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Re-thinking first principles of transfer pricing rules.

This article rejects the conventional wisdom that "transfer pricing rules" are designed either to level the playing field between Multi-National Enterprises (MNEs) and medium sized enterprises or to prevent pre-meditated tax evasion by MNEs. Rather, this article posits that "transfer pricing rules" (TPRs) are substitutes for diminished tariff revenue, or imposed artificial mark-ups, shifting costs to ultimate purchasers, and contradicting the fundamental rule of microeconomic theory of firm, maximizing profits by equating marginal cost and marginal revenue. The debate about transfer pricing now centers on tweaking the "arm's length" principle, safe harbor rules, and advance pricing agreements. Lost in this abyss of profound distraction is the question: why a vertically integrated company that need not obtain a profit at each stage of the production process be treated, counter-factually, like a non-vertically integrated company operating on the open market paying higher prices at each stage of the production process. Further support for the claim against transfer pricing rules is that counter-intuitively, transfer pricing inures to the benefit of the integrated producer by inflating accounting costs and permitting the producer to hide economic profit, thereby achieving a result undermining transfer pricing theory and regulation. While this article recognizes that MNE's may abuse transfer prices, Tax Authorities, in their zeal to augment revenue, fad to distinguish among tax abuse, efficient production methods, and pro-growth tax policy.

I.     INTRODUCTION                                              614

II.    THE QUESTION                                              615


       A. The United States                                      616

       B. Early International Developments                       618

       C. The Organisation of Economic Cooperation and           618
          Development (OECD)

       D. Global Formulary Apportionment                         620

IV.    THE ILLUSTRATION                                          621


VI.    RETHINKING TRANSFER PRICING RULES                         626

VII.   ALTERNATIVE SOLUTIONS                                     627

VIII.  CONCLUSION                                                629


Transfer pricing, from a financial perspective, "is probably the most important tax issue in the world." (1) Several developments support this statement. First, more than sixty percent of international trade is conducted within the company group structure of Multi-National Enterprises (MNEs). (2) Even medium sized companies have subsidiaries or "permanent establishments" in a country other than where the parent company is located. (3) Second, economic drivers, such as location of the production of final products, skilled labor, tax incentives and productions costs, lead companies to engage in cross-border transactions. (4) Third, the emergence of 24-hour trading in commodities and financial instruments has accelerated the pace of globalisation. Fourth, the relocation of intangible property to countries deemed "tax havens" may result in tax abuse. In parallel with these developments, the multilateral trading agreements under the auspices of the GATT reduced tariffs and therefore a source of tax revenue collected at the border. (5) The combined effect of these incidents likely explains the phenomenal rise of transfer pricing rules. (6)


The cross-border provision of goods and services to related entities within a company group underscores the raison d'etre of transfer pricing rules. The definition of "transfer price" in business economics is: "the price paid for goods and services involved in intracorporate transactions between a subsidiary and other branches of the corporate family." (7) An analysis of prices charged for goods and services transferred within a group enables managers to decide whether it is cheaper to buy and sell within the group or on the open market. In the absence of "manipulation" for the deliberate evasion of tax payments, prices of goods and services set at a marginal cost enable a vertically integrated firm to produce a product or service at a price lower than a non-integrated firm. (8) The question that arises is: why defeat a global firm advantage that benefits the ultimate user? Expert consensus states: "If there is a competitive open market for the products and services transferred internally, the best solution from a business economics point of view is to use the market price as a transfer price." (9) To the contrary, the best solution from a business point of view is to permit vertically integrated multinational firms to maximize integrated profits and confer benefits to the customer base.


