THE BALRM APPROACH TO TRANSFER PRICING**

DANIEL J. FRISCH*

Introduction would search for comparable licensing.arrangements between unrelated parties.

N October 18, 1988, the Treasury De- The problem is, simply, that comparablesOpartment and IRS jointly released "A often cannot be found. When this occurs,Study of Intercompany Pricing," com- the traditional methods come to amonly called the Section 482 White Paper screeching halt. In many cases, intangi-(WP).' It is a response to the change made bles transferred between related partiesby the Tax Reform Act of 1986 to section are never transferred to unrelated ones,482 of the Internal Revenue Code, and fo- and different but similar intangibles docusses on the proper allocation of income not exist or, if they do, are also not li-when one related party licenses or oth- censed to outsiders, The evidence dis-erwise transfers intangible property to cussed in the White Paper as to the se-another.' The White Paper discusses the riousn'ess of this problem includes a longproblems that have occurred in this are .a, line of court cases which could not be de-the concerns expressed by Congress. in cided on the basis of comparables. Fur-1986, and possible approaches for dealing ther, in chapter 10, the White paper pointswith them. Because patents, trademarks, out that economists have long known thatknow-how, and other intangibles are such market failures prevent the exploitationcrucial ingredients in multinational cor- of intangibles among unrelated parties inporations' operations, these approaches many cases; indeed, this fact is frequentlyhave generated a great deal of contro- cited as a principal reason why multina-versy. tional corporations exist.

This paper is concerned with one of the What is the solution to this problem?most controversial aspects, the so-called Rather than abandoning the arm's lengthBALRM approach to transfer-pricing. Af- standard, even in a limited set of circum-ter describing BALRM, the paper dis- stances, the White Paper suggests an al-cusses criticisms of and possible alterna- ternative interpretation of it. The tradi-tives to it. Next, an alternative way to view tional approach looks for the arm's lengthit is presented; the goal is to interpret price-in the case of a license, the roy-BALRM in a way that depends only on alty rate that unrelated parties would havematerial that should be familiar to a broad charged. The White Paper's alternative isclass of the business community. This to consider the returns that unrelatedinterpretation leads to several sugges- parties would have earned had they en-tions for implementing BALRM, which are gaged in the enterprise-in other words,discussed. A final section summarizes the to look for the arm's length returns.results. This general approach has not been es-

pecially controversial, at least airnong thoseGenesis of BALRM who do not wish to abandon the arm's

length standard. Even severe critics of theThe White Paper's discussion of the White Paper often agree that courts, tax-

problems with pre-1986 rules is based on payers, and the IRS have found it usefula simple point. Transfer prices are judged "to look to the bottom line" and use in-according to the arm's length standard. formation about the profits each partyThis approach has traditionally been in- earns to help resolve transfer-pricing is-terpreted as a search for comparables- sues. 3 What is controversial is the Whitein the case of a license of a patent be- Paper's application of this approach totween related parties, for example, one what it calls "basic" situations and the re-

*Institute for Intez-national Economics, Washing- sulting "basic am@s length return methocr'ton, DC, 20220. (BALRM).

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A BALRM situation is one in which the mula apportionment" approaches to "un-related party licensee performs functions itary businesses."5 Chapter 10 of the Whitethat lots of unrelated parties perform, and Paper considers formula apportionmentdoes so using only "measurable factors of and decides it is unwise and unnecessaryproduction and routine amounts of intan- because it would conflict with interna@gibles" (VvT P. 103). "Routine" intangibles tional norins for transfer-pricing and couldare intangibles ". . . that unrelated par- lead to economic distortions. Chapter 10ties performing similar activities will, in also decides that the existence of integra-general, possess . . ." (WP p. 98). Fur- tion economies is not inconsistent with thether, BALRM/ is unambiguously appro- theory underlying the arrws length ap-

