Post by Sapphire Capital on Jul 11, 2008 23:36:12 GMT 4
PUBLIC LAW AND LEGAL THEORY WORKING PAPER SERIES
WORKING PAPER NO. 92 SEPTEMBER 2007
JOHN M. OLIN CENTER FOR LAW & ECONOMICS
WORKING PAPER NO. 07-017
THE RISE AND FALL OF ARM’S LENGTH:
A STUDY IN THE EVOLUTION OF
U.S. INTERNATIONAL TAXATION
REUVEN S. AVI-YONAH
THE SOCIAL SCIENCE RESEARCH NETWORK ELECTRONIC PAPER COLLECTION:
ssrn.com/abstract=1017524
THIS PAPER CAN BE DOWNLOADED WITHOUT CHARGE AT:
MICHIGAN JOHN M. OLIN WEBSITE
HTTP://WWW.LAW.UMICH.EDU/CENTERSANDPROGRAMS/OLIN/PAPERS.HTM
THE RISE AND FALL OF ARM'S LENGTH: A STUDY IN THE EVOLUTION OF U.S. INTERNATIONAL TAXATION
Reuven S. Avi-Yonah1
I. INTRODUCTION
In 1988, the U.S. Treasury Department published a study of intercompany pricing, the "White Paper," that included the following endorsement of the so-called arm's length standard (henceforth, the "ALS") for examining the reasonableness of transactions between related parties for tax purposes:
The arm's length standard is embodied in all U.S. tax treaties; it is in each major model treaty, including the U.S. Model Convention; it is incorporated into most tax treaties to which the United States is not a party; it has been explicitly adopted by international organizations that have addressed themselves to transfer pricing issues; and virtually every major industrial nation takes the arm's length standard as its frame of reference in transfer pricing cases. . . The United States should continue to adhere to the arm's length standard. n1
What is the ALS, and why did the Treasury seek to defend it in these terms? The problem for which the ALS attempts to provide the solution may be illustrated by a simple example. Suppose that a product (e.g., computers) is manufactured by a corporation in country A, and then sold to a wholly owned subsidiary of the manufacturer in country B, which proceeds to resell it to unrelated customers. In this common situation, the taxable profit of the subsidiary is determined by three factors: (1) the price at which it resells the computers to the unrelated customers, (2) its expenses other than cost of goods sold, and (3) the price which it pays its parent corporation for the computers. The first two of these factors are governed by market forces outside the control of the parent or the subsidiary. However, because the parent controls the subsidiary, the third factor (the price for which the manufacturer sells the computers to the reseller, or the "transfer price") is wholly within the control of the related parties. Accordingly, the potential for abuse arises because the related parties will seek to increase aftertax profits by manipulating the transfer price. If the effective tax rate in the manufacturer's country is higher, the price will be set as low as possible so as to channel all taxable profit to the reseller. Conversely, if the effective tax rate in the reseller's jurisdiction is higher, the transfer price will be as high as possible, so as to eliminate any taxable profit of the reseller and concentrate the entire profit in the hands of the manufacturer. But for tax considerations, the affiliated parties do not care what the transfer price is, since it merely re-allocates profits within the affiliated group.
Given these facts, it is understandable that transfer pricing manipulation is one of the most common techniques of tax avoidance. This is especially true in the international sphere, as there are great differences in effective tax rates among jurisdictions. Indeed, some economists have argued that the ability to manipulate transfer prices is a major reason for the existence of multi-national enterprises, which are groups of affiliated corporations operating in more than one country. n2 It is estimated that trading among such affiliates encompasses about one third of world manufacturing
trade, n3 and that percentage is constantly increasing. The transfer pricing problem is, therefore, one of the major international tax policy challenges for the coming century.
The ALS, as traditionally conceived, responds to the transfer pricing problem by seeking to determine whether transactions between related taxpayers reflect their "true" tax liability by comparing them to similar transactions
1 Irwin I. Cohn Professor of Law and Director, International Tax LLM Program, the University of Michigan Law School. The first part of this article is based on an article by the same name in the Virginia Tax Review, 15 Va. Tax Rev. 89 (1995).
between unrelated taxpayers dealing at arm's length. This was the definition of the ALS that was understood when the White Paper was published in 1988. n4 However, as is reflected in the defensive tone of the Treasury's pronouncements, the White Paper was written at a time when this traditional conception of the ALS was coming under increasing criticism and suggestions for its replacement were rampant. In particular, the legislative history of the Tax Reform Act of 1986 indicates that Congress had mandated that the Treasury Department reevaluate the continued viability of the ALS. n5 The White Paper was issued in response to this mandate. However, despite Treasury's findings, the process begun by the Congressional mandate eventually resulted in the abandonment of the ALS, as it was understood in 1988. Its replacement, in the United States and elsewhere, was a broader and more flexible method of determining the allocation of taxable profits between related entities. Although this broader method may also be characterized as 'arm's length," it is a different type of arm's length standard than the one defended by the White Paper. Indeed, the White Paper itself played a major part in the demise of the traditional ALS.
This Article explores the process by which the traditional ALS became the dominant method for determining transfer prices for tax purposes, the reasons for its eventual downfall, and methods that can be used in its place. First, a few definitional points are in order. The traditional ALS refers primarily to a process by which the transfer price between affiliated taxpayers is determined by using comparables -- either of the same product sold by one of the affiliated parties to an unrelated party, of the same product bought by an affiliated party from an unrelated party, or of the
same product sold between two parties unrelated to the affiliated parties and to each other. This method of comparison is usually called the "comparable uncontrolled price," or CUP method. n6 In addition, the traditional ALS also encompasses two methods that likewise rely on comparables, but do not require a transaction in the same product. Under the "cost plus" method, the transfer price is determined by comparing the manufacturer to a similar entity (under a more relaxed standard of comparability than under the CUP method), which is dealing with unrelated parties, and allocating to the manufacturer the costs borne by the unrelated comparable, plus the unrelated party's profit margin. n7 The "resale price" method is identical to the cost plus method except that it applies to the reseller rather than the manufacturer. n8
The ALS, as traditionally conceived, is frequently contrasted with "unitary", "global" or "formulary apportionment" methods, such as those used by some states. Here the entire profit of an affiliated group is allocated among its constituent entities by means of a formula (e.g., based on each entity's assets, payroll and sales). n9 The major difference between the ALS and the formulary method is that the ALS starts with treating each entity in an affiliated group as a separate taxpayer, hypothetically dealing with each other entity in the group at arm's length. Conversely, the formulary approach starts with the entire affiliated group as one unitary enterprise.
This article proposes that despite the common practice of contrasting the ALS and the formulary methods of dealing with the transfer pricing problem, they are actually not dichotomous. Instead, they form the two extreme ends of a continuum. n10 The cost plus and resale price methods, which are included in the traditional ALS, already represent one step away from pure separate treatment of each entity in the group. This is because they involve taking the group's profits as a whole, subtracting the profit margin allocable to the manufacturer or the reseller on the basis of the comparables, and then allocating the residual profit to the other party.
Next on the continuum comes the "comparable profit method" (CPM), which is a major innovation of the recent regulations under Section 482 of the Internal Revenue Code ("the Code"), under which the profit of either the manufacturer or the reseller is set by comparing it to the average profit earned by a very broad group of corporations operating in the same or a similar industry. n11 The standard of comparison in this case is very relaxed, and one may indeed regard the CPM as a type of formula designed to ensure that the profits of the related party do not fall outside a reasonable range of profit margins earned by other corporations which are not truly comparable with the related party. n12 As will be shown below, the CPM falls outside the traditional or narrow definition of the ALS, but it still uses some form of comparables.
Even further along on the continuum of possible methods of determining transfer prices is the "profit split" method. This method was first introduced in the 1988 White Paper. n13 Here, the allocation of profits is determined in two steps. First, the functions performed by each of the related parties are analyzed and a market rate of return is allocated to each function on the basis of comparables. n14 Then, the residual profit is split between the related parties on the basis of a formula, without using comparables. n15 The profit split method is very close to the pure formulary apportionment end of the transfer pricing continuum, because it starts with the enterprise as a whole and allocates the profits in a formulary fashion. The only differences are that some of the profits are allocated on the basis of
comparables, and that the formula used to split the rest is more flexible than the traditional assets, payroll and sales-based formula used by the states.
Consequently, the words "arm's length" can be used in two ways to refer to two different possible ranges of solutions to the transfer pricing problem. Under the traditional or narrow definition, "arm's length" refers to methods of determining transfer prices by using comparables, and encompasses only the CUP, cost plus and resale price methods. n16 On the other hand, "arm's length" can also be used to refer to any method of determining transfer prices that reaches results (i.e., a profit allocation) that are the same as those that would have been reached between unrelated parties. In this latter, broader sense, "arm's length" can be used to refer to the entire transfer pricing continuum, because even pure formulary apportionment may result in the same profit allocation as that which unrelated parties would have reached.
The first four parts of this Article analyze the origins, rise, decline and fall of the traditional or narrow ALS, as applied to international transactions between related parties under section 482 of the Code and its predecessors. n17 The analysis will show that despite the Treasury's affirmation of the traditional ALS in its 1988 White Paper, n18 this narrow conception of the standard was already obsolete by 1988 in the large majority of cases, insofar as the United States' approach to international taxation was concerned. Subsequent developments, especially the recently issued proposed, temporary and final regulations under section 482 of the Code, merely strengthened the nails in its coffin. The last section of the Article will focus on the following questions: (1) why has the traditional ALS proven so inadequate, (2) what methods are now used to supplement it, and (3) what additional improvements can be made in resolving the transfer pricing problem?
II. ORIGINS
Transfer pricing manipulation is one of the simplest ways to avoid taxation. It is, thus, not surprising that the predecessors of section 482 of the Code, legislation designed to combat such manipulation, date back almost as far as the modern income tax itself. They originated in Regulation 41, Articles 77 and 78, of the War Revenue Act of 1917, which gave the Commissioner authority to require related corporations to file consolidated returns "whenever necessary to more equitably determine the invested capital or taxable income." n19 The earliest direct predecessor of section 482 of the Code dates to 1921, when the Commissioner was authorized to consolidate the accounts of affiliated corporations "for the purpose of making an accurate distribution or apportionment of gains, profits, income, deductions, or capital between or among such related trades or business." n20 This legislation was enacted, in part, because of the tax avoidance opportunities afforded by possessions corporations, which were ineligible to file consolidated returns with their domestic affiliates. n21 Thus, the problem of international tax avoidance through related corporations was one of the original motives for the enactment of the earliest predecessor of section 482 of the Code. n22
In 1928, the provision was removed from the consolidated return provisions (which were eliminated) and expanded to read as follows:
Section 45. Allocation of Income and Deductions.
