Using Intercompany Transfer Price Analyses in Bankruptcy Valuations Part I

An intercompany transfer price is the price one related entity charges another related entity for (1) tangible assets
(including fixed assets and inventory), (2) intangible assets (including the use of intellectual property) and (3)
services (such as corporate administration and accounting). For purposes of this discussion, a related party can
include either (1) a parent/ subsidiary relationship or (2) a brother/sister corporation owned by a corporate parent/
common shareholder relationship.

Within a bankruptcy context, intercompany transfer-price considerations are important when one related company
is included in the bankruptcy estate and the other related entity is not. This situation could occur when a
subsidiary is in bankruptcy, but the parent (or another subsidiary) is not. Likewise, this situation could occur when
a corporation is in bankruptcy, and the controlling shareholder owns another corporation that is not.

In these situations, parties to the bankruptcy (including creditors, minority shareholders and the court) want to be
assured that the earnings (pre-petition or post-petition) of the company in bankruptcy are not artificially understated
or overstated. This would occur if the bankrupt company paid/received excessive prices for the intercompany transfer
of tangible/intangible assets or services. Accordingly, in these circumstances, parties to the bankruptcy want to
ensure that the subject intercompany prices are fair, arm's-length transfer prices.

The Objective of Intercompany Transfer Prices

This concern about earnings manipulation may be resolved if the debtor company uses the intercompany
transfer-pricing methods allowed for assets/services under Internal Revenue Code §482. For decades, the Internal
Revenue Service (IRS) has been concerned that a domestic taxpayer could shelter income/avoid taxes by transferring
assets/ services to a foreign affiliate. The IRS is concerned that a domestic taxpayer could avoid domestic taxes by
transferring assets/allocating income to a low-tax-rate foreign country. Income could be shifted to the foreign
country through the payment of a transfer price (typically, a royalty rate) to the foreign (but controlled) entity for the
use of the transferred assets/services. Likewise, the IRS is concerned that a foreign taxpayer could avoid domestic
taxes by not allocating sufficient income to the United States for the use of assets/services that are owned/used by a
domestic (and controlled) affiliate of the foreign taxpayer.

In order to appropriately reflect the income attributable to the use of transferred assets or services, the Treasury
promulgated rigorous and comprehensive regulations related to §482. These regulations describe in detail (with
numerous illustrative examples) the allowable methods for determining the appropriate intercompany transfer price
between controlled/related parties for transferred assets/services. These transfer price regulations have been interpreted
by the IRS and practitioners for decades. Likewise, these regulations—and the specified transfer price
methods—have been tested in/interpreted by the federal courts for decades. The transfer pricing regulations are
updated when needed (including the currently proposed regulation updates issued in September 2003). In addition,
U.S. intercompany transfer price regulations are generally consistent with transfer price rules adopted by foreign
taxing authorities in other major industrial countries.

In broad concept, the §482 transfer price rules treat the related party assets/services as if they were owned/provided
by a truly independent, arm's-length entity. Arm's-length prices are determined by the application of a specified set
of approved economic analysis methods. The resulting transfer prices are designed to appropriately allocate the
income of the overall taxpayer between the use of the subject assets/ services. This same objective would be
appropriate for bankruptcy valuation purposes.

Typically, the IRS is concerned with an intercompany transaction like the following:

In the first scenario, the domestic taxpayer has the incentive to pay an excessive transfer price to its foreign affiliate
located in a low/no-tax-rate country. This is because the intercompany payment would be a deductible expense in
the United States, thereby reducing the taxpayer's domestic taxable income. The §482 methods are designed to
ensure that the transfer price for the use of the assets/services is a fair, arm's-length price (no more and no less). The
§482 transfer price is intended to clearly reflect the domestic taxable income of the domestic taxpayer.

The parties to a bankruptcy would be interested in ensuring the intercompany transfer-price scenario. In this second
scenario, the §482 methods would ensure that Parent Corporation A pays a fair arm's-length transfer price for the
transferred assets/services from Subsidiary Corporation B.

First, this discussion presents the framework for the intercompany transfer pricing of tangible/intangible assets for
federal income tax purposes. The methods described are used to allocate the total income of a multinational taxpayer
between the intercompany use of tangible and intangible assets. Second, this discussion presents the recently
proposed/expanded pricing methods for the intercompany transfer of services.

U.S. Regulatory Framework for Intercompany Transfer Pricing

The current U.S. tax rules concerning the intercompany transfer pricing of assets/services are provided by §482 and
the related regulations. These final regulations were published by the U.S. Treasury Department on July 8, 1994.
This section summarizes the regulatory framework of the transfer-pricing regulations, including a review of the
arm's-length standard. This discussion summarizes each transfer-pricing method presented in the federal regulations
related to the allocation of consolidated entity income between (1) tangible assets, (2) intangible assets and (3)
shared corporate services.

