The International Transfer-Pricing Debate...THE INTERNATIONAL TRANSFER-PRICING DEBATE 1567 (1995), Vol. 43, No. 5 / no 5 methods. As we look ahead, many uncertainties remain. There

1566 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE

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The International Transfer-PricingDebate

Carl F. Steiss and Luc Blanchette*

PRÉCIS

La question de l’établissement des prix de transfert entre parties liées faitinextricablement partie de toutes les opérations internationales au seind’un groupe de sociétés et elle est devenue une des préoccupations lesplus vitales de l’heure pour de nombreuses entreprises multinationales.Récemment, l’établissement des prix de transfert a pris une importanceaccrue, les pays participant au commerce international en expansionintensifiant de plus en plus la concurrence pour s’assurer des recettesfiscales et protéger leur assiette fiscale. L’intérêt et les débats ont étéparticulièrement vifs aux États-Unis, et une série de faits nouveaux dansce pays ont à leur tour déclenché un examen complet par l’OCDE del’établissement des prix de transfert et des opérations entre parties liées.Au cours de la dernière décennie, le Canada n’a pas été inactif dans cedomaine. Il a réagi aux nouveautés survenues à l’étranger et intensifié sesefforts par la voie de législations et d’autres initiatives visant lasurveillance et l’examen des méthodes d’établissement des prix detransfert entre parties liées. Il reste encore de nombreuses incertitudes;cependant, il est certain que l’établissement des prix de transfertcontinuera d’être un sujet de vif intérêt pour les gouvernements et lesmultinationales pour encore un certain temps.

ABSTRACTThe subject of related-party transfer pricing is inextricably involved in allinternational transactions within a global corporate group, and it hasemerged as one of today’s most vital considerations and concerns formany multinational enterprises. Recently, transfer pricing has taken onadded significance as countries involved in expanding international tradedisplay increasing aggressiveness in competing for tax revenues andprotecting their tax bases. Interest and debate have been particularlyvigorous in the United States, and a series of developments in thatcountry has in turn triggered a comprehensive review of related-partypricing and transactions by the OECD. In the past decade or so, Canadahas not been idle in this area. It has responded to developments abroadand intensified its own efforts through legislative and other initiativeswith respect to the monitoring and review of related-party transfer-pricing

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* Of Price Waterhouse, Montreal.

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methods. As we look ahead, many uncertainties remain. There can belittle doubt that transfer pricing will continue to be a subject of keeninterest to governments and multinationals for some time to come.

INTRODUCTIONThe application of transfer-pricing1 techniques has often been describedas an art rather than a science. Yet, whatever the fundamentals applied tothe practice of the “art,” the immense surge of interest in recent years andongoing expressed concerns by governments and taxpayers have cast doubtupon and initiated serious re-examination of those fundamentals.

Transfer Pricing: A National PrerogativeThe recent focusing of attention on transfer pricing is not associated witha single cataclysmic development or event. Rather, interest in the area hasgathered momentum over a period of years, as governments have becomeincreasingly preoccupied with issues of national sovereignty, economicgrowth, and stability, which sometimes conflict with the realities of theemerging global economy, unprecedented world trade, and the loweringof international trade barriers.

Predictably, tax administrations tend to view transfer pricing from anational rather than a global perspective; their activities are basicallydirected toward securing appropriate national returns on taxpayers’ rev-enues from international investment and trade. Conversely, the motivationsand interests of multinational enterprises2 (MNEs) are essentially global,not national. In any consideration of international transactions, the pric-ing of products and services crossing borders is a dominant factor indetermining which government enjoys taxing pre-eminence. Countrieswhose economies rely on expansive international trade—both inboundand outbound—compete for the allocation of income of MNEs to theirjurisdiction. Tax considerations are viewed, certainly by tax authorities,as a potentially significant influence on related-party transfer-pricing de-cisions. However, it must be recognized that there can be many otherinfluences on the pricing arrangements chosen by MNEs—for example,customs duties, exchange controls, import quotas and price controls, ap-propriate jurisdiction of ownership, statutory protection of intellectualproperty, and anti-dumping laws. (Theses other influences are not dis-cussed in this article.)

1 In this article, the term “transfer pricing” refers to pricing between related entitiesand establishments of a multinational enterprise, particularly with respect to sales of tan-gible property and sales and licensing of intangible property crossing borders. Related, ofcourse, to the subject of transfer pricing are cost-sharing arrangements among relatedmembers of a multinational. The subject of cost sharing is not specifically considered inthis article.

2 The term “multinational enterprise” is used throughout this article to refer to enter-prises pursuing business operations across borders and transacting between and amongrelated parties located in different jurisdictions.


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The increasing activity of government in monitoring, reviewing, andchallenging transfer-pricing approaches has inevitably drawn a reactionfrom MNEs. From their viewpoint, these activities have created an unset-tled, if not threatening, environment, and recent developments have givenrise to a number of serious and by no means ephemeral concerns. Inparticular, as competing jurisdictions seek to protect, if not increase, theirshare of tax revenues from MNEs, the threat of double taxation may wellbecome a reality. Further, the volume and scope of information requestsand reporting requirements of the various tax authorities are increasingand imposing a growing compliance burden on MNEs. As well, the penal-ties for transgressing the rules, certainly in the United States, are reachinglevels considered to be excessive and unacceptable. Transfer pricing hasclearly moved to the forefront among the many issues confronting gov-ernments and MNEs, and the debate is far from over.

Transfer Pricing: A New EnvironmentFrom the adviser’s perspective, an entirely new area of specialization isevolving which calls for increasingly sophisticated expertise, as well asfirst-hand knowledge and experience in the field of transfer pricing. Notvery long ago, young professionals considering a career in internationaltax would likely have reacted with dismay to the suggestion that theyconcentrate their efforts on transfer pricing as a long-term specialty. Then,transfer pricing was essentially viewed as an internal corporate matter,orchestrated by the taxpayer as a business-managed process subject tocontinuous monitoring and fine-tuning. For the most part, assuming that amore or less reasonable approach was adopted, transfer-pricing decisionsand their implementation were not viewed as particularly hazardous. Evenwhere challenges arose regarding the pricing of related-party transfers ofproduct sales and technology, it was generally considered that the issuecould be resolved through negotiation with the tax authorities or, in anextreme case, through correlative jurisdictional adjustments. The scenehas changed dramatically. Today, many MNEs view transfer pricing as acomplex area of specialization, an area of significant exposure, uncer-tainty, and potentially costly penalties.

Understanding Past EventsA review of the historical evolution of transfer-pricing law and policy helpsto explain where we find ourselves today and how we got there. The pri-mary point of reference must be the United States, since it is that countrythat has most encouraged the recent focus on transfer pricing and theongoing national and international debate. This is not to suggest that therehave been no important developments in other countries; but it is univer-sally acknowledged that the United States can claim primary responsibilityfor instigating international interest and often provoking controversy.

The reason for the predominant role assumed by the United States isthat the stakes are higher in that country than in other jurisdictions, par-ticularly in view of the enormous levels of international investment that


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move into and out of the United States. Arguably, US foreign policy,reflecting the ambitions and interests of a dominant world power, alsoexplains concurrent US political activity, which in turn greatly influencesthe directions of US economic policy. The focus on internationaltransfer-pricing issues has intensified in recent years, not only as a resultof specific US legislative initiatives, but also because of recurring andoften emotionally charged accusations by elected representatives that for-eign companies have been dramatically underpaying their appropriate shareof US tax. Other countries have not been slow to react. On the contrary,they have responded with alarm, perceiving US actions as a direct threatto their own tax base.

Starting with this initial reference point, we have organized the discus-sion that follows into three main segments:

1) an overview of the highlights of US transfer-pricing history,

2) a review of the Canadian scene, and

3) observations on some of the more apparent areas of interest andconcern as we move forward.

TRANSFER-PRICING DEVELOPMENTS IN THEUNITED STATESSection 482 of the Internal Revenue Code3 provides that the InternalRevenue Service (IRS) may, in reviewing transactions between entitiesunder common control, allocate income in such a manner as to ensure anappropriate reflection of income between the entities. While the legisla-tive history of section 482 is long, the fiscal objective underlying theprovision has always been to ensure that the substance of related-partytransactions satisfies an arm’s-length test. Briefly stated, the arm’s-lengthtest in the context of transfer pricing requires that the cross-border pricetransacted between related parties, whether for goods, services, or intan-gibles, equate to the price that would have applied if the parties had notbeen related. Historically, the United States has maintained this focus onthe application of the elusive arm’s-length principle in dealing with trans-fer-pricing issues.

In fact, the arm’s-length standard is the primary basis in most devel-oped nations for assessing reasonableness in related-party dealings. Thestandard has surfaced in most bilateral income tax conventions, and theconcept is firmly entrenched in the OECD model income tax treaty.4 Thedilemma, particularly observable in US history, lies in the formulation ofpragmatic rules for applying the arm’s-length standard in respect of spe-cific related-party transactions.

3 Internal Revenue Code of 1986, as amended (herein referred to as “IRC”).4 See, for example, article 9 of the Organisation for Economic Co-operation and Devel-

opment, Model Tax Convention on Income and on Capital (Paris: OECD) (looseleaf )(herein referred to as “the OECD model convention”).


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The Early YearsCongress expressed interest in and concern about transfer pricing as earlyas 1917. The commissioner of internal revenue was authorized to forceworldwide consolidation of affiliated groups if he believed it necessary inorder to “equitably determine the invested capital or taxable earnings” ofa related corporate group.5 Related-party transactions and opportunitiesfor abuse remained a congressional concern into the 1920s:

In an attempt to evade (United States) taxation, they (parent companies)would make separate returns and divide up income and keep out of the highbrackets or transfer the greater proportion to the foreign subsidiary.6

IRS authority to consolidate the accounts of related parties was clarifiedand confirmed in the Revenue Act of 1921.7 Such authority was deemed“necessary to prevent the arbitrary shifting of profits and related busi-nesses, particularly in the case of subsidiary corporations and foreigntrade corporations.”8

The Revenue Act of 1928 introduced IRC section 45, the predecessorto today’s section 482. Section 45 affirmed the authority of the IRS “toinitiate such adjustments to a taxpayer’s income as may be necessary toprevent tax avoidance and to ensure clear reflection of income amongstrelated parties in determining true tax liability.”9

Regulations to section 45 were promulgated in 1935 and remainedessentially unchanged until 1968. Those regulations presented thearm’s-length standard as the fundamental principle in determining andmeasuring acceptability of related-party pricing:

The standard to be applied in every case is that of an uncontrolled taxpayerdealing at arm’s length with another uncontrolled taxpayer.10

5 War Revenue Act, Pub. L. no. 65-50, enacted on October 13, 1917, regulation 41.6 Congressman Hawley, 61st Cong., Rec. 5203 (1921).7 Section 240(d) of the Revenue Act of 1921, Pub. L. no. 67-98, enacted on November

23, 1921, provided, “In any case of two or more related trades or businesses (whetherunincorporated or incorporated and whether organized in the United States or not) ownedor controlled directly or indirectly by the same interests, the Commissioner may consoli-date the accounts of such related trades and businesses, in any proper case, for the purposeof making an accurate distribution or apportionment of gains, profits, income, deductions,or capital between or among such related trades or businesses.”

8 S. rep. no. 275, 67th Cong., 1st sess. 20 (1921).9 HR rep. no. 2, 70th Cong., 1st sess. 16-17 (1928). Section 45 provided, “In any case

of two or more trades or business (whether or not incorporated, whether or not organizedin the United States, and whether or not affiliated) owned or controlled directly or indi-rectly by the same interests, the Commissioner is authorized to distribute, apportion, orallocate gross income or deductions between or among such trades or businesses, if hedetermines that such distribution, apportionment, or allocation is necessary in order toprevent evasion of taxes or clearly to reflect the income of such trades or businesses.”Revenue Act of 1928, Pub. L. no. 70-562, enacted on May 29, 1928. Section 45 was ulti-mately enacted, essentially unchanged, as section 482 of the 1954 Internal Revenue Code.

