Contents - AL-Tax

38 3 Overview and Critique of Existing Transfer Pricing MethodsThe market capitalization method is limited to situations in which only onegroup member owns intellectual property, and all such property is contributed tothe cost-sharing arrangement at the outset. The market capitalization method willalso generally result in an over-valuation of intangible assets constituting externalcontributions by including goodwill and going concern value. (Because the value ofthese intangible assets is almost always determined as a residual, one cannot carvethem out of the combined value of all intangible assets.) Moreover, even the comparativelystraightforward valuation of tangible assets can prove difficult. Accountingmeasures of tangible asset values often bear little relationship to their fair marketvalue.The residual profit split method, also discussed elsewhere in this Chapter, hasvirtually no economic foundation. Moreover, the IRS does not hold it in very highregard. Hence, as a practical matter, it will probably cease to be widely used in acost-sharing context.Given the extremely limited applicability of all methods other than the residualprofit split and income methods, and the IRS’ discomfort with the former, it followsthat intercompany cost-sharing arrangements will frequently be evaluated under theincome method. Consistent with this view, the CIP states that “the income or foregoneprofits method will generally constitute the most reliable method for measuringan initial buy-in ...” 34 This is quite unfortunate, because the income method is flatlyinconsistent with the arm’s length standard, as explained in detail below. Moreover,the income method permits the IRS to recharacterize intercompany transactions in amanner that other portions of the U.S. transfer pricing regulations expressly prohibit:The contractual terms, including the consequent allocation of risks, that are agreed to inwriting before the transactions are entered into will be respected if such terms are consistentwith the economic substance of the underlying transactions. In evaluating economic substance,greatest weight will be given to the actual conduct of the parties, and the respectivelegal rights of the parties. 35Independent companies contemplating an investment opportunity will only commitcapital (and will only maximize shareholder value thereby) if the undertakingyields a positive expected net present value, accurately measured:The objective of the firm is assumed to be the maximization of shareholders’ wealth.Towards this end, managers should [under]take projects with positive NPVs [net presentvalues] down to the point where the NPV of the last acceptable project is zero. Whencash flows are properly defined for capital budgeting purposes and are discounted at theweighted average cost of capital, the NPV of a project is exactly the same as the increase inshareholders’ wealth. 3634 Internal Revenue Service, Coordinated Issue Paper: Section 482 CSA Buy-In Adjustments,LMSB-04-0907-62, September 27, 2007. See IV, “Initial Buy-In: Best Method Analysis – IncomeMethod is Generally the Best Method.”35 Treas. Reg. Section 1.482-1(d)(3)(ii)(B).36 Thomas E. Copeland and J. Fred Weston, Financial Theory and Corporate Policy, Addison-Wesley Publishing Company: New York, 1988.