In any case of two or more 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 Commissioner is authorized 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 of such trades or businesses. n23
This language is almost identical to section 482 of the Code as it read prior to the Tax Reform Act of 1986. n24
The legislative history of Section 45 of the Code, in its entirety, is as follows:
Section 45 is based upon section 240(f) of the 1926 Act, broadened considerably in order to afford adequate protection to the Government made necessary by the elimination of the consolidated return provisions of the 1926 Act. The section of the new bill provides that the Commissioner may, in the case of two or more trades or businesses owned or controlled by the same interests, apportion, allocate, or distribute the income or deductions between or among them, as may be necessary in order to prevent evasion (by the shifting of profits, the making of fictitious sales, and other methods frequently adopted for the purpose of "milking"), and in order clearly to reflect their true tax liability. n25
Senator Gifford stated on the floor that "what worries us is that any two of these corporations can get together and take advantage of questionable sales to each other to get deductions." n26 Senator Green replied that "Section 45. . .permits the bureau to allocate the income where it belongs. It. . .does not permit these corporations to place the expenses just where they want to put them." n27
Congress' focus in enacting the predecessor of section 482 of the Code was, thus, to prevent tax evasion and to clearly reflect "true" tax liability. However, there was no discussion of what the standard of "true" liability was. In 1935, the Service issued regulations under section 45 of the Code, which stated that the following standards would govern its application:
(b) Scope and purpose. -- The purpose of section 45 is to place a controlled taxpayer on a tax parity with an uncontrolled taxpayer, by determining, according to the standard of an uncontrolled taxpayer, the true net income from the property and business of a controlled taxpayer. The interests controlling a group of controlled taxpayers are assumed to have complete power to cause each controlled taxpayer so to conduct its affairs that its transactions and accounting records truly reflect the net income from the property and business of each of the controlled taxpayers. If, however, this has not been done, and the taxable net incomes are thereby understated, the statute contemplates that the Commissioner shall intervene, and, by making such distributions, apportionments, or allocations as he may deem necessary of gross income or deductions, or of any item or element affecting net income, between or among the controlled taxpayers constituting the group, shall determine the true net income of each controlled taxpayer. The standard to be applied in every case is that of an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer. n28
Thus, the ALS, under U.S. tax law, was born. This section of the regulations, in very similar language, remained in effect under section 482 of the Code until the recently-issued modifications. n29
However, the regulations were not modified to explain what methods should be used to arrive at an arm's length price until 1968. Previously, this task was left to the courts.
III. RISE
The early cases applying section 45 of the Code did not mention the ALS. Instead, they focused on the statutory terms "evasion of taxes" and "clear reflection of income." n30 It was not until the 1935 regulations were issued, that the arm's length nature of the transaction between related parties came into focus. n31 However, for a long period thereafter, the courts applied a wide variety of standards to determine what constituted a transaction that clearly reflected the taxpayer's income. n32
Seminole Flavor Co. v. Commissioner n33 is a good example of these early cases. The issue was whether transactions between a corporation and a partnership organized to market the corporation's products should be adjusted to shift income from the partnership to the corporation. n34 The Tax Court, in holding for the taxpayer, stated that the arm's length nature of the transaction should be determined by whether it was "fair and reasonable," and that the question of whether unrelated parties would have entered into the same agreement was irrelevant. n35 It then went on to hold that-
The commission fixed does not appear to be out of line with petitioner's own experience [i.e., its expenses for marketing prior to forming the partnership]. On this basis the transaction would seem to be fair and entitled to classification as an arm's length transaction. Whether any such business agreement would have been entered into by petitioner with total strangers is wholly
problematical. n36
Other cases from the same period show similar tendencies to apply a variety of standards and to ignore the question of whether comparables exist. The standards employed included whether the transaction was "fair" on the basis of the functions performed by the parties; n37 whether the related party paid "full fair value;" n38 and whether the prices paid would have been considered "fair and reasonable" in the trade. n39
On the other hand, in Hall v. Commissioner, n40 a somewhat later Tax Court case, a comparable was used to establish the arm's length price. Hall involved sales to a Venezuelan marketing affiliate at cost plus 10% (a price which amounted to a discount of over 90% from the regular list price) when unrelated distributors of the same product received a discount of only 20%. n41 The Tax Court held that gross income had been arbitrarily shifted to the Venezuelan corporation, and that the Commissioner's allocation "reflected Hall's income as if he had been dealing with unrelated parties. That, of course, was the purpose of the statute." n42
The early cases, thus, appear inconsistent in their application of arm's length. The question of whether the ALS should always be applied was finally raised in Frank v. International Canadian Corporation, n43 decided in 1962, which was 27 years after the initial promulgation of the standard in regulations. n44 The case involved transfer prices for sales of chemicals by a U.S. parent to a Western Hemisphere Trade Corporation (WHTC). The parties stipulated that the sales reflected a "reasonable price and profit" between the two corporations, and the District Court found that the Commissioner had thereby stipulated himself out of court on the section 45 issue. n45 The Commissioner appealed, arguing that the District Court used the "reasonable return" standard instead of the proper arm's length standard. The Court of Appeals for the Ninth Circuit affirmed in the following terms:
We do not agree with the Commissioner's contention that "arm's length bargaining" is the sole criterion for applying the statutory language of section 45 in determining what the "true net income" is of each "controlled taxpayer." Many decisions have been reached under section 45 without reference to the phrase "arm's length bargaining" and without reference to Treasury Department Regulations and Rulings which state that the talismanic combination of words-"arm's length"-is the "standard to be applied in every case." For example, it was not any less proper for the District Court to use here the "reasonable return" standard than it was for other courts to use "full fair value," "fair price, including a reasonable profit," "method which seems not unreasonable," "fair consideration which reflects arm's length dealing," "fair and reasonable," "fair and reasonable" or "fair and fairly arrived at," or "judged as to fairness," all used in interpreting section 45. n46
Thus, the Ninth Circuit essentially invalidated the regulations, and held that it was not necessary to establish what unrelated taxpayers would have done in order to clearly reflect the "true" income and correct tax liability of related parties. n47
One can only speculate as to what would have happened had the courts been left free to develop their own definition of "fair" or "reasonable" without having to adhere to the ALS. n48 During the same era as the Frank decision, major developments were taking place in Washington that would ultimately lead to the establishment of standards under section 482 of the Code (as section 45 of the Code had now been renumbered). The early 1960's were marked by a rise in concern on the part of the Treasury that domestic corporations were achieving deferral through transfer pricing practices with tax haven affiliates, and that foreign corporations were avoiding taxes altogether by artificially lowering the profits of their U.S. affiliates. The Treasury contended that section 482 of the Code was not effectively protecting the U.S. tax jurisdiction. n49
Congress responded with legislation intended to stop these perceived abuses. Section 6 of H.R. 10650, as introduced by the House Committee on Ways and Means, provided for a new Code section, section 482(b). n50 Under the House proposal, in section 482 cases involving international transfers of tangibles, unless the taxpayer could demonstrate an arm's length price (defined, in accordance with the traditional view, as a price based on a matching or comparable adjustable transaction), or unless the taxpayer and the IRS could agree on a different method, the transfer price would be determined under a formula based on assets, compensation, and expenses related to the transferred tangible property. n51
The House Report explained the intent of section 6 of the bill as follows:
Present law in section 482 authorizes the Secretary of the Treasury to allocate income between related organizations where he determines this allocation is necessary "in order to prevent evasion of taxes or clearly to reflect the income of any such organizations." This provision appears to give the Secretary the necessary authority to allocate income between a domestic parent and its foreign subsidiary. However, in practice the difficulties in determining a fair price under the provision severely limit the usefulness of this power especially where there are thousands of different transactions engaged in between a domestic company and its foreign subsidiary.
Because of the difficulty in using the present section 482, your committee has added a subsection to this provision authorizing the Secretary of the Treasury or his delegate to allocate income in the case of sales or purchases between a U.S. corporation and its controlled foreign subsidiary on the basis of the proportion of the assets, compensation of the officers and employees, and advertising, selling and promotion expenses attributable to the United States and attributable to the foreign country or countries involved. This will enable the Secretary to make an allocation of the taxable income of the group involved (to the extent it is attributable to the sales in question) whereas in the past under the existing section 482 he has attempted only to determine the fair market sales price of the goods in question and build up from this to the taxable income -- a process much more difficult and requiring more detailed computations than the allocation rule permitted by this bill.
The bill provides, however, that the allocation referred to will not be used where a fair market price for the product can be determined. It also provides that other factors besides those named can be taken into account. In addition, it provides that entirely different allocation rules may be used where this can be worked out to mutual agreement of the Treasury Department and the taxpayer. n52
Predictably, the taxpayer community responded by lobbying Congress to remove section 6 from H.R. 10650, claiming that the regulatory authority under section 482 of the Code was sufficient to curb abuses. n53 Their efforts were rewarded in the Senate version of the bill, which omitted the section. In conference, the House receded. The Conference Report states the reasons as follows:
The conferees on the part of both the House and the Senate believe that the objectives of section 6 of the bill as passed by the House can be accomplished by amendment of the regulations under present section 482. Section 482 already contains broad authority to the Secretary of the Treasury or his delegate to allocate income and deductions. It is believed that the Treasury should explore the possibility of developing and promulgating regulations under this authority which would provide additional guidelines and formulas for the allocation of income and deductions in cases involving foreign income. n54
Treasury took three years to respond to this invitation. n55 In the meantime, however, significant new developments were taking place in the courts. Oil Base, Inc. v. Commissioner n56 represented a classic case of the application of the ALS to sales commissions paid by a U.S. corporation to its Venezuelan marketing affiliate. These commissions were about twice the amount that the same corporation had paid its previous unaffiliated distributor of the same product in Venezuela, and were twice the amount it was currently paying to distributors in other countries. The taxpayer, however, argued that the Frank standard should be applied instead of arm's length, and that since it still retained higher profits from export sales to Venezuela even after the double commission than from domestic sales, the commissions were "reasonable" under Frank. The Tax Court, in a memorandum decision, disagreed. It held that: It is unnecessary for us to decide whether the sole standard in cases under section 482 is one of an amount which would be arrived at in arm's
length transactions between unrelated parties. The commissioner has been given much latitude in his use of section 482 when necessary to prevent the evasion of Federal income tax by shifting of profits between taxpayers subject to common control. The burden is on petitioner to show error in respondent's allocation. . .There is no evidence to show that the percentage return retained by petitioner on domestic sales would represent a reasonable return on export sales. There is likewise no evidence to show that the amount of commissions and discounts paid to Oil Base, Venezuela, represented a reasonable amount, a fair amount, or an amount which would meet any of the other criteria referred to by the Court in Frank. Certainly the fact that these commissions are almost double those paid by petitioner to unrelated persons in arm's length transactions is evidence that they were not fair and reasonable. n57
Presumably, the taxpayer in Oil Base was encouraged to litigate, despite the egregious facts, because appeal lay to the Ninth Circuit. On appeal, the taxpayer, citing Frank, repeated the argument that the Commissioner erred in applying a standard of arm's length bargaining that was not in the statute. The court of appeals, however, held that the application of arm's length was appropriate:
We cannot agree. Where, as here, the extent of the income in question is largely determined by the terms of business transactions entered into between two controlled corporations it is not unreasonable to construe "true" taxable income as that which would have resulted if the transactions had taken place upon such terms as would have applied had the dealings been at arm's length between unrelated parties.
Frank v. International Canadian Corporation [308 F.2d. 520 (9th Cir. 1962)], did not hold that the arm's length standard established by regulation was improper. It held that it was not "the sole criterion" for determining the true net income of each controlled taxpayer. However, permissible departure from the regulation's arm's length standard was, under the facts of that case, very narrowly limited and the holding has no application to the facts before us.
