Question

Compco, a U.S. corporation, produces CD-ROM disk drivers in the United States. Compco uses a wholly owned subsidiary, Pacifico, which was organized in Singapore, to distribute products in Asia. Compco charges Pacifico $70 per unit delivered to Pacifico’s warehouse in Singapore. The cost of shipment is $2 per unit. Compco also sells the same product to unrelated wholesalers and distributors in other parts of the world. Compco charges such customers $80 per unit under a contract providing sales are f.o.b. Compco’s factory in the United States. You are the IRS agent responsible for the case.

(a) What method should be applied in determining whether to seek an adjustment under Internal Revenue Code Section 482? What adjustments would you recommend?

(b) How would your answer in part (a) above be affected if sales to unrelated distributors were at $60 per unit?

Answer 1

Transfer pricing refers to the pricing of transactions between controlled entities. For example, when a US parent (USP) sells a product to its controlled foreign corporation (CFC), IRC 482 requires USP to sell that product at an arm’s length price to its CFC. Under IRC 482, controlled entities should price transactions in the same way that uncontrolled entities would under similar circumstances. This is the “arm’s length standard”, which means that the price of the product that USP charges its CFC should be the same as it would charge to an unrelated party for the same product under similar circumstances.

If the transfer price is not arm’s length, the IRS has the authority under IRC 482 to make adjustments by reallocating items of gross income, deductions, credits, or allowances in order to properly reflect income between the entities.

a) The difference of $10 ($80 -$70) being diffenece in price sold to unrelated wholesalers and distributors and related party i.e Pacifico shall be added back to the gross income. The cost of shipment of $2 shall be allowed as per the normal conditions.

b) If sales to unrelated distributors were at $60, then there woulb be no adjustments to gross income of Compco.