So You Think You’re in Control: When Do Transfer Pricing Rules Apply? 

Do the transfer pricing rules apply to your transaction?  If you are asking that question because adjusting transfer prices could reduce your tax bill, the answer likely is “yes.”  If mispricing a transaction could yield tax benefits, the opportunity to obtain those tax benefits evidences “control,” likely causing the transfer pricing rules to apply.  To most clients, this answer seems backward.  Shouldn’t you first establish whether the situation is subject to transfer pricing rules and, if so, evaluate how those rules apply?  But this formulation – if mispricing occurs and a tax benefit is thereby obtained, the transfer pricing rules likely apply – is consistent with the transfer pricing regulations and with U.S. case law. 

Internal Revenue Code section 482, the U.S. transfer pricing statute, allows the Internal Revenue Service (“IRS”) to adjust prices of any “controlled” transaction to ensure that the parties to the transaction earn the “taxable income that would have resulted had [they] dealt with [each other] at arm’s length.”[1]  The presence of “control” is not, however, always obvious.  Transactions between two 100% commonly owned companies may not be subject to transfer pricing rules, while transactions between entities with no common ownership may be subject to those rules.  This Alert explains the U.S. approach to applying transfer pricing rules and uses case law and other examples to show outcomes that some may find surprising.

What is (and is not) Control?

The section 482 regulations define control broadly:

Controlled includes any kind of control, direct or indirect, whether legally enforceable or not, and however exercisable or exercised, including control resulting from the actions of two or more taxpayers acting in concert or with a common goal or purpose. It is the reality of the control that is decisive, not its form or the mode of its exercise. A presumption of control arises if income or deductions have been arbitrarily shifted.[2]

Noticeably absent from the above definition is the word “ownership”.  Ownership is in fact nearly irrelevant to control.  Control has been found to exist where there was no common ownership and found not to exist where there was 100% common ownership.  The key element is not ownership, but instead whether two or more parties are “acting in concert or with a common goal or purpose.”

That concerted action, or common goal or purpose, must also have an inappropriate objective.  It must be intended to achieve some additional or inappropriate tax benefit through mispricing of one or more transactions.  The last sentence of the “control” definition above provides an example that reflects this concept: “[a] presumption of control arises if income or deductions have been arbitrarily shifted.” 

While the control regulation does seem to elevate arbitrary shifting of income or deductions above other mispricing situations, the case law does not.  In the cases discussed below, the courts make clear that any type of inappropriate tax benefit can cause the transfer pricing rules to apply if that tax benefit is achieved through mispricing.  

In short, the transfer pricing rules apply if the parties to the transaction have some tax incentive to engage in mispricing.  Common ownership often presents tax-motivated mispricing opportunities but is, alone, neither necessary nor sufficient to invoke the transfer rules.

Common Ownership, But No Effective Control

The Tax Court established the principle that common ownership does not equate to “control” for transfer pricing purposes over fifty years ago, in R.T. French v. Commissioner, 60 T.C. 836 (1973).  R.T. French, a U.S. company, agreed to pay a royalty to a U.K. company, M.P.P.  When the royalty rate was set, the 100% shareholders of R.T. French owned 51% of the shares of M.P.P.—i.e., they owned a majority of the shares of both the licensor and licensee.  Later, the two companies became 100% commonly owned. 

The IRS thereafter made a transfer pricing adjustment reducing the royalty rate, and thereby partially disallowing R.T. French’s deduction.  The Tax Court held that the IRS could not reduce the royalty rate on the basis of transfer pricing rules because, when the royalty was originally negotiated, the shareholders of R.T. French had an economic incentive to keep the royalty as low as possible:  they earned 100% of the profits of the U.S. company, but only 51% of the profits of the U.K. company. 

As the examples below further illustrate, what matters for “control” is not common ownership but rather a shared incentive to engage in mispricing.

Common Control, But No Majority Ownership

Courts have in several cases found control to exist between businesses lacking common majority owners. 

For example, in Garbini Electric, Inc. v. Commissioner, 43 T.C.M. 919 (1982), the Garbini family owned all of the stock of Garbini Electric but only 50% of the stock of Garbini Management, with the remaining 50% owned by a longtime employee of Garbini Electric.  Garbini Management provided management services to Garbini Electric for a fee.  The IRS asserted the corporations had set an excessive fee in order to mitigate a then-applicable corporate surtax on Garbini Electric, producing an after-tax windfall for all parties.  Notwithstanding the absence of common majority ownership, the Tax Court found that the parties had acted in concert to artificially shift income, and thereby achieve their common goal of reducing the income subject to the surtax.

The Tax Court has found control to exist where common owners held even less than 50% of two companies’ stock.  In Collins Electrical Co. v. Commissioner, 67 T.C. 919 (1977), for example, two unrelated individuals each owned about one-third of two otherwise unrelated electrical contracting companies.  Although the companies operated independently of one another and might have competed if in the same area, the Tax Court found that transfer pricing rules applied to the companies’ interest-free loans to one another because of the close business relationship between the two shareholders.  Similarly, in Charles Town, Inc. v. Commissioner, 25 T.C.M. 77 (1966), aff’d, 372 F.2d 415 (4th Cir. 1967), cert. denied, 389 U.S. 841 (1967), the Tax Court found common control existed where two brothers owned all of the stock of one corporation and only 2% of another.  The court focused on the brothers’ actual control over the 2%-owned corporation, including that they had formed it, were named as officers, maintained active management roles, and provided capital necessary for its operation.