We conclude that the arm's length bargaining standard was properly applied pursuant to regulation. Hall v. Comm'r, 294 F.2d 82 (5th Cir. 1961). n58
In a footnote, the Ninth Circuit specified that Frank only applied in cases where (a) there was no evidence of an arm's length price, and (b) because of the "complexity of the circumstances . . . it would have been difficult for the court to hypothesize an arm's length transaction." n59
It is difficult to reconcile this reading of Frank with the list of possible standards given by the Frank panel four years earlier, which relegated the ALS to a very minor role. In effect, the Ninth Circuit overruled Frank, holding that the ALS must be applied not only when comparables exist, but also when they do not exist, as the court can "hypothesize" a comparable. This abrupt reversal was very likely influenced by the egregious facts of Oil Base and by the difficulties in applying a "reasonableness" standard. It also seems likely that the Tax Court and the Ninth Circuit were influenced by the perception of widespread abuse as a result of the Washington hearings on the Revenue Act of 1962, and by the endorsement of the Commissioner's powers in the legislative history of that Act. n60
The Commissioner's victory in Oil Base was followed by a series of cases which applied the ALS, although not always to the Commissioner's satisfaction. In Johnson Bronze Company v. Commissioner, n61 the taxpayer formed an international marketing subsidiary in Panama for the majority of its foreign sales accounts. The Commissioner reallocated 100% of the subsidiary's income to the parent under section 482 of the Code. The Tax Court held that the 100% allocation was arbitrary and unreasonable. n62 In determining the proper allocation, the court held that "the standard to be applied in every case is that of an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer." n63 In a footnote, the court referred to Frank as requiring a choice between the "reasonable" and "arm's length" standards, but stated that "on this subject we shall only say that, on the facts of this case, the only reasonable price charged by petitioner would be one which would have been arrived at if the parties were at arm's length." n64 The court then held that the allocation should be based on the prices charged by unrelated parties that bought the same products from the taxpayer for resale in foreign markets. n65
Eli Lilly & Company v. Commissioner, n66 the first of several section 482 cases involving pharmaceutical manufacturers, involved transfer pricing between Eli Lilly and Company (Lilly) and its subsidiary which qualified as a WHTC. The Commissioner based his reallocation on the profit earned by Lilly on sales to domestic distributors, arbitrarily divided in half to reflect volume discount. The Claims Court agreed, holding that Lilly's contention that it should be allowed to benefit from the tax subsidy to Western Hemisphere trade corporations "would require the court to ignore the provisions of Treas. Reg. 1.482-1," requiring the application of the ALS. This is because if the subsidiary were unrelated it would not have been able to retain all the profit on the sales. n67
Lilly then cited Frank, in arguing that its allocation was motivated by business purposes and was "fair" and "reasonable," and thus that the ALS should not control. The Court of Claims disagreed:
The Ninth Circuit has since indicated that only a very narrow departure from the arm's length standard was allowed in the particular circumstances of Frank [citing Oil Base]. Moreover, even accepting Eli Lilly's interpretation that Frank establishes a criterion of a fair and reasonable price, such a price can best be determined by hypothesizing to an arm's length transaction. The thrust of section 482 is to put controlled taxpayers on a parity with uncontrolled taxpayers. Consequently, any measure such as "fair and reasonable" or "fair and fairly arrived at" must be defined within the framework of "reasonable" or "fair" as among unrelated taxpayers. Simply because a price might be considered "reasonable" or "fair" as a business incentive in transactions among controlled corporations, does not mean that unrelated taxpayers would so consider it. Thus, even if the arm's-length standard is not the sole criterion, it is certainly the most significant yardstick. n68
The problem, as the taxpayer pointed out, is that in the absence of any comparables, it is unclear how the arm's length price should be "hypothesized." To this question, the Court of Claims gave no answer. It rejected the comparables offered by Lilly (bulk sales to government agencies) because the market was not comparable, yet
accepted the revenue agent's arbitrary decision to cut the profits of the Western Hemisphere trade affiliates by half because the results were "reasonable." n69 When examining the outcome, it is hard to see what relevance the ALS had to the court's ultimate determination. n70
In 1968, the regulations under section 482 of the Code were finalized, and thereafter, they formed the starting point of the analysis in the courts. n71 With few changes, these regulations applied to transfer pricing until the temporary regulations became effective in April, 1993. n72 Despite the invitation in the legislative history of the 1962 act, the Treasury made no attempt to devise "formulas" to apply section 482 of the Code. n73 Instead, for the first time, the regulations attempted to establish rules for applying the ALS to specific types of transactions, but with different degrees of specificity. n74 For services, the regulations merely recited the ALS without any guidance as to its application in the absence of comparables. n75 For intangibles, the regulations contemplated a failure to find comparables. They list twelve factors to be taken into account, but without establishing any priority or relative weight among them. n76
The greatest detail was given for transfers of tangible property. Treasury Regulation section 1.482-2(e) described the three methods that should be used in determining an arm's length price: the comparable uncontrolled price ("CUP") method, the resale price method, and the cost plus method, in that order of priority. n77 All
three methods relied on finding comparable transactions, either directly or by reference to appropriate markups. n78 In the absence of comparables, the regulations stated that:
Where none of the three methods of pricing . . . can reasonably be applied under the facts and circumstances as they exist in a particular case, some appropriate method of pricing other than those described in subdivision (ii) of this subparagraph, or variations on such methods, can be used. n79
The courts were, therefore, left free to determine their own "fourth methods" in the absence of comparables.
These regulations effectively ensured that the courts would apply the ALS. A 1970 case, Woodward Governor Company v. Commissioner, n80 may have represented the last challenge to the standard. The taxpayer organized foreign subsidiaries to act as marketing agents for overseas sales of aircraft parts. The Commissioner applied the resale
price method in reallocating income to the taxpayer. The taxpayer argued that the regulations were invalid in their requirement that the ALS should govern all cases. In the alternative, they argued that if the ALS should be applied, the CUP method should be used on the basis of sales of the same parts to General Electric. The Tax Court accepted the latter argument and therefore did not reach the former. n81
In the meantime, other courts were finding that the ALS must be applied in section 482 cases. Baldwin-Lima-Hamilton Corp. v. United States n82 involved transfer pricing between the taxpayer and its WHTC subsidiary. The Commissioner reallocated all of the income of the subsidiary to the taxpayer. The district court held that the reallocation was arbitrary, and upheld the taxpayer's allocation based on pricing studies using assumptions that were "tipped in the taxpayer's favor," by using inappropriate comparables. n83 The court of appeals reversed in part, and remanded to the district court for partial re-allocation on the basis of the ALS, stating that the district court "should reject those aspects of the [taxpayer's] theories which do not meet the arm's length standard." n84
United States Gypsum Co. v. United States, n85 involved two section 482 issues: shipping fees paid by the taxpayer to its Panamanian subsidiary and transfer pricing for goods sold by the taxpayer to its WHTC. The district court held for the taxpayer on both issues. On the shipping issue, it held that the amounts were "reasonable and . . . equal to an arm's length charge" because they were "within the range" of unrelated party prices (based on comparables). n86 On the transfer pricing issue, the district court held that even though the prices were arbitrarily set to shift income to the WHTC, on the basis of cases like Frank and Polak's Frutal which allowed similar mark ups, the prices were "not unreasonable" (which the district court considered to be automatically equivalent to arm's length). n87
The Court of Appeals for the Seventh Circuit affirmed the first holding and reversed the second. n88 On the shipping issue, the Seventh Circuit had considerable misgivings as to whether the alleged comparables were indeed comparable, and whether unrelated parties would not have adjusted the terms of the contract once the profits that the shipping subsidiary was making became clear, but affirmed under a "clearly erroneous" standard. n89 On the transfer pricing issue, the Seventh Circuit reversed, rejecting the district court's reliance on Frank and its predecessors and its application of a "reasonableness" standard:
We do not consider the cited cases helpful in deciding whether, as a matter of fact, USG's prices to [the WHTC] were the same as would have been reached in arm's length dealing. Insofar as these cases support a proposition that there may be "reasonable" prices, different from those which would have been reached in arm's length dealing, which will result in clearly reflecting the income of controlled taxpayers, we respectfully decline to follow them. n90
Thus, the Seventh Circuit held, as argued by the Commissioner, that applying the ALS was mandatory in all section 482 cases. n91 Two other cases from approximately the same period illustrate the courts' determination to adhere to the ALS even when the Commissioner attempted to apply a different standard. PPG Industries, Inc. v. Commissioner n92 involved the application of section 482 of the Code to a Swiss marketing subsidiary of a U.S. manufacturer of glass, paint, and chemical products. The Tax Court held for the taxpayer on the grounds that (a) the Commissioner's original allocation, based on the Source Book of Statistics of Income, was arbitrary and did not meet the ALS; n93 (b) most of the taxpayer's sales were at arm's length prices based on comparables; n94 and (c) the Commissioner's comparable for the remaining sales was inappropriate, and the taxpayer's allocation was "fair" and "reasonable" and therefore met the arm's-length standard. n95
Ross Glove Co. v. Commissioner n96 represents the application of section 482 of the Code to an inbound transaction, involving the sale of sheepskins to the taxpayer by a Bahamian corporation which also provided sewing services. The Commissioner attempted to hold the taxpayer to its representations to the Philippine authorities, regarding the markup on its costs for currency control purposes. The Tax Court rejected this argument and held that "there is nothing in section 482 or the regulations thereunder to indicate that the arm's-length standard of section 482 is to be ignored simply because of representations made in foreign countries." n97 The court then determined the transfer price on the basis of arbitrary adjustments to an approximate comparable. n98
Finally, perhaps the greatest triumph for the ALS came in Lufkin Foundry and Machine Co. v. Commissioner. n99 The case involved transfer pricing between the taxpayer and its WHTC. The taxpayer introduced evidence regarding the reasonableness of its marketing arrangements, and the Tax Court held for it on that basis. n100 The Commissioner appealed, citing the need to meet the ALS and arguing that no evidence regarding a taxpayer's internal operations could satisfy the standard on its own. n101 The Fifth Circuit held for the Commissioner, stating that -
No amount of self-examination of the taxpayer's internal transactions alone could make it possible to know what prices or terms unrelated parties would have charged or demanded. We think it palpable that, if the [arm's length] standard set by these unquestioned regulations is to be met, evidence of transactions between uncontrolled corporations unrelated to Lufkin must be adduced in order to determine what charge would have been negotiated for the performance of such marketing services. n102
The courts came a long way. A mere decade before Lufkin, the Frank court had declared that, contrary to the regulations, the ALS was only one of many possible criteria under section 482. n103 It then became the sole criterion, set by "unquestioned" regulations, and any attempt to establish transfer prices without referring to comparables was invalid. Little guidance, however, was given on what to do in the absence of comparables; and in light of his failed attempts in PPG Industries and Ross Gloves to use evidence that was not based on the ALS, the Commissioner may well have wondered whether his victory in Lufkin could turn out to be a pyrrhic one.
IV. DECLINE
The period between 1972 (when Lufkin was decided) and 1992 (when the proposed section 482 regulations were issued) can be described as a gradual realization by all parties concerned, but especially Congress and the IRS, that the ALS, firmly established by 1972 as the sole standard under section 482, did not work in a large number of cases, and in other cases its misguided application produced inappropriate results. The result was a deliberate decision to retreat from the standard while still paying lip service to it. This process, which began with the 1986 amendments to section 482, was exacerbated by the White Paper in 1988, and culminated in the proposed section 482 regulations of 1992, the temporary section 482 regulations of 1993, and the final section 482 regulations of 1994, essentially eliminated the traditional ALS for the great majority of section 482 cases.