A. The United States

Transfer pricing rules did not pop up out of the blue. Academics observe that "problems of apportionment" attracted attention at the domestic level within federal systems of government and not at the international level. (10) The United States Congress, presumably concerned about "double taxation" of enterprises, enacted legislation to purge this evil on the ground that foreign subsidiaries were established to "milk" the income of U.S. parent companies. (11) In 1921, the United States Congress enacted legislation requiring multinationals to provide consolidated accounting reports "[to make] an accurate distribution or apportionment of gains, profits, income, deductions, and capital between or among ... related business." (12) In 1928, the United States Congress, reformulating the 1921 law, enacted legislation providing:
  In any case of two or more trades or businesses (whether or not
  incorporated, whether or not organised in the United States, and
  whether or not affiliated) owned or controlled directly or indirectly
  by the same interests, the Commissioner is authorised to distribute,
  apportion, or allocate gross income or deductions between or among
  such trades or businesses, if he determines that such distribution,
  apportionment, or allocation is necessary in order to prevent evasion
  of taxes or clearly to reflect the income of any such trades or
  businesses. (13)

This language introduces an augmented and novel power. The Commissioner, a state-appointed official, has authority to reformulate a company's consolidated financial statements to make certain that they clearly reflect "the income of any such trade or businesses." Current section 482 of the Tax Code "authorizes the IRS to adjust the income, deductions, credits, or allowances of commonly controlled taxpayers to prevent the evasion of taxes or to clearly reflect their income." (14) Section 482 provides that prices charged by one affiliate to another "yield results that are consistent with the results that would have been realised if uncontrolled taxpayers had engaged in the same transaction. ..." (15) In other words, the price of the transaction should reflect an arm's length transaction.

The "arm's length" principle embodies the formulation that "prices set for transactions between related group entities should, for tax purposes, be derived from prices that would have been applied by unrelated parties in similar transactions under similar conditions in the open market." (16) Examples of transactions between controlled taxpayers subject to scrutiny by the Internal Revenue Service (Service) under section 428, if they do not reflect an "arm's length transactions," include: (1) a loan or advance of money, (2) performance of a service, (3) leasing of property, (4) sale of property, (5) leasing of intangible property, and (6) cost sharing arrangements to develop intangibles.

B. Early International Developments

Transfer pricing regulation did not remain the exclusive province of the United States. "In a multilateral context the arm's length principle was formulated for the first time in Article 6 of the League of Nations draft Convention on the Allocation of Profits and Property of International Enterprises in 1936." (17) The principle was also incorporated in Article VII of the Mexico Draft of 1943 and the London Draft of 1946. (18) A nexus of treaties incorporating transfer pricing rules spread widely across the major industrial countries during and following World War II. The language used to describe the "arm's length" principle contained in the present OECD and UN Model tax treaties does not differ substantially from the language used in these predecessor documents.

C. The Organisation of Economic Cooperation and Development (OECD) (19)

Not to be outdone by the United States, the OECD produced a report in 1979 entitled Transfer Pricing and Multinational Enterprises. The 1979 Report has been replaced by the "OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD TP Rules)." (20) The Model Transfer Pricing Rules published by the OECD have attained almost biblical-like status. The OECD TP Rules ostensibly address two issues: (1) avoidance of double taxation of MNEs operating in diverse tax jurisdictions and the simplification of tax compliance of MNEs with divisions in various jurisdictions, and (2) creation of guidelines for Tax Administrations to tax income accurately in the context of cross-border MNE activity to prevent impediments to cross-border flows of goods, services, and capital. Noting that both residence and source based taxation systems treat each entity with the company group as a separate entity, the OECD adopts the "separate entity approach as the most reasonable means of achieving equitable results and minimising the risk of unrelieved double taxation." (21)

The separate entity approach leads inexorably to the infamous "arm's length principle" that treats related entities within a single company group as independent enterprises operating in open markets. The authoritative statement of the arm's length principle, expressed in the worst sort of legalese, is found in paragraph 1 of Article 9 of the OECD Model Tax Convention, which provides:
  [When] conditions are made or imposed between the two [associated]
  enterprises in their commercial or financial relations which differ
  from those which would be made between independent enterprises, then
  any profits which would, but for those conditions, have accrued to
  one of the enterprises, but, by reason of those conditions, have not
  so accrued, may be included in the profits of that enterprise and
  taxed accordingly.