In each of these cases, the Tax Court focused not on common ownership, but instead on whether the facts as a whole demonstrated a shared economic incentive to shift income or deductions through the mispricing of transactions.  Indeed, the Tax Court has at least twice found control to exist, such that IRS transfer pricing adjustments were warranted, between parties having no common ownership whatsoever.  In Southern College of Optometry, Inc. v. Commissioner, 6 T.C.M. 354 (1947), the court found control to exist between a for-profit college and two affiliated charities because the organizations had historically followed the pricing suggestions of the majority shareholders of the college, who also sat on both charities’ boards of trustees.  Similarly, in Ach v. Commissioner, 42 T.C. 114 (1964), the court held that transfer pricing rules applied to transactions between a corporation and its chairman, president, and treasurer because, although she owned no stock during the years at issue, she independently managed and operated the corporation’s business during that period and was later gifted all of its stock by her sons upon request.

Common ownership thus is neither necessary nor sufficient to invoke U.S. transfer pricing rules.  Instead, opportunity for mispricing, coupled with economic incentive, triggers their application.

Some Hypothetical Cases

Translating these principles to hypothetical cases further illustrates their unintuitive outcomes.

• Case 1: No Common Ownership and no Overall Mispricing, But Compensation Allocated to the “Wrong” Transaction.

Transfer pricing rules may be relevant to disputes regarding the character, as well as the amounts, of deductible payments.  Recent transfer pricing disputes in some foreign jurisdictions have centered on the issue of “embedded royalties”:  where a foreign parent sells services or products with embedded intangible property through a wholly owned local distributor, and the intercompany contract either does not provide for a license or characterizes only a small portion of the consideration as a royalty, local tax authorities have relied on transfer pricing rules to assert that some (or a larger) portion of the overall consideration is a royalty—and, unlike most payments for goods or services, subject to withholding tax. 

Embedded royalty disputes typically involve 100% ownership.  Suppose, however, that the parties are entirely unrelated.  Assume that two publicly traded, competing pharmaceutical companies engage in two transactions – one for the sale of tangible goods and one for the license of the intellectual property.  Despite the absence of common ownership and their roles as competitors, the companies may still have a tax incentive to shift compensation from one transaction to the other.  As in the embedded royalty cases, if the royalty transaction is subject to withholding tax, but the tangible goods transaction is not, the parties may obtain a collective benefit from shifting consideration from the royalty transaction to the tangible goods transaction.  We think a U.S. court likely would allow an IRS adjustment that shifts compensation from the tangible goods transaction to the royalty transaction if necessary to achieve arm’s length results. 

• Case 2: Three One-Third Owners of U.S. Company; Only One Benefits from Mispricing

Although the Tax Court has found control in a case involving as little as 2% common ownership, control may not be present even in the case of closely held businesses.  For example, assume that three unrelated U.S. companies each own 33% of a foreign corporation (ForCo), and further suppose that one of them provides favorable (mis)pricing to ForCo.  Whether the transfer pricing rules apply may depend on the circumstances. 

For example, if the mispricing was negotiated and agreed when the ownership percentages were established, transfer pricing rules might apply.  If two of the three shareholders invested $100 each and the third invested nothing but agreed to provide specified services or property at less than arm’s-length prices, a court could sustain an IRS adjustment increasing the prices.  If, alternatively, the pricing is agreed after the relative shareholdings have been determined, it seems less likely to us that transfer pricing rules would apply—and in fact less likely that the third shareholder would be willing to offer below-market pricing, since it would be entitled to only one-third of every foregone dollar. 

• Case 3: 100% Common Ownership; Mispricing and Tax Benefit Caused by External Factors

As in R.T. French, even in circumstances that seem ripe for collusion, transfer pricing rules may not be relevant.  Assume, for example, that a U.S. parent licenses intangible property to a wholly owned foreign distribution subsidiary located in a jurisdiction with a lower corporate tax rate than the U.S. rate.  Local law in the subsidiary’s jurisdiction caps the royalty rate that can be paid to a foreign licensor at an artificially low threshold.  The subsidiary pays the maximum royalty rate permissible under local law, even though the parties internally conclude that a higher rate would be arm’s length, and the IRS makes a transfer pricing adjustment.  What result?

Common ownership and an economic incentive for mispricing (the U.S.-to-foreign tax rate differential) are both present and ordinarily would trigger the application of U.S. transfer pricing rules.  There is an argument, however, that the parties do not have control over the pricing of the royalty because local law in the subsidiary’s jurisdiction ties their hands, such that transfer pricing rules should not apply.  In a challenge to the validity of the IRS’ “blocked income” regulation involving a much more complex set of facts, the Tax Court did not accept this argument.  The case is now on appeal and potentially could turn on the issue of “control.”[3]

Conclusion

Applicability of U.S. transfer pricing rules is not intuitive and is not uniformly based on share ownership.  Instead, it is based on the actions of the parties to arbitrarily shift income, deductions or other items in a manner that produces a collective tax benefit.  If in doubt, assume the U.S. transfer pricing rules apply and seek guidance.  It is a separate question whether foreign transfer pricing rules apply.  Applicability of transfer pricing rules is not uniform across countries and as a result you could have U.S. transfer pricing exposure with no foreign exposure and vice versa.  We can help navigate the complexities of whether and how transfer pricing rules may apply.