The decline of arm's length can be illustrated by comparing major international section 482 cases decided prior to 1973, with major cases decided after 1973 and prior to 1993. Relative to the cases of the pre-1973 era, comparables were infrequently found in the later cases. n104 The causes for this decline in the application of
arm's length are complex, and are discussed more fully in section V. Part of the explanation, of course, is that after the courts accepted the ALS, cases where comparables could easily be found were less likely to get litigated. But the fact that litigation proliferated nonetheless suggests that in too many cases the ALS was not workable. In order to understand why, it is necessary to examine the major section 482 cases from the last two decades. n105
Consider first some major cases in which a comparable was found. R.T. French Co. v. Commissioner, n106 decided in 1973, illustrates one type of problem that the IRS encountered in applying arm's length. In French, the taxpayer, a U.S. subsidiary of a U.K. parent, negotiated a royalty rate for the parent's valuable patented process for producing instant mashed potatoes in 1946, for a 21 year period. This was before the profitability of the process was known and when there was an unrelated 49% minority shareholder in the parent. In 1960, when the minority shareholder had been bought out and the process had proved extremely profitable, the licensing contract was amended, but the royalty rate remained unchanged for the duration of the contract. n107
The Service argued that unrelated parties would have amended the royalty rate so that it would be commensurate with the income derived from the patent, and that the low rates of the contract resulted in constructive dividends to the U.K. parent, which should be subject to withholding. n108 The Tax Court disagreed. It held that the original 1946 contract was negotiated at arm's length because of the 49% minority shareholder in the U.K. parent: "The position of [the
minority shareholder] in the scheme of things in all likelihood assured the arm's-length character of the transaction." n109 Thereafter, the fact that profitability changed "in no way detracted from the reasonableness of the agreement when it was made," and there was no basis for a section 482 adjustment "so long as the "arm's length' test is met . . . There is no reason to believe that an unrelated party in [the parent's] position would have permitted petitioner to avoid its contractual obligations." n110
French illustrates the fallacy of relying entirely on the arm's length nature of the original contract, when the economic results are clearly disproportionate to the parties' expectations when that contract was signed. The Service found itself in the position of having to argue against the ALS it had espoused for so long, citing as its primary authority a case (Nestle) that was decided in the short interval between Frank and Oil Base, when the standard was not established as the main criterion for section 482. Not surprisingly, the Tax Court found this hard to accept after the Service had worked so hard to establish arm's length as the standard in all section 482 cases. n111 It took 13 years and the 1986 Tax Reform Act to reverse the result of French.
U.S. Steel Corp. v. Commissioner, n112 illustrates another type of problem that is recurrent in applying arm's length: the difficulty of comparing intragroup with outside transactions, even when the same product or service is involved. U.S. Steel owned a Liberian subsidiary, Navios, which it used to ship steel from Venezuela to the United States. The prices charged by Navios were set at a level that would make the steel price equal to the price of domestic steel manufactured by U.S. Steel, and the same price was charged by Navios for shipping for unrelated corporations, albeit at much lower quantities. n113 As a result Navios had high profits which were totally exempt from tax. In Tax Court, the Service successfully upheld its reallocation of $52 million in profits to the taxpayer. n114
The taxpayer appealed and the Court of Appeals for the Second Circuit reversed. The court held:
We are constrained to reverse because, in our view, the Commissioner has failed to make the necessary showings that justify reallocation under the broad language of section 482 . . . The Treasury Regulations provide a guide for interpreting this section's broad delegation of power to the Secretary, and they are binding on the Commissioner . . . [citing the ALS] This "arm's length" standard . . . is meant to be an objective standard that does not depend on the absence or presence of any intent on the part of the taxpayer to distort his income . . . We think it is clear that if a taxpayer can show that the price he paid or was charged for a service is "the amount which was charged or would have been charged for the same or similar services in independent transactions with or between unrelated parties" it has earned the right, under the Regulations, to be free from a section 482 reallocation despite other evidence tending to show that its activities have resulted in a shifting of tax liability among controlled corporations. n115
The court thus concluded that the only issue was the comparability of Navios' transactions with those of unrelated parties. It held that they were comparable, despite the differences in volume and the assurance of continued service as a result of the parties' relationship, and despite the taxpayer's ability to manipulate the prices of the steel so as to leave a larger profit to the tax exempt shipper. n116 The court stated that:
Attractive as this argument is in the abstract, it is a distortion of the kind of inquiry the Regulations direct us to undertake. The Regulations make it clear that if the taxpayer can show that the amount it paid was equal to "the amount which was charged . . . for the same or similar services in independent transactions" he can defeat the Commissioner's effort to invoke section 482 against him. n117
The court rejected the Commissioner's argument that transactions with "independent" parties are only relevant in a competitive market and not where U.S. Steel had a de facto monopoly, holding that this would impose an "unfair" burden on the taxpayer. Finally, it addressed the Tax Court's attempt to return to a reasonableness standard:
In at least one portion on Judge Quealy's opinion, however, it appears that the reason he relied upon to hold Navios' charges too high is not at all a matter involving the comparison of rates Steel paid to those paid by other steel companies. He said that what the rates paid by Steel must be measured against in order to see if a section 482 reallocation is justified is "what might be a reasonable charge for a continuing relationship involving the transportation of more than 10 million tons of iron ore per year." If this is indeed the inquiry, then the fact that other steel companies paid Navios the same rates Steel did is irrelevant . . . We are constrained to reject this argument. Although certain factors make the operations undertaken by Navios for Steel unique -- at one point, for example, Navios' ore carriers were the largest of their kind in the world -- the approach taken by the Tax Court would lead to a highly undesirable uncertainty if accepted. In very few industries are transactions truly comparable in the strict sense used by Judge Quealy . . . To say that Pittsburgh Steel was buying a service from Navios with one set of expectations about duration and risk, and Steel another, may be to recognize economic reality; but it is also to engraft a crippling degree of economic sophistication onto a broadly drawn statute, which -- if "comparable" is taken to mean "identical," as Judge Quealy would read it -- would allow the taxpayer no safe harbor from the Commissioner's virtually unrestricted discretion to reallocate. n118
Given the history of the ALS, it is hard to see how the court could have reached a different conclusion; the "reasonableness" standard used by the Tax Court had, by 1980, been officially pronounced dead for 16 years. n119 However, the Service's frustration at being thus hoist by its own petard is understandable, as is its subsequent attempt to reverse U.S. Steel in regulations. n120 The continued vitality and extensive effect of both French and U.S. Steel was illustrated in one of the major recent section 482 cases, Bausch & Lomb, Inc. v. Commissioner. n121 In Bausch & Lomb, the taxpayer licensed its unique process for manufacturing soft contact lenses to an Irish tax haven manufacturer and charged a royalty of five percent. The Irish subsidiary manufactured the lenses for $1.50 each and sold them to the taxpayer for $7.50 each-- the same price charged by unrelated parties with much higher manufacturing costs for the same product. n122
The Commissioner's proposed adjustments included eliminating the royalty (on the theory that B&L Ireland was a contract manufacturer assured of a market for its sales) but adjusting the income to give B&L Ireland its costs plus a profit of 20%. n123 The Tax Court held that these adjustments were an abuse of discretion. In a 86-page long opinion it first rejected the Service's "contract manufacturer" analysis on the grounds that there was no contractual obligation by B&L to purchase the product (as if such an obligation was needed between related parties!). n124 Then, the Tax Court held that the transfer price was correct on the basis of the unrelated sales, despite the economic differences (volume differences, integrated business differences, and the fact that B&L had much lower production costs than its competitors) between the alleged comparables:
We find that use of the comparable-uncontrolled-price method of determining an arm's-length price is mandatory. The third-party transactions identified by petitioner provide ample evidence that the $7.50 per-lens price charged by B&L Ireland is equal or below prices which would be charged for similar lenses in uncontrolled transactions . . . We place particular reliance on the Second Circuit's opinion in U.S. Steel . . . To posit that B&L, the world's largest marketer of soft contact lenses, would be able to secure a more favorable price from an independent manufacturer who hoped to establish a long-term relationship with a high volume customer may be to recognize economic reality, but to do so would cripple a taxpayer's ability to rely on the comparable uncontrolled price method in establishing transfer pricing by introducing to it a degree of economic sophistication which appears reasonable in theory, but which defies quantification in practice. n125
The court then rejected the argument from disparities of volume and from the taxpayer's lower costs, holding that the $7.50 price was "a market price" and therefore the taxpayer had "earned the right to be free of adjustment" under U.S. Steel. n126 In the second part of its opinion, the Tax Court applied French and held that the subsequent profitability of the intangible was irrelevant for establishing a royalty rate, even though the licensing agreement in Bausch & Lomb (unlike the one in French) was terminable at will. n127 Accordingly, the court rejected the taxpayer's 5% and the Service's 27-33% rates, and, since there were predictably no comparables, arbitrarily set its own rate at 20%. n128
The Commissioner appealed and the Second Circuit affirmed. n129 It admitted that "the Commissioner's position is not without force," but held that under the regulations and the ALS, applying the comparable uncontrolled price method was mandatory, even though economic reality may differ:
The position urged by the Commissioner would preclude comparability precisely because the relationship between B&L and B&L Ireland was different from that between independent buyers and sellers operating at arm's length. This, however, will always be the case when transactions between commonly controlled entities are compared to transactions between independent entities. n130
The IRS position would, in effect, "nullify" the CUP method. The court thus felt compelled to affirm that, under the regulations, as long as the ALS governed, uneconomic results would have to be upheld even though transactions between related parties cannot realistically be compared to arm's length transactions. But if that is the case, why should the ALS apply? n131
French, U.S. Steel and Bausch & Lomb illustrate a major problem in applying the ALS: if inexact comparables are used because the market had changed, n132 or because the relationship between the parties makes for a different nature of transaction, n133 the ALS leads to results that are completely unrealistic as an economic matter. n134 Why, then, were the courts in these cases so avid to find that comparables were controlling? The regulations and precedents applying the ALS provide only partial answers. The main reason was the courts' stated awareness of the morass they would be getting into by seeking to determine transfer prices in the absence of comparables. Decisions (not based on comparables) that cover hundreds of pages only to reach unpredictable and arbitrary results seem to justify this conclusion.
