A division, branch, department, or any other component of an entity may transfer goods or services to other subdivisions of the same entity. The transfers include tangible property (raw materials, unfinished components, or finished goods); intangible property (patents, trademarks, or copyrights); services (marketing and distribution, research and development, or consulting and managerial assistance); money (loans), and the use of property (equipment or building). These transfers may be viewed as internal sales for which the seller receives a transfer price that is charged to the buyer (Evans, Taylor, Holzmann, 1994). As companies increasingly practice these internal sales through foreign subsidiaries, joint ventures, and parent-owned distribution systems, the question of what price they charge to their affiliates becomes increasingly complex. Intracompany pricing of this type, referred to as international transfer pricing, is the price of goods and services sold between related parties such as parent and subsidiary.
Empirical researchers have singled out tax minimization to be one of the most important variables affecting international transfer pricing decisions of multinational companies (Arpan 1972; Burns 1980). This focus is not surprising because transfers between related business units account for approximately 40 percent of total world trade. The economic benefits are obvious and immediate if transfer prices become the instrument for shifting profits from a country with a higher tax rate to a country with a lower tax rate. However, a company's evaluation of this avenue toward maximized profits must be balanced by the assurance that its practices are consistent with regulations of taxing agencies.
Governments are not all alike, nor are they all equally concerned about the effects of transfer prices. The United States, Canada, and most developing countries rank among the most concerned (Arpan and Radebaugh 1985). In this country, for example, Section 482 of the Internal Revenue Code, permits the Internal Revenue Service (IRS) to "distribute, apportion, or allocate gross income, deductions, credits, or allowances" between related companies in order to prevent tax evasion. The IRS prefers that all internal transfers take place at "arm's-length" prices, the prices which would take place between unrelated parties.
We first briefly describe major findings of government's studies on transfer pricing practices of foreign multinational companies. The second section of this paper discusses new regulations about Section 482: the 1988 White Paper and the 1993 temporary regulations. Finally, we evaluate important provisions of the 1993 temporary regulations: other pricing methods, the best method rule, and advance pricing agreements.
U.S. GOVERNMENT STUDY FINDINGS
In the 1980s, U.S. policy makers focused on trade imbalances, now they worry about investment imbalances, particularly Japanese direct investment. U.S. multinational companies dominated foreign direct investment from World War II until 1980. In fact, two familiar patterns emerged in decades since. First, a multinational company tended to be based in the United States. Second, these U.S. multinational companies made foreign direct investment. In other words, America dominated in foreign direct investment worldwide; the Japanese served as a host to investing nations. However, recent statistics indicate that these two patterns no longer exist; these two positions have been changed. More specifically, the United States was the dominant direct investor abroad from the1950s through the 1970s, but since 1980 it has become the world largest recipient of foreign direct investment funds.
Japan's direct investment in the United States has become uncomfortably large although its firms still account for a small fraction of foreign presence. Still, concerns about foreign direct investment in the United States focused on Japanese firms for two major reasons. …