6priate only when the intangible being proach, properly interpreted.transferred between the related parties is"unique."" Using a manufacturing affili- Use of Unrelated-Party Licensingate in this situation as an example, the ArrangementsWhite Paper states that BALRM is ap-plied by first measuring the affiliate's The other extreme, in terms of alle-production assets. Then: giance to arm's length, is the view that

Rates of return on production assetsused in similarunrelated-party licenses must be used as

manufacturing activities of similar risk must be iden- the only basis for the allocation of incometified or estimated. Income will then be allocated to whenever a company licenses an intan-the affiliate for its manufacturingactivity in an gible to an affiliate. This approach pointsamount equal to the identified or estimated rate of out that intangibles, even very valuablereturn as applied to its production assets. This rateof return will include, by definition, a return on rou- ones, are in fact licensed among unre-tine manufacturing intangibles that manufacturers lated parties. One version of this viewcommonly possess as well as a return for assuming holds that related parties should simplynormal buisiness risks that manufacturers bear . . . use an industry or product-area averageThe residual amount of income from the line of busi-ness is allocated to [the parent]. (WP pp. 96-97. foot- royalty rate in all circumstances. Thenotes omitted.) White Paper rejects this view, as did Con-

gress in 1986.'A more sophisticated variant looks to

Criticisms of BALRM and Suggested analyses of large numbers of unrelated-Alternatives party licenses. Appendix D of the White

Paper summarizes the academic studies

Criticisms of Arm's Lengthof licensing arrangements; these studiesgenerally conclude that licensees capture

The most general criticism of BALRM 50-75 percent of the total profits of ven-is really a criticism of the arm's length tures observed in the real world. The im-approach. h holds that transactions among plication, according to this school, is thatthe parts of a multinational corporation related-party licensees should be attrib-are so complex and numerous that it is uted as much as 75 percent of the com-hopeless to try to analyze each one to de- bined income from the lines of businesscide how it would have occurred among involving the intangibles transferred tounrelated parties. A more sophisticated them.'variant is that each multinational enter- If a large number of unrelated-party li-prise is more than the sum of its parts, censing arrangements exists, why did theand there are "integration economies" that White Paper feel the need to develop anlead to sizeable amounts of income that approach not based on them? The reasoncannot, indeed should not, be identified is, in short, because there are licensingwith any one member of the group. This agreements and there are licensingview leads to the conclusion that the in- agreements. The academic studies discusscome of each corporation should be split why the unrelated-party licensees earnedaccording to shares of payroll, assets, and the majority of the profits. The licensorssales, as the states do under their "for- in unrelated-party dealings typically can-

No. 31 DANIEL J. FRISCH 263

not exploit their intangibles alone, be- fraction of combined profits to related-cause they lack the know-how in the party licensees across the board, withoutproduct area, the marketing skill in the inquiring into the functions they performmarket to which the license applies, or and the assets they employ.some other necessary ingredient of theventure. For example, some licenses in-volve a pharmaceutical company that has Contract Manufacturingdiscovered a drug that works on a disease Another alternative to BALRM thatin a medical area in which it does not have could be used when comparable licensingknow-how or a reputation; the drug is arrangements are absent is "contractmuch more valuable, therefore, to an- manufacturing." The IRS has taken thisother company that is active in the area. approach in several cases involvingIn other cases, the licensor may be a pro- transfers of intangibles to manufacturingfessor without the capacity to produce, affiliates, most recently in'Bausch &market, or distribute the product em- Lomb. (Bausch & Lomb [19891 pp. 83-86.)bodying her discovery. It is clear from It is based on the idea that, in many sit-these studies that unrelated-party licen- uations in which one cannot find compa-sees generally undertake complex, diffi- rable unrelated-party licensing agree-cult activities in which their own know- ments, one can find companies owning ahow, reputation, marketing skill, and valuable intangible that hire an unre-other assets are crucial. lated party to manufacture an associated