10 Treas. reg. 86, section 45-1(b) (1935).


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If the standard was not met, the IRS had authority to reallocate income.The regulations neither described nor mandated the use of any particularallocation method.

While opportunities for income shifting among foreign entities werenoted from time to time by Congress, before the 1960s, IRS enforcementactivities were primarily domestic in nature, challenging income-shiftingactivities pursued within and between US-based entities. A review of USlitigation confirms a relatively broad judicial approach in interpreting thelaw and determining whether specific related-party transactions reflectedthe arm’s-length standard. Specific transactions challenged were exam-ined in detail to determine whether related parties had received full andfair value,11 at a fair and reasonable price,12 or at a fair price encompass-ing and reflecting reasonable profit.13

The 1960sIt was in the 1960s that Congress and the IRS began particularly to inten-sify their efforts to facilitate and enforce transfer-pricing law in respectof international transactions.

The business climate within which US, as well as foreign-based, MNEswere operating was dramatically changing. The economic resurgence fol-lowing World War II, as well as the ongoing economic surge of the 1960s,was creating a very different economic order. With the assistance of tre-mendous advances in communication, the world was entering the globalvillage era; international trade and cross-border investment accelerated atan unparallelled pace. National issues were emerging, involving taxingprerogatives and the determination of appropriate income allocations ofMNEs within countries and across international boundaries. Societies andeconomies were becoming much more interdependent: people, goods, capi-tal, and technology were moving unimpeded across borders, andtransfer-pricing issues and concerns were attracting more and more atten-tion. Whereas historically international trade had for the most part involvedthe shipment of finished products, the new trend among MNEs was tocoordinate multiple cross-border transfers of components, which wouldultimately be delivered to one destination and there assembled into a finalproduct. MNEs were unbundling and centralizing varied activities in cho-sen countries. Location decisions were sensitive to such factors as cost,availability of labour, accessibility to financial markets, and, of course,fiscal policy. The fiscal scene itself revealed significant disparities in taxrates among developed nations and an emerging desire among developingnations to ensure appropriate allocations of income.

The Kennedy administration expressed strong concerns that US-basedMNEs were substantially reducing their US tax liabilities through the use

11 Friedlander Corporation, 25 TC 70, at 77 (1955).12 Polak’s Frutal Works, Inc., 21 TC 953, at 975 (1954).13 Grenada Industries, Inc., 17 TC 231, at 260 (1951).


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of foreign entities. Treasury urged the consideration of substantial changeto the tax law, observing that section 482 was not providing adequateprotection to the US tax base, particularly with regard to income alloca-tions to and from foreign affiliates.14 The Joint House and SenateConference Committee in turn recommended that Treasury “should ex-plore the possibility of developing and promulgating regulations (undersection 482) which would provide additional guidelines and formulas forthe allocation of income and deductions in cases involving foreign in-come.”15 The committee specifically recommended bolstering the tax lawto minimize “the difficulties in determining a fair price, particularly ininstances where there are thousands of different transactions engaged inbetween a domestic company and its foreign subsidiary.”16

Treasury responded by formulating regulations that were issued in fi-nal form in 1968.17 These regulations were the first comprehensivelegislative pricing guidelines developed by any country, and they essen-tially governed US transfer-pricing practices until the early 1990s.18 Theinitiative marked the first serious attempt to establish detailed rules fordefined intercompany transactions. The regulations confirmed the arm’s-length standard as the principal basis for monitoring and reviewingrelated-party transfer pricing and adjustments, and they established groundrules for specific intercompany transactions, including the performanceof services, the licensing and sale of intangible property, and the sale oftangible property.

Addressing licensing and sales of intangible property, the regulationsrecognized the possibility, if not the probability, of failure to find appro-priate arm’s-length comparables. In the absence of comparables, theregulations listed a variety of factors to be taken into account, althoughno guidance was offered on the relative weighting of those factors.19

Relatively detailed rules were presented for determining the appropri-ateness of related-party transfer prices of tangible property and particularlythe application of the arm’s-length standard. Three specific pricing meth-ods were given priority: the comparable uncontrolled price method, theresale price method, and the cost plus method. All three methods relied oncomparables for determining arm’s-length price, either directly or by ref-erence to appropriate markups and markdowns from unrelated transactions.The regulations also authorized the use of other “unspecified methods.”20

14 Hearings on the President’s 1961 Tax Recommendations Before the Committee onWays and Means, 87th Cong., 1st sess., vol. 4 3549 (1961).

15 HR rep. no. 2508, 87th Cong., 2d sess. 18-19 (1962).16 HR rep. no. 1447, 87th Cong., 2d sess. 28 (1962).17 IRC reg. section 1.482.18 In fact, proposed regulations were actually issued in 1965, withdrawn, reproposed in

1966, and ultimately enacted in 1968. These regulations were the first such changes of anysubstance to section 482, or its predecessor section 45, since 1935.

19 IRC reg. section 1.482-2(d)(2)(iii).20 IRC reg. section 1.482-2(e)(1)(iii).


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During the rather difficult birth of these regulations, many taxpayersargued for “calculated safe harbours” based upon profit margins, percent-age markups or markdowns, etc. Safe harbours were rejected. The drafterssuggested that the likelihood of widely divergent ranges of returns earnedin arm’s-length transactions, even within a single industry or company,simply meant that no acceptable and equitable basis for safe harbours couldbe devised. Further, safe harbour approaches would likely, if not inevita-bly, evolve into an effective “floor” that would invariably apply to taxpayersnot otherwise able to document a more advantageous fact pattern.21

Overall, this first significant attempt at expanding the thrust of section482 and providing legislative guidance relied mainly on finding compara-ble transfer prices and/or comparable transactions. The legislation was asubstantive influence in defining the ultimate scope of today’s section 482.

The 1970sMounting world interest in transfer pricing, particularly following the1968 enactment of the US regulations, encouraged the OECD to undertakea detailed study of the subject during the 1970s.22 This study culminatedin a report published in 1979 containing transfer-pricing guidelines.23

Drawing heavily on the US regulations, the OECD report reflected a broadlysimilar approach to the use of alternative pricing methods. Like the UnitedStates, the OECD favoured the comparable uncontrolled price method asbest reflecting the arm’s-length standard. The OECD also agreed with theuse of the cost plus and resale price methods where comparables were notavailable; but, unlike the United States, it considered both of these meth-ods equally acceptable. While the US regulations acknowledged thepossible use of “other methods,” the OECD went further by commentingspecifically on a profit-based “fourth method,” such as comparisons withprofitability of third parties in similar businesses, splitting combined profitson a controlled transaction between parties on a basis that reflects theirrelative contributions, and arm’s-length return on invested capital. Thereport noted very serious weaknesses inherent in such other methods.

21 See, for example, comments of Stanley S. Surrey, “Treasury’s Need To Curb TaxAvoidance in Foreign Business Through Use of Section 482" (February 1968), 28 TheJournal of Taxation 75-79.

22 The Organisation for Economic Co-operation and Development is an intergovern-mental organization based in Paris. It was set up in 1960 to promote policies for economicgrowth and the expansion of world trade. Today’s membership encompasses Australia,Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Iceland, Ireland,Italy, Japan, Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Portugal, Spain,Sweden, Switzerland, Turkey, the United Kingdom, and the United States.

23 Organisation for Economic Co-operation and Development, Transfer Pricing andMultinational Enterprises (Paris: OECD, 1979) (herein referred to as “the OECD 1979report”). This report was supplemented by further releases in 1984 dealing with mutualagreement procedures, international banking enterprises, and allocation of central manage-ment and service costs: see Organisation for Economic Co-operation and Development,Transfer Pricing and Multinational Enterprises: Three Taxation Issues (Paris: OECD, 1984).


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The OECD report was strongly critical of formulary approaches to taxa-tion. In the United States, several state governments (the most notoriousbeing California) had enacted legislation to determine the amount of world-wide income of a consolidated group.24 Typically, such legislation includedformulas for apportioning profits among jurisdictions of group operationson the basis of revenues, labour costs, and property attributable to eachjurisdiction. The OECD condemned such an arbitrary approach to transferpricing:

Proposals for radical reformulations of the approach to intra-group transferpricing which would move away from the arm’s length approach towardsso-called global or direct methods of profit allocation, or towards fixingtransfer prices by reference to predetermined formulae for allocating prof-its between affiliates, are not endorsed in the report.25

Through the 1970s, a period of legislative calm ensued in the UnitedStates on the subject of transfer pricing. Nevertheless, it was clear that theIRS was intensifying its enforcement efforts. At the same time, tax authori-ties in other jurisdictions also started to direct more attention to the areaof transfer-pricing. US-based MNEs began to experience transfer-pricingchallenges from other countries.26 Such challenges were probably inevita-ble. As foreign activities of major US MNEs expanded, so did the interestof the governments of countries in which these activities took place. USinitiatives, and particularly increasing IRS aggressiveness, attracted the at-tention of other governments, raising their awareness of transfer-pricingissues and potential threats to their own tax bases. In the 1970s as well,the apparently unassailable economic dominance of the United States inglobal business, which had grown and flourished through the 1950s and1960s, began to show signs of vulnerability in the face of the rise of eco-nomic superpowers such as Japan and Germany, the emerging EuropeanUnion, and developments along the Pacific Rim.

The 1980sBy the mid-1980s, section 482 had again come under US congressionalscrutiny. The IRS was experiencing increasing frustration in applying the

24 Taxpayers and governments strongly contested the right of a state to collect taxableincome on the unitary basis. Indeed, the United Kingdom threatened retaliatory legislationagainst US companies operating in the United Kingdom. In a leading case, Barclays Bankv. Franchise Tax Bd. of California, 114 S. Ct. 2268 (1994), the US Supreme Court heldthat California had the right to impose tax on the unitary basis. The decision would affirmthe rights of other states to levy unitary taxes. The extreme sensitivities on this issue wereultimately assuaged when California decided to allow companies to report unitary incomebased only on their operations within the United States.

25 OECD 1979 report, supra footnote 23, chapter 1, at paragraph 14.26 Following publication of the OECD 1979 report, a number of countries introduced

changes to their transfer-pricing policies and practices. See, for example, article 209B ofthe French Tax Code introduced by legislation dated January 18, 1980; Circular Letter no.9.2267 of the Italian Ministry of Finance dated September 22, 1980; and United Kingdom,Board of Inland Revenue, “Inland Revenue Guidance Notes on Transfer Pricing and Mul-tinational Enterprises,” January 26, 1981.


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relevant tax law; in fact, consistent application of the arm’s-length stand-ard was proving immensely difficult. The frequent absence of arm’s-lengthcomparables obstructed the IRS in reviewing and, if it was deemed appro-priate, challenging the acceptability of related-party transfer prices. Ofparticular concern were issues involving intangibles, since intangiblesnow played a vital role in international business. Congress noted a strongincentive on the part of US-based MNEs to transfer ownership of intangi-bles to related foreign entities in relatively low-tax jurisdictions and toset low prices for such transfers, particularly where the intangibles wereat an early stage of development and/or exploitation.27

Under then prevailing US tax law, in particular circumstances, US com-panies could carry out a tax-free transfer of intangibles to “possessionscorporations.” The Tax Reform Act of 1984 required that US companiescarrying out research and development (R & D) in the United States en-sure that they receive full consideration or an ongoing fair return fromforeign subsidiaries to which the resulting technology is transferred byway of either sale or licence.28

This amendment, in Congress’s view, provided only a limited remedy toperceived abuses; there still existed significant potential for avoidance ofUS tax. As noted above, the difficulties in applying the comparable uncon-trolled price, resale price, and cost plus methods were particularly inevidence where unique and valuable intangibles were involved. Evolvingtransfer-pricing litigation was predominantly being decided on the basis ofprofit splits.29 Although the decisions of the courts frequently representeda compromise between the position of the IRS and that of the taxpayer, itwas widely perceived that in the majority of these cases, the reference toprofit allocations produced a result that tended to favour the taxpayer. Thisencouraged the next major development in the US transfer-pricing saga:the 1986 adoption of the so-called superroyalty rule, a development thatproved immensely controversial both within and outside the United States.

