Transfer Pricing and Transfer of Property Outside the US
Transfer Pricing is one of the most well known areas of International Tax (probably because it often results in high-profile litigation). In practice, Transfer Pricing issues are more often within the domain of economists than tax professionals since, ultimately, the questions that need to be resolved are economic questions rather than legislative ones.
Transfer Pricing rules were introduced to control the following abuses:
Assume that a multinational corporation, WorldCo, has two subsidiaries, one in the US (USCo) and one in Hong Kong (HKCo). Hong Kong taxes HKCo at a rate of 10% whereas the United States taxes USCo at a rate of 35%. USCo manufactures radios and sells them to HKCo. HKCo distributes the radios to retailers in Hong Kong. The cost to manufacture the radios is $5 per unit and the sales price to retailers is $20 per unit. The $15 of gain is realized by the WorldCo enterprise regardless of the portion earned by USCo or HKCo.
It is therefore in WorldCo’s interest to set the intercompany price between USCo and HKCo as low as possible. For example, if USCo sold the radios to HKCo for $7, there would be $2 of gain attributed to USCo that would be taxed at 35%. Meanwhile, $13 of gain would be attributed to HKCo and taxed at only 10%. By shifting more of the gain to HKCo, which is in a lower tax jurisdiction, WorldCo can minimize the amount of tax it pays on the transaction. It does not matter to USCo that it is being short-changed since it is part of the same enterprise as WorldCo and, ultimately, WorldCo’s shareholders will receive the entire $15 of gain (no matter how it is spread between USCo and HKCo).
If HKCo was unrelated to USCo, USCo would never tolerate a price as low as $7 since $2 gain is well below the acceptable mark-up for radios. The IRS aims to ensure that the prices in intercompany transactions do not deviate from the prices that would exist between unrelated parties. The purpose of the Transfer Pricing rules is to require related parties to charge each other “arm’s length” prices for goods and services (i.e. prices that would be excepted if the transactions were between unrelated parties).
Transfer Pricing Methods
The tricky part is to determine what the appropriate intercompany price should be – what price would reflect a transaction between independent parties. There are three generally accepted methods to establish the proper transfer price:
Comparable Uncontrolled Price (“CUP”) Method
Under this method, you find comparable transactions between unrelated parties and look at the price that is charged between those parties. For instance, if another US company manufactured similar radios for $5 and sold them to an unrelated distributor in Hong Kong for $10, the CUP Method would require USCo to charge $10 to HKCo for the radios it sells.
Since it is difficult to find exact comparables, certain adjustments must often be made.
Resale Price (“RSP”) Method
In this case we are not looking at comparable products, but comparable distribution functions. We look at the gross profit margin that is realized by an unrelated distributor and apply that gross profit margin to our distributor (HKCo).
If no other company in the US manufactures radios we could not use the CUP method. However, assume that we identify a Hong Kong company that distributes televisions. Assume that this other Hong Kong company buys the TVs from an unrelated party for $20 per unit and sells them to retailers for $45 per unit. The gross profit margin is 56% (($45-$20) / $45). Using the RSP method, we can conclude that the gross profit margin realized by HKCo should also be 56%. Since HKCo charges the retailers $20, a 56% gross profit margin would be $11.20. In order to receive $11.20 of profit it must have paid USCo $8.80 for the radios. Hence, using the RSP method $8.80 should be the appropriate intercompany price.
Notice two things: 1/ We don’t need comparable goods using this method, only comparable distribution services, 2/ We work backwards from the sale price to the retailers (remember we can be assured that the $20 charged to retailers is a fair market price since the retailers are unrelated to HKCo and wouldn’t tolerate a higher price).
Cost Plus Method (“CPM”)
This method is appropriate where there are no comparable products or any comparable distribution services (e.g. HKCo does more than just distribute the goods, it also provides unique services). In this case we apply an appropriate gross-profit mark-up to the manufacturer’s costs to determine the intercompany price.
Assume that we determine that there is a manufacturer selling MP3 players to unrelated parties for a mark-up of 80%. We can therefore apply this mark-up to USCo’s radios: since it costs USCo $5 to manufacture the radios, an 80% mark-up would result in a distributor sales price of $9 ($5 + (80% x $5)).
Notice that in this case we are working forward, starting with the costs and adding a mark-up.
The appropriate method to be selected depends on the comparable information that is available. Generally, the Cost-Plus method appears to be the method that is most commonly used.
Transfer of Property Outside the US
Section 367 of the Tax Code, which discusses the transfer of property outside the US, is where corporate tax meets international tax. Those of you who have already taken corporate tax will be familiar with some of the concepts we will discuss. For those of you who don’t have experience with corporate tax here is a brief primer:
Non-recognition Transactions in Corporate Tax
Generally, when one party transfers property to another party in exchange for cash or property, the transferor is subject to tax on the difference between her amount realized and her basis. Assume that T owns a car. T’s basis in the car is $5,000 and the car’s fair market value is now $12,000. If T transfers her car to XCorp, a US corporation, and, in exchange, XCorp gives T a painting worth $12,000, T has realized a gain of $7000. T must pay tax on the amount of this gain.