Related-party licensees may also un- product or component. The contract man-dertake these types of activities and em- ufacturers do not share in the risks of de-ploy significant intangibles of their own. veloping the production process or mar-If so, the White Paper would not apply keting the product and are often paid onBALRM to them (WP p. 107). Other re- a cost-plus basis. The IRS has attemptedlated-party licensees, however, perform to apply these arrangements to related-only a limited range of functions such as party situations; the usual result is thatmanufacturing or distribution, and do not only a small amount of profit, such as 50employ their own significant intangibles. or 100 percent of costs, is attributed to theThis is clear from the record of a number related-party licensee.of court cases discussed in the White Pa- Many observers have concluded, in ef-per such as DuPont and Hospital Corpo- fect, that using contract manufacturingration of America, and from the recently arrangements as comparables is just asreleased Bausch & Lomb decision. In these inappropriate as using unrelated-party li-circumstances, the White Paper would not censes in which the licensees performallow an unrelated-party license of the much more complex functions. Congresstype described above to determine the al- rejected contract manufacturing as a gen-location of income. Specifically, it would eral approach in 1986 (House of Repre-reject such a license as an "inexact com- sentatives [19851, p. 426). It has also notparable" because the functions performed done well in the courts. In particular,by the licensees differ so significantly. If Judge Korner provides a careful discus-a large number of such unrelated-party sion of the issue in Bausch & Lomb [19891.agreements were to be subjected to the His main reason for rejecting it concernsWhite Paper's analysis, all of them would the risks borne by a manufacturing affil-be rejected as comparables. By extension, iate. He interprets the IRS's analysis asstudies examining these types of licenses, claiming that the affiliateeven if based on a large number of them,also should not be used to analyze re- was little more than a contract manufacturer thelated-party licensees of the type to which sale of whose total production was assured and whoBALRM applies. Therefore, the White thus was not entitled to the return normally associ-

ated with an enterprise which bears the risk as to thePaper decided that it would be inappro- olume of its product it will be able to sell and atPriate to allocate 75 percent or any other what price. (Bausch & Lomb fl9891, p. 85.)

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264 NATIONAL TAX JOURNAL [Vol. XLII

The manufacturing affiliate did not meet an unrelated party offer in return for tak-this definition because the parent was not ing on the affiliate's activities? Note that,required to purchase its affiliate's pro- unlike the contract manufacturer ap-duction. Thus, the affiliate took the nor- proach, this analysis should not requiremal risks that any supplier has with that a particular form for the relationshipregard to the business of a major cus- be used or that the risks inherent in thetomer . . . (p. 86). Note that the level of affiliate's activities be borne by the parrisk necessary to invalidate the contract ent.manufacturer approach needn't be large.Judge Korner later describes the risksborne by the affiliate as follows: Textbook Analysis of Investment

Considering the proven, low-cost production technol- Decisionsogy to which B&L Ireland [the afriliatel gained access This interpretation is useful becausevia the licensing agreement, and its accessto world-wide markets through its relationship with B&L [the there is a large literature that seeks toparent], we consider the risks assumedby B&L Ire- advise managers how they should decideland to be moderate in comparison to those of other whether to undertake a project and, bymanufacturing ventures. (Bausch & Lomb (19891, extension, how much they should bid top. 126)

be in the affiliate's situation. In fact, thisCompensation for risk-taking in BALRM topic is one of the main subjects in every

is discussed below. One should note here, MBA's first-year coursework. The goal,however, that the White Paper seems to then, is to use material taught to first-yearagree quite closely as to the risks that MBA students as a basis for BALRM. Ashould be attributed to a manufacturing further goal is to suggest modifications soaffiliate: that nothing more than this material (and[A manufacturing] affiliate's return should reflect only the facts of the affiliate's situation, ofthe moderate level of risk home by manufacturers of Course) are necessary to apply it.products that are reasonably expected to achieve The pertinent opic is taught in an MBA'smarket acceptance.(WP p. 105.) corporate finance course; a widely usedTherefore, one may conclude that the textbook is Brealey and Myers [19881White Paper agrees with Judge Korner (B&M). This book states that it is con-that contract manufacturing as a general cemed withapproach is inappropriate. ... two basicproblems. First, how much should the

firm invest, and what specific assetsshould the firminvest in? Second,how should the cash required forAn Interpretation of BALRM the investment be raised? The answer to the first