Commensurate-with-Income RuleWith the enactment of the Tax Reform Act of 1986,30 the law was amendedto require that payments to a related party with respect to a licensed or

27 See United States, Staff of Joint Committee on Taxation, General Explanation of theRevenue Provisions of the Deficit Reduction Act of 1984, 98th Cong., 2d sess. 427 (1984),where it is observed, “By engaging in such practices, the transferor U.S. companies hopedto reduce their U.S. taxable income by deducting substantial research and experimentationexpenses associated with the development of the transferred intangible and, by transferringthe intangible to a foreign corporation at the point of profitability, to ensure deferral of U.S.tax on the profits generated by the intangible. By incorporating the transferee in a low-taxjurisdiction, the U.S. companies also avoided any significant foreign tax on such profits.”

28 IRC section 367(d).29 See, for example, Eli Lilly and Co. and Subsidiaries, 84 TC 996 (1985), rev’d. in

part, aff ’d. in part, 856 F2d 855 (7th Cir. 1988); Ciba-Geigy Corporation, 85 TC 172(1985); and GD Searle & Co. and Subsidiaries, 88 TC 252 (1987).

30 Pub. L. no. 99-514, enacted on October 22, 1986.


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transferred intangible would have to be commensurate with the incomeattaching to that intangible.31 The approach was to be applied in respectof outright transfers of ownership via sale or contribution, as well aslicences and other arrangements. Congress was convinced that neitherunrelated-party transactions nor industry norms provided appropriate ref-erences for related-party intangible transfers and licences. The clearintention was that payments for intangibles would be subject to adjust-ment over time and must reflect changes that may occur in the incomeattributable to a particular intangible. In other words, consideration mustbe given to the actual profit gained following the transfer. The division ofincome between related parties should further reflect, on a “going for-ward basis,” the relevant economic activity undertaken by each party.32

This approach was viewed as totally disregarding arm’s-length licencesthat might have been entered into by US corporations as appropriate com-parative standards.

In many respects, the introduction of the commensurate-with-incometest can be better understood by reference to the US environment at thetime. Broadly speaking, as the United States moved more and more to aservice economy, growing emphasis was being placed upon productivity.US economic and fiscal policy was directed toward the encouragement ofR & D, in part through the provision of tax incentives such as currentdeductions and tax credits for R & D expenditures. The government wasaware of two important factors that might frustrate the intentions of theseincentives: to a considerable extent, major R & D endeavours contem-plated MNE status; and MNEs themselves would seek global recovery ontheir R & D investments.

With respect to transfer pricing, it was recognized that regulararm’s-length market information on, for example, high-value patents cov-ering the results of leading-edge R & D was generally unavailable, sinceMNEs could usually obtain higher profits by exploiting the results of theirR & D through controlled foreign subsidiaries rather than licensing it torelated parties. The US government foresaw, on the one hand, a reductionin tax revenues resulting from R & D incentives and, on the other hand, adiminished ultimate return to the US Treasury as a result of the fact that asignificant portion of MNE incomes would be earned offshore bynon-arm’s-length licensees. In these circumstances, in the government’sview, reliance on outdated transfer-pricing benchmarks, such as arm’s-length licences of old technology, would be quite inappropriate. Thereasoning was simplistic, somewhat circular, and self-serving: if R & Dresults were licensed to a non-arm’s-length entity, there was an impliedassumption that the potential profit from the arrangement must be greaterthan the profit that could be earned through licensing in an arm’s-length

31 Ibid., sections 1231(e)(1) and 1231(e)(2), amendments to IRC sections 482 and 367(d),respectively.

32 United States, Staff of Joint Committee on Taxation, General Explanation of the TaxReform Act of 1986, 100th Cong., 1st sess. 1016-17 (1987).


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market. Consequently, the government decided that the best approach wasto determine transfer prices in respect of intercompany licences by refer-ence to the profit potential of the R & D results.

Major US trading partners expressed dismay at this highly controver-sial development and the perceived departure by the United States fromthe arm’s-length standard. Critics believed that the superroyalty rule wouldinevitably encourage US companies to levy excessive licensing and othercharges to their subsidiaries and affiliates operating in other countries.Considering the sheer magnitude of US inbound investment into Canada,the legislation was of particular concern to Canadian taxation authori-ties.33 The OECD also was highly critical of the superroyalty approach,and it proposed that such retrospective adjustments should be applied inonly the most obviously abusive situations.34

In the course of the 1986 deliberations on transfer pricing generally,and particularly the introduction of the commensurate-with-income test,Congress concluded there still remained many unresolved section 482issues. Accordingly, it recommended that a comprehensive study ofrelated-party pricing be undertaken, with the clear objective and intent offormulating such modifications to the law as may be needed to ensure itseffective application.35

1988 White PaperIn October 1988, the US government released the comprehensive IRS-Treasury white paper on intercompany pricing. The white paper containedextensive commentary on the difficulties experienced in applying section482 and its attendant regulations, and offered recommendations, method-ology, and basic principles that should be reflected in the drafting offurther amendments.36

The primary motivation for the white paper had been the need to con-sider how the 1986 commensurate-with-income standard should be appliedin respect of intangibles. However, the study went much further,

33 See J.A. Calderwood, “Impac t of the IRS Section 482 White Paper: A Perspectivefrom Revenue Canada, Taxation,” in Report of Proceedings of the Fortieth Tax Confer-ence, 1988 Conference Report (Toronto: Canadian Tax Foundation, 1989), 42:1-19, at42:15-19.

34 Organisation for Economic Co-operation and Development, Tax Aspects of TransferPricing Within Multinational Enterprises: The United States Proposed Regulations (Paris:OECD, 1993).

35 See HR rep. no. 841, 99th Cong., 2d sess. II-638 (1986), where it is stated, “Theconferees are also aware that many important and difficult issues under section 482 areleft unresolved in this legislation [the 1986 Tax Reform Act]. The conferees believe that acomprehensive study of intercompany pricing rules by the Internal Revenue Service shouldbe conducted and that careful consideration should be given to whether the existing regu-lations could be modified in any respect.”

36 United States, Treasury Department and Internal Revenue Service, A Study of Inter-company Pricing (Washington, DC: Treasury Department, October 18, 1988) (herein referredto as “the white paper”).


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re-examining in great detail the underlying theory and the administrationof section 482. It is a valuable source of reference for an understandingof the perceived frustrations of the IRS in applying and interpreting thearm’s-length standard.

In 1989 and 1990, Congress focused on one key area of the white paperdiscussion, namely, the problems encountered by the IRS in obtaining ap-propriate information to enable it to pursue pricing examinations on a timelybasis, particularly with respect to US activities of foreign-based entities.The legislators’ response was to strengthen the Code requirements for recordkeeping and information reporting.37 Penalties for failure to comply withinformation demands were increased. An indication of the seriousness ofCongress’s response was the granting to the IRS of authority, in the case ofnon-compliance, to determine at its discretion the taxpayer’s cost of goodssold to the extent incurred in a related-party transfer.38

The 1990sTargeting Foreign-Based MNEsBy the end of the 1980s, the United States was no longer the world’slargest capital exporter but rather a very substantial net capital importer.Successive deficits were being financed in part through sales of securitiesto foreign interests, and the United States entered the 1990s languishingin recession, as well as facing severe budgetary problems. As the govern-ment endeavoured to improve its international trade position and controlits deficits, political attention focused particularly on the US activities offoreign-based MNEs as a popular scapegoat for the current state of af-fairs. A popular view emerged that such entities were not bearing theirfair share of US tax as a result of diversion of income offshore. Eventhough US transfer-pricing principles and enforcement mechanisms hadconsistently been intended to be, and accepted as being, neutral in theirapplication to inbound and outbound transactions and investments (thatis, the direction of movement of goods, services, technology, and capitalwas irrelevant), suggestions surfaced that special rules may be needed todeal exclusively with US inbound activities of foreign-based MNEs.

The Foreign Tax Equity Act introduced in 1990 was essentially aimedat facilitating examination of inbound transactions and further enhancinginformation access by the IRS. The law as ultimately implemented intro-duced a rather formidable “accuracy-related” penalty targeted to section482 transfer-pricing allocations.39 A highly controversial aspect of the

37 IRC section 6038A and IRS form 5472.38 IRC reg. section 1.6038A-7.39 IRC sections 6662(e) and (h). A 20 percent accuracy-related penalty would apply if

a taxpayer priced the product or service at 200 percent or more (or 50 percent or less) ofthe “correct” price. The penalty would also apply if the net section 482 adjustment wasmore than $10 million. The penalty would double if the percentage of inaccuracy reached400 percent or more (or 25 percent or less) of the “correct” price. Further, a “net adjustment

(The footnote is continued on the next page.)


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1990 legislative initiatives was a complementary proposal, not actuallyincluded in the legislation, which was directly aimed at foreign-basedMNEs. The proposal would have introduced a rebuttable presumption thatwould have limited transfer prices in certain foreign-related transactionsand presumed a US subsidiary’s entitlement to a 50 percent profit split ontaxable income arising from sales of property acquired from a relatedperson. An enforced transfer price would have evolved “that results in aUnited States corporation having taxable income from the sale of not lessthan 50% of the combined taxable incomes of the United States corpora-tion and any related person from such property, unless the taxpayer provesotherwise.”40 Although this tentative proposal of arbitrary apportionmentdid not proceed, it certainly sparked a heated controversy. In the views ofsome, the issue of formulary apportionment continues to lurk ominouslyin the background. It is regarded by many as the “ultimate threat.”

Perhaps the most disturbing aspect of the 1990 legislative process wasthe ensuing and widely publicized open hearings of the House Ways andMeans Committee.41 On the eve of those hearings, obviously fuelling thedebate, several members of Congress publicly observed that US taxes werebeing significantly understated by foreign-based MNEs as compared withoverall tax levels of US-based entities. Tax underpayment for the three-yearperiod ending in 1989 was conservatively estimated at US $50 billion.42 Inopening remarks to the hearings in July 1990, Chair J.J. Pickle observed that“foreign multinational corporations are setting the transfer prices for theirUnited States subsidiaries too high.”43 He further noted, “The misallocationof profits amongst foreign multinationals and their subsidiaries will con-tinue to present monumental problems unless the IRS has an effectiveinternational enforcement program.”44 There followed repeated calls to dealwith the alleged underpayment of US tax by foreign-based MNEs.45

penalty” provided for the application of the 20 percent accuracy-related penalty where thenet increase to taxable income of all section 482 adjustments exceeded $10 million. Wherethe net adjustments exceeded $20 million, the penalty rose to 40 percent. A reasonablecause exception was introduced to protect those companies that could show good faith intheir manner of determining transfer prices.

40 Statement of Chair Rostenkowski of the House Ways and Means Committee onintroducing the Foreign Tax Equity Act of 1990, HR 4308, 101st Cong., 2d sess., March20, 1990.

41 Hearings Before the Subcommittee on Oversight of the Committee on Ways andMeans: Tax Underpayments by United States Subsidiaries of Foreign Companies, 101stCong., 2d sess., July 10 and 12, 1990.

42 “Congressmen Ask Negotiators To Focus on Foreign Corporations’ Tax Liability,”Daily Tax Report, June 29, 1990, G-7.

43 Supra footnote 41, at 3-17.44 Ibid.45 For example, the inbound investment activity of foreign-based MNEs in the United

States became an issue in the 1992 presidential campaign when candidate Clinton pro-posed to raise $45 billion by stopping “international corporations from avoiding taxes anddiverting their profits overseas.” See “Clinton Seeks Taxes on Hidden Profits,” The NewYork Times, October 24, 1992.

