Using Intercompany Transfer Price Analyses in Bankruptcy Valuations Part I
An intercompany transfer price is the price one related entity charges another related entity for (1) tangible assets (including fixed assets and inventory), (2) intangible assets (including the use of intellectual property) and (3) services (such as corporate administration and accounting). For purposes of this discussion, a related party can include either (1) a parent/ subsidiary relationship or (2) a brother/sister corporation owned by a corporate parent/ common shareholder relationship.
Within a bankruptcy context, intercompany transfer-price considerations are important when one related company is included in the bankruptcy estate and the other related entity is not. This situation could occur when a subsidiary is in bankruptcy, but the parent (or another subsidiary) is not. Likewise, this situation could occur when a corporation is in bankruptcy, and the controlling shareholder owns another corporation that is not.
In these situations, parties to the bankruptcy (including creditors, minority shareholders and the court) want to be assured that the earnings (pre-petition or post-petition) of the company in bankruptcy are not artificially understated or overstated. This would occur if the bankrupt company paid/received excessive prices for the intercompany transfer of tangible/intangible assets or services. Accordingly, in these circumstances, parties to the bankruptcy want to ensure that the subject intercompany prices are fair, arm's-length transfer prices.
The Objective of Intercompany Transfer Prices
This concern about earnings manipulation may be resolved if the debtor company uses the intercompany transfer-pricing methods allowed for assets/services under Internal Revenue Code §482. For decades, the Internal Revenue Service (IRS) has been concerned that a domestic taxpayer could shelter income/avoid taxes by transferring assets/ services to a foreign affiliate. The IRS is concerned that a domestic taxpayer could avoid domestic taxes by transferring assets/allocating income to a low-tax-rate foreign country. Income could be shifted to the foreign country through the payment of a transfer price (typically, a royalty rate) to the foreign (but controlled) entity for the use of the transferred assets/services. Likewise, the IRS is concerned that a foreign taxpayer could avoid domestic taxes by not allocating sufficient income to the United States for the use of assets/services that are owned/used by a domestic (and controlled) affiliate of the foreign taxpayer.
In order to appropriately reflect the income attributable to the use of transferred assets or services, the Treasury promulgated rigorous and comprehensive regulations related to §482. These regulations describe in detail (with numerous illustrative examples) the allowable methods for determining the appropriate intercompany transfer price between controlled/related parties for transferred assets/services. These transfer price regulations have been interpreted by the IRS and practitioners for decades. Likewise, these regulations—and the specified transfer price methods—have been tested in/interpreted by the federal courts for decades. The transfer pricing regulations are updated when needed (including the currently proposed regulation updates issued in September 2003). In addition, U.S. intercompany transfer price regulations are generally consistent with transfer price rules adopted by foreign taxing authorities in other major industrial countries.
In broad concept, the §482 transfer price rules treat the related party assets/services as if they were owned/provided by a truly independent, arm's-length entity. Arm's-length prices are determined by the application of a specified set of approved economic analysis methods. The resulting transfer prices are designed to appropriately allocate the income of the overall taxpayer between the use of the subject assets/ services. This same objective would be appropriate for bankruptcy valuation purposes.
Typically, the IRS is concerned with an intercompany transaction like the following:
In the first scenario, the domestic taxpayer has the incentive to pay an excessive transfer price to its foreign affiliate located in a low/no-tax-rate country. This is because the intercompany payment would be a deductible expense in the United States, thereby reducing the taxpayer's domestic taxable income. The §482 methods are designed to ensure that the transfer price for the use of the assets/services is a fair, arm's-length price (no more and no less). The §482 transfer price is intended to clearly reflect the domestic taxable income of the domestic taxpayer.
The parties to a bankruptcy would be interested in ensuring the intercompany transfer-price scenario. In this second scenario, the §482 methods would ensure that Parent Corporation A pays a fair arm's-length transfer price for the transferred assets/services from Subsidiary Corporation B.
First, this discussion presents the framework for the intercompany transfer pricing of tangible/intangible assets for federal income tax purposes. The methods described are used to allocate the total income of a multinational taxpayer between the intercompany use of tangible and intangible assets. Second, this discussion presents the recently proposed/expanded pricing methods for the intercompany transfer of services.