But this arm's length principle misses the point by ignoring the economic reality of the MNE. The profitability of the MNE is attributable to its organizational form: a group of related entities the architecture of which is designed to benefit from economies of scale and from reduction of transaction costs. The income of an MNE cannot be allocated among the members of the affiliated group in any principled manner. (22)

The OECD TP Rules state:
  These international taxation principles have been chosen by OECD
  member countries to service the dual objectives of securing the
  appropriate tax base in each jurisdiction and avoiding double
  taxation, thereby minimising conflict between tax administrations
  and promoting international trade and investment. In a global
  economy, coordination among countries is better placed to achieve
  these goals tan tax competition. (23)

In applying these principles, the OECD has identified that the most nettlesome issue is the establishment for tax purposes of appropriate transfer prices. Transfer prices determine in large part the taxable profits of associated enterprises in different tax jurisdictions.

The salutary goals of the OECD and U.S. Tax Code section 482 of double taxation avoidance and cooperative conduct among Tax Administrations mask the underlying reality of the separate entity approach. Global firms have the advantage of maximising integrated profit precisely because members of the company group are not independent enterprises and are not required to behave like single entities in the open market. Therefore, transfer pricing rules render illegitimate the production of goods and services at lower prices precisely because of company group structure. The consequence is untenable as demonstrated by the following sets of illustrations.

D. Global Formulary Apportionment

The OECD is aware that the arm's length approach does not track economic reality of integrated company groups. However, it rejects, in absolute terms, one alternative: global formulary apportionment. Global formulary apportionment treats the MNE as a single entity and relies upon the corporate group's consolidated accounts. Formulary apportionment divides income among tax jurisdictions according to a formula, mainly sales. Global formulary apportionment is not a new concept as it is used in several U.S. states and Canadian provinces. (24) The European Union also is considering the adoption of the Common Consolidated Corporate Tax Base permitting allocation of corporate income tax based on a formula. The global formulary apportionment alternative is mentioned here only to yellow mark the obstinacy of the OECD and to cut off alternatives to the arm's length principle even though the latter does not work and MNEs waste time and money tax planning around the rules.


The illustration is predicated upon a competitor facing a normal demand curve: P = a - bX, where P is Price; "a" is fixed costs, "b" is variable costs, "v" is value-added, "m" is mark-up, "n" is stage numbers, and "X" is quantity. A firm maximizes profit when MC = MR. (26) Consequently, X = [a - MC]/[2.sub.b] and P = (1/2)*(a + MC). The illustration further presumes that MC is the result of a multi-stage production process. The depiction below demonstrates the difference in MC when the multi-stage production process takes place wholly within a fully vertically integrated firm and a nonintegrated firm.
        Integrated                    Nonintegrated

MC * V (No mark-up)            MC = V + M

P < MC                         P = MC

AVCC is greater                AVCC is less

Lower price, greater quantity  Higher price, less quantity

Comparable higher profits      Comparable lower profits

Group of companies are concerned with profit maximization, they maximize profit by setting MC = MR.

(1) X = (a - MC)/[2.sub.b]

(2) P = 1/2 * (a + MC)

(3) M = P - V

Suppose MC is a result of a multistage production process. For the final product,

MC = [MC.sub.n] = [P.sub.(n-1)] + [V.sub.n]

"M" is a sum of the markups, which are "transfer prices," imposed at each stage of the production process. However, if the producer is vertically integrated, the actual MC of the final product excludes the mark-ups, or simply MC* = V. The transfer prices are artificially imposed mark-ups distributing final profits to various stages of the production process. These distributions are unrelated to the economic reality of the vertically integrated firms' profit maximization, ignore economies of scale, and increase transaction costs.