39 Continued . . .


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The transfer-pricing debate continued. After 1990, one of the morecontroversial events was the 1992 tabling of the Rostenkowski-GradisonBill.46 Intended as a sort of trial balloon, the Bill became a centre ofcontroversy. In particular, the Bill (which did not proceed) would haveforced a calculation of minimum taxable income to any US company thatwas more than 25 percent foreign-owned and having at least $2 millionfrom transactions with foreign related parties. The minimum income wouldessentially have been computed separately for each category of businessactivity of each US subsidiary, determined by multiplying the entity’sgross receipts in respect of each category by 75 percent of the averagefinancial book income of all US companies in that category. An outcrygreeted this ad hoc apportionment proposal targeted at foreign-owned UScorporations. The proposal was viewed as gravely offending the interna-tionally accepted arm’s-length standard.47 Taxpayers could have avoidedthe formulary computation only by entering into a “qualified section 482agreement,” a form of advance pricing agreement, which would requirethem to negotiate prospectively an acceptable transfer-pricing methodol-ogy with the IRS. The mere fact that this proposal surfaced was a clearindication of the congressional mood.

Advance Pricing AgreementsMeanwhile, the IRS had been considering alternative means of settlingissues and avoiding time-consuming and costly disputes. In mid-1990, adraft Revenue procedure48 was released which provided the basis for anadvance determination ruling process. At the time of the release, the IRScommented that the purpose of this ruling process was “to produce anunderstanding between the Service and the taxpayer on an appropriatemethod under section 482 for determining the transfer pricing practicesor cost sharing arrangements of controlled taxpayers.”49 This initiativerepresented a major departure from the IRS’s historical resolve to ruleonly on matters of legal interpretation as opposed to factual issues, suchas pricing. After comments on the draft had been reviewed and consid-ered, formal ruling procedures dealing with advance pricing agreements(APAs) were released in 1991.50

46 HR 5270, Foreign Income Tax Rationalization and Simplification Act of 1992, 102dCong., 2d sess., introduced on May 27, 1992.

47 For a review of comments on the reaction of foreign governments to proposed HR5270, see Joanna Richardson, “U.S. Foreign Tax Bill Hearings Find Detractors, Few Sup-porters” (July 27, 1992), 5 Tax Notes International 171-74; John Turro, “German OfficialsFault U.S. Foreign Tax Bill and Proposed Transfer-Pricing Regs” (July 27, 1992), 5 TaxNotes International 175-78; and John Turro, “OECD Ambassadors Protest RostenkowskiForeign Tax Bill” (August 10, 1992), 5 Tax Notes International 289.

48 See “Full Text of Draft Revenue Procedure on Advance Transfer Pricing Rulings”(June 1990), 2 Tax Notes International 565-73.

49 Ibid., at 565-66.50 Rev. proc. 91-22, 1991-1 CB 526. By the end of June 1995, the United States had

some 35 APAs in place, approximately 100 at varying stages of completion, and another(The footnote is continued on the next page.)


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Section 482 Regulations: An Unfolding SagaUS legislative developments now accelerated at a rather heady pace. In1992, at last responding to the 1988 white paper, the IRS issued compre-hensive proposed regulations to section 482.51 A revised version of theregulations was issued in 199352 and final regulations in July 1994.53 Theentire initiative really began with the 1986 amendments and the conse-quent need to interpret the commensurate-with-income rule. However,like the authors of the 1988 white paper, the IRS determined that tangibleproperty transfers also should be addressed and coordinated with the in-tangible property rules. The new regulations completely replace thehistorical rules dating back to 1968.

It is beyond the scope of this article to deal with the section 482 regu-lations in any detail. In any event, the literature already provides compre-hensive analyses of the successive versions of the regulations and reactionsto them.54 Nevertheless, it does seem appropriate to highlight one or twoof the more controversial aspects of the regulations and their emphasis.

The 1992 proposed regulations generated a torrent of criticism fromUS- and foreign-based MNEs and received generally critical reviews fromother governments. Particular concern was expressed about the restrictiveintent and design of the regulations. The classic historic and primarymethod of applying the arm’s-length standard in respect of intangibles,the comparable uncontrolled price method, was transformed into a so-calledmatching transaction method. Use of the method would be narrowly re-stricted to those limited and unusual instances where a virtually identicalintangible had been transferred or licensed to an unrelated party undermore or less the same economic conditions and contractual terms.

Another area of concern was the unveiling of the “comparable profitinterval” (CPI) as a test of related-party pricing.55 If the restrictive conditionsfor application of the proposed matching transaction method in the case of

(The footnote is continued on the next page.)

60 or so on which taxpayers had initiated pre-filing conferences. The US APAs contem-plated transactions with approximately 20 countries, including Australia, Canada, China,France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, and the United Kingdom.

51 Proposed IRC reg. section 1.482, January 24, 1992.52 Temporary and proposed IRC reg. section 1.482, January 13, 1993.53 IRC reg. section 1.482, July 1, 1994.54 See Peter A. Glicklich and Seth B. Goldstein, “Changes in US Transfer-Pricing Regu-

lations Increase Compliance Burdens for Multinationals and Up the Ante in Transfer-PricingDisputes,” Selected US Tax Developments feature (1993), vol. 41, no. 2 Canadian TaxJournal 382-94; Philip D. Morrison, “Commensurate with Income Takes a Back Seat toContemporaneous Documentation in New Transfer Pricing Regulations” (April 5, 1993), 6Tax Notes International 857-66; John Turro, “U.S. Releases Final Transfer Pricing Regula-tions Under Section 482” (July 11, 1994), 9 Tax Notes International 79-81; and George N.Carlson et al., “The U.S. Final Transfer Pricing Regulations: The More Things Change, theMore They Stay the Same” (August 1, 1994), 9 Tax Notes International 333-48.

55 Proposed 1992 IRC reg. section 1.482-2(e)(1)(iii). The CPI was defined as “variousamounts of profit that a tested party would have earned if objective measures of its profitability

50 Continued . . .


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intangibles, or the comparable uncontrolled price method in the case of tan-gibles, could not be met, the regulations forced the application of secondarymethods. Where such methods were applied, an “overriding” test would bewhether the operating income of the taxpayer fell within a calculated com-parable profit interval. The CPI contemplated a determination of whether,on the basis of objective measures of profitability, the overall operatingincome of the taxpayer was comparable with that of its competitors.56 Basi-cally, the 1992 regulations would have reduced the determination of theappropriateness of related-party transfer prices to one of two methods: amethod that called for more or less exact third-party comparables or amethod that yielded an acceptable profit level within the CPI. Further, thereturn on intangibles would have to be reviewed annually to ensure that theconsideration charged in each taxation year was commensurate with income.Determination that the amount charged in a prior year was equivalent to anarm’s-length amount would not obviate the possibility of an adjustment inlater years. The annual test would essentially be performed by evaluatingthe tested entity’s profits against an appropriate CPI.

Taxpayers were offended by such emphasis on profit-based, as op-posed to traditional transaction-based, methods.57 Comparable profitanalysis was viewed as a radical abrogation of the arm’s-length standardand a major threat to existing international consensus on arm’s-lengthprinciples, which increased the risk of double taxation. Comparable profitanalysis was viewed as an obvious barrier to US market penetration byforeign-based MNEs. By comparing profit levels of US affiliates and sub-sidiaries with those of other entities in the same or similar businesses,and particularly of US entities, the approach was regarded as tantamountto a trade barrier protecting longer-established and profitable US entitiesfrom offshore competition.

After the IRS had reflected on the many representations made in re-spect of the 1992 draft regulations, it issued a revised version, thetemporary section 482 regulations, in 1993.58 The temporary regulationsoffered substantially more flexibility than had the previous year’s version.

There was, however, a further unsettling development in 1993: theenactment of amendments to the IRC that significantly broadened thepotential application of section 482-related penalties.59 In particular, a

(profit level indicators) had been equivalent to those if various uncontrolled taxpayers had per-formed similar functions.” The CPI would have to be determined from independent companyprofit data from a three-year period centred around the “audit year.”

56 Proposed 1992 IRC reg. section 1.482-2(f ).57 For examples of criticism in this regard, see “Section 482—Allocations Between

Related Parties” (April 27, 1992), 4 Tax Notes International 868; and “Section 482—Allocations Between Related Parties” (August 24, 1992), 5 Tax Notes International 389-94.

58 Supra footnote 52.59 Section 13236 of the Omnibus Budget Reconciliation Act of 1993, Pub. L. no. 103-66,

enacted on August 10, 1993. On August 31, 1995, final regulations were issued imple-menting changes made by the Omnibus Budget Reconciliation Act of 1993 to the accuracy-related penalty under IRC section 6662.

55 Continued . . .


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“net adjustment” 20 percent penalty would apply where the net increaseto taxable income, as a result of section 482 adjustments in a taxationyear, exceeded the lesser of $5 million and 10 percent of the taxpayer’sgross receipts.60 A 40 percent penalty would apply where section 482adjustments exceeded the lesser of $20 million and 20 percent of thetaxpayer’s gross receipts.61 The penalty could be avoided only if certainprescribed procedures were followed, including the selection and applica-tion of a pricing method that essentially provided the most reliable measureof an arm’s-length result, and only then if the taxpayer could demonstratethat it had made a reasonable effort to evaluate the potential applicabilityof other methods. All of these rules contemplated major efforts by thetaxpayer to maintain contemporaneous supporting documentation and toensure its availability at the time of filing annual tax returns.

Finally, on July 1, 1994, culminating an eight-year odyssey that hadbegun with the 1986 Tax Reform Act, the IRS released the final section482 regulations. The final version went some distance in responding todomestic and international criticisms aimed at earlier proposed and tem-porary versions.

OECD InfluenceOne of the most significant influences on the ultimate US law was theOECD, which had responded, on behalf of its membership, to both the1992 proposed and the 1993 temporary US regulations.62 The OECD par-ticularly commented on issues arising from the dominant role given to thecomparable profit method as a basis for determining transfer prices, andit expressed strong reservations on provisions for periodic adjustmentunder the commensurate-with-income test in respect of intangible property.

Both OECD and US officials were well aware of the vital importance ofbeing more or less in step. Obviously, the United States is not alone inviewing transfer pricing as an area of current concern and potential taxabuse by MNEs. The zeal with which taxation authorities pursuerelated-party international transactions and perceived transgressions in-creases the likelihood of double taxation, and this in turn threatens toundermine the provisions and spirit of international tax treaties and rela-tionships, particularly if the taxation authorities concerned apply differentmethods in testing transfer prices. MNEs have an enormous stake in en-suring that transfer-pricing rules and guidelines are sound in theory, thatthey are relatively clear and unambiguous, and that they establish a moreor less level playing field among, at minimum, developed nations. It waslikely not entirely coincidental that the OECD issued a discussion draft of

60 IRC section 6662(e)(1)(B)(ii).61 IRC section 6662(h)(2)(A).62 See supra footnote 34; and Organisation for Economic Co-operation and Develop-

ment, Intercompany Pricing Regulations Under United States Section 482: Temporary andProposed Regulations (Paris: OECD, April 1993).


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part I of its revised transfer-pricing guidelines just one week after therelease of the final section 482 regulations.63

Final Section 482 Regulations and OECD GuidelinesThe final section 482 regulations substantially reduced the rigidity andimpact of forced profit-test analyses implicit in the proposed 1992 ver-sion. The arm’s-length standard was reaffirmed, and the available rangeof pricing methods was broadened, with emphasis placed on the selectionof a “best method” approach, a facts-and-circumstances approach basedon functional analysis of the taxpayer’s business and use of the bestavailable information. This enhanced flexibility also reflected more lib-eral use of comparables and contemplated adjustments to inexactcomparables. Indeed, the final version eased the restrictions that had beenviewed by many as making the comparable uncontrolled price methodnearly impossible to achieve. The highly criticized comparable profit testthat had surfaced with the infamous CPI was progressively relaxed anddowngraded from a test that, for all practical purposes, all pricing wouldhave had to pass, to just another pricing method, the comparable profitmethod. Less restrictive profit-split approaches evolved and are presentedas specified methods.