In sum, none of the alternatives dis- queti.. is the fin,,. inve8t.,?n,,,,r .piwl ,,dget-ing,decision.Theanswerto thesecondis itsfinanc-

cussed so far can be successfully applied ing decision. (B&M p. 3; emphasis in the original.)to the situation in which BALRM is to beused. Therefore, it is essential to find an We need consider only the first topic, theinterpretation that allows the develop- methods to be used to analyze a firrws in-ment of a concrete and appropriate vestment decisions. The basic frameworkmethod. is expressed in the title to an early chap-

It is useful to consider a "de novo" sit- ter-"Making Investment Decisions withuation, in which transfer-pricing issues can the Net Present Value Rule"-and is

7 be examined while the affiliate's opera- summarized as follows:tions are being planned. The White Pa-

First, forecast the cash flows generated by project Xper's goal can then be interpreted as the over its economic life. Second,determine the appro-question: how would a businessman who priate opportunity costof capital. This should reflecthas his own interests in mind analyze the both the time value of money and the risk involvedaffiliate's planned operations and how in project X. Third, usethe opportunity costof capitalmuch income would he require to agree to to discount the future cash flows of project X. The

sum of the discounted cashflows is called present valuedo them? In the case of a license, this (PV). Fourth, calculate net present value (NPV) byquestion becomes, what royalty rate would subtracting the [initial amount of] investment from

No. 31 DANIEL J. FRISCH 265

PV. Invest in project X if its NPV is greater than zero. anisms that merely shift risks within the group. (WP(B&M p. 71.) P. 104).

Why should a manager who is trying to Some analyses of BALRM seem to dis-maximize the value of his firm for its agree with this approach. One school seemsshareholders use this decision rule? The to reject the idea that the risks inherentreason is the "value additivity concept": in an activity can be defined, or that it is

reasonable to attribute only these risks toIf the capital market establishes a value PV(A) for the affiliate that performs it. Instead, itasset A and PV(B) for B, the market value of a firmthat holds only these two assets is: says that a firm should be allowed to ar-

range its affairs so that any type andPV(AB) = PV(A) + PV(B) amount of risk, along with the income ap-

A three-amt firm combining assetsA, B, and C wouldpropriate as compensation, may be placed

be worth PV(ABC) = PV(A) + PV(B) + PV(C), and in an affiliate.' A line of court cases, how-so on for any number of assets. (B&M p. 141.) ever, has made clear that nothing of sub-

stance happens if a corporation attemptsOne may view PV(A) as the firm's initial to shift its risks to a wholly-owned sub-market value and PV(AB) as the market sidiary that does nothing else.'o The Whitevalue after undertaking a project. To Paper interprets the legislative history ofmaximize the latter, therefore, the man- the Tax Reform Act of 1986 as agreeingager should accept a project as long as the with this view and, by extension, pro-present value is greater than zero. A key hibits allocation of income to the affiliateimplication is that the manager can and on the basis of risks not inherent in theshould judge each project on its own, with activities the affiliate actually performsregard only to its own economic funda- (WP pp. 103-104).mentals and risk characteristics. In par- Another school agrees that the risks re-ticular, "felach project should be evalu- lated to the affiliate's activities are theated at its own opportunity cost of capital" relevant ones, but seems to hold that, if(B&M p. 173, emphasis in the original) to the related-party licensee's activities in-reflect the compensation due the firm for volve any nontrivial risk, this fact is sotaking the risks inherent in the project. important that BALRM or any other

method that looks only at the licensee's

Treatment of Risk in Investment operations is inappropriate. An extreme

Decisions view is that risk-bearing alone, and notfunctions performed or skills contributed,

