The Methods (And Madness) Of Transfer Pricing For Tangible And Intangible Property

The Methods (And Madness) Of Transfer Pricing For Tangible And Intangible Property

Transfer pricing has to do with the allocation of income among parties controlled by the same persons (controlled parties) that engage in transactions with each other (controlled transactions).[1] In the international context where controlled parties may operate in different countries with different tax burdens, the concern is that the controlled parties may shift income from a higher-taxed country from a lower-taxed country. Here’s a simple example:

The Example

Here ProdCo and WidgCo are controlled parties because they are both 100% owned by Owner. And they’re engaged in a controlled transaction, because ProdCo is purchasing Widgets from WidgCo, which ProdCo then incorporates into Product which it sells to consumers for $100 a pop. ProdCo is based out of Country A, which has a 20% income tax rate, while WidgCo is based out Country B with a 10% income tax rate.

Under these circumstances, there’s an incentive to increase the price that ProdCo pays WidgCo for the Widgets, perhaps even beyond the going market rate for Widgets. Doing so would shift the income that ProdCo earns from the sale of Product from the tax base of Country A (with its 20% income tax rate and under the assumption that Country A would allow ProdCo to deduct the amount it pays WidgCo for the Widgets) to Country B (with its 10% income tax rate).

The Law

That’s where transfer pricing comes into the picture. In the United States, controlled transactions must meet what’s called the arm’s length standard.[2] In other words, does the controlled transaction match up with what happens (or would happen) in uncontrolled transactions under the same circumstances.[3] The parenthetical “would happen” is key, because identical controlled and uncontrolled transactions can only rarely be found.[4] Thus, the need to find comparable transactions under comparable circumstances—a process the rules for which take up much real estate in the Treasury Regulations.[5]

Interwoven with the idea of comparability is what’s called the best method rule. Under the best method rule, whether a controlled transaction achieves an arm’s length result must be determined by applying the method that achieves the most reliable measure of an arm’s length result.[6]  The two factors that go into determining the best method are comparability and between the controlled and uncontrolled transaction and the quality of the data and assumption used in the analysis.[7]

The Treasury Regulations set out several methods for determining an arm’s length result that vary based whether property of a service is the subject of the controlled transaction and, if property, whether it’s tangible or intangible. Each of these methods also emphasizes certain comparability criteria in addition to generally comparability criteria.

In this post, we’ll focus on methods involving controlled transfers of property.

The Methods

The Treasury Regulations lay out six methods for determining the arm’s length price in a controlled transfer of tangible property. These are:

  1. the comparable uncontrolled price method;
  2. the resale price method;
  3. the cost plus method;
  4. the comparable profits method;
  5. the profit split method; and
  6. unspecified methods.[8]

Many of the same methods show up for determining the arm’s length price in controlled transfers of intangible property. These are:

  1. the comparable uncontrolled transaction method;
  2. the comparable profits method;
  3. the profit split method; and
  4. unspecified methods.[9]

Comparable Uncontrolled Price (“CUP”) Method and Comparable Uncontrolled Transaction (“CUT”) Method

The CUP method and CUT method are basically analogous. The main difference between the methods is that they’re applied to different types of property. The CUP method is used for transfers of tangible property, while the CUT method is used for transfers of intangible property.

Under the CUP and CUT methods, the amount charged in the transfer of property in a controlled transaction is compared to the amount charged in a comparable uncontrolled transactions.[10] In order for controlled transaction and uncontrolled transaction to be comparable for purposes of these methods, both sets of transactions should involve similar products, similar economic conditions, and similar contractual terms.[11] Provided these comparability factors are present, these method generally will be the most direct and reliable measure of an arm’s length price.[12]

However, there’s rarely sufficient comparability between controlled and controlled transactions for the use of the CUP and CUT methods to be immune from question oer challenge by the IRS.

Resale Price Method (“RPM”)

The RPM is specific to the transfer of tangible property. The RPM compares whether the amount charged in a controlled transaction is arm’s length by reference to the gross profit margin realized in comparable uncontrolled transaction.[13]The RPM is typically used in cases where there is the purchase and resale of tangible goods and the reseller does not add substantial value to the tangible goods by physically altering them before resale.[14] Thus, the RPM establishes an arm’s length price for the sale between a supplier and a related reseller.