Example (for nonintegrated):

P = 1000 - X (27)

1000 - 2X = M + V

M = 500 V = 100

1000-2X = 600

X = 200, P = 1000 - 200 = 800, Profit = X*P = 200*800 = $160,000

Example (for integrated):

P = 1000 - X

1000 - 2X = V

M = 500 V = 100

1000 - 2X = 100 [without M]

X = 450, P = 1000 - 450 = 550, Profit = X*P = 450*550 = $247,500

Profit Differential: Integrated and Nonintegrated Firm

$247,500 - $160,000 = $87,500

Under the above illustration, consumers benefit from permanent increase in supplies and lower prices. However, the integrated firm. avoiding mark-ups at each stage of the production process, would be accused of a violation of transfer pricing rules under the counter-factual "separate entity approach to intra-group transactions." In the event. Tax Administrations adjusted the "intra-group" prices to include not only value added ([V.sub.n]) but also state-mandated transfer prices ([M.sub.n]), then final prices are set on distorted marginal cost, although the integrated firm would lose its MC benefit.

In his unpublished manuscript, Dr. Stevens provides a second illustration in support of his explanation of "dumping." This illustration may be flipped to apply with equal force to transfer pricing regulation and to an alternative method of taxing entities to achieve economic efficiency. Assume a state owned oil refinery purchases crude oil at monopolistic prices from a private company that pays income taxes to the state. The extraction cost of crude oil is $50 and the cost of refinery is $50, then the un-integrated MC is $600 ($50 + $500 + $50), the $500 being the mark-up (world market price) of the crude producer. The integrated MC is $100 ($600 - $500 mark-up (transfer price)).

Reverting to the formula above, (29) if profits are maximized using MC = $600 and MC = 1000 - 2x, then X = 200 and P = 1000 - X = 800. Revenue generated equals $160,000, and costs equal $20,000 [100 (MC) * 200 units], which yields a profit of $140,000. By contrast, if joint profits are maximized, we return to our calculation of selling 450 units at a price of $550, for a total revenue stream of $247,500, minus real costs of $45,000 [100*450], for a total profit of $202,500, an increase in profits of $62,500.

However, joint maximization of profits are achieved if MC* = V: the refinery makes a profit of $40,000 and does not lose $22,500 to transfer pricing. The crude producer makes a profit of $202,500 and does not lose $62,500 to transfer pricing. Pareto efficiency is achieved if the Tax Administration imposes a tax of $62,500 upon the crude producer and that tax is used to subsidize the refinery. Neither refinery nor the crude producer is worse off. Even if the producer eliminates competition and establishes a monopoly, the monopolist has no incentive to increase prices absent a change in demand.

In final, an integrated firm may have a lower average cost of capital than a nonintegrated firm as the former may be deemed to pose less risk of insolvency. (30) That being true, then the nonintegrated firm must fix its mark-up to include its increased cost of borrowing, and demand a higher required rate of return at each stage of the production process. The implicit cost of capital in the required rate of return between the integrated and nonintegrated firm skews the application of transfer pricing, and provides further support for the lack of logic underpinning transfer pricing rules, as demonstrated by the section that follows.

V. The Paradox of Transfer Pricing Rules: How They Backfire

Counter-intuitively, transfer pricing rules have the following effect: inflation of accounting costs on a firm's financial statements and failure to make transparent the economic profit made by the integrated producer. This unintended effect of transfer pricing rules stems from the incorporation of opportunity costs in the production of a good. (31) A firm produces a good by using inputs and incurring direct costs or operating expenses. In this context, the opportunity cost is the required rate of return "R" on direct expenses. (32) Integrated firms are likely to have the leverage to borrow funds at interest rates more favorable than those available to the non-integrated producer. Therefore, the competitive price for any good is less for the integrated producer than for the nonintegrated producer precisely due to lower financing costs for the integrated producer, thereby giving the integrated producer a competitive advantage. In other words, transfer pricing rules do not work to achieve their intended effect: to place the integrated producer and nonintegrated producer on the same footing.

