Transfer Pricing and Arm's-Length Standard

ABSTRACTTransfer pricing is a pricing method used for transactions for tax purposes. A standard called the arm's-length standard was created to aid in setting a transfer price and simplify the process to prevent double taxation for multinational companies. Over the years, the standard has created problems for multinational corporations and the commissioner of the Internal Revenue Service (IRS) in relation to arm's-length standard transactions. Cases between multinational corporations and the IRS are reviewed to discuss the use of the arm's-length standard and the disagreements concerning the treatment of employee stock options, cost sharing agreements, and buy-in payments in relation to the arm's-length standard. The analysis of these cases sheds some light on how the arm's-length standard of transfer pricing is diminishing in its effectiveness as a rule to set transfer prices. The paper suggests that the arm's-length standard of transfer pricing be modified or the formulary apportionment approach be implemented to alleviate potential problems of setting up transfer pricing.Key words: Transfer pricing, Arm's-length transaction, Stock options, Intangible assets, Formulary apportionment approach, Cost sharing agreementsIntroductionGlobalization has played a big part in the expansion of businesses. Sixty percent of world trade takes place within multinational enterprises. Many implications will arise due to doing business internationally. One of the important issues related to international trading is transfer pricing, which sets the rates or prices utilized when selling goods or services between company divisions and departments, or between a parent company and a subsidiary. Generally, transfer pricing is considered to be a relatively simple method of moving goods and services within the overall corporate family. However, it has faced serious issues lately and has caused problems for multinational corporations and tax authorities. A popular case that deals with multinational companies will be discussed in relation to employee stock options, research and development costs, and the implications for the arm's-length standard. Another case is related to intangible assets and a buy-in payment between a parent and a subsidiary. The case discussion intends to shed some light on the issues and potential flaws of the arm's-length standard. An alternative method to the arm's-length rule is suggested at the end of the discussion.Transfer PricingThe transfer price set for the goods or services determines the cost to the buying division and revenue to the selling division. As a result, transfer pricing affects the allocation of profits for tax and other purposes between segments of a multinational corporate group. For example, a computer group in the United Kingdom buys microchips from its subsidiary in Korea. The price that the United Kingdom company pays will be the transfer price, which will determine how much profit the Korean subsidiary reports and how much tax it pays. Transfer pricing helps multinational enterprises identify which parts are performing well or poorly. Also, without transfer pricing, a multinational enterprise would suffer from double taxation of the same profits (Neighbour, 2002).However, companies can manipulate transfer pricing by creating subsidiaries in countries that have a lower tax rate in order to lower the tax liabilities. Differences in taxation between countries give multinationals an incentive to modify their transfer prices from what a nonaffiliated customer would be charged. The case of Google's Double Irish and Dutch Sandwich illustrates such manipulation. Google, a publicly traded company since 2004 and a producer of mainly internet software, utilizes entities known as patent holding companies to create tax havens. Although primarily based in California, Google creates licensing agreements with its international subsidiaries by allowing them to realize profits from the use of Google's software outside U. …