One of the most confusing and contro- explains the fact that unrelated licenseesversial aspects of BALRM is its treat- typically earn 50-75 percent of combinedment of risk. An especially valuable fea- profits. The conclusion is that, in any sit-ture of corporate finance theory, therefore, uation in which a related-party licenseeis that it devotes considerable attention bears risk, the White Paper's "profit-split"to this issue and recommends methods for method must be employed if comparablehandling it. It is important to stress that licensing arrangements are absent." If it"value additivity" holds, and a project were true that BA-LRM could be appliedshould be evaluated only on the-basis of only to affiliates that took no risks, thenits own attributes, even in the presence of of course it would hardly ever be used, be-risk. This approach is consistent with the cause all real economic activities are atWhite Paper's views on evaluating a risky least somewhat risky. A major advantageproject performed by a related party: of the interpretation of BALRM as in-

How should risk be accounted for in related party vestment decision analysis, therefore, istransactions? The riskiness of true economic activi- that the risks inherent in a project can beties gives rise to greater returns in the marketplace; included in a relatively straightforwardtherefore, if one part of an enterprise is inherently fashion.more risky than another, more income should be al- The textbook analysis of risk is basedlocated to it. This allocation should be based on the ctrisks arising out of the true economic activities un- on the capital asset pricing model"dertaken by the parts of the enterprise, not on mech- (CAPM). The validity of this approach, like

266 NATIONAL TAX JOURNAL [Vol. XLII

all theories in the social sciences, can never project specific and should reflect thebe proven beyond doubt. However, B&M project's fundamental economic charac-discusses the evidence for and criticisms teristics. For example, 0 is higher if theof it (pp. 161-164), and clearly gives it the project is in a cyclical industry or if fixedplace that modem science textbooks give costs are especially important. Table 9-3to the theory of evolution, another theory (p. 182) presents betas that have been cal-that will never be proven to everyone's culated for various industries." They pro-satisfaction. CAPM is based on the idea vide a range that should apply to a sig-that a firm's shareholders must be re- nificant fraction of projects for whichwarded when the firm undertakes a risky BALRM is appropriate. These betas andproject, but they can diversify away some the annual discount rates they imply whenof the risks by spreading their money combined with the figures quoted aboveamong investments in other firms. There- are:fore, it is "undiversifiable" or "system-

Discountatic" risks for which they must be re- Industry Beta Ratewarded. Undiversifiable risk of aninvestment can be defined by mea- Electronic components 1.49 21.1%

Crude petroleum 1.07 17.6suring how sensitive it is to market Retail department stores 0.95 16.6movements. This sensitivity of an invest- Petroleum refw,,g 0.95 16.6menvs return to market movements is Motor vehicle parts 0.89 16.1usually called its beta (p)." (B&M p. 134.) Chemicals 0.88 16.0

Metal mining 0.87 15.9This line of reasoning leads to a SMP'E Food 0.84 15.7yet powerful way to include an invest- Tricking 0.83 15.6ment's risk characteristics in its evalua- Textile mill products 0.82 15.5tion." Specifically, the opportunity cost Paperandallied products 0.82 15.5

Retail grocery stores 0.76 15.0of capital to be used as the discount rate, Airline. 0.75 14.9r, in the NPV calculation should be: steel 0.66 14.1

Railroads 0.61 13.7r = rf + (r. - rf) Natural gas transmission 0.52 13.0

Telephone companies 0.50 12.8

rf is the return on a risk-free investment;Electric utilities 0.46 12.5

the Treasury bill rate is usually used forit. r,, is the return on the market POrt- Application of Textbook Analysisfolio; it represents the return that some-one would earn if she invested in a fully Although B&M discusses many otherdiversified portfolio of market invest- topics, the essential pieces are now inments. Thus, if a project has zero chance place. The BALRM approach to transferof varying, p is zero and, not surprisingly, pricing should be interpreted as a test ofthe risk-free rate should be used to dis- whether unrelated parties would be sat-count the project. A P of 1 implies that isfied with the allocation of income to thethe project is equivalent to a market port- licensee resulting from a related-party li-folio, so the market return should be used. censing agreement. Unrelated partiesIf the project has a p of 2, so that it varies would analyze this question by perform-twice as much as the market portfolio, the ing the following steps. First, they woulddiscount rate should be the risk-free rate forecast the licensee's cash flows. The nextplus twice the market portfolio's risk pre- step is to analyze the risks involved in itsmium. activities in light of CAPM and to pick the

