Transfer pricing has been a top tax concern of corporate tax executives for decades, largely thanks to how difficult, complex, and expensive it can be to resolve transfer pricing disputes.
Transfer pricing disputes have produced some of the largest tax adjustments in the U.S., including a 2006 settlement of the GlaxoSmithKline case for $3.4 billion in additional tax, penalty and interest and several recent cases with proposed adjustments well in excess of $1 billion.1 Transfer pricing cases also take a long time to resolve. For example, transfer pricing cases in mutual agreement procedure programs take an average of 35 months to settle, nearly twice as long as non-transfer pricing cases.2 Transfer pricing litigation can take as long as 10 years to complete after the initial proposed adjustment.
Also, transfer pricing cases are increasing in number. Statistics from the Organisation for Economic Co-operation and Development show that global inventories of disputes between treaty partners, largely composed of transfer pricing issues, nearly doubled from 3,328 cases in 2010 to 6,478 cases in 2020.3 Most analysts expect the number of disputes to continue rising in the coming years. One reason is that governments that were forced to reduce audits during the COVID-19 pandemic are now increasing their audit activity to recoup lost tax revenue.4
Clearly, transfer pricing cases are difficult to resolve, but why? To shed some light on this question, we will evaluate transfer pricing disputes between a taxpayer and two involved countries through the lens of a negotiation and dispute-resolution analysis.
Obstacles to resolution
The ultimate purpose of a transfer pricing analysis is to determine and allocate the correct amount of taxable income among related parties in different taxing jurisdictions. The accepted global standard is the “arm’s length standard,” essentially the price in a transaction that would have resulted from “a taxpayer dealing at arm’s length with an uncontrolled taxpayer.”
Transfer pricing is often a taxpayer’s largest tax issue, frequently involving potential income adjustments in the tens of millions of dollars. Due to the cross-border nature of the issue, all transfer pricing disputes involve at least three parties affected by the outcome: the taxpayer and the two countries affected by a change in transfer price. Any country-to-country negotiation to resolve transfer pricing issues employs the arm’s-length standard.
Based on decades of collective experience with transfer pricing disputes, at least three major factors contribute to the difficulty of resolving transfer pricing disputes.
Three or more parties to the dispute
The involvement of multiple parties makes negotiations more difficult due to the differing relationships between parties and the need to satisfy at least three divergent interests.5 Each country involved in the dispute has a financial self-interest in the outcome that is at odds with the financial interests of any other country. The taxpayer can be expected to have an interest that differs from any involved country. Each country may also have a concern about its reputation with taxpayers and other governments for the fair application of transfer pricing rules. If more than two countries are involved in the dispute, the interests and voices involved in any negotiations will be multiplied.
Large amounts in issue
The larger the amount in dispute, the greater the scrutiny of the outcome by each of the parties to the dispute. Disputes sometimes proceed to trial because one of the parties does not want responsibility for participating in its resolution.
The sheer size of the tax amounts in dispute in a transfer pricing issue contributes substantially to the difficulty of resolution. As stated above, transfer pricing is often the largest tax issue faced by multinational enterprises, with disputes routinely involve tens of millions of dollars in disputed amounts. Because the stakes are higher, the negotiating teams for governments and multinational enterprises face greater difficulty maintaining constituency support while making concessions.
Defining a recognizable objective standard
According to one of the best-known books on negotiation dynamics, Getting to Yes, insistence on a recognizable objective standard is a cornerstone of a principled negotiation process.6 Approaching agreement by relying on objective criteria takes some of the pressure off the relationship between the parties and reduces the number of commitments that each side must make, and unmake, when they move toward agreement.7
As mentioned above, transfer pricing rules are enforced pursuant to the “arm’s-length standard,” defined by the U.S. government as “the amount of consideration that would have been charged or paid…in comparable transactions between uncontrolled taxpayers.”8 Although the arm’s-length standard is based upon well-defined comparability factors, the objective nature of this standard is undermined by the degree of subjective judgment involved in its application.9
Identification of the facts in dispute and understanding the opponent’s legal theory are crucial to settlement negotiations. However, the opposing viewpoints expressed in transfer pricing disputes often bear little resemblance to one another, effectively undermining settlement opportunities. Because transfer pricing issues are intensely factual in nature and integral to business operations, the taxpayers tend to have a better understanding of the facts well into the examination process. Despite recent IRS efforts to encourage a sharing of a “working theory” early in the examination process, little sharing of legal theories occurs in transfer pricing cases.
Conclusion
Transfer pricing cases are often contentious, and their resolution can be protracted and expensive. Long-established government dispute resolution procedures, such as administrative appeals, mutual agreement procedures and advance pricing agreement programs are intended to alleviate the burden on taxpayers and governments alike.
Effective use of those programs requires understanding the interests of and standards applied by the parties involved in the transaction. Further, a clear articulation of the relevant facts and a transparent application of the transfer pricing rules to those facts contributes to resolutions under any of the dispute resolution procedures.
1 See US vs GlaxoSmithKline Holdings, September 2006, IR-2006-142 (involving assertions by the IRS regarding the development of marketing intangibles and other contributions by GlaxoSmithKline's U.S. subsidiary). More recent cases include Coca-Cola Co. v. Commissioner, 155 T.C. 10 (U.S.T.C. 2020) (a $9 billion income adjustment over a three-year period involving the allocation of income to Coca-Cola's off-shore "supply points"); Medtronic v. Comm'r, T.C.Memo 2022-84, August 18, 2022 (approximately $1.3 billion in IRS adjustments over a two-year period relating to the allocation of profits between the U.S. parent and a Puerto Rican manufacturing affiliate); and a settlement between the Caterpillar, Inc. and the IRS involving a $2.3 billion proposed adjustment (incluing penalties) relating to sales of replacement parts by a Swiss subsidiary. For a detaled description, see Caterpillar's Offshore Tax Strategy. Majority Staff Report. Permanent Subcommittee on Investigations. U.S. Senate. April 1, 2014.
2 https://www.oecd.org/ctp/dispute/mutual-agreement-procedure-statistics.htm
3 Id.
4 See, for example, Transfer Pricing Chat: Harumi Yamada of Grant Thornton Taiyo Tax. Bloomberg Tax, Transfer Pricing Report, August 3, 2022.
5 Fisher, R., Ury, W., & Patton, B. (2006). Getting to yes (2nd ed.). Penguin Putnam, at 7.
6 Id. at Ch 5.
7 Id.
8 Treas. Regs. §1.482-1(b)(1).
9 Alan W. Granwell and Kenneth Klein, Objective Tests of Transfer Pricing Proposed Regulations Require Subjective Determinations, 76 J of Tax’n 308 (1992).
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