Assume good S requires three inputs, A, B, and C, and requires direct expenses (operating costs) in its production. S is a function the three inputs [S = f(A, B, C)]. Each input is associated with operating costs. Expressed as a formula, direct expenses equal PaA + PbB + PcC. The required rate of return, R, on the direct expenses is the opportunity cost of producing good S. The opportunity cost is R(PaA + PbB + PcC). Total economic costs are TC = (PaA + PbB + PcC)(1 + Rs) where Rs is the required rate of return on the production of S. Under competitive conditions, the producer does not make any economic profit since Total Cost is equal to Total Revenue. Economic profit is the difference between revenue received from the sale of an output and the opportunity costs of the inputs used. (33) An economic profit accounts for a capital charge consisting of the WACC * Invested Capital. (34) An accounting profit is not equivalent because it does not incorporate opportunity costs.

The required rate of return at each stage of the production process explains the effect of transfer pricing inflating accounting profits and hiding economic profits. Assume that the production of S requires an intermediate product T and the input C, the production of T requires the intermediate product Q and input B and the production of Q requires input A; then, we have the following: S = f[T, C], T = f[Q, B] and Q = f[A].

If these intermediate products are produced independently by different firms and sold at competitive prices, then these prices are the arm's length prices an integrated firm may be required to use for internal transfers. Computing the final independent price of S requires integration of the required rate of return on the production of each separate input.

Example (for nonintegrated: competitive price of S):

PS = [PaA(1 + Rq)(1 + Rt)(1 + R) + PbB(1 + Rt)(1 + Rs) + PcC(1 + Rs)]/S 1000 - X

Example (for integrated: competitive price of S):

Ps = [PaA + PbB + PbC](1 + Rs]/S

The integrated producer earns a mark-up at the earlier stages of production. Assume Rs = 20% (.2). If we allocate 60% of the Required Rate of Return at stage 1, and 20% at stage 2 of the production process, then profits = PaA(0, 6) + PbB(0, 24). The problem is compounded when the required rates of return differ at each stage of the production process.

Competitive price differential (integrated and non-integrated firm):

Assume Rs = .2 (20%), Rq = .3 (30%), Rt = .25 (25%) and Rs = .05 (5%), then profits for the integrated firm are:

PaA(1.3)(1.25)(1.05)[or PaA(1.7)] - PaA(1.05) + PbB(1.25)(1.05)[1.31] - PbB(1.05) = PaA(.66) + PbB(.26)

It therefore follows that transfer pricing inflates the accounting cost of production at each stage of the production process, thereby masking the economic profit earned by the integrated producer. The actual cost of financing required by the integrated producer is less than the accounting financial costs. The result is highly advantageous for the integrated firm.

VI. Rethinking Transfer Pricing Rules

A significant corporate strategy is vertical integration or establishment of an M-Form company. Vertical integration refers to the purchase by a single firm of downstream entities such as suppliers of raw materials, and upstream entitles such as assembly plants, service providers and distributors. Vertical integration creates a value chain. A vertically integrated firm need not add to its cost of production at each stage of the process a required rate of return or profit. Rather, a vertically integrated firm may defer profit maximization until the final point of sale.

By contrast, a non-vertically integrated firm, at each stage of the production process, incurs not only the marginal cost of production from an unrelated firm, but also the required rate of return or profit demanded by that unrelated entity. Thus, the total cost of producing a good or service, and therefore the price charged to the ultimate purchaser, is less for a globally integrated firm than for a non-vertically integrated firm. Viewed in this context, compulsory transfer pricing rules undermine the benefit of vertical integration by forcing the M-Form global firm to behave as a collection of unrelated enterprises.

The conventional wisdom appears to be that, "Because ... prices are not negotiated in a free, open market, it is possible that they may deviate from prices agreed upon by non-related parties in comparable transactions under the same or similar circumstances." (35) However, the whole point of the M-Form Corporation is precisely to deviate from prices agreed upon by non-related parties, because the economic reality is that the divisional centers are related and constitute a single enterprise as an integrated company group.

Hence, transfer pricing destroys an economic benefit following from developments of how firms in a competitive market attempt to achieve price efficiency through economics of scale and reduction of transaction costs. In addition, transfer pricing rules confer an unintentional benefit upon integrated producers by allowing the producer to mask economic profit behind bloated accounting costs of production. Consequently, transfer pricing rules generate a loophole through which the integrated producer gains a competitive edge against the nonintegrated producer.

