9.3.1[a] Introduction to Arm’s Length Standard

The transfer pricing rule of the United States is arguably some of the most highly complex and specialized in U.S. federal law.

Section 482 of the Internal Revenue Code (and regulations thereunder) provide the foundation for the transfer pricing rules that the U.S. follows. Section 842 provides the U.S. Treasury with discretion to distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among two or more commonly controlled parties if necessary to reflect clearly the income of such parties.

Under the section 842 regulations, the standard to be applied in determining the true taxable income of a controlled business is that of a business dealing at arm’s length with an unrelated business.

Methods to Determine Taxable Income in Connection with a Transfer of Tangible Property

There are five methods for determining an arm’s length amount charged in a controlled transfer of tangible property. Under the so-called traditional transaction methods, taxpayers can choose among:

The comparable uncontrolled price method:

This method evaluates whether the amount charged in a controlled transaction is arm’s length by reference to the amount charged in a comparable uncontrolled transaction.

The Resale Price Method:

This method evaluates whether the amount charged in a controlled transaction is arm’s length by reference to the gross profit margin realized in comparable uncontrolled transactions. The resale price is most appropriate in situations where the related party adds relatively little value to the goods prior to resale, as may occur with respect to the activities conducted by a related party distributor.

The Cost Plus Method:

Under the cost-plus method, the taxpayer adds an appropriate profit percentage or markup to its costs of producing the product, prior to a sale to a related party. This method is often employed with respect to manufacturing operations where the costs of products are marked-up to arrive at a transfer price.

The Profit Split Method:

The profit split method is suitable where transactions among members of a multinational firm are highly integrated so that it is difficult to evaluate the separate components of a particular transaction. It is also appropriate where a transaction involves unique transfers of intangible goods and services and it is difficult to find comparable non-arm’s length transactions in order to come up with an appropriate price.

The Comparable Profits Method:

The main difference between the profit split method and the comparable profits method is that the former is applied to all participants in the controlled transaction whereas the comparable profits method is typically applied to only one participant. The comparable profits method compares net profit margins derived from a transaction involving related parties with net profit margins realized by unrelated parties from similar transactions (unlike the cost plus and resale price method that look to gross profit margins).

Services

There are separate regulations that deal with the treatment of controlled services transactions. One of the following methods must be used:

The services cost method.

The comparable uncontrolled services price method.

The gross services margin method.

The cost of services plus method.

The comparable profits method.

The profit split method.

Unspecified methods.

9.3.1[b] Introduction to Arm’s Length Standard

Methods to Determine Taxable Income in Connection with a Transfer of Intangible Property

The arm’s length amount charged in a controlled transfer of intangible property must be determined under one of the four methods listed below:

The comparable uncontrolled transaction method.

The comparable profits method.

The profit split method.

The unspecified methods.

Sharing of Costs:

A cost-sharing arrangement is an agreement under which the parties agree to share the costs of development of one or more intangibles in proportion to their shares of reasonably anticipated benefits from their individual exploitation of the interests in the intangibles assigned to them under the arrangement.

References:

Advisor’s Guide to Canada – U.S. Tax Treaty

By: Vitaly Timokhov, Raymond Montero, David Kerzner

Published by: Thomson Carswell