Corporate Taxation: Profit Shifting, Transfer Pricing, and Cost Sharing

November 1, 2023

Corporate Taxation: Profit Shifting, Transfer Pricing, and Cost

Sharing

Recent events have highlighted the issue of corporate profit

shifting using transfer pricing and cost sharing methods. In

its October 11, 2023, 8-K filing with the Securities and

Exchange Commission, Microsoft indicated that it had

received a notice of a $28.9 billion deficiency from the

Internal Revenue Service (IRS). Microsoft communications

indicated that the deficiency is related to the allocation of

profits among countries using a transfer pricing method

referred to as cost sharing. This deficiency refers to taxes

during the 2004 to 2013 period. In a separate development,

on October 20, 2023, the IRS announced a number of new

initiatives, including a focus on large corporations’ crossborder transactions and transfer pricing methods of U.S.

subsidiaries of foreign corporations. Senator Ron Wyden,

chairman of the Senate Finance Committee, has also

proposed legislative changes to address transfer pricing

following an investigation of multinational pharmaceutical

companies by the committee.

best method for achieving arms-length prices is through

prices in comparable uncontrolled transactions. For some

goods and services, and particularly for intangible assets,

such comparable prices are not available because of the

unique nature of the commodity. Examples of intangibles

likely to confront this problem are drug formulas and digital

assets such as software.

This In Focus explains how transfer pricing, and

specifically the cost sharing method, can be used to allocate

profits from intangible assets out of the United States and

into low-taxed jurisdictions.

comparable firms as a share of assets, sales, or operating

costs are used to determine the transfer price.

What Is Transfer Pricing?

Transfer pricing is one of the two main methods, along with

the allocation of debt, that affects how multinationals report

profits across different countries. In general, profits are

attributed to the country where the asset generating the

profits is produced or acquired. When sales of goods or

assets occur between related corporations, such as a U.S.

parent and its foreign subsidiary, transfer pricing rules

generally require that the transaction occur at arms-length

prices, that is, prices that would occur between unrelated

parties.

The Internal Revenue Code (IRC) section that governs

transfer pricing, Section 482, is a brief section, general in

nature, which consists of three sentences. The first

sentence, which is long-standing in the tax code, allows the

Secretary of the Treasury to adjust tax items to address tax

evasion or to properly reflect income. The second sentence,

added by the Tax Reform Act of 1986 (P.L. 99-514),

provides that in the case of intangibles the payment for the

transfer or license of an intangible must be commensurate

with the income received from the intangible. The third

sentence, added by a law commonly referred to as the Tax

Cuts and Jobs Act of 2017 (P.L. 115-141), provides that

intangible assets can be aggregated to determine valuation.

The details of rules regarding transfer pricing are contained

in the Treasury regulations under Section 482, which are

generally designed to reflect the arms-length standard. The

Treasury regulations outline the basic methods for setting

transfer prices for tangible property, intangible property,

loans, and services. In the case of intangibles there are three

methods:

• The comparable uncontrolled transactions method

compares the payments between unrelated businesses to

determine the transfer price (similar to comparison of

sales prices for tangible goods).

• The comparable profits method, where profits of

• The split-profits method, where profits are allocated

based on the contribution of each firm (including

functions performed, resources invested, and risks

assumed). When a firm has ongoing research and

development, the allocations are often determined by the

split-profits method with cost sharing. A variation of the

split-profits method is the residual split-profits method,

where an amount of profit is assigned for routine

functions and the residual is split between the

corporations.

Cost Sharing Agreements and the SplitProfits Method

Cost sharing agreements (CSAs) are a common way to

allocate profits derived from intangible assets between a

parent and its subsidiary, usually by payments to the parent

for the rights to exploit the intangible in a particular

geographic area. Under a cost sharing arrangement there is

an initial buy-in payment (sometimes called a platform

contribution) to acquire a share of the existing intangible.

After that point, the subsidiary firm makes a cost

contribution to reflect its share of any ongoing profits from

the original intangible. The buy-in payment could be an

ongoing royalty that reflects the increased earnings due to

the intangible or an upfront payment that would reflect the

present value of those increased earnings. The buy-in

payment is deductible to the subsidiary and is taxable to the

parent.

After this initial buy-in payment, profits are divided based

on cost sharing payments by the subsidiary to the parent,

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Corporate Taxation: Profit Shifting, Transfer Pricing, and Cost Sharing

again deductible by the subsidiary and taxable to the parent.

The research and development often takes place solely in

the United States and is managed by the U.S. parent.

