Summary of Article:
- The arm’s length principle is the most important and enduring feature of transfer pricing regulations.
- It compares transfer prices to the price that would be paid in an identical or comparable transaction between unrelated parties in similar circumstances.
- The standard to be applied in determining the taxable income of a controlled taxpayer is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer.
- The arm’s length range is determined from an array of discrete results obtained through different transfer pricing evaluation methods.
- The interquartile range is used in almost every case where precise adjustments are not possible.
- The IRS has the authority to adjust the results of controlled transactions to either the median or the mean of the arm’s length range if the actual results reported by the taxpayer are outside the range.
- Section 482 allows for the reallocation of income or expenses in situations where parties are owned or controlled by the same interests.
- Control for transfer pricing purposes extends to any kind of control, whether direct or indirect and irrespective of whether it is legally enforceable.
- The courts have interpreted the term “control” broadly to include an ability to cause parties to a transaction to enter into arrangements that differ from those that independent parties would make if dealing at arm’s length.
- The focus of the court is on the real situation rather than on the formal level of shareholdings.
- The transfer pricing rules may apply in situations where loans have been made to a corporation by its two 50% shareholders, and where two or more parties act in concert or with a common goal.
- The transfer pricing rules may not apply in situations where there is no common design or plan to shift income between related corporations owned by two different families.
Detail Article:
The most important and enduring feature of the transfer pricing regulations is the notion of the “arm’s length principle,” which is the idea that, for tax purposes, a transfer price is to be determined or evaluated by comparing it to the price that would be paid in an identical (or, in practice, comparable) transaction entered into between unrelated parties dealing as independent entities in similar circumstances; i.e. an arm’s length price.
In determining the true taxable income of a controlled taxpayer, the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer. A controlled transaction meets the arm’s length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (arm’s length result).[1] The regulations acknowledge that the application of a particular transfer pricing evaluation method may produce an array of discrete results, any one of which may be considered an arm’s length price, and from which a range of reliable results may be determined.
The entire (or full) range of results may be used as an arm’s length range in situations where any material differences between the controlled and uncontrolled transactions have been quantified and reasonable adjustments have been made to allow for the differences. In situations where precise adjustments are not possible, the regulations allow the use of the interquartile range[2]. In practice, the IRS uses an interquartile range in almost every case. There are no requirements that the actual result equates to any particular point within the arm’s length range. However, during an audit, the IRS has the authority to adjust the results of controlled transactions to either the median or the mean of the arm’s length range if the actual results reported by the taxpayer are outside the range.
Section 482 permits the reallocation of income or expenses in situations where parties are owned or controlled directly by the same interests. The definition of control for transfer pricing purposes extends to any kind of control whether it is direct or indirect and irrespective of whether it is legally enforceable. This includes control resulting from two or more parties acting in concert or with a common goal, whether or not they are affiliated.
The courts have interpreted the term “control” broadly to include an ability to cause the parties to a transaction to enter into arrangements that differ from those that independent parties would make if dealing at arm’s length. In the case, B. Forman Co v Commissioner the court determined that the transfer pricing rules applied where loans had been made to a corporation by its two 50% shareholders. Although the two shareholders were unrelated, the court decided that they acted in concert in the transactions to achieve their collective interests. The focus of the court was on the real situation rather than on the formal level of the shareholdings.
In another case, Brittingham v Commissioner, the court held that Section 482 did not apply. The families of two brothers owned two corporations in different proportions and shifting income between the two companies led to gains for one corporation and losses for the other. Despite the family relationship between the owners of the business, there was no common design and no plan to shift the income between them. This situation did not amount to them having the same interests in the transfer pricing legislation.
The court determined in W.L. Gore v Commissioner that control exists in the case of corporate joint ventures, so the transfer pricing rules may apply in this situation.
[1] Treas. Reg. § 1.482-1(b) (1)
[2] The “interquartile range” is the range from the 25th to the 75th percentile of the results of the comparables.