Cadillac Textiles v. Commissioner n135 is an early example of the courts' predicament in a domestic section 482 case. The case involved commissions paid by the taxpayer to a related entity for weaving. The taxpayer relied on the comparability of these commissions to those paid to unrelated entities. n136 The Tax Court, in a memorandum opinion, held that the alleged comparables were dissimilar because of volume differences and because there was no commitment for a continuing relationship -- precisely the same factors that should have been applied in U.S. Steel and Bausch & Lomb. n137 However, having properly struck down the comparables, and having rejected the Commissioner's allocation as "heavy handed," the court was faced with the necessity of making an arbitrary determination of the transfer price:
Where some allocation is justified, if the respondent fails to follow a reasonable method in making such allocation, the Court must substitute its judgment . . . Unfortunately, this places upon the Court the burden of decision without having all the facts . . . Looking to the combined profits of both enterprises, and applying factor, it is the Court's conclusion that there should be allocated to the petitioner under section 482 . . . the sum of $100,000 [instead of $193,045.37, as proposed by the Commissioner]. n138
The Tax Court thus applied a "profit split," the method later advocated by the White Paper n139 and ultimately specified in the current regulations. n140 However, as the round figures indicate, n141 the result was largely arbitrary. In the absence of any guidance in the regulations, the court had little choice. This explains why other courts were so reluctant to abandon any comparable, if one could be found. n142
WORKING PAPER NO. 92 SEPTEMBER 2007
JOHN M. OLIN CENTER FOR LAW & ECONOMICS
WORKING PAPER NO. 07-017
THE RISE AND FALL OF ARM’S LENGTH:
A STUDY IN THE EVOLUTION OF
U.S. INTERNATIONAL TAXATION
REUVEN S. AVI-YONAH
THE SOCIAL SCIENCE RESEARCH NETWORK ELECTRONIC PAPER COLLECTION:
ssrn.com/abstract=1017524
THIS PAPER CAN BE DOWNLOADED WITHOUT CHARGE AT:
MICHIGAN JOHN M. OLIN WEBSITE
HTTP://WWW.LAW.UMICH.EDU/CENTERSANDPROGRAMS/OLIN/PAPERS.HTM
THE RISE AND FALL OF ARM'S LENGTH: A STUDY IN THE EVOLUTION OF U.S. INTERNATIONAL TAXATION
Reuven S. Avi-Yonah1
I. INTRODUCTION
In 1988, the U.S. Treasury Department published a study of intercompany pricing, the "White Paper," that included the following endorsement of the so-called arm's length standard (henceforth, the "ALS") for examining the reasonableness of transactions between related parties for tax purposes:
The arm's length standard is embodied in all U.S. tax treaties; it is in each major model treaty, including the U.S. Model Convention; it is incorporated into most tax treaties to which the United States is not a party; it has been explicitly adopted by international organizations that have addressed themselves to transfer pricing issues; and virtually every major industrial nation takes the arm's length standard as its frame of reference in transfer pricing cases. . . The United States should continue to adhere to the arm's length standard. n1
What is the ALS, and why did the Treasury seek to defend it in these terms? The problem for which the ALS attempts to provide the solution may be illustrated by a simple example. Suppose that a product (e.g., computers) is manufactured by a corporation in country A, and then sold to a wholly owned subsidiary of the manufacturer in country B, which proceeds to resell it to unrelated customers. In this common situation, the taxable profit of the subsidiary is determined by three factors: (1) the price at which it resells the computers to the unrelated customers, (2) its expenses other than cost of goods sold, and (3) the price which it pays its parent corporation for the computers. The first two of these factors are governed by market forces outside the control of the parent or the subsidiary. However, because the parent controls the subsidiary, the third factor (the price for which the manufacturer sells the computers to the reseller, or the "transfer price") is wholly within the control of the related parties. Accordingly, the potential for abuse arises because the related parties will seek to increase aftertax profits by manipulating the transfer price. If the effective tax rate in the manufacturer's country is higher, the price will be set as low as possible so as to channel all taxable profit to the reseller. Conversely, if the effective tax rate in the reseller's jurisdiction is higher, the transfer price will be as high as possible, so as to eliminate any taxable profit of the reseller and concentrate the entire profit in the hands of the manufacturer. But for tax considerations, the affiliated parties do not care what the transfer price is, since it merely re-allocates profits within the affiliated group.
Given these facts, it is understandable that transfer pricing manipulation is one of the most common techniques of tax avoidance. This is especially true in the international sphere, as there are great differences in effective tax rates among jurisdictions. Indeed, some economists have argued that the ability to manipulate transfer prices is a major reason for the existence of multi-national enterprises, which are groups of affiliated corporations operating in more than one country. n2 It is estimated that trading among such affiliates encompasses about one third of world manufacturing
trade, n3 and that percentage is constantly increasing. The transfer pricing problem is, therefore, one of the major international tax policy challenges for the coming century.
The ALS, as traditionally conceived, responds to the transfer pricing problem by seeking to determine whether transactions between related taxpayers reflect their "true" tax liability by comparing them to similar transactions
1 Irwin I. Cohn Professor of Law and Director, International Tax LLM Program, the University of Michigan Law School. The first part of this article is based on an article by the same name in the Virginia Tax Review, 15 Va. Tax Rev. 89 (1995).
between unrelated taxpayers dealing at arm's length. This was the definition of the ALS that was understood when the White Paper was published in 1988. n4 However, as is reflected in the defensive tone of the Treasury's pronouncements, the White Paper was written at a time when this traditional conception of the ALS was coming under increasing criticism and suggestions for its replacement were rampant. In particular, the legislative history of the Tax Reform Act of 1986 indicates that Congress had mandated that the Treasury Department reevaluate the continued viability of the ALS. n5 The White Paper was issued in response to this mandate. However, despite Treasury's findings, the process begun by the Congressional mandate eventually resulted in the abandonment of the ALS, as it was understood in 1988. Its replacement, in the United States and elsewhere, was a broader and more flexible method of determining the allocation of taxable profits between related entities. Although this broader method may also be characterized as 'arm's length," it is a different type of arm's length standard than the one defended by the White Paper. Indeed, the White Paper itself played a major part in the demise of the traditional ALS.
This Article explores the process by which the traditional ALS became the dominant method for determining transfer prices for tax purposes, the reasons for its eventual downfall, and methods that can be used in its place. First, a few definitional points are in order. The traditional ALS refers primarily to a process by which the transfer price between affiliated taxpayers is determined by using comparables -- either of the same product sold by one of the affiliated parties to an unrelated party, of the same product bought by an affiliated party from an unrelated party, or of the
same product sold between two parties unrelated to the affiliated parties and to each other. This method of comparison is usually called the "comparable uncontrolled price," or CUP method. n6 In addition, the traditional ALS also encompasses two methods that likewise rely on comparables, but do not require a transaction in the same product. Under the "cost plus" method, the transfer price is determined by comparing the manufacturer to a similar entity (under a more relaxed standard of comparability than under the CUP method), which is dealing with unrelated parties, and allocating to the manufacturer the costs borne by the unrelated comparable, plus the unrelated party's profit margin. n7 The "resale price" method is identical to the cost plus method except that it applies to the reseller rather than the manufacturer. n8
The ALS, as traditionally conceived, is frequently contrasted with "unitary", "global" or "formulary apportionment" methods, such as those used by some states. Here the entire profit of an affiliated group is allocated among its constituent entities by means of a formula (e.g., based on each entity's assets, payroll and sales). n9 The major difference between the ALS and the formulary method is that the ALS starts with treating each entity in an affiliated group as a separate taxpayer, hypothetically dealing with each other entity in the group at arm's length. Conversely, the formulary approach starts with the entire affiliated group as one unitary enterprise.
This article proposes that despite the common practice of contrasting the ALS and the formulary methods of dealing with the transfer pricing problem, they are actually not dichotomous. Instead, they form the two extreme ends of a continuum. n10 The cost plus and resale price methods, which are included in the traditional ALS, already represent one step away from pure separate treatment of each entity in the group. This is because they involve taking the group's profits as a whole, subtracting the profit margin allocable to the manufacturer or the reseller on the basis of the comparables, and then allocating the residual profit to the other party.
Next on the continuum comes the "comparable profit method" (CPM), which is a major innovation of the recent regulations under Section 482 of the Internal Revenue Code ("the Code"), under which the profit of either the manufacturer or the reseller is set by comparing it to the average profit earned by a very broad group of corporations operating in the same or a similar industry. n11 The standard of comparison in this case is very relaxed, and one may indeed regard the CPM as a type of formula designed to ensure that the profits of the related party do not fall outside a reasonable range of profit margins earned by other corporations which are not truly comparable with the related party. n12 As will be shown below, the CPM falls outside the traditional or narrow definition of the ALS, but it still uses some form of comparables.
Even further along on the continuum of possible methods of determining transfer prices is the "profit split" method. This method was first introduced in the 1988 White Paper. n13 Here, the allocation of profits is determined in two steps. First, the functions performed by each of the related parties are analyzed and a market rate of return is allocated to each function on the basis of comparables. n14 Then, the residual profit is split between the related parties on the basis of a formula, without using comparables. n15 The profit split method is very close to the pure formulary apportionment end of the transfer pricing continuum, because it starts with the enterprise as a whole and allocates the profits in a formulary fashion. The only differences are that some of the profits are allocated on the basis of
comparables, and that the formula used to split the rest is more flexible than the traditional assets, payroll and sales-based formula used by the states.
Consequently, the words "arm's length" can be used in two ways to refer to two different possible ranges of solutions to the transfer pricing problem. Under the traditional or narrow definition, "arm's length" refers to methods of determining transfer prices by using comparables, and encompasses only the CUP, cost plus and resale price methods. n16 On the other hand, "arm's length" can also be used to refer to any method of determining transfer prices that reaches results (i.e., a profit allocation) that are the same as those that would have been reached between unrelated parties. In this latter, broader sense, "arm's length" can be used to refer to the entire transfer pricing continuum, because even pure formulary apportionment may result in the same profit allocation as that which unrelated parties would have reached.
The first four parts of this Article analyze the origins, rise, decline and fall of the traditional or narrow ALS, as applied to international transactions between related parties under section 482 of the Code and its predecessors. n17 The analysis will show that despite the Treasury's affirmation of the traditional ALS in its 1988 White Paper, n18 this narrow conception of the standard was already obsolete by 1988 in the large majority of cases, insofar as the United States' approach to international taxation was concerned. Subsequent developments, especially the recently issued proposed, temporary and final regulations under section 482 of the Code, merely strengthened the nails in its coffin. The last section of the Article will focus on the following questions: (1) why has the traditional ALS proven so inadequate, (2) what methods are now used to supplement it, and (3) what additional improvements can be made in resolving the transfer pricing problem?
II. ORIGINS
Transfer pricing manipulation is one of the simplest ways to avoid taxation. It is, thus, not surprising that the predecessors of section 482 of the Code, legislation designed to combat such manipulation, date back almost as far as the modern income tax itself. They originated in Regulation 41, Articles 77 and 78, of the War Revenue Act of 1917, which gave the Commissioner authority to require related corporations to file consolidated returns "whenever necessary to more equitably determine the invested capital or taxable income." n19 The earliest direct predecessor of section 482 of the Code dates to 1921, when the Commissioner was authorized to consolidate the accounts of affiliated corporations "for the purpose of making an accurate distribution or apportionment of gains, profits, income, deductions, or capital between or among such related trades or business." n20 This legislation was enacted, in part, because of the tax avoidance opportunities afforded by possessions corporations, which were ineligible to file consolidated returns with their domestic affiliates. n21 Thus, the problem of international tax avoidance through related corporations was one of the original motives for the enactment of the earliest predecessor of section 482 of the Code. n22
In 1928, the provision was removed from the consolidated return provisions (which were eliminated) and expanded to read as follows:
Section 45. Allocation of Income and Deductions.