U.S. Regulatory Framework for Intercompany Transfer Pricing
The current U.S. tax rules concerning the intercompany transfer pricing of assets/services are provided by §482 and the related regulations. These final regulations were published by the U.S. Treasury Department on July 8, 1994. This section summarizes the regulatory framework of the transfer-pricing regulations, including a review of the arm's-length standard. This discussion summarizes each transfer-pricing method presented in the federal regulations related to the allocation of consolidated entity income between (1) tangible assets, (2) intangible assets and (3) shared corporate services.
The Arm's-length Standard
The transfer-pricing regulations give the IRS broad authority to allocate income or expenses between related entities if it determines that such an allocation is necessary (1) to prevent the evasion of taxes or (2) to clearly reflect the income of the related entities. The regulations state that "the purpose of §482 is to ensure that taxpayers clearly reflect income attributable to controlled transactions, and to prevent the avoidance of taxes with respect to such transactions..." (Regulation 1.482-1(a)(1)). The regulations state that the standard applied to any related party transaction is that of the same or similar transaction carried out by an independent taxpayer dealing at arm's-length with another independent 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..." (Regulation 1.482-1(b)(1)).
The concept underlying the §482 regulation's arm's-length standard is the reliance on transactions that are independent or uncontrolled. In order to apply the arm's-length standard, taxpayers should identify some transaction or transactions between independent, uncontrolled parties where the price (or profitability) can be ascertained. Once such transactions are identified, the "best-method rule" relies on the standard of comparability to determine which transaction(s) provide the most reliable transfer-price conclusion. In this regard, taxpayers should compare the results of the subject-related party transaction to the results of comparable transactions between uncontrolled parties under comparable circumstances.
The Best-method Rule
The §482 regulations provide several methods for determining intercompany transfer prices. The regulations require that the "best method" be used to determine the arm's-length pricing for each asset/service intercompany transaction. The best method is defined as the method that produces the most reliable measure of an arm's-length price for the related party transaction, considering all relevant facts and circumstances.
There are two primary considerations when selecting which of the allowed transfer pricing methods is the best method. The first consideration for determining the best method is the degree of comparability between (1) the subject controlled transaction and (2) the selected uncontrolled transaction. According to Regulation 1.482-1(d)(1), these five factors should be considered when determining comparability:
- functions performed
- contractual terms
- risks borne
- economic conditions experienced and
- nature of the property or services.
The second consideration for determining the best method is the quality of the data and assumptions used in the analysis. Again, there are three factors to consider in assessing the quality of the data and assumptions. These three factors are:
- completeness and accuracy of data
- reliability of assumptions and
- sensitivity of the results to deficiencies in data and assumptions.
Allowable Tangible Asset Transfer Pricing Methods
Regulation 1.482-3(a) provides five methods of determining an arm's-length price for the related party transfer of tangible property:
- the comparable uncontrolled price method
- the resale price method
- the cost plus method
- the comparable profits method and
- the profit split method.
1. The Comparable Uncontrolled Price Method (CUP). The CUP method uses actual tangible asset transactions between unrelated parties to determine the arm's-length price for the transfer of tangible assets between related parties. This method analyzes whether the amount charged in the subject related party (controlled) transaction is at arm's-length by reference to the amounts charged in comparable uncontrolled transactions.
In this analysis, it is important that the selected CUP comparable transactions involve substantially the same products as the subject controlled transaction. This is because "similarity of products generally will have the greatest effect on comparability under this method... If there are material product differences for which reliable adjustments cannot be made, this method ordinarily will not provide a reliable measure of an arm's-length result" (Regulation 1.482-3(b)(2)(ii)(A)).
2. The Resale-price Method. The resale-price method can be used to determine the arm's-length price to be paid by the purchaser entity in the subject intercompany transaction when the purchaser entity, in turn, resells the subject tangible asset to unrelated parties. According to Regulation 1.482-3(c)(1), this method "evaluates whether the amount charged in a controlled transaction is arm's-length by reference to the gross profit margin realized in comparable uncontrolled transactions. The resale-price method measures the value of the function performed and is ordinarily used in cases involving the purchase and resale of tangible property in which the reseller has not added substantial value to the tangible goods by physically altering the goods before resale."
