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September 17, 2008
Reflections on the Death of Transfer Pricing
by Lee A. Sheppard

Full Text Published by Tax Analysts®

Document originally published in
Tax Notes Today on September 17, 2008.

"Transfer pricing is dead."

That was Edward Kleinbard, chief of staff of the Joint Committee on Taxation, stating the obvious a few months back.

In some quarters, however, them's fightin' words, so David Hardy of Osler, Hoskin & Harcourt LLP invited Kleinbard to the International Tax Institute in New York on September 16 to make his case. Kleinbard's debating partner, Willard B. Taylor of Sullivan & Cromwell LLP, didn't defend current law.

"The data speak for themselves," said Kleinbard, pointing to recent reports from the Commerce Department's Bureau of Economic Analysis, the Government Accountability Office, and the IRS, all of which say the same thing. (For the GAO report, see Doc 2008-19132 or 2008 TNT 175-24 . For discussion, see Doc 2008-18118 or 2008 TNT 166-4 .)

"The data show, unequivocally, that low-tax countries have a disproportionate share of profit relative to their share of business activity measures," Kleinbard noted. The GAO listed as measures of business activity: physical assets, compensation, and employment. High-tax countries have a parallel deficit. Only China is outside this dichotomy.

"We think there is a credible story of systemic shifting of profits to low-tax countries due to high-value intangibles," said Kleinbard. High-value intangibles are sent to tax haven affiliates, which report no subpart F income because they have associated contract manufacturing attributed to them. The intangibles have little value when they are transferred. Taylor noted that appraisers tend to agree with their paymasters on these questions.

"Good ideas are identified early and transferred early," said Kleinbard. "We're being gamed because of the low value at the time of the transfer." How would he identify an intangible? An intangible is an idea that survives its creator being squashed by a municipal bus.

In 1986 Congress, Kleinbard explained, put the "commensurate with income" clause in section 482 to correct what it saw as flaws in the arm's-length method. Congress intended to require royalties commensurate with the income earned by high-value intangibles transferred to low-tax countries.

What happened? The commensurate with income clause appears to have been read out of the law. "The arm's-length brigade has co-opted 'commensurate with income,'" said Kleinbard, and turned it into "a footnote." So high-value intangibles go out of the country and no income is attributed back to their American creators.

"We take the fiction of arm's-length relationships among companies that are constrained not to act at arm's length," said Kleinbard. "There is only one brain at work here, and that is the U.S. parent," he said of a typical outbound intangible setup in which a tax haven intangibles holding company avoids subpart F income by having manufacturing attributed to it.

Exhibit A in this co-option by those with a vested interest in the status quo is Xilinx Inc. et al. v. Commissioner, 125 T.C. No. 4 (2005), Doc 2005-18073 , in which the Tax Court held that the IRS could not adjust for cost items that industry did not care to include in its pricing. Xilinx, which is on appeal, "has a lot riding on it, and is very important for section 482 generally," said Kleinbard.

"Is that what Congress intended?" Kleinbard asked rhetorically about outbound intangibles transfers. "The 1986 act was saying that there is no arm's length here." He argued that contracts among related companies should not be treated as real. He mused that the IRS's capitulation in the captive insurance cases had deleterious knock-on effects in transfer pricing.

"We need a systemic solution," said Kleinbard. That means that further patching of the transfer pricing rules and devoting more resources to transfer pricing audits would not be productive, in his view. The Treasury Department's report on transfer pricing would not address the outbound intangibles problem, he noted. (For the report, see Doc 2007-26269 .)

A systemic solution might include, obviously, enforcement of the commensurate with income clause, or redefining subpart F income to include all of the income earned by tax haven intangibles holding companies. Or, as Kleinbard wrote in his previous capacity as a private lawyer, repeal of deferral and full inclusion of foreign income could be considered.

Alternatively, the intangibles holding company could be required to have "its own white coats" -- its own employees performing all of the separately contracted functions attributed to it. Perhaps the cost-sharing regulations, which are in proposed form, could be finalized, assuming they are strong enough. (For the proposed cost-sharing regs (REG-144615-02), see Doc 2005-17678.)

Kleinbard was making no predictions or recommendations. "Congress will look closely at the issue in light of the evidence that's been developed," he said. Lower rates for corporations are on the table. "We have the worst of all worlds -- high marginal rates and low collections," he noted, adding that this produces "a very serious economic distortion."

An audience member objected that the point of the discussion appeared to be collecting more tax, not less. Kleinbard responded that the size of government is the most important question and that his job is to figure out how to collect tax once that size has been determined by Congress.

Taylor mused that the inbound transfer pricing problem could be addressed by extension of the interest-stripping rules of section 163(j) to other types of income such as insurance premiums. He fretted that going too far in this direction might discourage foreign investment in the United States.

Kleinbard was careful not to use the F word -- formulary apportionment -- despite the similarity of the GAO's measures to state formulas. Formulary apportionment is "widely seen as particularly problematic," he said, noting that it would require international agreement.

Hence less drastic amendments to existing rules would be less disruptive. "We can simply interpret arm's length to mean what we think it should mean, and if we say it correctly, that's what it means," he noted. What if other countries see American reinterpretation as a land grab, as some have reacted to the proposed cost-sharing rules? Then better dispute resolution mechanisms are called for, Kleinbard responded, putting in a good word for baseball-style arbitration.

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