VII. Alternative Solutions

Criticism is easier than production of viable alternatives. The radical alternative is the elimination of transfer pricing regulation wholesale, an alternative that is politically unfeasible. If transfer pricing functions as a substitute for lost tax revenue, due to cross border transactions among affiliated companies, and the opportunity of companies to benefit from regulatory arbitrage in taxation rates, then the radical alternative is justified on the ground that sovereigns have the right to set their levels of taxation, and companies should not be penalized for acting to maximize profits. Two examples suffice: first, a company should not be taxed when exiting a particular State because the company has the opportunity to take advantage of lower costs elsewhere. The shift provides undeniable benefits to the new home country. (36) Second, assume a MNE operates an oil rig in Kazakhstan under an operational lease agreement. The choice of leasing the asset is from a lessor located in one of the three following States: Japan, Kazakhstan or the Cayman Islands. Japan has a corporate tax rate of 39%, Kazakhstan a corporate tax rate of 20%, and the Cayman Islands a corporate tax rate of 0%. If regulatory arbitrage is prohibited, then the States with the highest tax rates, and not necessarily the most stable and efficient legal system, compel MNEs to reduce profits on debatable social policy justifications. The second alternative is to borrow the economic reality test to determinewhen transfers are made solely or primarily to evade taxes. (37) The economic reality test focuses upon the genuineness of the transaction, not its form alone. These transactions can be voided and infringing companies punished stiffly. The social costs of imposing large fines are de minimis compared to the cost of global enforcement of transfer pricing rules. The criticism levied at this alternative is that the solution is no more precise than current transfer pricing methods. However, the difference lies in the absence of micro-analysis of transactions of your largest taxpayers. The third alternative is based again on the elimination of transfer pricing and allocating consolidated profits among members of a company group based on actual financing costs in the production of a good at each stage of the production process. In the long run, tax initiatives ought to be based on pro-growth policies. (38) Finally, the fourth alternative is a reasoned and non-mechanical application of the OECD transfer pricing guidelines.

The five methodologies set forth in the OECD rules to simulate an arm's length transaction are not intended to be mechanically applied. The OECD states, "Tax administrations are encouraged to take into account the taxpayer's commercial judgment about the application of the arm's length principle in their examination practices and to undertake their analyses of transfer pricing from that perspective." The OECD recognizes the difficulty in applying the "arm's length principle" to intra-group transactions and sends a clear signal to tax administrations to implement the underlying policy of the rules without getting caught up in the technicalities of methodology.


This article has demonstrated problems inherent in the assumptions of transfer pricing regulation. The approach to revenue collection is posited on a counterfactual economic reality, and disregards the benefits of vertical integration for profit maximization and lower prices for consumers. Equally insidious is the unintended advantage conferred on integrated producers. Given the difficulties of determining an arm's length price and the cost of information sharing and tax adjustments among diverse Tax Administrations, it is essential to reconsider the underlying first principles of transfer pricing rules with a view toward their revision, if not elimination. The doctrinal rejection of the global formulary approach deserves to be revisited, but it is unlikely to be an effective solution because the process of deconstructing the value chain and assigning costs remains.

(1) Ad Hoc Group of Experts on International Cooperation in Tax Matters, transfer Pricing: History, State of the Art, Perspectives, 2, U.N. Doe. ST/SG/AC.8/2001/CRP.6 (June 26, 2001) [hereinafter Transfer Pricing].

(2) Id.

(3) See Transfer Pricing, supra note 1, at 2.

(4) See Ricky W. GRIFFIN & MICHAEL W. PUSTAY, INTERNATIONAL BUSINESS 562 (Global 6th ed. 2010).

(5) See World Trade Organization, Some Facts and Figures, (last visited Jan. 20, 2011) (demonstrating that during the first four GATT rounds weighted tariff reductions exceeded 35 percent per round).