As of this writing, the Treasury bill rate appropriate opportunity cost of capital,is 8.6 percent. 13 B&M suggests that a sen- taking into account both the time valuesible estimate of the difference between of money and the costs of bearing the risks.rm and rf is 8.4 percent per annum, its av- The above discussion indicates that thiserage over the last sixty years (B&M p, discount rate is likely to be in the 12-22136). The remaining unknown is 0. As percent range for most projects. The cashB&M discusses in chapter 9, it should be flows should then be discounted and

No. 31 DANIEL J. FRISCH 267

summed and the initial investment sub- NPV; in effect, it is analogous to the ini-tracted to compute NPV. A negative NPV tial investment in the start-up case. Theindicates that an unrelated licensee would difficulty, of course, is that market valuenot accept the project. An NPV signifi- may be difficult to measure, even thoughcantly greater than zero indicates that the affiliates for which BALRM is appropri-licensee is receiving too much income and ate should not possess significant intan-would accept less in a market transac- gible assets. Some attempt at including ittion. In either case, the royalty rate (or in the analysis would seem to be neces-other transfer price) should be adjusted. sary, however.

Two issues remain. The first is the wordttsignificantly" in the next to last sen-

Implications for Implementation oftence in the preceding paragraph. If there BALRMwere no question as to the projected cashflows and the right discount rate, the li- The IRS is drafting regulations to im-censee should be happy with an NPV of plement the suggestions made in theliterally zero. However, the above analy- White Paper. Some analyses, includingsis will always involve judgement and many of the ones cited in this paper, haveuncertainty in its application. A busi- urged that these regulations not include

,6nessman presented with a project ana- BALRM in any form. As the first partlyzed as having a zero NPV would thus of this paper shows, however, the alter-presumably reject it, and the licensor natives to it cannot be applied in a sig-would have to offer somewhat more fa- nificant class of transfer-pricing situa-vorable terms. It is tempting to conclude, tions. It seems quite unlikely, therefore,therefore, that BALRM should test the that the regulations will neglect to in-project's NPV against a number greater clude some version of BALRM, because tothan zero, such as $1 million. However, do so would be to fail to provide guidanceany such figure will be trivially small for in important circumstances. It is useful,some projects and too large for others. An therefore, to discuss the implications ofalternative, which is at least independent the textbook analysis for implementationof the projecfs scale, may be to use a gen- of BALRM.erous discount rate, perhaps as much asfive percentage points above the one re Framework for BALRMsulting from the above analysis. (There issome evidence to indicate that a five per- Basing the regulatory version ofcentage point addition to the discount rate BALRM on the textbook analysis of in-may affect allocations of income in a rea- vestment decisions would have severalsonable way.") If so, the range for likely advantages. The basic framework woulddiscount rates may be extended to 12-27 be clear and would be familiar to a broadpercent per annum. class of the business community. Further,

The other issue is the application of this this paper does not have the space to goanalysis to ongoing operations. Transfer into the myriad practical issues that arisepricing questions will arise for these op- in investment decision analyses. But theerations when an existing licensing textbooks do discuss such issues and reachagreement expires and when "periodic clear conclusions on many of them. Foradjustments" are necessary; the latter is- example, B&M's chapter 6 discusses howsue is discussed below. Extending this cash flow is to be measured and how in-analysis to continuing operations is flation should be included. The regula-straightforward in theory, although per- tions could either draw on this discussionhaps not in practice. To be in the situa- or simply state that the resolution of suchtion of the affiliate, an unrelated party practical issues should be in line withwould have to acquire or establish the af- standard textbook treatment.filiate's facilities and other assets. Thus, It would also clear up some confusionsthe market value of the ongoing opera- that have arisen in discussions of BALRM.tions should be subtracted in computing For example, the White Paper waffles on