In any case of two or more 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 Commissioner is authorized 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 of such trades or businesses. n23
This language is almost identical to section 482 of the Code as it read prior to the Tax Reform Act of 1986. n24
The legislative history of Section 45 of the Code, in its entirety, is as follows:
Section 45 is based upon section 240(f) of the 1926 Act, broadened considerably in order to afford adequate protection to the Government made necessary by the elimination of the consolidated return provisions of the 1926 Act. The section of the new bill provides that the Commissioner may, in the case of two or more trades or businesses owned or controlled by the same interests, apportion, allocate, or distribute the income or deductions between or among them, as may be necessary in order to prevent evasion (by the shifting of profits, the making of fictitious sales, and other methods frequently adopted for the purpose of "milking"), and in order clearly to reflect their true tax liability. n25
Senator Gifford stated on the floor that "what worries us is that any two of these corporations can get together and take advantage of questionable sales to each other to get deductions." n26 Senator Green replied that "Section 45. . .permits the bureau to allocate the income where it belongs. It. . .does not permit these corporations to place the expenses just where they want to put them." n27
Congress' focus in enacting the predecessor of section 482 of the Code was, thus, to prevent tax evasion and to clearly reflect "true" tax liability. However, there was no discussion of what the standard of "true" liability was. In 1935, the Service issued regulations under section 45 of the Code, which stated that the following standards would govern its application:
(b) Scope and purpose. -- The purpose of section 45 is to place a controlled taxpayer on a tax parity with an uncontrolled taxpayer, by determining, according to the standard of an uncontrolled taxpayer, the true net income from the property and business of a controlled taxpayer. The interests controlling a group of controlled taxpayers are assumed to have complete power to cause each controlled taxpayer so to conduct its affairs that its transactions and accounting records truly reflect the net income from the property and business of each of the controlled taxpayers. If, however, this has not been done, and the taxable net incomes are thereby understated, the statute contemplates that the Commissioner shall intervene, and, by making such distributions, apportionments, or allocations as he may deem necessary of gross income or deductions, or of any item or element affecting net income, between or among the controlled taxpayers constituting the group, shall determine the true net income of each controlled taxpayer. The standard to be applied in every case is that of an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer. n28
Thus, the ALS, under U.S. tax law, was born. This section of the regulations, in very similar language, remained in effect under section 482 of the Code until the recently-issued modifications. n29
However, the regulations were not modified to explain what methods should be used to arrive at an arm's length price until 1968. Previously, this task was left to the courts.
III. RISE
The early cases applying section 45 of the Code did not mention the ALS. Instead, they focused on the statutory terms "evasion of taxes" and "clear reflection of income." n30 It was not until the 1935 regulations were issued, that the arm's length nature of the transaction between related parties came into focus. n31 However, for a long period thereafter, the courts applied a wide variety of standards to determine what constituted a transaction that clearly reflected the taxpayer's income. n32
Seminole Flavor Co. v. Commissioner n33 is a good example of these early cases. The issue was whether transactions between a corporation and a partnership organized to market the corporation's products should be adjusted to shift income from the partnership to the corporation. n34 The Tax Court, in holding for the taxpayer, stated that the arm's length nature of the transaction should be determined by whether it was "fair and reasonable," and that the question of whether unrelated parties would have entered into the same agreement was irrelevant. n35 It then went on to hold that-
The commission fixed does not appear to be out of line with petitioner's own experience [i.e., its expenses for marketing prior to forming the partnership]. On this basis the transaction would seem to be fair and entitled to classification as an arm's length transaction. Whether any such business agreement would have been entered into by petitioner with total strangers is wholly
problematical. n36
Other cases from the same period show similar tendencies to apply a variety of standards and to ignore the question of whether comparables exist. The standards employed included whether the transaction was "fair" on the basis of the functions performed by the parties; n37 whether the related party paid "full fair value;" n38 and whether the prices paid would have been considered "fair and reasonable" in the trade. n39
On the other hand, in Hall v. Commissioner, n40 a somewhat later Tax Court case, a comparable was used to establish the arm's length price. Hall involved sales to a Venezuelan marketing affiliate at cost plus 10% (a price which amounted to a discount of over 90% from the regular list price) when unrelated distributors of the same product received a discount of only 20%. n41 The Tax Court held that gross income had been arbitrarily shifted to the Venezuelan corporation, and that the Commissioner's allocation "reflected Hall's income as if he had been dealing with unrelated parties. That, of course, was the purpose of the statute." n42
The early cases, thus, appear inconsistent in their application of arm's length. The question of whether the ALS should always be applied was finally raised in Frank v. International Canadian Corporation, n43 decided in 1962, which was 27 years after the initial promulgation of the standard in regulations. n44 The case involved transfer prices for sales of chemicals by a U.S. parent to a Western Hemisphere Trade Corporation (WHTC). The parties stipulated that the sales reflected a "reasonable price and profit" between the two corporations, and the District Court found that the Commissioner had thereby stipulated himself out of court on the section 45 issue. n45 The Commissioner appealed, arguing that the District Court used the "reasonable return" standard instead of the proper arm's length standard. The Court of Appeals for the Ninth Circuit affirmed in the following terms:
We do not agree with the Commissioner's contention that "arm's length bargaining" is the sole criterion for applying the statutory language of section 45 in determining what the "true net income" is of each "controlled taxpayer." Many decisions have been reached under section 45 without reference to the phrase "arm's length bargaining" and without reference to Treasury Department Regulations and Rulings which state that the talismanic combination of words-"arm's length"-is the "standard to be applied in every case." For example, it was not any less proper for the District Court to use here the "reasonable return" standard than it was for other courts to use "full fair value," "fair price, including a reasonable profit," "method which seems not unreasonable," "fair consideration which reflects arm's length dealing," "fair and reasonable," "fair and reasonable" or "fair and fairly arrived at," or "judged as to fairness," all used in interpreting section 45. n46
Thus, the Ninth Circuit essentially invalidated the regulations, and held that it was not necessary to establish what unrelated taxpayers would have done in order to clearly reflect the "true" income and correct tax liability of related parties. n47
One can only speculate as to what would have happened had the courts been left free to develop their own definition of "fair" or "reasonable" without having to adhere to the ALS. n48 During the same era as the Frank decision, major developments were taking place in Washington that would ultimately lead to the establishment of standards under section 482 of the Code (as section 45 of the Code had now been renumbered). The early 1960's were marked by a rise in concern on the part of the Treasury that domestic corporations were achieving deferral through transfer pricing practices with tax haven affiliates, and that foreign corporations were avoiding taxes altogether by artificially lowering the profits of their U.S. affiliates. The Treasury contended that section 482 of the Code was not effectively protecting the U.S. tax jurisdiction. n49
Congress responded with legislation intended to stop these perceived abuses. Section 6 of H.R. 10650, as introduced by the House Committee on Ways and Means, provided for a new Code section, section 482(b). n50 Under the House proposal, in section 482 cases involving international transfers of tangibles, unless the taxpayer could demonstrate an arm's length price (defined, in accordance with the traditional view, as a price based on a matching or comparable adjustable transaction), or unless the taxpayer and the IRS could agree on a different method, the transfer price would be determined under a formula based on assets, compensation, and expenses related to the transferred tangible property. n51
The House Report explained the intent of section 6 of the bill as follows:
Present law in section 482 authorizes the Secretary of the Treasury to allocate income between related organizations where he determines this allocation is necessary "in order to prevent evasion of taxes or clearly to reflect the income of any such organizations." This provision appears to give the Secretary the necessary authority to allocate income between a domestic parent and its foreign subsidiary. However, in practice the difficulties in determining a fair price under the provision severely limit the usefulness of this power especially where there are thousands of different transactions engaged in between a domestic company and its foreign subsidiary.
Because of the difficulty in using the present section 482, your committee has added a subsection to this provision authorizing the Secretary of the Treasury or his delegate to allocate income in the case of sales or purchases between a U.S. corporation and its controlled foreign subsidiary on the basis of the proportion of the assets, compensation of the officers and employees, and advertising, selling and promotion expenses attributable to the United States and attributable to the foreign country or countries involved. This will enable the Secretary to make an allocation of the taxable income of the group involved (to the extent it is attributable to the sales in question) whereas in the past under the existing section 482 he has attempted only to determine the fair market sales price of the goods in question and build up from this to the taxable income -- a process much more difficult and requiring more detailed computations than the allocation rule permitted by this bill.
The bill provides, however, that the allocation referred to will not be used where a fair market price for the product can be determined. It also provides that other factors besides those named can be taken into account. In addition, it provides that entirely different allocation rules may be used where this can be worked out to mutual agreement of the Treasury Department and the taxpayer. n52
Predictably, the taxpayer community responded by lobbying Congress to remove section 6 from H.R. 10650, claiming that the regulatory authority under section 482 of the Code was sufficient to curb abuses. n53 Their efforts were rewarded in the Senate version of the bill, which omitted the section. In conference, the House receded. The Conference Report states the reasons as follows:
The conferees on the part of both the House and the Senate believe that the objectives of section 6 of the bill as passed by the House can be accomplished by amendment of the regulations under present section 482. Section 482 already contains broad authority to the Secretary of the Treasury or his delegate to allocate income and deductions. It is believed that the Treasury should explore the possibility of developing and promulgating regulations under this authority which would provide additional guidelines and formulas for the allocation of income and deductions in cases involving foreign income. n54
Treasury took three years to respond to this invitation. n55 In the meantime, however, significant new developments were taking place in the courts. Oil Base, Inc. v. Commissioner n56 represented a classic case of the application of the ALS to sales commissions paid by a U.S. corporation to its Venezuelan marketing affiliate. These commissions were about twice the amount that the same corporation had paid its previous unaffiliated distributor of the same product in Venezuela, and were twice the amount it was currently paying to distributors in other countries. The taxpayer, however, argued that the Frank standard should be applied instead of arm's length, and that since it still retained higher profits from export sales to Venezuela even after the double commission than from domestic sales, the commissions were "reasonable" under Frank. The Tax Court, in a memorandum decision, disagreed. It held that: It is unnecessary for us to decide whether the sole standard in cases under section 482 is one of an amount which would be arrived at in arm's
length transactions between unrelated parties. The commissioner has been given much latitude in his use of section 482 when necessary to prevent the evasion of Federal income tax by shifting of profits between taxpayers subject to common control. The burden is on petitioner to show error in respondent's allocation. . .There is no evidence to show that the percentage return retained by petitioner on domestic sales would represent a reasonable return on export sales. There is likewise no evidence to show that the amount of commissions and discounts paid to Oil Base, Venezuela, represented a reasonable amount, a fair amount, or an amount which would meet any of the other criteria referred to by the Court in Frank. Certainly the fact that these commissions are almost double those paid by petitioner to unrelated persons in arm's length transactions is evidence that they were not fair and reasonable. n57
Presumably, the taxpayer in Oil Base was encouraged to litigate, despite the egregious facts, because appeal lay to the Ninth Circuit. On appeal, the taxpayer, citing Frank, repeated the argument that the Commissioner erred in applying a standard of arm's length bargaining that was not in the statute. The court of appeals, however, held that the application of arm's length was appropriate:
We cannot agree. Where, as here, the extent of the income in question is largely determined by the terms of business transactions entered into between two controlled corporations it is not unreasonable to construe "true" taxable income as that which would have resulted if the transactions had taken place upon such terms as would have applied had the dealings been at arm's length between unrelated parties.
Frank v. International Canadian Corporation [308 F.2d. 520 (9th Cir. 1962)], did not hold that the arm's length standard established by regulation was improper. It held that it was not "the sole criterion" for determining the true net income of each controlled taxpayer. However, permissible departure from the regulation's arm's length standard was, under the facts of that case, very narrowly limited and the holding has no application to the facts before us.