The Arm's-length Standard

The transfer-pricing regulations give the IRS broad authority to allocate income or expenses between related entities
if it determines that such an allocation is necessary (1) to prevent the evasion of taxes or (2) to clearly reflect the
income of the related entities. The regulations state that "the purpose of §482 is to ensure that taxpayers clearly
reflect income attributable to controlled transactions, and to prevent the avoidance of taxes with respect to such
transactions..." (Regulation 1.482-1(a)(1)). The regulations state that the standard applied to any related party
transaction is that of the same or similar transaction carried out by an independent taxpayer dealing at arm's-length
with another independent taxpayer. "A controlled transaction meets the arm's-length standard if the results of the
transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the
same transaction under the same circumstances..." (Regulation 1.482-1(b)(1)).

The concept underlying the §482 regulation's arm's-length standard is the reliance on transactions that are
independent or uncontrolled. In order to apply the arm's-length standard, taxpayers should identify some transaction
or transactions between independent, uncontrolled parties where the price (or profitability) can be ascertained. Once
such transactions are identified, the "best-method rule" relies on the standard of comparability to determine which
transaction(s) provide the most reliable transfer-price conclusion. In this regard, taxpayers should compare the
results of the subject-related party transaction to the results of comparable transactions between uncontrolled parties
under comparable circumstances.

The Best-method Rule

The §482 regulations provide several methods for determining intercompany transfer prices. The regulations require
that the "best method" be used to determine the arm's-length pricing for each asset/service intercompany transaction.
The best method is defined as the method that produces the most reliable measure of an arm's-length price for the
related party transaction, considering all relevant facts and circumstances.

There are two primary considerations when selecting which of the allowed transfer pricing methods is the best
method. The first consideration for determining the best method is the degree of comparability between (1) the
subject controlled transaction and (2) the selected uncontrolled transaction. According to Regulation
1.482-1(d)(1), these five factors should be considered when determining comparability:

1. functions performed
2. contractual terms
3. risks borne
4. economic conditions experienced and
5. nature of the property or services.

The functional analysis procedures of a transfer-price analysis are critical to assessing these five factors as they relate
to the subject entity. A functional analysis involves finding and organizing facts about a business in terms of its
functions, risks and intangibles in order to identify how these characteristics are divided between the subject
taxpayer business entities. In the functional analysis, the analyst describes the value added activities undertaken by
the taxpayer in order to identify independent comparable transactions that establish an arm's-length range of prices.
Therefore, the functional analysis provides the factual foundation on which to apply the selected transfer pricing
method—consistent with the arm's-length standard.

The second consideration for determining the best method is the quality of the data and assumptions used in
the analysis. Again, there are three factors to consider in assessing the quality of the data and assumptions.
These three factors are:

1. completeness and accuracy of data
2. reliability of assumptions and
3. sensitivity of the results to deficiencies in data and assumptions.

The regulations describe several methods for determining arm's-length tangible/intangible asset intercompany
transfer prices. The best-method rule does not suggest a priority in the application of the allowable methods. In
addition, no allowable method is generally considered more reliable than another. Indeed, there may be several
possible methods that a taxpayer may use to establish an arm's-length benchmark for its intercompany transfer
prices. The best-method rule takes into account all facts and circumstances, including the above considerations, to
determine which method provides the most reliable measure of an arm's-length result.

Allowable Tangible Asset Transfer Pricing Methods

Regulation 1.482-3(a) provides five methods of determining an arm's-length price for the related party transfer of tangible property:

1. the comparable uncontrolled price method
2. the resale price method
3. the cost plus method
4. the comparable profits method and
5. the profit split method.

The regulations also allow for methods other than these five methods, known as unspecified methods. The
Regulation 1.482-1(c) best-method rule is applied to select the most appropriate method. Each allowable method
should be applied in accordance with the general comparability rules outlined in Regulation 1.482-1.

1. The Comparable Uncontrolled Price Method (CUP). The CUP method uses actual tangible asset transactions
between unrelated parties to determine the arm's-length price for the transfer of tangible assets between related
parties. This method analyzes whether the amount charged in the subject related party (controlled) transaction is at
arm's-length by reference to the amounts charged in comparable uncontrolled transactions.

In this analysis, it is important that the selected CUP comparable transactions involve substantially the same
products as the subject controlled transaction. This is because "similarity of products generally will have the greatest
effect on comparability under this method... If there are material product differences for which reliable adjustments
cannot be made, this method ordinarily will not provide a reliable measure of an arm's-length result" (Regulation
1.482-3(b)(2)(ii)(A)).

2. The Resale-price Method. The resale-price method can be used to determine the arm's-length price to be paid by
the purchaser entity in the subject intercompany transaction when the purchaser entity, in turn, resells the subject
tangible asset to unrelated parties. According to Regulation 1.482-3(c)(1), 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 method measures the value of the function performed and is
ordinarily used in cases involving the purchase and resale of tangible property in which the reseller has not added
substantial value to the tangible goods by physically altering the goods before resale."