3. The Cost-plus Method. The cost-plus method determines the arm's-length price that the seller entity should receive in an intercompany transaction based on the markup on gross profit earned by sellers in comparable uncontrolled transactions. Specifically, Regulation 1.482-3(d)(1) states that the method "evaluates whether the amount charged in a controlled transaction is arm's-length by reference to the gross profit markup realized in comparable uncontrolled transactions. The cost-plus method is ordinarily used in cases involving the manufacture, assembly or other production of goods that are sold to related parties."
The cost-plus method focuses on the circumstances of the subject transaction/ comparable transactions. This method does not require that the tangible asset being sold in the uncontrolled transactions be essentially identical to the tangible asset in the subject controlled transaction. "[C]omparability under this method is particularly dependent on similarity of functions performed, risks borne and contractual terms, or adjustments to account for the effects of any such differences. If possible, the appropriate gross profit markup should be derived from comparable uncontrolled transactions of the taxpayer involved in the controlled sale, because similar characteristics are more likely to be found among sales of property by the same producer than among sales by other producers" (Regulation 1.482-3(d)(3)(ii)(A)).
4. The Comparable-profits Method (CPM). The CPM determines an arm's-length price for the related party transfer of tangible assets by reference to a measure of profitability of an unrelated company that engages in similar activities under similar circumstances. This method compares the profitability of either the related party buyer or the related party seller, measured using a "profit level indicator" (PLI), to the profitability of the selected comparable company. According to Regulation 1.482-5(c)(2)(ii), comparability under the CPM depends primarily on the related party's (1) functions performed, (2) resources employed and (3) risks assumed. The degree of functional comparability required to obtain a reliable result using the CPM generally is less than the degree of functional comparability required under either the resale-price method or the cost-plus method.
The first step in the CPM is to select either (1) the related party buyer or (2) the related party seller to be the "tested party." The tested party is the entity for which profitability can be ascertained and for which reliable data on comparables can be found. In general, the tested party is also the party that has the least complex business operations and employs the fewest intangible assets. When the tested party has complex activities and uses significant intangible assets, it is usually difficult to identify uncontrolled companies that are sufficiently similar. The selected tested party should also be the related party with data that involve (1) the fewest (and the smallest) and (2) the most reliable adjustments.
The second step in the CPM is to select the appropriate PLI. The selection of the appropriate PLI depends on (1) the reliability of the available data and (2) the specific facts and circumstances of the taxpayer business. The regulations cite the following three basic profit level indicators:
- the return on capital employed ratio
- the ratio of operating profit to sales (net margin) and
- the ratio of gross profit to operating expenses.
The third and final step in the CPM is to establish an arm's-length price range based on the PLIs of the selected uncontrolled companies. If the tested party PLI falls within a reasonable range of price results, then its tangible asset intercompany prices are considered to be at arm's-length.
5. The Profit-split Method. The profit split method determines a tangible-asset arm's-length transfer price based on the relative value of each related party's contribution to the combined profit or loss in a particular controlled transaction or set of controlled transactions. According to Regulation 1.482-6(b), these related party contributions (1) are to reflect "the functions performed, risks assumed and resources employed by each participant in the relevant business activity" and (2) should "correspond to the division of profit or loss that would result from an arrangement between uncontrolled taxpayers, each performing functions similar to those of the various controlled taxpayers engaged in the relevant business activity."
Regulation 1.482-6(c)(2)(i) describes the comparable-based profit-split method. In this method, uncontrolled taxpayers' proportions of the combined operating profit in situations similar to the controlled transaction are used to allocate the related parties combined operating profit. Regulation 1.482-6(c)(3)(i) describes the residual profit split method. In this method, profit is first allocated to (1) routine functions, services, and intangible assets, and then to (2) profit not accounted for by the routine contributions. This allocation is based on the related parties' contributions to the total taxpayer residual profit.
6. Unspecified Methods. From the standpoint of the intercompany transfer-price regulations, a method that has not been explicitly defined (that is, a method other than the CUP method, resale-price method, cost-plus method, CPM, CUT method or the profit-split method) can be applied if it provides the most reliable measure of an arm's-length return under the best method rule. The use of an unspecified transfer price method "should take into account the general principle that uncontrolled taxpayers evaluate the terms of a transaction by considering the realistic alternatives to that transaction, and only enter into a particular transaction if none of the alternatives are preferable to it" (Regulation 1.482-3(e)(1)).