CSAs are widely used by multinationals with intangible

assets such as software, search algorithms, and other digital

assets, as well as large pharmaceutical companies. These

arrangements are generally with subsidiaries in tax havens

which have low or no taxes, such as Bermuda, the Cayman

Islands, Ireland, Switzerland, Singapore, or, in the

Microsoft case and others, Puerto Rico, which is not subject

to the U.S. tax and often offers tax reductions and holidays.

Puerto Rico is treated the same as a foreign country for

allocating income. The arrangements can allow exploitation

of the intangible in a particular area (such as Europe or

Asia) but can also involve selling back to the United States.

A case can be made that cost sharing agreements are not

consistent with arms-length prices for several reasons.

While a wholly owned subsidiary can contribute to the cost

of research, it cannot assume the risk. A Government

Accountability Office (GAO) study pointed out that any

loss of the subsidiary will be reflected in the market value

of the parent so that any loss to the subsidiary is a loss to

the parent. Thus, related corporations do not have the same

ability to transfer risk as do unrelated corporations.

Moreover, for a company whose ongoing profitability

exceeds normal or competitive returns (for example,

because of its unique status in the market), a company

would not likely contract with an unrelated corporation for

an ongoing share of its profits based on the share of costs

contributed.

A University of Michigan law professor, Reuven AviYonah, has argued that the cost sharing method should be

eliminated.

Another issue that arises with the CSA is that the buy-in

payment may be structured as a royalty that is relevant to

current profits, but which declines and disappears as the

technology decays. For many intangibles (e.g., the

Microsoft Windows code), each new development is

layered on top of the existing technology so the original

intangible has an indefinite life.

Another issue is that CSAs allocate a disproportionate

amount of profits to the subsidiary even though the

subsidiary has no active role in the management and

oversight of the research, which is carried out in the United

States under the complete control of the U.S. parent.

The Commensurate With Income

Standard and Period Adjustments

The IRS regulations include a provision to make periodic

adjustments to transfer prices to reflect profitability. These

regulations are based on the commensurate with income

standard for the transfer of intangibles (the second sentence

of Section 482) added by the Tax Reform Act of 1986.

In an extensive article in Tax Notes discussing cost sharing

arrangements in general and Microsoft in particular, Steven

Curtis and Reuven Avi-Yonah indicate that the IRS has not

invoked periodic adjustments but that it would be a tool to

enforce what they consider gaping holes in the cost-sharing

approach.

There is some debate about whether periodic adjustments

conflict with the arms-length standard, which has been the

underlying focus of regulations reflecting the first and longstanding sentence of Section 482. One issue might be

whether periodic adjustments reflect the ex post realization

of profits that was not expected at the time of the buy-in or

whether ex post realization of profits is evidence that the

payments were originally understated. However, the armslength standard is a regulatory concept while the

commensurate with income measure is in the statute, with

the latter taking precedence in defining IRS authority.

Other Measures to Challenge Cost

Sharing

While the periodic adjustments rule could be used to adjust

transfer prices under the cost sharing method, there are

other parts of the tax code that might be used to challenge

these prices. These options are discussed in the Curtis and

Avi-Yonah article on Microsoft and also in an earlier

related study by Steven Curtis and Richard Chamberlain.

These alternatives include treating the income as effectively

connected with U.S. source income, or challenging the

agreement as lacking economic substance or as a sham

transaction.

From a legislative perspective there are changes in the tax

law that could capture some of the profits allocated to tax

havens through CSAs as contained in the House version of

the Build Back Better Act (H.R. 5376) in the 117th

Congress, and as recently proposed by Chairman Wyden.

This proposal related to the Senate Finance Committee’s

study of multinational pharmaceutical companies. Under

current law, a U.S. tax is imposed on foreign source income

from intangibles (the tax on Global Intangible Low Taxed

Income, or GILTI), but the tax rate is lower than the U.S.

rate and can be reduced by the use of unused foreign tax

credits from non-tax haven countries. These revisions

would raise the GILTI rate and apply credits against the tax

only for foreign taxes paid to the country. (See CRS In

Focus IF11943, GILTI: Proposed Changes in the Taxation

of Global Intangible Low-Taxed Income, by Jane G.

Gravelle for a discussion of these proposals.)

The ability to shift profits to low-tax jurisdictions could

also change if a global minimum tax (Pillar 2) proposed by

the OECD/G20 is widely adopted. (See CRS In Focus

IF11874, International Tax Proposals Addressing Profit

Shifting: Pillars 1 and 2, by Jane G. Gravelle for an

explanation.) Many countries have already begun the

process of adopting this minimum tax.

Jane G. Gravelle, Senior Specialist in Economic Policy

IF12524

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Corporate Taxation: Profit Shifting, Transfer Pricing, and Cost Sharing

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