3. The Cost-plus Method. The cost-plus method determines the arm's-length price that the seller entity should
receive in an intercompany transaction based on the markup on gross profit earned by sellers in comparable
uncontrolled transactions. Specifically, Regulation 1.482-3(d)(1) states that the method "evaluates whether the
amount charged in a controlled transaction is arm's-length by reference to the gross profit markup realized in
comparable uncontrolled transactions. The cost-plus method is ordinarily used in cases involving the manufacture,
assembly or other production of goods that are sold to related parties."

The cost-plus method focuses on the circumstances of the subject transaction/ comparable transactions. This method
does not require that the tangible asset being sold in the uncontrolled transactions be essentially identical to the
tangible asset in the subject controlled transaction. "[C]omparability under this method is particularly dependent on
similarity of functions performed, risks borne and contractual terms, or adjustments to account for the effects of any
such differences. If possible, the appropriate gross profit markup should be derived from comparable uncontrolled
transactions of the taxpayer involved in the controlled sale, because similar characteristics are more likely to be
found among sales of property by the same producer than among sales by other producers" (Regulation
1.482-3(d)(3)(ii)(A)).

4. The Comparable-profits Method (CPM). The CPM determines an arm's-length price for the related party transfer
of tangible assets by reference to a measure of profitability of an unrelated company that engages in similar activities
under similar circumstances. This method compares the profitability of either the related party buyer or the related
party seller, measured using a "profit level indicator" (PLI), to the profitability of the selected comparable company.
According to Regulation 1.482-5(c)(2)(ii), comparability under the CPM depends primarily on the related party's (1)
functions performed, (2) resources employed and (3) risks assumed. The degree of functional comparability required
to obtain a reliable result using the CPM generally is less than the degree of functional comparability required under
either the resale-price method or the cost-plus method.

The first step in the CPM is to select either (1) the related party buyer or (2) the related party seller to be the "tested
party." The tested party is the entity for which profitability can be ascertained and for which reliable data on
comparables can be found. In general, the tested party is also the party that has the least complex business
operations and employs the fewest intangible assets. When the tested party has complex activities and uses
significant intangible assets, it is usually difficult to identify uncontrolled companies that are sufficiently similar.
The selected tested party should also be the related party with data that involve (1) the fewest (and the smallest) and
(2) the most reliable adjustments.

The second step in the CPM is to select the appropriate PLI. The selection of the appropriate PLI depends on
(1) the reliability of the available data and (2) the specific facts and circumstances of the taxpayer business. The
regulations cite the following three basic profit level indicators:

1. the return on capital employed ratio
2. the ratio of operating profit to sales (net margin) and
3. the ratio of gross profit to operating expenses.

Regulation 1.482-5(b)(4)(ii) imposes a greater standard of comparability when using the net margin ratio or the
gross profit to operating expense ratio than the return on capital employed ratio: "[C]loser functional comparability
normally is required under a financial ratio than under the rate of return on capital employed to achieve a similarly
reliable measure of an arm's-length result." If there are differences between the tested party and the uncontrolled
comparable company, Regulation 1.482-5(c)(2)(iv) provides that the comparable company financial data should be
adjusted in order to take these differences into account.

The third and final step in the CPM is to establish an arm's-length price range based on the PLIs of the selected
uncontrolled companies. If the tested party PLI falls within a reasonable range of price results, then its tangible asset
intercompany prices are considered to be at arm's-length.

5. The Profit-split Method. The profit split method determines a tangible-asset arm's-length transfer price based on
the relative value of each related party's contribution to the combined profit or loss in a particular controlled
transaction or set of controlled transactions. According to Regulation 1.482-6(b), these related party contributions
(1) are to reflect "the functions performed, risks assumed and resources employed by each participant in the relevant
business activity" and (2) should "correspond to the division of profit or loss that would result from an arrangement
between uncontrolled taxpayers, each performing functions similar to those of the various controlled taxpayers
engaged in the relevant business activity."

Regulation 1.482-6(c)(2)(i) describes the comparable-based profit-split method. In this method, uncontrolled
taxpayers' proportions of the combined operating profit in situations similar to the controlled transaction are used to
allocate the related parties combined operating profit. Regulation 1.482-6(c)(3)(i) describes the residual profit split
method. In this method, profit is first allocated to (1) routine functions, services, and intangible assets, and then to
(2) profit not accounted for by the routine contributions. This allocation is based on the related parties'
contributions to the total taxpayer residual profit.

6. Unspecified Methods. From the standpoint of the intercompany transfer-price regulations, a method that has not
been explicitly defined (that is, a method other than the CUP method, resale-price method, cost-plus method, CPM,
CUT method or the profit-split method) can be applied if it provides the most reliable measure of an arm's-length
return under the best method rule. The use of an unspecified transfer price method "should 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 are preferable to
it" (Regulation 1.482-3(e)(1)).