Contents - AL-Tax
Contents - AL-Tax Contents - AL-Tax
40 3 Overview and Critique of Existing Transfer Pricing MethodsTaking as given a particular buy-in payment, one can determine which of thesetwo options yields a higher NPV. Alternatively, one can treat the buy-in paymentas a variable and derive a minimum payment by (a) equating the NPVs associatedwith each option (taking into account USP’s projected development expenses undereach scenario, licensing fees, etc.), and (b) solving for the unknown (the minimumbuy-in payment). Moreover, it is not sufficient that USP have an incentive to enterinto a cost-sharing arrangement; the net present value of joining for each prospectiveparticipant must be positive. One can derive a maximum buy-in payment for eachparticipant that does not make external contributions using the same analytics.However, the proposed regulations do not take this more nuanced approach.Instead, they convert the cost-sharing arrangement into a de facto licensing arrangementby brute force under the income method, applied in conjunction with thecomparable uncontrolled transaction method. Participants’ incentives to enter intoa cost-sharing arrangement, and the cost-sharing option in substance, are taken offthe table entirely.The mechanics are slightly different when one applies the income method in conjunctionwith the comparable profits method. However, such applications produceat least as draconian an allocation of intangible income. Moreover, the comparableprofits variant of the income method eliminates non-U.S. participants’ incentivesto invest not only in cost-shared intangibles, but all independently developed,territory-specific intangible assets as well. With a return capped at some arbitrarilydetermined “routine” level, non-U.S. cost-sharing participants would earn a negativeNPV if they invested in the development of any intangible assets, cost-sharedor otherwise, inasmuch as the cash flows generated thereby would flow directly toUSP. 39Clearly, regulations that require affiliated companies to agree to and abide byterms that third parties would never negotiate cannot be considered arm’s length.Correspondingly, regulations that do not permit commonly controlled companiesto enter into collaborative research joint ventures, while third parties routinely doso, cannot be considered arm’s length. As such, the 2005 proposed cost-sharingregulations’ income method is markedly inconsistent with the arm’s length standard.In short, the income method incorporated into the 2005 proposed cost-sharingregulations, and embroidered on in the CIP, flagrantly violates the foundationalarm’s length principle, as well as the U.S. transfer pricing regulations’ strictureagainst recharacterizing the form of an intercompany transaction if the parties39 There are more narrowly defined problems with the mechanics of the income method as well. Asdescribed in Example 1.482-7(g)(4)(iii)(C) of the proposed regulations, the ratio of cost-sharingpayments to sales is calculated by separately discounting projected cost-sharing payments andprojected sales. Therefore, contrary to what one would logically expect, the more risky the researchproject jointly undertaken, the smaller the discount from an arm’s length royalty charge for rightsto pre-existing intellectual property. Moreover, because cost-sharing payments are made over ashorter period of time than royalty payments, the should be calculated on a lump-sum basis (thatis, using the discounted present value of projected royalty payments as well), rather than on acontingency basis, as the proposed regulations contemplate.
3.7 Global Dealing Regulations and Notice 94–40 41thereto have acted in conformity with it. Despite these enormous drawbacks, theCIP indicates that the income method will generally be the best method for purposesof analyzing intra-group cost-sharing arrangements. The comparable uncontrolledtransaction method is flawed for the reasons discussed elsewhere in this chapter andcan rarely be applied in practice. The acquisition price method is extremely limitedin its applicability as well. The market capitalization method will systematicallyresult in an over-valuation of external contributions on those comparatively rareoccasions that it applies.3.7 Global Dealing Regulations and Notice 94–40The proposed global dealing regulations are intended to provide guidance vis-a-vistransfer pricing to multinational financial intermediaries that deal in various financialproducts and services. These proposed regulations expressly exclude globaltrading firms that deal in non-financial products (e.g., physical commodities). Inlieu of specific regulations (proposed or otherwise), Notice 94–40 is used by thelatter in formulating their transfer pricing policies under certain circumstances.3.7.1 Circumstances in Which the Proposed Global DealingRegulations and Notice 94–40 ApplyMany tax practitioners, both in and outside the government, believe that the globaltrading of commodities and financial instruments presents unique difficulties vis-avisthe application of transfer pricing regulations. A number of features set tradingactivities apart from many other types of economic activity: (a) there is often limiteddivision of labor among legal entities constituting a controlled trading group;(b) traders in different jurisdictions may work collectively on a single “book ofbusiness” or otherwise collaborate quite closely; (c) debt and equity capital used tofinance trades may be fungible across legal entities; (d) traders are not physicallytied to a particular geographic location by necessity (that is, they could make thesame contributions to the generation of trading profits independent of their geographicbase of operations); and (e) by its nature, trading is a multi-jurisdictionalactivity.Given the limited division of labor among controlled trading group members,transfer pricing methods that presuppose a particular division of labor (the resaleprice and cost plus methods) are generally not applicable. Because individual membersof a trading group can contribute to the generation of joint trading profitsin a variety of ways, and, depending on booking conventions, may not purchase(or sell) commodities or financial products from (or to) one another, the comparableuncontrolled price method, likewise, is often not a viable approach. By virtueof the fungibility of financial capital, traders’ flexibility regarding their physicallocation, and the fact that commodities and financial products trading requires
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3.7 Global Dealing Regulations and Notice 94–40 41thereto have acted in conformity with it. Despite these enormous drawbacks, theCIP indicates that the income method will generally be the best method for purposesof analyzing intra-group cost-sharing arrangements. The comparable uncontrolledtransaction method is flawed for the reasons discussed elsewhere in this chapter andcan rarely be applied in practice. The acquisition price method is extremely limitedin its applicability as well. The market capitalization method will systematicallyresult in an over-valuation of external contributions on those comparatively rareoccasions that it applies.3.7 Global Dealing Regulations and Notice 94–40The proposed global dealing regulations are intended to provide guidance vis-a-vistransfer pricing to multinational financial intermediaries that deal in various financialproducts and services. These proposed regulations expressly exclude globaltrading firms that deal in non-financial products (e.g., physical commodities). Inlieu of specific regulations (proposed or otherwise), Notice 94–40 is used by thelatter in formulating their transfer pricing policies under certain circumstances.3.7.1 Circumstances in Which the Proposed Global DealingRegulations and Notice 94–40 ApplyMany tax practitioners, both in and outside the government, believe that the globaltrading of commodities and financial instruments presents unique difficulties vis-avisthe application of transfer pricing regulations. A number of features set tradingactivities apart from many other types of economic activity: (a) there is often limiteddivision of labor among legal entities constituting a controlled trading group;(b) traders in different jurisdictions may work collectively on a single “book ofbusiness” or otherwise collaborate quite closely; (c) debt and equity capital used tofinance trades may be fungible across legal entities; (d) traders are not physicallytied to a particular geographic location by necessity (that is, they could make thesame contributions to the generation of trading profits independent of their geographicbase of operations); and (e) by its nature, trading is a multi-jurisdictionalactivity.Given the limited division of labor among controlled trading group members,transfer pricing methods that presuppose a particular division of labor (the resaleprice and cost plus methods) are generally not applicable. Because individual membersof a trading group can contribute to the generation of joint trading profitsin a variety of ways, and, depending on booking conventions, may not purchase(or sell) commodities or financial products from (or to) one another, the comparableuncontrolled price method, likewise, is often not a viable approach. By virtueof the fungibility of financial capital, traders’ flexibility regarding their physicallocation, and the fact that commodities and financial products trading requires
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