For there to be comparability between controlled and uncontrolled transactions under the RPM, there must be similarity of functions performed, risks borne, and contractual terms, physical similarity between the products transferred, the presence of intangibles, cost structures, business experience, and management efficiency.[15]

Cost Plus Method

This is another method that is specific to the transfer of tangible property. The cost plus method compares gross profit markup in controlled and comparable uncontrolled transactions.[16] This method is typically used in cases where there is the production of tangible goods sold to related parties.[17] For controlled and uncontrolled transactions to be comparable there should be similarity of the functions performed, risks borne, and contractual terms, physical similarity between the products transferred, the presence of intangibles, cost structures, business experience, and management efficiency.[18]

Comparable Profits Method (“CPM”)

The CPM is the most commonly used method and is used for transfers of tangible and intangible property. Under the CPM, the amount charged in a controlled transaction is determined to be arm’s length based on profit level indicators derived from uncontrolled taxpayers that engage in similar business activities in similar circumstances.[19] In determining comparable transactions for this method, there should be similar size and scope of operations, lines of business, product, and service markets involved, asset composition, and the age in the business product cycle.[20]

Profit Split Method (“PSM”)

The PSM also is also used for transfers of both tangible or intangible property. The profit split method analyzes the allocation of the combined operating profit or loss attributable to controlled transactions to the relative value of each controlled party’s contribution to that combined operating profit or loss, which should correspond to the allocation of profit or loss in uncontrolled transactions where each party performs functions similar to those of the controlled parties.[21] There are two types of PSMs: the comparable PSM and the residual PSM.

The comparable PSM divides the total operating income the buyer and seller in the controlled transaction in a manner that is consistent with the way comparable uncontrolled parties divide their operating income in similar transactions.[22] The comparable profit split method requires similarity of functions, risks, and contractual terms, and generally can’t be used if the combined operating profits of the uncontrolled comparable varies significantly from that earned by the controlled parties.[23]

The residual profit split method has two steps. First, an arm’s length return is assigned to the routine activities of the buyer and seller in the controlled transaction for the function they perform that contribute to profits.[24] Such functions include manufacturing, distributing, marketing, the performance of services, and the exploitation of routine intangibles.[25]Second, the residual profit is allocated between the buyer and seller based on the relative value of their relative nonroutine contributions to the business activity.[26]

Unspecified Methods

The Treasury Regulations also acknowledge the possibility that the best method for determining an arm’s length result may be one that they don’t mention. Hence, the unspecified methods. These unspecified methods still need to “take into account the general principle that uncontrolled taxpayers evaluate the terms of a transaction by considering the realistic alternatives to that transaction, and only enter into a particular transaction if none of the alternatives is preferable to it.”[27]

So not much to go on. But recently, the Tax Court has indicated that an unspecified method could be a combination of various other specified methods, given the right circumstances.[28]

Final Thoughts

Transfer pricing is a complicated topic. Have a question?
Contact TL Fahring and Freeman Law Legal Team.


[1] See 26 U.S.C. § 482.

[2] 26 C.F.R. § 1.482-1(b)(1).

[3] Id.

[4] Id.

[5] Id.

[6] Id. § 1.482-1(c)(1).

[7] Id. § 1.482-1(c)(2).

[8] 26 C.F.R. § 1.482-3(a).

[9] Id. § 1.482-4(a). For these purposes intangible property includes a:

  1. patent, invention, formula, process, design, pattern, or know-how;
  2. copyright, literary, musical, or artistic composition;
  3. trademark, trade name, or brand name,
  4. franchise, license, or contract;
  5. method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list, or technical data;
  6. goodwill, going concern value, or workforce in place (including its composition and terms and conditions (contractual or otherwise) of its employment); or
  7. other item the value or potential value of which is not attributable to tangible property or the services of any individual. See id. §§ 367(d)(4), 482.

[10] Id. §§ 1.482-3(b)(1), -4(c)(1).

[11] Id. §§ 1.482-3(b)(2)(ii)(A), -4(c)(2)(iii)(B).

[12] Id. §§ 1.482-3(b)(2)(ii)(A), -4(c)(2)(ii).

[13] Id. § 1.482-3(c).

[14] 26 C.F.R. § 1.482-3(c).

[15] Id. 1.482-3(c)(3)(ii)(A), (B).

[16] Id. § 1.482-3(d)(1).

[17] Id. § 1.482-3(d)(1).

[18] Id. § 1.482-3(d)(3)(ii)(A), (B).

[19] Id. § 1.482-5(a).

[20] 26 C.F.R. § 1.482-5(c)(2)(i).

[21] Id. § 1.482-6(a), (b).

[22] Id. § 1.482-6(c)(2)(i).

[23] Id. § 1.482-6(c)(2)(ii)(B)(1).

[24] Id. § 1.482-6(c)(3)(i)(A).

[25] Id. § 1.482-6(c)(3)(i)(A).

[26] 26 C.F.R. § 1.482-6(c)(3)(i)(B).

[27] Id. §§ 1.482-3(e)(1), -4(d)(1).

[28] Medtronic, Inc. v. Comm’r, T.C. Memo. 2022-84. See here for a break down of the case.

TL Fahring

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