Perhaps one of the more controversial aspects of the OECD 1995 guide-lines was the apparent yielding to the United States through the sanctioningof the use of profit-based methods. The OECD and US profit methods aregenerally similar, and the OECD 1995 guidelines seem to draw upon theUS rules. The comparable profit method endeavours to determine appro-priate profit levels that should have resulted in controlled businesstransactions if the returns on such transactions had been realized in acomparable, uncontrolled business. The final OECD version of the UScomparable profit method is labelled the transactional net margin method.Both methods are basically similar in approach, although there are differ-ences in emphasis with respect to application. While the OECD 1995guidelines are rather lukewarm in their endorsement of the transactionalnet margin method, they do acknowledge its use in more or less excep-tional circumstances.64

63 Part I of the guidelines, dealing mainly with the principles and methods to be used insetting transfer prices with respect to tangible property, was issued in draft form on July 8,1994 and in final form in July 1995, including a revised chapter III on “Other Methods.”Part II of the guidelines, dealing with intangibles, intragroup services, and cost contribu-tion arrangements, was released in draft form in March 1995. Two chapters of the March1995 draft, “Administrative Approaches to Avoiding and Resolving Transfer Pricing Dis-putes” and “Documentation,” were released in final version in July 1995. See Organisationfor Economic Co-operation and Development, Transfer Pricing Guidelines for Multina-tional Enterprises and Tax Administrations: Part II: Applications (Paris: OECD, July1995) (herein referred to as “the OECD 1995 guidelines”).

64 For a review of the US comparable profit and the OECD transactional net marginmethods, see Robert E. Culbertson, “A Rose by Any Other Name: Smelling the Flowers atthe OECD’s (Last) Resort” (August 7, 1995), 11 Tax Notes International 370-82.


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The OECD’s criticisms of the commensurate-with-income approach wereacknowledged in the final US regulations by the provision of safe harbourrules that will apply under certain conditions.65 For example, periodicadjustments will not apply if actual profits generated by intangibles fallwithin a range of 80 to 120 percent of projected profits.66 Further, wherethe test is met for each of the first five years, the taxpayer is insulatedfrom the threat of a subsequent adjustment.67

Overall, the final section 482 regulations and the OECD 1995 guide-lines reflect compromise on both sides, and the two documents are similarin structure and broadly compatible in approach. While differences re-main, they are essentially differences of emphasis. The approaches aresufficiently similar as to suggest that the United States and its majortrading partners may be able to resolve what might otherwise have beenpotentially irreconcilable differences in transfer-pricing approaches to,and resolution of, bilateral issues.

In concluding this overview of the US scene, it is appropriate to em-phasize again that it has been developments in the United States,particularly in recent years, that have primarily and significantly influ-enced attitudes and approaches of other governments in respect ofinternational related-party transactions. The influence will inevitably con-tinue, particularly as MNEs—whether US- or foreign-based—experiencethe application of the US law by the IRS and as, in the longer term, theinterpretation of that law and its application evolves in US courts, as wellas among other nations with vested interests.

THE CANADIAN SCENEUS legislative developments and congressional rhetoric in respect of trans-fer pricing have not gone unnoticed in Canada. Canada and the UnitedStates are perhaps the world’s largest international trade and investmentpartners, with enormous volumes of goods, services, and capital flowingrelatively unimpeded across a common border. Cross-border investmentbetween the countries is an overwhelmingly dominant feature of the Ca-nadian economy, and the implementation of the free trade agreements hasfurther stimulated the flow of trade and capital.

Over 75 percent of Canada’s imports come from the United States andover 80 percent of its exports flow to that country.68 Indeed, US-boundexports grew from $94 billion in 1985 to over $180 billion by the end of1994. A very large proportion of trade between the countries is representedby transactions between parent companies and their subsidiaries andaffiliates. In addition, Canada directs a large proportion—approximately

65 IRC reg. section 1.482-4(f )(2)(ii).66 IRC reg. sections 1.482-4(f )(2)(ii)(B) and (C).67 IRC reg. section 1.482-4(f )(2)(ii)(E).68 Statistics Canada, Canadian International Merchandise Trade, December 1994, cata-

logue no. 65-001.


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60 percent—of its total foreign investment to the United States. In con-trast, US investment in Canada constitutes only about 14 percent of itstotal foreign investment.69

Given these facts, it is not surprising that related-party transfer pric-ing, particularly in the US context, is a sensitive area, or that Canadafeels somewhat threatened by the recent increase in US fiscal aggressive-ness. Canada may have been placed at a greater disadvantage becausehistorically it has not taken the initiative in addressing the consequencesof expanding operations of both Canadian- and foreign-based MNEs. Incontrast to the diligent efforts of the US government to codify its transfer-pricing law and enhance its enforcement procedures, in Canada, untilrecently, there has been relatively little activity in this area. However, inthe last decade or so—no doubt in response to the US developmentsdescribed above—the Canadian government has taken on a more activerole in confronting transfer-pricing issues.

Legislative ApproachCanadian tax law takes a broad legislative approach to related-party pric-ing. The cornerstone is the requirement that related-party transactionsreflect the arm’s-length principle. Subsection 69(1) of the Income Tax Act70

embodies and confirms that principle; specifically, in its application toacquisitions and dispositions between non-arm’s-length parties, it directsthat the prices established for such transactions must be equivalent to “fairmarket value.” Subsections 69(2) and (3) are the primary references inrespect of cross-border pricing.71 These subsections particularly addressnon-arm’s-length transactions between non-resident persons and Canadiantaxpayers and apply to tangible and intangible property transfers, royal-ties, transportation charges, and fees for services. The law dictates that thepricing of inbound goods and services provided by a related non-residentmust be no greater than the amount that would have been reasonable inthe circumstances if the non-resident and the taxpayer had been dealing atarm’s length. The corollary, applying in the case of outbound goods andservices, is that the Canadian resident must have received considerationfrom a related non-resident equivalent to the amount that would have beenreasonable in the circumstances if the parties had been dealing at arm’slength. Subsections 69(2) and (3) contemplate consideration that is

69 Organisation for Economic Co-operation and Development, Department of Econom-ics and Statistics, Main Economic Indicators, March 1994 (Paris: OECD, 1994). Thesefigures are somewhat misleading because they are based on historical book values. Ingeneral, Canada’s investment in the United States may be viewed as more recent than USinvestment in Canada.

70 RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as “the Act”).71 Information Circular 87-2, “International Transfer Pricing and Other International

Transactions,” February 27, 1987, paragraph 6, confirms Revenue Canada’s interpretationthat subsections 69(2) and (3) override subsection 69(1). Revenue Canada sources haveindicated that IC 87-2 is currently under revision to reflect the numerous changes thathave occurred, in Canada and elsewhere, since the circular was issued.


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“reasonable in the circumstances” as opposed to the more generally famil-iar fair market value test. Revenue Canada’s position is that reasonableconsideration “may mean fair market value or another amount dependingon the circumstances in a particular case.”72

Section 69 is transaction-oriented.73 More specifically, the law doesnot contemplate the “results” of a non-arm’s-length transaction and presentsno test that would directly consider the resulting profit or loss derivedfrom it. Other than a “reasonableness” test, no statutory guidance is of-fered for the method of determining whether a price corresponds to theamount that would have applied in arm’s-length dealings. The broad thrustof the legislation may explain the flexibility of Canadian assessing prac-tices in the past in determining arm’s-length prices, and particularly therecognition that judgmental elements are involved.

Unlike IRC section 482, subsections 69(2) and (3) have no comple-menting regulations. In fact, no formal guidelines for the application ofthe law were offered until 1987, when Revenue Canada issued an infor-mation circular for the guidance of Canadian taxpayers transacting withrelated foreign entities.74 However, in applying the arm’s-length princi-ple, the Canadian tax authorities have consistently endorsed the methodsof pricing set out in the OECD 1979 report.75 Specifically, Revenue Canadahas emphasized the use of transaction-based methods and rejectedprofit-based methods, such as the comparable profit method that has sur-faced in recent US law.76

Case LawThere is very little Canadian case law on the subject of transfer pricing.The reason seems to be that, in the great majority of situations, RevenueCanada’s challenge of an arrangement has been resolved through negoti-ated settlement. In situations involving Canadian and US taxpayers, theissue has often been settled through competent authority agreement and

72 See, for example, Calderwood, supra footnote 33, at 42:4. Esentially, Revenue Canadacontemplates that a reasonable arm’s-length price would normally equate to fair marketvalue. However, it recognizes that, for example, where a supplier may be attempting toincrease market share, a reasonable price may (temporarily) be less than an “arm’s-lengthprice.”

73 It should be noted that there are other sections of the Act that may have relevance inrespect of particular related-party transactions. Examples include section 67 restricting thedeductibility of outlays and expenses to reasonable amounts; paragraph 18(1)(a) limitingdeductions to outlays incurred for purposes of earning or producing income; subsection15(1) dealing with shareholder appropriation benefits and advantages conferred; and thegeneral anti-avoidance rule presented in section 245.

74 See IC 87-2, supra footnote 71.75 Ibid., at paragraph 9.76 Notwithstanding Revenue Canada’s stated approach, in the past some transfer-pricing

issues have been settled, at least in part, by reference to the profits derived from related-partytransactions. However, the situation may be changing, particularly in view of recent devel-opments such as the US section 482 regulations and the OECD guidelines.


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correlative adjustment within the terms and spirit of the Canada-US taxconvention.77 It is also likely that, in the absence of regulatory guidanceon the interpretation and application of section 69, both the tax authori-ties and taxpayers have been reluctant to pursue judicial determinationsin respect of transfer-pricing disputes.

There have been only two decisions to date that have specifically con-sidered related-party cross-border transfer pricing and more particularlythe fair market value test contemplated under subsection 69(1).78 Forpresent purposes, there is not much to be learned from these dated cases.In both instances, the taxpayers prevailed. Perhaps the primary messagegained from a review of the decisions is the importance of arm’s-lengthcomparables and the demonstrable difficulty of finding them.

There are other, more recent cases in which related-party pricing hasbeen considered. However, these cases have been concerned, not so muchwith the question of appropriate pricing standards and approaches, aswith other issues such as sham and tax avoidance.79

One case that is worth commenting upon briefly is Indalex.80 The caseinvolved Canadian companies that imported raw materials from offshorerelated companies; at issue were the reinvoicing arrangements betweenthe parties. In considering the prices agreed to by the Canadian entity andthe related non-resident, the court essentially determined that appropriatecomparables were not available. Further, the court did not pursue consid-eration of the alternative cost plus and resale price methods. Instead, thecourt adopted a fourth or “other” method involving a review of functionsperformed and risks assumed by the parties—in other words, a functionalanalysis approach—to determine whether pricing was commensurate withrelative economic inputs.81

77 See article XXVI of the Convention Between Canada and the United States of Americawith Respect to Taxes on Income and on Capital, signed at Washington, DC on September26, 1980, as amended by the protocols signed on June 14, 1983, March 28, 1994, andMarch 17, 1995 (herein referred to as “the Canada-US convention”).

78 J. Hofert Ltd. v. MNR, 62 DTC 50 (TAB); and Central Canada Forest Products Ltd.v. MNR, 52 DTC 359 (TAB). Both cases were considered under section 17 of the formerIncome Tax Act.

79 See, for example, Dominion Bridge Co. Ltd. v. The Queen, 75 DTC 5150 (FCTD),aff ’d. 77 DTC 5367 (FCA); Spur Oil Ltd. v. The Queen, 81 DTC 5168 (FCA); R v.Redpath Industries Ltd. et al., 83 DTC 5117 (Que. Ct. Sess.), aff ’d. 84 DTC 6349 (Que.SC); and Irving Oil Limited v. The Queen, 88 DTC 6138 (FCTD), aff ’d. 91 DTC 5106(FCA).

