpayers are subject to new requirements for documenting their transfer prices, and they face stiff penalties for substantially misstating them. IRS’ international examiners continued to propose substantial adjustments to the taxable income of FCCs and USCCs in fiscal years 1993 and 1994, although the total dollar value of the adjustments in 1993 was $1.3 billion less than in 1994. In examinations finished in fiscal year 1993, international examiners proposed adjustments to taxable income of $2.2 billion for 369 corporations—$900 million for 247 FCCs and $1.3 billion for 122 USCCs. For 1994, IRS data showed $3.5 billion in proposed adjustments. Most of the dollar value of these proposed section 482 adjustments was for large cases, those that had total proposed adjustments of $20 million or more. For example, in 1993 examiners proposed $1.8 billion in adjustments for 51 of these large cases—$700 million for 18 FCCs and $1.1 billion for 33 USCCs. Although the 18 large FCCs subject to proposed income adjustments in 1993 represented an increase in number over the previous 4 years, when 11 to 13 FCCs were subject to proposed income adjustments for transfer pricing, they also represented a decrease in dollars. The number of USCCs subject to income adjustments for transfer pricing in 1993, in contrast, was about the same as in previous years, although this group also involved fewer dollars. According to IRS, the 1993 adjustments for transfer pricing might be understated due to data that were lost in implementing a new management information system. Transfer pricing issues for which IRS examiners proposed income adjustments in 1993 occurred about equally in four categories, while pricing of tangible goods represented the largest share of the adjustment dollars proposed. As shown in figure 1, the categories with the most frequent section 482 issues were interest, royalties, pricing of tangible goods, and a nonspecific category of income allocations and deductions, each accounting for between 11 and 14 percent of occurrences found by IRS examiners. Yet, adjustments for pricing of goods accounted for 49 percent of all the section 482 adjustment dollars proposed. IRS’ recent experience with section 482 issues in the appeals process—the IRS administrative process that attempts to negotiate disputes—and with the Chief Counsel’s office, which is also involved in dispute resolution, was in some ways similar to, but also different from, the experience about which we testified in March 1993. The section 482 issues pending resolution in Appeals or in litigation with Counsel involved about the same dollar value, $14 billion in both June 1994 and September 1992, the dates for which information was available for our current report and for our March 1993 testimony. However, fewer taxpayers were involved at the more recent date—114 as opposed to 180 in the earlier time. Foreign-controlled taxpayers accounted for just under 20 percent of the total both times. The sustention rate for section 482 issues, which is the ratio of income adjustments proposed by the examiners to the final income adjustment after the appeals and legal processes ran their courses, peaked at 52 percent in 1990, then in succeeding years fell back to prior levels of less than 30 percent. While the data IRS maintains on examination and appeals staff time do not have sufficient detail to link them to specific tax issues, we determined that IRS examiners, economists, and appeals staff spent about 186 staff years on cases closed in fiscal year 1993 which contained transfer pricing issues, compared to about 227 staff years on cases closed in fiscal year 1992. The 1993 cases, which involved section 482 issues among other IRS findings, represented 148 international examiner years, 13 economist years, and 25 appeals years. According to IRS officials, the number of years associated with closed cases can fluctuate over time because large cases incur time charges over a period of years and close at different times within a year. In calendar year 1993 and the first part of calendar year 1994, IRS was more successful in litigating section 482 issues than it had been in calendar years 1990 through 1992. While IRS did not prevail in any of the four major court cases with section 482 issues that we analyzed, it lost only one and was a partial winner in the other three. IRS has a number of procedural tools—that is, discretionary measures, including designated summonses and formal document requests, and additional penalties specifically for section 482—that can be invoked to obtain needed documents, to encourage a recalcitrant taxpayer’s cooperation, or to otherwise facilitate examinations. IRS, however, actually used these tools infrequently because, according to IRS officials, they had their desired effect as deterrents inducing a positive change in taxpayer behavior, and recordkeeping requirements were also helping. Arbitration, a tool available only if both parties agree, was used only once for section 482 issues—with a favorable outcome for IRS. Simultaneous examinations of related parties by IRS and foreign tax enforcement agencies promote tax compliance and exchange of documents, but, for a number of reasons, including questions of the timing of examinations, IRS and the foreign governments have only agreed to examine five to eight each year. Advance pricing agreements (APA), which allow the taxpayer to detail and IRS to approve in advance the methodology to be used in setting transfer prices, require an upfront investment of resources to negotiate in order to save IRS examination time in future years. APAs increased from the 9 we cited in our 1993 testimony to 26 completed as of January 1995. IRS expected the number of APAs to grow significantly in the immediate future, which will require additional upfront staff time. Issued in July 1994, the final transfer pricing regulations are too recent for their impact to be known. The new regulations replace the strict priority of pricing allocation methods contained in the prior regulations with the best method rule, which recognizes that the most reliable measure of an arm’s length result will vary depending upon the facts and circumstances of the transaction under review. As a result, taxpayers will have flexibility in selecting and justifying transfer prices, and IRS will also be using considerable judgment in applying the arm’s length standard. As it was, taxpayers were already using transfer pricing methods other than the three formerly most well-defined methods for a large proportion of their transfer pricing activity reviewed by IRS, including that in APAs. The new regulations also recognize a range of acceptable transfer prices, providing a taxpayer protection for a reasonable and economically justified pricing methodology. The Omnibus Budget Reconciliation Act of 1993 required contemporaneous documentation of the pricing method used in setting transfer prices and established more widely applicable penalties for transfer pricing abuses than existed earlier. The extent to which the new documentation requirements and IRS’ use of judgment in applying the arm’s length standard will offset the risks of controversy brought on by taxpayer flexibility remains to be seen. In each of the 5 years studied, FCCs were less likely than USCCs to pay U.S. income tax, as shown in figure 2 and appendix V. In 1991, 73 percent of FCCs paid no U.S. income tax compared with 62 percent of USCCs. The relative flatness of the top two lines in the figure demonstrates how little has changed overall during this 5-year period.