(6) The decline of The Bretton Woods system and the parallel rise of transfer pricing raises the question: coincidence or something more? Arguably, the multilateral trading system hit its zenith in the 1970s and 1980s, coinciding with the production and aggressive enforcement of transfer pricing rules. Parallel to this development was the rise of the value in intellectual property portfolios resulting from increased cross-border activity and the emergence of digital information.

(7) GRIFFIN & PUSTAY, supra note 4, at 562.

(8) The MC envisaged is MC * = [V.sub.n] where V is value and "n" is the number of stages in the production process. MC does not include "mark-ups." The illustration assumes that MC=MR. See W. BRUCE ALLEN ET AL., MANAGERIAL ECONOMICS 388 (6th ed. 2005).

(9) Transfer Pricing, supra note 1, at 3.

(10) See Michael C. Durst & Robert E. Culbertson, Clearing Away the Sand: Retrospective Methods and Prospective Documentation in Transfer Pricing Today, 57 TAX L REV. 37, 43(2003).

(11) Id.

(12) Id. at 43-44 (quoting Revenue Act of 1921, Pub. L. No. 67-98, [section] 240, 42 Stat. 227, 260).

(13) Revenue Act of 1928, Pub. L. No. 70-562, [section] 45, 45 Stat. 791, 806. For a history of I.R.C. [section] 482, see Transfer Pricing, supra note 1, at 10.

(14) See United States International Tax Site, The US Transfer Pricing Regime, (last visited May 23, 2010). The current version of [section] 482 reads:
  In any case of two or more organizations, trades, or businesses
  (whether or not incorporated, whether or not organized in the United
  States, and whether or not affiliated) owned or controlled directly
  or indirectly by the same interests, the Secretary may distribute,
  apportion, or allocate gross income, deductions, credits, or
  allowances between or among such organizations, trades, or
  businesses, if he determines that such distribution, apportionment,
  or allocation is necessary to prevent evasion of taxes or clearly to
  reflect the income of any such organizations, trades, or businesses.
  In the case of any transfer (or license) of intangible properly
  (within the meaning of 936(h)(3)(B)), the income with respect to
  such transfer or license shall be commensurate with the income
  attributable to the intangible.

I.R.C. [section]482.

(15) Id.

(16) See Transfer Pricing, supra note 1, at 4.

(17) Id. at 6.

(18) See Transfer Pricing, supra note 1, at 6.

(19) The OECD consists of thirty member countries. Notably absent, however, are some of the largest, and fastest growing countries economic-wise in the world: China, Russia, Brazil, India, Indonesia and South Africa, though they are listed as "enhanced engagement countries." This raises the question of why the world should take orders from the United States, United Kingdom, and Germany.


(21) Id. at 12.

(22) The rationale follows that set forth in Robert A. Green, The Future of Source-Based Taxation of the Income of Multinational Enterprises, 79 CORNELL L. REV. 18, 46 (1993). Arm's length pricing is difficult to determine. Hence, the United States and the OECD adopt a best method approach based on the nature of the intercompany transaction. U.S. regulations, for example, provide for:

(1) Comparable Uncontrolled Price Method

(2) Comparable Profits Method

(3) Profit Split Method

(4) Resale Price Method

(5) Cost Plus Method

Reflecting the growing importance of the value of intangibles, the Internal Revenue Service (Service) and Treasury Department amended the rules in 2004 and continue to revise Idem.

(23) ORG. FOR ECON. COOPERATION AND DEV., supra note 20, at 12.

(24) See Susan C. Morse, Revisiting Global Formulary Apportionment, 29 VA. TAX REV. 593, 600 (2010).

(25) The illustration is a modification of an unpublished manuscript. Dana Stevens, Dumping: A Simple Explanation (Jan. 2009) (unpublished manuscript, on file with author).

