A Cheesey Tax-Induced Export Subsidy with Transfer Pricing Holes

Letters To Switzerland is the transfer pricing chapter of David Kay Johnson’s Perfectly Legal – who argues certain multinationals are diverting income from the U.S. Treasury offshore. The topic of transfer pricing manipulation was also raised by a John Plender and Martin Simons article in the Financial Times on July 22, 2004, but this time in reference to diverting revenues away from the UK tax authorities. The Financial Times article reminded me of the E. I. DuPont de Nemeours classic, which involved a Swiss sales subsidiary formed about the time John Edwards was finally out of diapers. George Mundstock’s Leave No Corporation Behind  discusses the U.S. tax incentive for exports, which used to be DISC, then FSC (foreign sales corporation), and is now ETI, and each time has been challenged by the EU under WTO rules. The U.S. Treasury has tried to argue that FSC transfer pricing was arm’s length, but we shall use a simple example based on this Swiss classic to suggest otherwise.

Consider a U.S. manufacturer of winkettes that sells 100 million units to its EU distributors for a wholesale price of $10. The distributor sells to European customers each winkette for $12.50 and thereby earns a 20% gross profit margin to cover its accounting costs as well as provide for a normal return to its invested capital. Our U.S. manufacturer has two types of accounting costs: production costs equal to $8 per unit and logistics costs equal to $0.50. U.S. profits are therefore $1.50 per unit or $150 million per year generating $52.5 million in corporate income taxes at a 35% tax rate. The ETI rules allow for two types of tax planning: (a) a simple administrative pricing rule where 15% of profits could be sourced to a no-tax entity; or (b) arm’s length pricing under section 482 where any FSC profits would be get a 30% haircut from taxes, which is a tax rate equal to 24.5% of FSC income. Under the first type of planning, the effective tax rate would be only 29.75%. The other approach would make sense only if at least half of the profits should accrue to the FSC.

If the FSC were responsible for the logistics function, its arm’s length commission rate would be around 5.5% under most sensible approaches, which would mean the FSC would pay the manufacturer a price equal to $9.45 per unit, would generate $55 million in gross profits and incur $50 million in expenses, which results in only $5 million in net profits. Tax obligations under arm’s length pricing would be nearly $52 million. So do all multinationals go for the administrative rule?

Oddly, some tax advisors tell these multinationals that the FSC should earn a 20% gross profit margin, which has the effect of putting all income in the FSC taxed at an effective tax rate of only 24.5%. Their premise is that many distributors earn 20% gross profit margins or more, which was the taxpayer’s position in the E. I. DuPont de Nemeours case. Of course, the Tax Court saw the fatal flaw in this logic noting sensibly that gross profit margins depend on the functions of the sales entity and that related party entities with very few functions should earn more modest gross margins. Yet, this illogical argument has resurfaced. And if you are wondering who might argue such aggressive and illogical positions, Mr. Johnson has some clues for you.

I raise the Financial Times article only because it posits a similar pricing policy between a UK manufacturer and a Benelux subsidiary and tries to argue any gross profits in the subsidiary is evidence of an intercompany price that is below the arm’s length standard. That might be correct in our Swiss classic, but if the Benelux subsidiary was a typical distributor, then the authors should rethink their example.