We conclude that the arm's length bargaining standard was properly applied pursuant to regulation. Hall v. Comm'r, 294 F.2d 82 (5th Cir. 1961). n58
In a footnote, the Ninth Circuit specified that Frank only applied in cases where (a) there was no evidence of an arm's length price, and (b) because of the "complexity of the circumstances . . . it would have been difficult for the court to hypothesize an arm's length transaction." n59
It is difficult to reconcile this reading of Frank with the list of possible standards given by the Frank panel four years earlier, which relegated the ALS to a very minor role. In effect, the Ninth Circuit overruled Frank, holding that the ALS must be applied not only when comparables exist, but also when they do not exist, as the court can "hypothesize" a comparable. This abrupt reversal was very likely influenced by the egregious facts of Oil Base and by the difficulties in applying a "reasonableness" standard. It also seems likely that the Tax Court and the Ninth Circuit were influenced by the perception of widespread abuse as a result of the Washington hearings on the Revenue Act of 1962, and by the endorsement of the Commissioner's powers in the legislative history of that Act. n60
The Commissioner's victory in Oil Base was followed by a series of cases which applied the ALS, although not always to the Commissioner's satisfaction. In Johnson Bronze Company v. Commissioner, n61 the taxpayer formed an international marketing subsidiary in Panama for the majority of its foreign sales accounts. The Commissioner reallocated 100% of the subsidiary's income to the parent under section 482 of the Code. The Tax Court held that the 100% allocation was arbitrary and unreasonable. n62 In determining the proper allocation, the court held that "the standard to be applied in every case is that of an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer." n63 In a footnote, the court referred to Frank as requiring a choice between the "reasonable" and "arm's length" standards, but stated that "on this subject we shall only say that, on the facts of this case, the only reasonable price charged by petitioner would be one which would have been arrived at if the parties were at arm's length." n64 The court then held that the allocation should be based on the prices charged by unrelated parties that bought the same products from the taxpayer for resale in foreign markets. n65
Eli Lilly & Company v. Commissioner, n66 the first of several section 482 cases involving pharmaceutical manufacturers, involved transfer pricing between Eli Lilly and Company (Lilly) and its subsidiary which qualified as a WHTC. The Commissioner based his reallocation on the profit earned by Lilly on sales to domestic distributors, arbitrarily divided in half to reflect volume discount. The Claims Court agreed, holding that Lilly's contention that it should be allowed to benefit from the tax subsidy to Western Hemisphere trade corporations "would require the court to ignore the provisions of Treas. Reg. 1.482-1," requiring the application of the ALS. This is because if the subsidiary were unrelated it would not have been able to retain all the profit on the sales. n67
Lilly then cited Frank, in arguing that its allocation was motivated by business purposes and was "fair" and "reasonable," and thus that the ALS should not control. The Court of Claims disagreed:
The Ninth Circuit has since indicated that only a very narrow departure from the arm's length standard was allowed in the particular circumstances of Frank [citing Oil Base]. Moreover, even accepting Eli Lilly's interpretation that Frank establishes a criterion of a fair and reasonable price, such a price can best be determined by hypothesizing to an arm's length transaction. The thrust of section 482 is to put controlled taxpayers on a parity with uncontrolled taxpayers. Consequently, any measure such as "fair and reasonable" or "fair and fairly arrived at" must be defined within the framework of "reasonable" or "fair" as among unrelated taxpayers. Simply because a price might be considered "reasonable" or "fair" as a business incentive in transactions among controlled corporations, does not mean that unrelated taxpayers would so consider it. Thus, even if the arm's-length standard is not the sole criterion, it is certainly the most significant yardstick. n68
The problem, as the taxpayer pointed out, is that in the absence of any comparables, it is unclear how the arm's length price should be "hypothesized." To this question, the Court of Claims gave no answer. It rejected the comparables offered by Lilly (bulk sales to government agencies) because the market was not comparable, yet
accepted the revenue agent's arbitrary decision to cut the profits of the Western Hemisphere trade affiliates by half because the results were "reasonable." n69 When examining the outcome, it is hard to see what relevance the ALS had to the court's ultimate determination. n70
In 1968, the regulations under section 482 of the Code were finalized, and thereafter, they formed the starting point of the analysis in the courts. n71 With few changes, these regulations applied to transfer pricing until the temporary regulations became effective in April, 1993. n72 Despite the invitation in the legislative history of the 1962 act, the Treasury made no attempt to devise "formulas" to apply section 482 of the Code. n73 Instead, for the first time, the regulations attempted to establish rules for applying the ALS to specific types of transactions, but with different degrees of specificity. n74 For services, the regulations merely recited the ALS without any guidance as to its application in the absence of comparables. n75 For intangibles, the regulations contemplated a failure to find comparables. They list twelve factors to be taken into account, but without establishing any priority or relative weight among them. n76
The greatest detail was given for transfers of tangible property. Treasury Regulation section 1.482-2(e) described the three methods that should be used in determining an arm's length price: the comparable uncontrolled price ("CUP") method, the resale price method, and the cost plus method, in that order of priority. n77 All
three methods relied on finding comparable transactions, either directly or by reference to appropriate markups. n78 In the absence of comparables, the regulations stated that:
Where none of the three methods of pricing . . . can reasonably be applied under the facts and circumstances as they exist in a particular case, some appropriate method of pricing other than those described in subdivision (ii) of this subparagraph, or variations on such methods, can be used. n79
The courts were, therefore, left free to determine their own "fourth methods" in the absence of comparables.
These regulations effectively ensured that the courts would apply the ALS. A 1970 case, Woodward Governor Company v. Commissioner, n80 may have represented the last challenge to the standard. The taxpayer organized foreign subsidiaries to act as marketing agents for overseas sales of aircraft parts. The Commissioner applied the resale
price method in reallocating income to the taxpayer. The taxpayer argued that the regulations were invalid in their requirement that the ALS should govern all cases. In the alternative, they argued that if the ALS should be applied, the CUP method should be used on the basis of sales of the same parts to General Electric. The Tax Court accepted the latter argument and therefore did not reach the former. n81
In the meantime, other courts were finding that the ALS must be applied in section 482 cases. Baldwin-Lima-Hamilton Corp. v. United States n82 involved transfer pricing between the taxpayer and its WHTC subsidiary. The Commissioner reallocated all of the income of the subsidiary to the taxpayer. The district court held that the reallocation was arbitrary, and upheld the taxpayer's allocation based on pricing studies using assumptions that were "tipped in the taxpayer's favor," by using inappropriate comparables. n83 The court of appeals reversed in part, and remanded to the district court for partial re-allocation on the basis of the ALS, stating that the district court "should reject those aspects of the [taxpayer's] theories which do not meet the arm's length standard." n84
United States Gypsum Co. v. United States, n85 involved two section 482 issues: shipping fees paid by the taxpayer to its Panamanian subsidiary and transfer pricing for goods sold by the taxpayer to its WHTC. The district court held for the taxpayer on both issues. On the shipping issue, it held that the amounts were "reasonable and . . . equal to an arm's length charge" because they were "within the range" of unrelated party prices (based on comparables). n86 On the transfer pricing issue, the district court held that even though the prices were arbitrarily set to shift income to the WHTC, on the basis of cases like Frank and Polak's Frutal which allowed similar mark ups, the prices were "not unreasonable" (which the district court considered to be automatically equivalent to arm's length). n87
The Court of Appeals for the Seventh Circuit affirmed the first holding and reversed the second. n88 On the shipping issue, the Seventh Circuit had considerable misgivings as to whether the alleged comparables were indeed comparable, and whether unrelated parties would not have adjusted the terms of the contract once the profits that the shipping subsidiary was making became clear, but affirmed under a "clearly erroneous" standard. n89 On the transfer pricing issue, the Seventh Circuit reversed, rejecting the district court's reliance on Frank and its predecessors and its application of a "reasonableness" standard:
We do not consider the cited cases helpful in deciding whether, as a matter of fact, USG's prices to [the WHTC] were the same as would have been reached in arm's length dealing. Insofar as these cases support a proposition that there may be "reasonable" prices, different from those which would have been reached in arm's length dealing, which will result in clearly reflecting the income of controlled taxpayers, we respectfully decline to follow them. n90
Thus, the Seventh Circuit held, as argued by the Commissioner, that applying the ALS was mandatory in all section 482 cases. n91 Two other cases from approximately the same period illustrate the courts' determination to adhere to the ALS even when the Commissioner attempted to apply a different standard. PPG Industries, Inc. v. Commissioner n92 involved the application of section 482 of the Code to a Swiss marketing subsidiary of a U.S. manufacturer of glass, paint, and chemical products. The Tax Court held for the taxpayer on the grounds that (a) the Commissioner's original allocation, based on the Source Book of Statistics of Income, was arbitrary and did not meet the ALS; n93 (b) most of the taxpayer's sales were at arm's length prices based on comparables; n94 and (c) the Commissioner's comparable for the remaining sales was inappropriate, and the taxpayer's allocation was "fair" and "reasonable" and therefore met the arm's-length standard. n95
Ross Glove Co. v. Commissioner n96 represents the application of section 482 of the Code to an inbound transaction, involving the sale of sheepskins to the taxpayer by a Bahamian corporation which also provided sewing services. The Commissioner attempted to hold the taxpayer to its representations to the Philippine authorities, regarding the markup on its costs for currency control purposes. The Tax Court rejected this argument and held that "there is nothing in section 482 or the regulations thereunder to indicate that the arm's-length standard of section 482 is to be ignored simply because of representations made in foreign countries." n97 The court then determined the transfer price on the basis of arbitrary adjustments to an approximate comparable. n98
Finally, perhaps the greatest triumph for the ALS came in Lufkin Foundry and Machine Co. v. Commissioner. n99 The case involved transfer pricing between the taxpayer and its WHTC. The taxpayer introduced evidence regarding the reasonableness of its marketing arrangements, and the Tax Court held for it on that basis. n100 The Commissioner appealed, citing the need to meet the ALS and arguing that no evidence regarding a taxpayer's internal operations could satisfy the standard on its own. n101 The Fifth Circuit held for the Commissioner, stating that -
No amount of self-examination of the taxpayer's internal transactions alone could make it possible to know what prices or terms unrelated parties would have charged or demanded. We think it palpable that, if the [arm's length] standard set by these unquestioned regulations is to be met, evidence of transactions between uncontrolled corporations unrelated to Lufkin must be adduced in order to determine what charge would have been negotiated for the performance of such marketing services. n102
The courts came a long way. A mere decade before Lufkin, the Frank court had declared that, contrary to the regulations, the ALS was only one of many possible criteria under section 482. n103 It then became the sole criterion, set by "unquestioned" regulations, and any attempt to establish transfer prices without referring to comparables was invalid. Little guidance, however, was given on what to do in the absence of comparables; and in light of his failed attempts in PPG Industries and Ross Gloves to use evidence that was not based on the ALS, the Commissioner may well have wondered whether his victory in Lufkin could turn out to be a pyrrhic one.
IV. DECLINE
The period between 1972 (when Lufkin was decided) and 1992 (when the proposed section 482 regulations were issued) can be described as a gradual realization by all parties concerned, but especially Congress and the IRS, that the ALS, firmly established by 1972 as the sole standard under section 482, did not work in a large number of cases, and in other cases its misguided application produced inappropriate results. The result was a deliberate decision to retreat from the standard while still paying lip service to it. This process, which began with the 1986 amendments to section 482, was exacerbated by the White Paper in 1988, and culminated in the proposed section 482 regulations of 1992, the temporary section 482 regulations of 1993, and the final section 482 regulations of 1994, essentially eliminated the traditional ALS for the great majority of section 482 cases.