80 Indalex Limited v. The Queen, 86 DTC 6039 (FCTD), aff ’d. 88 DTC 6053 (FCA).81 It should be noted that the February 22, 1994 federal budget introduced a series of

substantive amendments to rules dealing with offshore foreign affiliates of Canadian tax-payers. In particular, and of interest with respect to transfer pricing and the use ofreinvoicing companies, new paragraph 95(2)(a.1) broadly provides that profits earned by acontrolled foreign affiliate from reselling goods will, in specified circumstances, be treatedas foreign accrual property income and be currently taxed to the Canadian shareholder ofthe affiliate.


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Early Transfer-Pricing InitiativesIt was in the late 1970s that the Canadian tax authorities began to paycloser attention to transfer pricing.82 Since then, Revenue Canada has car-ried out a series of initiatives, including the strengthening of enforcementprocedures through various legislative amendments to the Act.

These early initiatives included the announcement by Revenue Canadaof the “large file program,” contemplating a much more comprehensiveaudit approach to MNEs, and the unveiling of a working arrangementunder the terms of the Canada-US convention which provided for simulta-neous audits of Canadian and US companies.83 Subsequently, and again inresponse to concerns about transfer pricing, Revenue Canada announcedthat it would be undertaking a study of particular industries, for which itwould recruit the assistance of industry experts and consultants.84 Follow-ing a highly publicized and intensive examination of the pharmaceuticalindustry, Revenue Canada noted that by far the overwhelming issues inthat industry related to transfer pricing and particularly the use byforeign-based MNEs of low-tax and tax haven jurisdictions as locations ofmanufacturing and intangible licensing activity.

Information Circular 87-2Apart from Canada’s endorsement of the principles and approaches pre-sented in the OECD 1979 report, through the early 1980s, there was littleformal elaboration of the government’s position on the interpretation andapplication of the transfer-pricing rules in section 69. However, in 1983,Revenue Canada issued the first of a series of drafts of an informationcircular dealing with the taxation of multinational transactions and theapplication of the statutory arm’s-length test. Revenue Canada invitedcomments from the tax community and industry groups, and incorporateda number of their suggestions into subsequent drafts.85 Four years later,Information Circular 87-2 was released.86 Not surprisingly, the circular

82 In the late 1970s, Revenue Canada may have been particularly motivated by com-ments of both the Canadian Institute of Chartered Accountants and the Tax ExecutivesInstitute that drew attention to the apparent inactivity of Revenue Canada and its lack ofeffectiveness in administering and reviewing related-party transfer pricing. For additionalcomments, see James S. Peterson, “International Transfer Pricing: A Canadian Perspec-tive,” in Report of Proceedings of the Thirty-First Tax Conference, 1979 Conference Report(Toronto: Canadian Tax Foundation, 1980), 451-69, at 458.

83 The large file program was introduced by Revenue Canada in the summer of 1977.The simultaneous audit program was introduced on June 16, 1977 by an agreement be-tween the US commissioner of internal revenue and the Canadian minister of nationalrevenue.

84 See “Revenue Canada Round Table,” in the 1979 Conference Report, supra footnote82, 601-38, question 4, at 608-11.

85 See William R. Lawlor, “Revenue Canada’s Approach to International Transfer Pric-ing,” in International Fiscal Association, Canadian Branch, Special Seminar on Issues inInternational Transfer Pricing (Don Mills, Ont.: De Boo, 1987), 1-8.

86 Supra footnote 71.


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reflects and again endorses suggested approaches of the OECD 1979 re-port, particularly with respect to the interpretation and application of thearm’s-length principle.87 The principle, as applied to related-party trans-actions, is interpreted to mean

that each transaction should be carried out under terms and at a price thatone could reasonably have expected in similar circumstances (similar prod-uct or service, market, credit terms, reliability of supply and other pertinentcircumstances) had the parties been dealing at arm’s length.88

The circular considers the method by which intended “reasonablearm’s-length prices” contemplated under subsections 69(2) and (3) shouldbe determined and focuses on transfers of goods as well as service charges,R & D, and the use of intangibles.

Conforming to the OECD’s approach, the circular confirms the use ofthe comparable uncontrolled price method as the primary method fordetermining related-party transfer prices.89 It also recognizes that, in prac-tice, appropriate comparables may not be available and cautions that“variations in the respective circumstances should be minor or capable ofquantification on some reasonable basis.”90 The familiar secondary meth-ods of cost plus and resale price are endorsed and commented upon;however, neither is given preference over the other.

While the circular acknowledges the possible use of “other methods,” inthe event that comparable and secondary methods prove inappropriate, lit-tle guidance is offered on the actual method to be used. Where neither thecomparable uncontrolled price, the cost plus, nor the resale price method issuitable, a taxpayer’s pricing policy must reflect a proper assessment offunctions performed by different entities within the corporate group.91

The circular provides no discussion of profit-allocation or profit-splitmethods. As already noted, such approaches were the subject of muchcontroversy during the evolution of the US regulations and a matter ofconcern to many OECD members. An oblique reference to profit-splitanalyses may be discerned in the following extract from the circular:

The quantum of income taxed in Canada should be consistent with the realprofit contribution of the Canadian taxpayers involved, based on the eco-nomic functions performed and the risks assumed by them. This result isachieved when non-arm’s length transactions with non-residents are con-sistently made at reasonable arm’s length prices. The determination ofreasonable arm’s length prices, while necessarily somewhat subjective, isnevertheless a question of fact, and therefore the situation of each taxpayeris to be examined on its own particular circumstances and merits.92

87 Ibid., at paragraph 9.88 Ibid.89 Ibid., at paragraph 14.90 Ibid.91 Ibid., at paragraph 11.92 Ibid., at paragraph 12.


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Notwithstanding this comment, it should be emphasized that the Cana-dian tax authorities have publicly and consistently expressed their viewthat the profit-allocation and profit-split approaches are generally suspectand to be employed only as a last resort.93

The circular offers very limited commentary in respect of pricing ofintangibles. Noting that, subject to possible amortization, payments inrespect of intangible acquisitions represent capital outlays, the circularstates that the more difficult issue in the related-party context is thedetermination of arm’s-length consideration for ongoing “use” of intangi-bles.94 As one might anticipate, the circular recognizes that the bestcomparison is the arm’s-length comparable royalty where, for example, alicence in respect of the same intangible has been granted to an independ-ent third party. While it is recognized that it is often very difficult to findsuch uncontrolled comparables, the circular suggests that the best com-parison is “royalty rates in the same industry or a similar industry involvingrelatively similar products, similar marketing conditions, and similar li-censing arrangements.”95

Legislative AmendmentsAmendments to the Act in 1988 considerably strengthened Revenue Cana-da’s abilities to administer the transfer-pricing rules and monitorcross-border transactions. These amendments introduced statutory provi-sions dealing with reporting requirements,96 access to foreign-basedinformation,97 and an extension of the period within which internationaltransactions can be examined and reassessed.98 Aspects of these amend-ments correspond directly to the US rules. In particular:

• Canadian resident corporations, as well as non-resident corporationscarrying on business in Canada, are now required to file annual returns

93 It is understood that the internal intercompany pricing guidelines used by RevenueCanada refer to profit analyses and approaches as “other methods.” See Revenue Canada,Taxation Operations Manual (Ottawa: Revenue Canada) (looseleaf), section 14(53), “Inter-company Pricing Guidelines,” at paragraph 9.4. Although Revenue Canada evidentlydistrusts these methods as being inappropriate (a view shared by the OECD), in situationswhere the comparable uncontrolled price, cost plus, and resale price methods themselveshave proved inappropriate, profit approaches have in fact been used. For Revenue Cana-da’s views on the audit process of non-resident related-party transactions, including severaltransfer-pricing issues, see M. Przysuski and S. Polzin, “Cross Border Transactions,” apaper presented at a meeting of the International Tax Committee of the New York Chapterof the Tax Executives Institute, September 27, 1994, and reproduced in (November 1994),4 The Access Letter 463-78.

94 IC 87-2, supra footnote 71, at paragraph 43.95 Ibid., at paragraph 45.96 Section 233.1 of the Act.97 Section 231.6 of the Act. For Revenue Canada’s comments on foreign-based infor-

mation, see Przysuski and Polzin, supra footnote 93, at 471.98 Subparagraphs 152(4)(b)(iii) and (iv) of the Act in conjunction with paragraph

152(3.1)(a) of the Act.


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detailing transactions with related non-residents.99 Separate informationreturns must be filed in respect of transactions that the Canadian taxpayercarried out with each foreign non-arm’s-length party. The range of report-able transactions is extremely broad and significantly expands theinformation available to the tax authorities in evaluating a reporting enti-ty’s group transfer-pricing policies and related-party transactions. Theseincreased reporting requirements clearly strengthen Revenue Canada’sability to identify and deal with related-party cross-border transactions,and they are particularly useful in targeting audit issues.

• The Act was also amended to provide the minister of national rev-enue with the authority to require a Canadian resident or a non-residentcorporation carrying on business in Canada to provide on request anyforeign-based information and documentation that may be viewed as rel-evant to the administration and enforcement of the law.100 This amendmentwas particularly intended to facilitate the administration of subsections69(2) and (3).101 In the event of failure to comply with an informationrequest, the taxpayer may be prohibited from introducing the foreign-basedinformation or documentation in any future Canadian court proceeding.102

• Finally, in defined circumstances, the period within which the minis-ter of national revenue may reassess a taxpayer is extended. Specifically,the period is extended from three or four years to six or seven years in anycase where there may be reason to reassess by virtue of a transaction in-volving the taxpayer and a non-resident person with whom the taxpayer isnot dealing at arm’s length or as a consequence of an additional paymentor reimbursement of tax by a foreign government.103 The amendment givesthe Canadian tax authorities significantly more time to monitor, and pur-sue investigations of, intercompany pricing and related cross-border issues.

Recent DevelopmentsAdvance Pricing AgreementsFollowing the US lead in the implementation of its APA process in 1991,the Canadian tax authorities began to study the merits of adopting similarprocedures. In the spring of 1993, a draft information circular was issuedindicating Revenue Canada’s intention to implement an APA program andhighlighting its key features and requirements.104 Soon after, the introduction

99 Section 233.1 and related prescribed form T-106. The information to be provided inform T-106 is very similar to that required in US form 5472.

100 Supra footnote 97.101 See “Revenue Canada Round Table,” in the 1988 Conference Report, supra footnote

33, 53:1-188, at 53:27.102 Subsection 231.6(8) of the Act.103 Supra footnote 98.104 Revenue Canada, “International Transfer Pricing: Advance Pricing Agreements (APA)

Procedures and Guidelines,” May 21, 1993.


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of the program was officially announced.105 The objectives of the programinclude the reduction of uncertainty in establishing transfer prices and theelimination of double taxation for Canadian taxpayers. The APA process isin conformity with section 69 of the Act, the arm’s-length principle, andthe OECD guidelines on transfer pricing.106 While Revenue Canada willaccept applications for unilateral APAs, taxpayers are encouraged to extendcoverage to other countries.107 In this regard, the Canadian competent au-thority will endeavour to arrange parallel agreements with treaty partners.In the fall of 1994, Revenue Canada announced that Canada, the UnitedStates, Australia, and Japan had agreed on common procedures to be pur-sued in respect of mutual bilateral pricing agreements.108

Response to OECD GuidelinesCanada was quick to respond to the July 1995 release by the OECD of itsrevised transfer-pricing guidelines. In a news release issued by the De-partment of Finance,109 the government noted that the revised guidelinesrepresented “a consensus among the 25 OECD member countries on howto approach transfer pricing issues.” The government observed with obvi-ous approval the restrictions on the use of profit methods and the adoptionof such methods only as a last resort. Interestingly, while Canada obvi-ously supports the new version of the guidelines, the government notedand confirmed in the release that its current approach to transfer pricingis in harmony with the OECD 1979 report and, of course, with the viewsset out in IC 87-2.110

Continuing ActivityIn the 1990s, there has been a noticeable increase in Revenue Canada’saudit activities. This may be, in part, a reaction to the increased activityof IRS auditors in the transfer-pricing area. Other factors are the prepara-tion of IC 87-2, which required close examination of transfer-pricing

105 Revenue Canada, “Revenue Canada Initiates Advance Pricing Agreement Service,”Release, no. 48T/93, July 29, 1993. The program is described in Information Circular94-4, “International Transfer Pricing: Advance Pricing Agreements (APA),” December 30,1994. Paragraph 2 of IC 94-4 indicates that Revenue Canada will issue a supplement to thecircular providing detailed guidelines on the APA process.