Now assume that instead of the painting, XCorp transfers $12,000 worth of XCorp to stock T. Once again, T has received property valued at $12,000 for a car with a basis of $5,000, BUT Section 351 of the tax code permits T not to be subject to tax on this gain at the time of the transfer. So even though T has a “Realized Gain” of $7000 (i.e. the FMV of the amount realized is $7000 more than T’s basis in the property), T does not have “Recognized Gain” (i.e. T is not subject to tax on the gain). The reason for this Non-recognition treatment is that T continues to own the car indirectly through XCorp. Since T received XCorp stock, T is now a shareholder of XCorp which owns the car. Although T does not recognize gain, T’s basis in the XCorp remains at $5,000. So if XCorp stock did not appreciate and T sold the XCorp stock in one year, T would have to recognize $7,000 at that time. Meanwhile, XCorp’s basis in the car is also $5,000. So if XCorp sold the car, XCorp would have Recognized Gain of $7,000 at that time.
This non-recognition treatment is permitted for various transactions in corporate tax such as mergers, spin-offs and liquidations. The logic is that these transactions do not change the ownership of the property by T, only the manner in which T owns the property (i.e. indirectly through another entity rather than directly).
International Tax Implications
The problem occurs when the transferee corporation is a foreign corporation rather than a US corporation. So if XCorp is a foreign corporation instead of a US corporation, it is not enough to rely on the non-recognition treatment provided by Section 351. We must now consider the implications of Section 367.
As we saw above, when XCorp is a US corporation, taxation of the gain is deferred until such time as T sells the XCorp shares or XCorp sells the car. However, if XCorp was a foreign corporation, XCorp would be beyond the jurisdiction of the US. Hence, when T transfers the car to XCorp, she is in fact transferring the property outside the US’s jurisdiction. Even though T still owns the car indirectly through XCorp, the IRS believes it is necessary to disallow deferment of the gain because the property moves beyond the US’s jurisdiction.
So the rules are as follows:
1- Section 351 operates to allow for non-recognition when a taxpayer transfers property to a corporation in exchange for the corporation’s stock.
2- When the transferee corporation is a Foreign Corporation, Section 367 trumps Section 351 and gain must be recognized upon the transfer of the property.
Exceptions to Section 367: Active Trade/Business
If the assets that are transferred to the foreign corporation are used by that corporation in an Active Trade/Business, then Section 367 does not apply. As a result, non-recognition (under Section 351) is permitted when the assets that are transferred are used in an Active Trade/Business.
Exception to the Exception
Even if the foreign corporation is using the assets in an active trade/business, gain must nonetheless be recognized for the following assets:
The Active Trade/Business exception applies to all other assets such as Equipment, Real Property and Goodwill.
Depreciation Recapture Rule
Even if a transferred asset is used in an Active Trade/Business and the asset is NOT a tainted asset, gain must be recognized to the extent depreciation was taken on the asset against US income (this should remind you of the sourcing rule regarding depreciable personal property that we discussed in week 2). Consider the following example:
T buys an airplane for $500,000. She depreciates the plane to zero (so her basis in the plane is now zero). When the plane has a value of $700,000 she transfers it to ForCo, a foreign corporation, in exchange for stock in ForCo. ForCo will use the plane in an air-taxi business.
The Active Trade/Business exception applies since the asset will be used in an active business by ForCo. There is $700,000 of Realized Gain. However, $500,000 of that gain must be recognized (T must pay taxes on it) since $500,000 of depreciation was taken against US income. The remaining $200,000 of Realized Gain need not be recognized. So T’s basis in the ForCo stock will be $500,000. The $200,000 of built-in gain (difference between T’s basis in ForCo stock and the Fair Market Value) won’t be recognized until T sells the ForCo stock.
Branch Loss Recapture Rule
If the transferred assets are part of a branch operation that has sustained a net loss at the time of the transfer, gain on those assets must be recognized at the time of the transfer. The objective is to prevent taxpayers from operating as a branch during the early period of a new business when it sustains losses and then transferring the branch assets to an offshore corporation just before the operation becomes profitable. The theory is that if the start-up’s losses offset US income, then the recapture of those losses must be recognized when the assets of the operation are transferred outside the US.
Assume that T operates a new start-up and the operation sustains losses in 2001 of $12,000 and losses in 2002 of $5,000. If T transfers the assets of the operation to a foreign corporation in 2003, then, to the extent that the assets produce $17,000 of realized gain, such gain must be recognized at the time of transfer.
Now assume instead that in 2002 the operation made a profit of $14,000 instead of a loss of $5,000. Here there is a net gain (of $2,000) at the time of the transfer so no gain must be recognized.
Transfers of Stock and Intangible Assets
The Section 367 rabbit hole runs quite deep and we’ve only touched the surface. We have not discussed the consequences of transferring stock or intangible property to foreign corporations. Such transfers are subject to another set of rules and the discussion of those rules could be an entire course in itself.