(26) A firm will not produce an additional unit of a good, that is, increase its marginal cost (MC) unless that increase is lesser than the benefit to be received, that is, marginal revenue (MR). A firm adjusts its MC and MR until they are in equilibrium, that is, the firm cannot produce an additional unit of a good without incurring increased costs thereby reducing MR. ROBERT COOTER & THOMAS ULEN, LAW & ECONOMICS 26 (5th ed. 2008).

(27) The numerical values of P = 1000, M = 500, and V = 100 are for purposes of illustration only. They are not essential to the arguments the illustrations seek to make.

(28) ORG. FOR ECON. COOPERATION AND DEV., supra note 20, at 12.

(29) For convenience, the formula is restated: nonintegrated profit = 1000 - 2X where X = 200, resulting in MC = 600; P (price) = 1000 - X (200) = 800. Selling 200 units at 800 = $160,000 (revenue generated). Given integrated MC = 100, real costs = 100*200 or $20.000, resulting in profits of $140,000. With MC at 100, then X = 450 (1000 - 2*450) yielding total revenue of $247,000. Real costs are 100*450 = $45,000, yielding profits of $202,500.

(30) While the author has not collected data to support the claim, it follows intuitively that a debtor with twice the revenues and twice the assets of a competing debtor is likely to obtain financing at more favorable rates of interest and payment terms.

(31) "Opportunity cost" is defined as the "economic cost of an alternative that has been foregone." COOTER & ULEN, supra note 26. at 34.

(32) The following analysis is based upon an unpublished transcript. Dana Stevens (May 2009) (unpublished manuscript, on file with author). The text is a restatement of this insight.

(33) To demonstrate the difference between economic profit and accounting costs, consider the following example. An entrepreneur invests $300,000 in a business. After year 1, the business returns profits of $350,000. The accounting profit is $50,000. Assume, however, that the entrepreneur could have earned an income, if employed, of $200,000; then the entrepreneur has incurred an economic loss of $150,000. In our hypothetical, the reverse effect is delineated: a bloated accounting cost and a hidden economic profit.

(34) WACC is the acronym for weighted average cost of capital.

(35) U.S. TRANSFER PRICING GUIDE [section] 100 (Deloris R. Wright ed., 1995).


(37) See, e.g., Donovan v. Agnew, 712 F.2d 1509, 1514 (1st Cir. 1983) (applying the "economic reality lest" in a labor case to determine the nature of an employment relationship); Equal Employment Opportunity Comm'n v. Dowd & Dowd, Ltd., 736 F.2d 1177, 1178 (7th Cir. 1984) (applying the "economic reality test" to conclude that four doctors were "more analogous to ... partner[s] in a partnership than ... to ... shareholder[s] ... of a general corporation" and therefore were not employees for purposes of the federal anti-discrimination law). The test also has been applied to mixed tax/labor cases. See, e.g., Hyland v. New Haven Radiology Assocs., P.C., 794 F.2d 793, 798 (9th Cir. 1986) (refusing to assert corporation status to reap tax and civil liability advantages and arguing that the entity is a partnership to avoid unlawful employment discrimination liability).

(38) Judy Shelton, Op-Ed., Currency Chaos: Where Do We Go From Here?, WALL ST. J., Oct. 18, 2010, at A15, available at (interviewing Nobel Prize winner Robert Mundell).

John JA Burke *

* Professor of Law, Kazakhstan Institute of Management, Economics and Strategic Research, Almaty, Kazakhstan; Associate Professor of Law, Riga International, School of Economics and Business Administration, Riga, Latvia. The author expresses thanks to Dr. Dana Stevens, Vice-President of Academic Affairs, KIMEP, who served as the principal inspiration behind this article and provided valuable comments: Lars Bjorn Christensen, PriceWaterhouseCoopers Denmark, (Seconded to Almaty) for his careful reading and immensely valuable questions and comments; Dr. Tomas Balco, Associate Professor, KIMEP, Bang College of Business, Almaty, for his constructive criticisms; and Saida Syzdykova, a graduate of the Bang College of Business at KIMEP and the author's Teaching Assistant.
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Author:Burke, John J.
Publication:Virginia Tax Review
Date:Jan 1, 2011
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