106 IC 94-4, supra footnote 105, at paragraph 13.107 Of the 29 applications submitted to Revenue Canada under the APA program to

date, 22 have been accepted. Of these 22 agreements, 5 are unilateral APAs and 17 arebilateral; 3 have been finalized, 4 will be signed shortly, and 15 are still being negotiated.All 22 APAs involve the United States, and most concern tangible property.

108 Revenue Canada, “Revenue Canada Reaches Agreement with Australia, Japan, andthe United States on Bilateral Advance Pricing Agreements,” Release, no. 67T/94, October28, 1994.

109 Canada, Department of Finance, “OECD Transfer Pricing Guidelines Released,”Release, no. 95-059, July 28, 1995.

110 As mentioned earlier (supra footnote 71), IC 87-2 is under revision, and one mightanticipate the possibility of a redraft in line with the OECD 1995 guidelines.


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arrangements between related parties, and the more extensive reportingrequirements introduced in 1988, which have provided Revenue Canadawith more information to support taxpayer audits.111 Audit strengths andexpertise have increased through the provision of specialized trainingcourses for audit staff, the use of specialists, and the formation of inter-national audit groups.

Canadian Reaction to US DevelopmentsAs discussed earlier, the 1992 version of the US section 482 regulationsproposed to adopt the comparable profit method for determining transferprices and also to test prices retroactively against the CPI.112 The Cana-dian tax authorities disagreed with both approaches and in early 1994issued a release intended to clarify their position on the issue of pricingmethods.113 The release expressed unequivocal support of the comparableuncontrolled price, resale price, and cost plus methods and strongly rec-ommended that the US comparable profit method should be consideredonly in instances where one could be assured that the price so establishedwould be consistent with the arm’s-length standard. The release notedthat “where neither the uncontrolled price methods nor the transactionalmethods can be applied, profits of the group should be allocated based onproper remuneration of functions performed by different entities withinthe group.”114 The authorities emphasized that there may be many otherfactors unrelated to intercompany pricing that will influence the profitlevels of comparable entities. The statement further noted that the UScomparable profit method could result in transfer prices that may notconform to the arm’s-length standard and in such instances would accord-ingly be unacceptable for Canadian income tax purposes. In the extreme,if the comparable profit method were applied by all countries, and eachcountry compared results with those of independent firms operating withinits jurisdictional boundaries, the total of allocations to countries couldeasily exceed total income of the consolidated group.

The Canadian tax authorities also stressed that if the United Statesreassessed a US affiliate of a Canadian taxpayer using either the compara-ble profit method or the commensurate-with-income test applicable tointangibles, in most cases Canada would not be able to grant a corre-sponding adjustment. In such instances, taxpayers were advised to seekrelief through competent authority procedures whereby Canada would

111 Revenue Canada is probably also responding to the urging of the Standing Commit-tee on Public Accounts of the House of Commons regarding comments of the auditorgeneral of Canada to the effect that the tax authorities should strengthen their efforts tomonitor transfer-pricing arrangements. See Canada, Minutes of Proceedings and Evidenceof the Standing Committee on Public Accounts, Twelfth Report to the House, 34th Parlia-ment, 3d session, 1991-92-93, issue no. 48, 48:8.

112 Supra footnote 55.113 Canada, Department of Finance, “Transfer Pricing Rules and Guidelines Clarified,”

Release, no. 94-003, January 7, 1994, including the accompanying note.114 Ibid.


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seek to reach agreement in respect of “an internationally accepted pricingmethod which satisfies the arm’s-length principle.”115

When the final US regulations were issued in July 1994, the Canadianauthorities welcomed the modified approach to the use of the comparableprofit method, although they are still concerned that its restrictiveapplication has been granted statutory endorsement.116 As well, thecommensurate-with-income test and the consequent possibility of periodicadjustment remain, even with safe harbour “parachutes,” a real concern inCanada.117 The Canadian authorities are also troubled by the implicationsof the US penalty provisions that may apply where taxpayers cannot pro-vide satisfactory contemporaneous documentation to support pricing. Inparticular, they are concerned that the low US $5 million pricing adjust-ment threshold may encourage taxpayers to “play it safe” by favouringprofit allocations to the United States.118

GOING FORWARDAlthough some resolution of the transfer-pricing debate has been reachedwith the affirmation of the OECD and the US positions, increasing vol-umes of world trade and ongoing realignment of trade patterns will ensurethe continuing interest of governments in related-party cross-border trans-actions of MNEs.119 Worldwide initiatives by international business tocompete, to penetrate new and emerging markets, and to contain costsand manage risks through varied techniques and approaches (including,for example, the popularity of joint venturing and strategic alliances) allhave corresponding “ripple” effects on governments. Governments of manycountries plagued with difficult national deficit issues are simultaneouslyexperiencing immense pressures in respect of income tax rates. The 1990economic downturn was not confined to the United States. Problems of

115 Ibid.116 See comments of Carole Gouin in “Summary of International Tax Planning 1:

Canada-US Cross-Border Issues,” in Report of Proceedings of the Forty-Sixth Tax Confer-ence, 1994 Conference Report (Toronto: Canadian Tax Foundation, 1995), 24:1-50, at24:42.

117 See comments of Carole Gouin in “OECD Transfer Pricing Guidelines, RevenueCanada and IRS Positions,” paper presented to the Infonex Conference, Toronto, January24, 1995, 10-11.

118 Supra footnote 116, at 24:47.119 It should be kept in mind that the OECD 1995 guidelines are essentially a consensus

document. The guidelines have been written in language that is sensitive to the particularareas of interest and concern of OECD members. That language will inevitably be inter-preted and applied somewhat differently by particular OECD members. For example, whileseveral commentators (including the US Treasury) view the OECD transactional net mar-gin method as an implied endorsement of the US comparable profit method, some countrieswill not agree. In particular, Germany has noted that, although the two methods are gener-ally applied on an exceptional basis, it intends to use profit-based approaches (thetransactional net margin method in particular) only as “an estimation or cross-check be-cause it deems traditional methods to be sufficient”: see Germany, Ministry of Finance,“Press Release on OECD Transfer Pricing Guidelines,” July 13, 1995 (unofficial translation).


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diminishing tax revenues and the servicing of expenditure commitmentsface many countries, including the United Kingdom, Germany, Japan,Canada, and, indeed, much of the industrialized world. One consequenceof these pressures is that governments face the challenge of increasingtax revenues without raising rates. The design of the US tax system inparticular may encourage this focus since income taxes are viewed as theprimary source of revenues and a much smaller role is assigned to con-sumption or sales taxes.

The revenue potential of transfer-pricing arrangements will likely bemost attractive to those countries with a relatively static domestic economybut increasing involvement in international markets. It is clearly politi-cally easier for governments to increase the tax take from foreign-ownedthan domestic companies, especially in the case of their own trade com-petitors. In fact, there is continuing evidence of this approach, especiallyin the United States. The several versions of the section 482 regulationswere launched into a somewhat volatile environment, and many countriesviewed the legislation as an overt attempt by the United States to obtaina disproportionate share of the worldwide profits of foreign-based MNEs.The threat of heavy penalties for non-compliance, and accordingly a per-ceived incentive for foreign companies to “play it safe,” has onlyencouraged this view. It will be interesting to see whether other countries,having criticized the magnitude and scope of the US penalties, will ulti-mately react by adopting similar deterrents.

A key issue in the years ahead may not be the methods to be used fordetermining and testing transfer prices, but rather the economic and po-litical struggle for tax revenues within and between major countries.Accordingly, it is likely that tax audits of MNEs will increase in bothintensity and sophistication. The scope and direction of those audits willbe facilitated and influenced by existing and perhaps further expandedinformation requirements with respect to the operations, structuring, andintercompany transactions of MNEs.

Formulary ApportionmentThe OECD 1995 guidelines strongly oppose the use of a global or formu-lary apportionment approach for allocating income and expenses inrelated-party transactions between countries.120 The OECD’s current posi-tion is consistent with the views expressed in its 1979 report.121

Broadly speaking, there are two fundamental approaches to related-partytransfer pricing. One is the arm’s-length principle and standard. This ap-proach, discussed earlier, is the foundation of article 9(1) of the OECDmodel convention. A second approach is some form of formulary appor-tionment. Formulary apportionment begins with the premise that certainconditions inherent in the structure and operations of MNEs, such as

120 OECD 1995 guidelines, supra footnote 63, chapter III, at paragraph 3.74.121 OECD 1979 report, supra footnote 23, at paragraph 14.


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economies of scale and the integration of functions among entities withinthe group, require that profit allocations among group members be deter-mined on a consolidated basis. Formulary approaches contemplateallocations of the global profits of MNEs on the basis of predetermined for-mulas, which usually reflect key factors such as sales, payroll, and assets.

Critics view formulary apportionment as totally arbitrary and a cleardisregard of market conditions. Global profit apportionments yield profitallocations that will only by sheer coincidence bear relation to economicfacts and realities. They produce results that do not reflect arm’s-lengthprices and therefore contravene the arm’s-length standard. Such methods,of course, ignore any reference to separate entities. Formulary apportion-ment can, for example, result in the allocation of income to an entity thatin reality, and tested against the arm’s-length standard, has suffered aneconomic loss. Canada, through its approval of the OECD 1995 guide-lines, rejects global formulary apportionments.

Implementation of a global formulary apportionment approach inevita-bly conflicts with the spirit of international tax treaties. Furthermore, inthe absence of some form of international consensus, the approach raisesthe spectre of double taxation. The only conceivable possibility, which atthis stage seems rather naive even to contemplate, would be internationalagreement on the use of such an approach and particularly the key factorson which allocations would be based. Even the administrative aspects offormulary apportionment seem daunting, since information would have tobe provided to multiple taxing jurisdictions detailing the MNE’s worldoperations and activities, in all instances presumably harmonized with theaccounting rules and tax laws of each jurisdiction. Presumably, too, theMNE would be required to maintain parallel separate entity accounts on abasis reflecting the arm’s-length standard for a variety of other purposes,including adherence to accounting rules and standards, customs duties, etc.

Notwithstanding its many critics and the near-impossibility of an inter-national consensus on its use, global formulary apportionment will likelyremain a major issue. Some observers suggest that if the application ofthe section 482 regulations and the use of traditional pricing methods donot yield acceptable results from the US perspective, formulary appor-tionment may become irresistible.122 In June 1995, the US Foreign RelationsCommittee held hearings to consider six treaties and protocols, includingthe outstanding protocol with Canada.123 During the hearings, SenatorDorgan expressed strong concerns about perceived massive transfer-pricingmanipulations by foreign MNEs, noting the specific examples of Japanesecar and electronics manufacturers. He pointed out that IRS audits based

122 See, for example, Daniel M. Berman, “Summary of International Tax Planning 1:Canada-US Cross-Border Issues,” supra footnote 116, at 24:45-46.

