Tax Analysts Blog

Transfer Pricing and Common Sense

Posted on Sep 21, 2012

Using its prestige and its unique powers of subpoena, the Senate Permanent Subcommittee on Investigations yesterday afternoon put the spotlight on the billions U.S. multinationals are saving with sophisticated tax planning. Committee Chairman Carl Levin (D-Michigan) and Ranking Republican member Tom Coburn (R-Oklahoma) chose Microsoft and Hewlett-Packard as case studies to demonstrate two phenomena: (1) multinationals can easily shift profits--especially profits from intellectual property--out of the United States and into offshore tax havens [Microsoft] and (2) multinationals can use elaborate schemes to disguise dividends (to US parent from foreign subsidiary) as loans to avoid paying tax normally due on repatriated earnings [HP].

This is hardly news to the tax community, but the hearing held yesterday is important because of the the publicity it is generating. Congress will need lots of 'loophole closers' to pay for lower corporate tax rates and these "perfectly legal" maneuvers are just the types of loopholes revenue-hungry tax reformers need to plug.

Why does the IRS let companies shift profits to places like the Cayman Islands when it would put any private citizen in jail for doing the same? Answer: the U.S. tax law is built around something called the "arms-length principle." According to this principle, any amount of profit can end up in any tax haven if it can be shown that it got there in a manner that it is similar to a transaction between two unrelated parties. So U.S. Parent Company can "sell" U.S. developed technology to U.S. Shell Company in Bermuda for a low price as long as it shows the sale price is something you might see in a real-world transaction. The problem is that for intellectual property--unlike wheat or machinery--there are no comparable real world transactions. In the vacuum of factual information, a cottage industry of valuation experts--known as transfer pricing consultants--have been put to work by U.S. multinationals to prove that transferred intangibles are near worthless when transferred even though many of them ultimately may generate billions.

My favorite exchange at the hearing was when Levin--referencing data showing huge profits in tax haven subsidiaries with few employees--asked IRS Deputy Commissioner Michael Danilack: "Where does common sense come in?" Danilack explained that nothing in the tax law required the IRS to look at the number of employees and the distribution of profits relative to the distribution of employees.

Hey, it's not the fault of the IRS. Congress needs to change the law--rid it of its obsession with the arm's length standard--and start injecting a little common sense.

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