Transfer Pricing

• Author: Russell L. Parr
• Profession: President of Intellectual Property Research Associates
• Pages: 384-400

CHAPTER 25

TRANSFER PRICING

The essence of transfer pricing issues is the fact that payments across state or national

borders for goods, services, or intellectual property rights are a tax deduction for the payer

and (perhaps) taxable income to the payee. When the payer and payee are both part of the

same business organization, tax authorities become concerned as to whether the amount

of the transfer payment is a function of tax avoidance and not based on business reality.

An arm’s-length standard is applied nearly universally to test such a transaction. This

chapter is not intended to be a denitive text on transfer pricing, but rather a discussion of

the “high spots” as they relate to licensing activities and intellectual property.

Exhibit 25.1 depicts the essence of transfer pricing issues. A, Ab, and Ac are three facil-

ities of the same multinational company. Facility A is the headquarters location at which

primary research and development takes place and where ownership of intellectual prop-

erty resides. Manufacturing is done at Ab using A’s technology. Ab ships nished products

to Ac for distribution. Ac packages the nished goods using A’s trademark and sells the

nished trademarked products to D, an independent party.

A, Ab, and Ac are all related. Only D is an independent entity. A popular strategy is for

the intellectual property at the heart of the related operations to be transferred to a tax haven

with low corporate taxes. From there, the intellectual property is licensed to the related oper-

ations that use the IP to make and sell products and services. High royalty payments from

the operating entities transfers a maximum amount of prots to the IP holding company in

the tax haven with low tax rates.

As an example, Amazon has created an entity in Luxemburg, called Amazon Europe

Holding Technologies SCS (AEHT), where taxes are low. AEHT licenses the IP back to

Amazon for use in the United States. Amazon makes royalty payments to the AEHT in

Luxemburg where taxes are much lower than in the United States. Amazon is not alone.

Many U.S. companies, such as Merck & Co., Facebook, Inc., and Apple, Inc., move their

intellectual property assets to tax havens overseas.

Companies shift billions of dollars to the tax havens through royalty payments, thus

lowering the parent company’s tax bill. In 2015, Amazon made royalty payments to AEHT

of $1 billion. Tax watchdogs are not happy.

HOLDING COMPANIES

Holding companies are business entities created for the purpose of owning intangible assets

and/or intellectual property. It is termed a holding company because its primary reason

for existence is to own and manage a portfolio of intangible assets. In many companies

384

Holding Companies 385

Trademark Rights

Technology Rights

AAb Ac

D

Finished Goods

Technology

Royalty

Payment

Trademark Royalty

Trademarked GoodsPayment

EXHIBIT 25.1. ILLUSTRATION OF TYPICAL TRANSFER PRICING TRANSACTIONS

the ownership of intangibles is distributed among the business units in which they were

created or acquired. A holding company can centralize ownership and management and

focus responsibility for the protection and exploitation of these important corporate assets.

Most holding companies are structured so that the business units that use the intangibles

license them from the holding company and pay royalties for their use. There may or may

not be tax benets, depending on the location of the holding company and its structure.

TRANSFERRING THE ASSETS. After the holding company is organized, the intangible

assets are transferred by the parent to the company in exchange for stock of the holding

company. Although such an exchange between companies should not be subject to federal

taxation under either § 351 or 368(a)(1)(B) of the Internal Revenue Code,1a federal tax

specialist should review these tax-free exchanges prior to the transfers.

VALUING THE ASSETS. In some instances, it may be necessary to value the intangible

assets or intellectual property at an amount that is realistic and reective of an arm’s- length

transaction. This is most often dened by fair market value, or the amount at which the

asset would exchange between a willing buyer and a willing seller, neither being under

compulsion, each having full knowledge of all relevant facts, and with equity to both.

The amount of the transfer consideration should be supported by an appraisal, and many

taxpayers are of the opinion that it should be independently prepared. The valuation of the

intangible asset will most often be measured by a capitalization of income approach. This

is because the costs to develop such assets are rarely indicative of their value,and a market

approach is impractical due to the absence of an active market for similar properties. A val-

uation by a capitalization of income approach may therefore be dependent on the amount

of the royalties that will be received in the future by the holding company in accordance

with the license agreement (as discussed next).

1USCA §§ 351 and 368(a)(1)(B); IRC §§ 351 and 368(a)(1)(B).