123 Protocol to the Canada-US convention signed on March 17, 1995 (herein referred toas “the 1995 Canadian protocol”). The protocol has yet to be ratified in Canada. The sixtreaties or protocols in question concern the income tax conventions that the United Statessigned with France, Mexico, the Ukraine, Sweden, Portugal, and Kazakhstan.


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on traditional methods have generated only minimal adjustments to per-ceived tax shortfalls. Senator Dorgan vigorously opposed any treaty whoseprovisions could be interpreted as prohibiting formulary apportionment.He further threatened that if the committee ignored his position, he wouldargue against ratification of the pending treaties and protocols when theywere considered by the Senate as a whole. The committee ultimatelyrecommended that the relevant treaties and protocols proceed to the Sen-ate without reservation, but only after Treasury had acceded to SenatorDorgan by promising a study on the possibility of adopting a federalformulary apportionment system for MNEs.124

Advance Pricing AgreementsAPAs are a recent development that has attracted considerable interestand attention. Generally, initial reactions to APA programs and proceduresseem favourable.125 The United States, Canada, and several other coun-tries have established an APA process.126 While the negotiation of an APAwill have no direct bearing on previous taxation years under audit, in theUS context, some applicants have found that APA negotiations can help inthe resolution of disputes pertaining to earlier years where tax auditorsmay have taken otherwise rigid, and perhaps even unreasonable, positions.

Although there are signs of growing European interest in APAs, somecountries appear reluctant to adopt the process, perhaps because they areconcerned that negotiated pricing agreements may result in a loss of flex-ibility for tax authorities. For other countries, APAs are an interestingalternative to the former adversarial approach to transfer-pricing disputes.APAs are, of course, attractive to MNEs that wish to avoid uncertaintiesand the risk of incurring substantial penalties, particularly under the USrules. A further potential advantage of APAs, particularly bilateral andmultilateral agreements, is that they can alleviate the concerns of somecountries that the differences of emphasis in the application of transfer-pricing methods by various tax authorities may lead to inappropriateapplications of methodology among the jurisdictions concerned. A bilat-eral or multilateral APA gives tax authorities the opportunity to resolvetheir differences before the pricing method is established.

124 For additional comments, see “Dorgan Opposes Pending Tax Treaties” (September4, 1995), 11 Tax Notes International 660- 61. The treaties and protocols under considera-tion, including the 1995 Canadian protocol, were ratified by the US Senate on August 11,1995.

125 For a discussion of the more apparent advantages and disadvantages of an APA, seeJill C. Pagan and J. Scott Wilkie, Transfer Pricing Strategy in a Global Economy (Amster-dam: IBFD Publications, 1993), 196-98; and Nathan Boidman, “Advance Pricing Agreementsin Canada” (July 1994), 21 Tax Planning International Review 3-18, at 13-14.

126 Australia, Japan, Mexico, the Netherlands, Korea, and Germany have introducedAPA programs. A number of other countries provide for the issuance of advance rulings ontransfer pricing; they are Belgium, Hong Kong, India, Ireland, New Zealand, Norway,Sweden, and Switzerland.


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In this regard, it is worth noting that the original version of the section482 regulations would have been incompatible with the APA program insome respects, particularly in the case of attempts to negotiate bilateral ormultilateral APAs. As noted earlier, the proposed regulations conflictedwith OECD standards, as well as transfer-pricing approaches and guide-lines adopted by other tax authorities. If, for example, the IRS had insistedon using profit analyses and comparisons as the basis for determiningtransfer prices, it would have met serious opposition from other tax au-thorities participating in the negotiation process. In the event, the finalregulations are much more in line with international standards and ac-cordingly may facilitate APAs. At the same time, the complexities ofthose regulations may serve to enhance the attractiveness of an APA,particularly in complex situations.

ArbitrationAlthough the United States has made an earnest attempt to legislate rulesthat will yield “the right answers” in respect of related-party transferpricing, it is impossible to predict, at this stage, how successful its effortswill prove to be. There is no doubt that the rules are extremely complexand somewhat inflexible from the viewpoint of taxpayers. However, theIRS seems determined to apply the legislation strictly as written. It willbe interesting to observe the response of Canada and other countries astaxpayers experience the effects of the legislation. One can anticipatetaxpayer requests for compensatory relief in respect of US adjustments,but how the competent authorities involved will deal with these casesremains to be seen.

The OECD model convention and most international treaties providethat treaty partners, through their competent authorities, will “endeavour”to resolve transfer-pricing disputes and eliminate double taxation.127 Thecompetent authorities are not required to reach an agreement. In the presentsituation, particularly in view of the international controversy over USinitiatives, there appears to be a real possibility that the authorities mayin fact be unable to agree. The prospect of such an impasse has generatedinterest in the feasibility of arbitration procedures.

Recent treaties negotiated by the United States, beginning with the1989 US-Germany convention,128 make provision for recourse to arbitra-tion. Other examples can be found in US treaties negotiated with Mexico129

127 See article 25 of the OECD model convention and article XXVI of the Canada-USconvention.

128 See article XXV(5) of the Convention and Protocol Between the United States ofAmerica and the Federal Republic of Germany for the Avoidance of Double Taxation andthe Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital and toCertain Other Taxes, signed at Bonn on August 29, 1989.

129 See article XXVI(5) of the Convention and Protocol Between the Government ofthe United States of America and the Government of the United Mexican States for theAvoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxeson Income, signed at Washington, DC on September 18, 1992.


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and the Netherlands130 and in the pending protocol to the Canada-USconvention.131 Arbitration as a method of resolution must be agreed to bythe parties.132 In the European Union, however, an agreement signed in1990 contemplates forced arbitration.133 Where the competent authoritiescannot reach consensus on a transfer-pricing dispute that would otherwiseresult in double taxation, the agreement provides for reversion to an advi-sory commission. Countries need not carry out the decision of the advisorycommission, but if they do not, they are required to eliminate doubletaxation in some other way. It will be interesting to see whether theconcept of transfer-pricing arbitration procedures is extended to othermulticountry arrangements. Obviously, recourse to arbitration requirescooperation between countries. In this regard, and notwithstanding con-troversial aspects of related-party pricing, there are signs of growingcooperation between tax authorities, notably with respect to informationexchanges. Some of these arrangements are formalized by their inclusionin treaty provisions,134 and some are informal, as in the case of theinformation-exchange mechanisms agreed to by the group of four.135

130 See article XXIX(5) of the Convention Between the United States of America andthe Kingdom of the Netherlands for the Avoidance of Double Taxation and the Preventionof Fiscal Evasion with Respect to Taxes on Income, signed at Washington, DC on Decem-ber 18, 1992.

131 Article 14 of the 1995 Canadian protocol proposes the introduction of an arbitrationprovision in article XXVI(6). Provision for arbitration also is made in article XXV(5) ofthe Convention Between the Government of Canada and the Government of the Kingdomof the Netherlands for the Avoidance of Double Taxation and the Prevention of FiscalEvasion with Respect to Taxes on Income, signed at The Hague on May 27, 1986, asamended by the protocol signed on March 4, 1993. Article 25 of the OECD model conven-tion, supra footnote 4, does not set out specific arbitration procedures, but see paragraph48 of the commentary on that article.

132 Revenue Canada has not always been in favour of arbitration committees as amechanism to resolve double taxation cases. See John A. Calderwood, “The CompetentAuthority Function: A Perspective from Revenue Canada,” in Report of Proceedings of theForty-First Tax Conference, 1989 Conference Report (Toronto: Canadian Tax Foundation,1990), 39:1-19, at 39:19.

133 See article 7 of the Convention on the Elimination of Double Taxation in Connec-tion with the Adjustment of Profit of Associated Enterprises, signed by European UnionMembers on September 20, 1990, EU Paper no. 1524. The convention entered into forceJanuary 1, 1995.

134 See the proposed amendment to articles XXVII(1) and (4) of the Canada-US con-vention contained in the 1995 Canadian protocol, supra footnote 123. It amends articleXXVII (exchange of information) in three ways: (1) it expands the type of informationthat can be exchanged to all taxes imposed by a country; (2) it makes such informationaccessible to political subdivisions of a country; and (3) it authorizes the release of theinformation to an arbitration board set up pursuant to article XXVI(6).

135 The group of four consists of representatives of the tax administrations of France,Germany, the United Kingdom, and the United States. In 1992, it released a report discuss-ing exchanges of information involving transfer-pricing issues, in response to the July1990 Ways and Means Oversight Subcommittee Hearings in the United States on abusesby MNEs.


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HindsightMNEs and tax authorities in other jurisdictions welcomed the US Treas-ury’s decision to modify the superroyalty and commensurate-with-incomerules in the final section 482 regulations, and also the introduction of safeharbour rules. It seems likely that the Treasury’s reversal of its originalposition was at least partly a response to criticism expressed by the OECD.Considering that the commensurate-with-income provision is a statutorymandate emanating from 1986 legislation,136 the efforts of the OECD andothers to influence the US proposals were probably as successful as onemight have hoped. Nevertheless, many countries, including Canada, con-tinue to object to the use of hindsight in establishing transfer prices andthe consequent possibility of periodic adjustments. The OECD considersperiodic adjustments to be justifiable in only exceptional circumstances,particularly where an intangible has been sold or licensed in a related-partytransaction under fixed terms and one can show that comparable depend-ent parties would have insisted on price adjustment clauses, bonus paymentsbased upon results, etc.137 As the US rules come into play, observers willbe particularly sensitive to the application of the commensurate-with-income test and the reactions of other countries—for example, competentauthority negotiations between the United States and its partners. One cananticipate strong objections to proposed adjustments to a price or royaltyreflecting the use of a hindsight approach.

CONCLUSIONIt seems inevitable that activity in the transfer-pricing arena will con-tinue. Some comfort can be taken from the fact that the OECD has updatedits guidelines and provided primary references to support related-partypricing approaches. Furthermore, and perhaps particularly appropriate tomore complex pricing matters, the negotiation of APAs may prove a use-ful and pragmatic solution in the more troublesome situations. Historicalsolutions to significant cross-border disputes—notably, competent au-thority resolutions—may not be as feasible as they have been in the past.Recourse to arbitration may prove an effective alternative. However, formany MNEs, there may be no attractive solution in the event of atransfer-pricing dispute: the stakes can be very high and the process, ifnot the outcome, extremely disruptive.

With the enactment of the new US law and the publication of theOECD 1995 guidelines, the rules of the game for MNEs have changedsignificantly. The primary defence of the MNE against challenges of re-lated-party pricing will be to ensure that transactions within the groupare “demonstrably” at arm’s length. What might have been appropriate inthe past will, in most instances, not suffice in the future. For example, it

136 Supra footnote 30.137 See paragraphs 33 to 41 of chapter IV of the OECD 1995 guidelines. Note that

chapter IV remains in draft since it was not adopted by the fiscal committee of the OECDin July 1995.


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will not be sufficient for an MNE to establish prices using the traditionalcost plus or resale price method unless it can also “demonstrate” thecommercial viability of the results. Group members must be able to sat-isfy tax authorities that their transfer-pricing approaches reflect theoutcome that one would anticipate in an arm’s-length situation, as well asthe different risks and functions undertaken by each entity in the group.Analysis of risks undertaken and functions performed by each participantin a production-distribution chain and the weighting of these factors inthe pricing decision will be vital. It will also be essential for MNEs tomaintain complete documentation and to carry out thorough business analy-ses to support their choice of pricing method. Failure to meet theserequirements will increase the possibility of a price adjustment and also,particularly under the US rules, may attract onerous penalties. MNE transfer-pricing decisions must also take into account the fact that intercompanytransactions involve two or more taxing jurisdictions. The arsenal of taxauthorities has been considerably bolstered over the last several years.Seeking to placate one tax authority while ignoring the position, if notthe expectations, of another will be a clear recipe for trouble.

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The International Transfer-Pricing Debate...THE INTERNATIONAL TRANSFER-PRICING DEBATE 1567 (1995), Vol. 43, No. 5 / no 5 methods. As we look ahead, many uncertainties remain. There