The decline of arm's length can be illustrated by comparing major international section 482 cases decided prior to 1973, with major cases decided after 1973 and prior to 1993. Relative to the cases of the pre-1973 era, comparables were infrequently found in the later cases. n104 The causes for this decline in the application of
arm's length are complex, and are discussed more fully in section V. Part of the explanation, of course, is that after the courts accepted the ALS, cases where comparables could easily be found were less likely to get litigated. But the fact that litigation proliferated nonetheless suggests that in too many cases the ALS was not workable. In order to understand why, it is necessary to examine the major section 482 cases from the last two decades. n105
Consider first some major cases in which a comparable was found. R.T. French Co. v. Commissioner, n106 decided in 1973, illustrates one type of problem that the IRS encountered in applying arm's length. In French, the taxpayer, a U.S. subsidiary of a U.K. parent, negotiated a royalty rate for the parent's valuable patented process for producing instant mashed potatoes in 1946, for a 21 year period. This was before the profitability of the process was known and when there was an unrelated 49% minority shareholder in the parent. In 1960, when the minority shareholder had been bought out and the process had proved extremely profitable, the licensing contract was amended, but the royalty rate remained unchanged for the duration of the contract. n107
The Service argued that unrelated parties would have amended the royalty rate so that it would be commensurate with the income derived from the patent, and that the low rates of the contract resulted in constructive dividends to the U.K. parent, which should be subject to withholding. n108 The Tax Court disagreed. It held that the original 1946 contract was negotiated at arm's length because of the 49% minority shareholder in the U.K. parent: "The position of [the
minority shareholder] in the scheme of things in all likelihood assured the arm's-length character of the transaction." n109 Thereafter, the fact that profitability changed "in no way detracted from the reasonableness of the agreement when it was made," and there was no basis for a section 482 adjustment "so long as the "arm's length' test is met . . . There is no reason to believe that an unrelated party in [the parent's] position would have permitted petitioner to avoid its contractual obligations." n110
French illustrates the fallacy of relying entirely on the arm's length nature of the original contract, when the economic results are clearly disproportionate to the parties' expectations when that contract was signed. The Service found itself in the position of having to argue against the ALS it had espoused for so long, citing as its primary authority a case (Nestle) that was decided in the short interval between Frank and Oil Base, when the standard was not established as the main criterion for section 482. Not surprisingly, the Tax Court found this hard to accept after the Service had worked so hard to establish arm's length as the standard in all section 482 cases. n111 It took 13 years and the 1986 Tax Reform Act to reverse the result of French.
U.S. Steel Corp. v. Commissioner, n112 illustrates another type of problem that is recurrent in applying arm's length: the difficulty of comparing intragroup with outside transactions, even when the same product or service is involved. U.S. Steel owned a Liberian subsidiary, Navios, which it used to ship steel from Venezuela to the United States. The prices charged by Navios were set at a level that would make the steel price equal to the price of domestic steel manufactured by U.S. Steel, and the same price was charged by Navios for shipping for unrelated corporations, albeit at much lower quantities. n113 As a result Navios had high profits which were totally exempt from tax. In Tax Court, the Service successfully upheld its reallocation of $52 million in profits to the taxpayer. n114
The taxpayer appealed and the Court of Appeals for the Second Circuit reversed. The court held:
We are constrained to reverse because, in our view, the Commissioner has failed to make the necessary showings that justify reallocation under the broad language of section 482 . . . The Treasury Regulations provide a guide for interpreting this section's broad delegation of power to the Secretary, and they are binding on the Commissioner . . . [citing the ALS] This "arm's length" standard . . . is meant to be an objective standard that does not depend on the absence or presence of any intent on the part of the taxpayer to distort his income . . . We think it is clear that if a taxpayer can show that the price he paid or was charged for a service is "the amount which was charged or would have been charged for the same or similar services in independent transactions with or between unrelated parties" it has earned the right, under the Regulations, to be free from a section 482 reallocation despite other evidence tending to show that its activities have resulted in a shifting of tax liability among controlled corporations. n115
The court thus concluded that the only issue was the comparability of Navios' transactions with those of unrelated parties. It held that they were comparable, despite the differences in volume and the assurance of continued service as a result of the parties' relationship, and despite the taxpayer's ability to manipulate the prices of the steel so as to leave a larger profit to the tax exempt shipper. n116 The court stated that:
Attractive as this argument is in the abstract, it is a distortion of the kind of inquiry the Regulations direct us to undertake. The Regulations make it clear that if the taxpayer can show that the amount it paid was equal to "the amount which was charged . . . for the same or similar services in independent transactions" he can defeat the Commissioner's effort to invoke section 482 against him. n117
The court rejected the Commissioner's argument that transactions with "independent" parties are only relevant in a competitive market and not where U.S. Steel had a de facto monopoly, holding that this would impose an "unfair" burden on the taxpayer. Finally, it addressed the Tax Court's attempt to return to a reasonableness standard:
In at least one portion on Judge Quealy's opinion, however, it appears that the reason he relied upon to hold Navios' charges too high is not at all a matter involving the comparison of rates Steel paid to those paid by other steel companies. He said that what the rates paid by Steel must be measured against in order to see if a section 482 reallocation is justified is "what might be a reasonable charge for a continuing relationship involving the transportation of more than 10 million tons of iron ore per year." If this is indeed the inquiry, then the fact that other steel companies paid Navios the same rates Steel did is irrelevant . . . We are constrained to reject this argument. Although certain factors make the operations undertaken by Navios for Steel unique -- at one point, for example, Navios' ore carriers were the largest of their kind in the world -- the approach taken by the Tax Court would lead to a highly undesirable uncertainty if accepted. In very few industries are transactions truly comparable in the strict sense used by Judge Quealy . . . To say that Pittsburgh Steel was buying a service from Navios with one set of expectations about duration and risk, and Steel another, may be to recognize economic reality; but it is also to engraft a crippling degree of economic sophistication onto a broadly drawn statute, which -- if "comparable" is taken to mean "identical," as Judge Quealy would read it -- would allow the taxpayer no safe harbor from the Commissioner's virtually unrestricted discretion to reallocate. n118
Given the history of the ALS, it is hard to see how the court could have reached a different conclusion; the "reasonableness" standard used by the Tax Court had, by 1980, been officially pronounced dead for 16 years. n119 However, the Service's frustration at being thus hoist by its own petard is understandable, as is its subsequent attempt to reverse U.S. Steel in regulations. n120 The continued vitality and extensive effect of both French and U.S. Steel was illustrated in one of the major recent section 482 cases, Bausch & Lomb, Inc. v. Commissioner. n121 In Bausch & Lomb, the taxpayer licensed its unique process for manufacturing soft contact lenses to an Irish tax haven manufacturer and charged a royalty of five percent. The Irish subsidiary manufactured the lenses for $1.50 each and sold them to the taxpayer for $7.50 each-- the same price charged by unrelated parties with much higher manufacturing costs for the same product. n122
The Commissioner's proposed adjustments included eliminating the royalty (on the theory that B&L Ireland was a contract manufacturer assured of a market for its sales) but adjusting the income to give B&L Ireland its costs plus a profit of 20%. n123 The Tax Court held that these adjustments were an abuse of discretion. In a 86-page long opinion it first rejected the Service's "contract manufacturer" analysis on the grounds that there was no contractual obligation by B&L to purchase the product (as if such an obligation was needed between related parties!). n124 Then, the Tax Court held that the transfer price was correct on the basis of the unrelated sales, despite the economic differences (volume differences, integrated business differences, and the fact that B&L had much lower production costs than its competitors) between the alleged comparables:
We find that use of the comparable-uncontrolled-price method of determining an arm's-length price is mandatory. The third-party transactions identified by petitioner provide ample evidence that the $7.50 per-lens price charged by B&L Ireland is equal or below prices which would be charged for similar lenses in uncontrolled transactions . . . We place particular reliance on the Second Circuit's opinion in U.S. Steel . . . To posit that B&L, the world's largest marketer of soft contact lenses, would be able to secure a more favorable price from an independent manufacturer who hoped to establish a long-term relationship with a high volume customer may be to recognize economic reality, but to do so would cripple a taxpayer's ability to rely on the comparable uncontrolled price method in establishing transfer pricing by introducing to it a degree of economic sophistication which appears reasonable in theory, but which defies quantification in practice. n125
The court then rejected the argument from disparities of volume and from the taxpayer's lower costs, holding that the $7.50 price was "a market price" and therefore the taxpayer had "earned the right to be free of adjustment" under U.S. Steel. n126 In the second part of its opinion, the Tax Court applied French and held that the subsequent profitability of the intangible was irrelevant for establishing a royalty rate, even though the licensing agreement in Bausch & Lomb (unlike the one in French) was terminable at will. n127 Accordingly, the court rejected the taxpayer's 5% and the Service's 27-33% rates, and, since there were predictably no comparables, arbitrarily set its own rate at 20%. n128
The Commissioner appealed and the Second Circuit affirmed. n129 It admitted that "the Commissioner's position is not without force," but held that under the regulations and the ALS, applying the comparable uncontrolled price method was mandatory, even though economic reality may differ:
The position urged by the Commissioner would preclude comparability precisely because the relationship between B&L and B&L Ireland was different from that between independent buyers and sellers operating at arm's length. This, however, will always be the case when transactions between commonly controlled entities are compared to transactions between independent entities. n130
The IRS position would, in effect, "nullify" the CUP method. The court thus felt compelled to affirm that, under the regulations, as long as the ALS governed, uneconomic results would have to be upheld even though transactions between related parties cannot realistically be compared to arm's length transactions. But if that is the case, why should the ALS apply? n131
French, U.S. Steel and Bausch & Lomb illustrate a major problem in applying the ALS: if inexact comparables are used because the market had changed, n132 or because the relationship between the parties makes for a different nature of transaction, n133 the ALS leads to results that are completely unrealistic as an economic matter. n134 Why, then, were the courts in these cases so avid to find that comparables were controlling? The regulations and precedents applying the ALS provide only partial answers. The main reason was the courts' stated awareness of the morass they would be getting into by seeking to determine transfer prices in the absence of comparables. Decisions (not based on comparables) that cover hundreds of pages only to reach unpredictable and arbitrary results seem to justify this conclusion.
Cadillac Textiles v. Commissioner n135 is an early example of the courts' predicament in a domestic section 482 case. The case involved commissions paid by the taxpayer to a related entity for weaving. The taxpayer relied on the comparability of these commissions to those paid to unrelated entities. n136 The Tax Court, in a memorandum opinion, held that the alleged comparables were dissimilar because of volume differences and because there was no commitment for a continuing relationship -- precisely the same factors that should have been applied in U.S. Steel and Bausch & Lomb. n137 However, having properly struck down the comparables, and having rejected the Commissioner's allocation as "heavy handed," the court was faced with the necessity of making an arbitrary determination of the transfer price:
Where some allocation is justified, if the respondent fails to follow a reasonable method in making such allocation, the Court must substitute its judgment . . . Unfortunately, this places upon the Court the burden of decision without having all the facts . . . Looking to the combined profits of both enterprises, and applying factor, it is the Court's conclusion that there should be allocated to the petitioner under section 482 . . . the sum of $100,000 [instead of $193,045.37, as proposed by the Commissioner]. n138
The Tax Court thus applied a "profit split," the method later advocated by the White Paper n139 and ultimately specified in the current regulations. n140 However, as the round figures indicate, n141 the result was largely arbitrary. In the absence of any guidance in the regulations, the court had little choice. This explains why other courts were so reluctant to abandon any comparable, if one could be found. n142