268 NATIONAL TAX JOURNAL [Vol. XLII

whether comparisons should be based on Implications for Periodic Adjustmentsrates of return to assets or ratios of in-

Even more controversial than BALRMcome to costs (WP pp. 97-98), and thereis the White Paper's discussion of periodicis debate on the issue." The textbookadjustments. The White Paper suggestsanalysis implies that neither is correct;that related-party arrangements be pe-instead, NPV is the proper framework. (A

rate of return approach is closer to NPV riodically examined and that they be ad-than a cost ratio, but cannot easily be de- justed if "substantial changes" have oc-

fined unless all investment takes place at curred (WP chapter 8). It presents two

the start of the project; in this situa ion, reasons why periodic adjustments aret'necessary. The first is that some sort ofmoreover, it is equivalent to NPV.)mechanism for adjustments is often in-cluded in arn@slength arrangements. Atthe very least, arm's length licenses are

A Safe Harbor Proposal generally limited in duration; therefore,By far the major criticism of BALRM's renegotiation can and presumably does

occur at least when a license expires. Thispracticality is the difficulty of identifyingargument for periodic adjustments doesthe rate of return target. Many of the

comments on the White Paper submitted not seem relevant to related-party ar-to the IRS contain extensive analyses rangements subject to BALRM. BALRM

showing that actual rates of return vary. is only necessary, after all, in cases where

In light of this fact, the comments ques- comparable unrelated-party arrange-ments cannot be found. Thus, the ques-tion whether a single rate can be appro-

priately identified. The chief virtue of the tion of what adjustment mechanisms thesetextbook analysis may be, therefore, to put comparables would have contained if theythis debate on a firm footing. Instead of existed is moot.a rate of return target, the NPV analysis The second reason for periodic adjust-requires finding a discount rate that re- ments is the more important one, there-

fore. Congress's reasons for changing sec-flects the opportunity cost of committingtion 482 in 1986 include that, whenfunds to a project. And the textbook anal- .

ysis carefully and concretely discusses how intangibles with the potential for highthis rate should be identified. profits are involved:

Perhaps this issue could even be re- T. y,@r,,may transfermuchintangiblesto foreignpsolved once and for all. The above discus- relatedcorporations at an early stage, for a relativelysion indicates that the range of a low royalty, and take the position that it was not pos-ppropri-atediscountrat4mmaynotbeall that large sible at the time of the transfers to predict the sub-

sequent succen of the product. (House of Represen-in terms of economic effects. Twelve to 27 tatives [19851 p. 4Z4.)percent is identified as the reasonablerange, and there is some evidence (in end- Thus, it is clear that Congress was con-note 15) that outcomes may not be all that cemed about the fact that taxpayers maysensitive to the choice of a rate within it. have the information needed to evaluateThis result seems to cry out for a safe their intangibles but can easily conceal itharbor proposal. Although safe harbors from the IRS. The White Paper's solutionwere criticized in the White Paper, they to this problem is to reaffirm that theare not categorically rejected." (MT burden of proof as to the adequacy of ap. 78.) To pick a round number, note that transfer price is on the taxpayer. In par-20 percent is almost exactly at the mid- ticular, the White Paper decides thatpoint of the range quoted above. There- Congress wanted the IRS to have the rightfore, the regulations could state that NPV to adjust a royalty rate that appears un-analyses need not inquire into the correct reasonable in light of subsequent events,discount rate and, instead, may simply unless the taxpayer can prove that he diddiscount cash flows at the rate of 20 per- not possess the information necessary tocent per annum. predict these events from the start. Fur-

No. 31 DANIEL J. FRISCH 269

ther, in footnote 175 (p. 64), the V*Thite sons (pp. 70-71). However, the IRS mayPaper seems to state that any attempt by be severely tempted to require an adjust-the taxpayer to prove what he didn't know ment in the middle years of a project likewill be a "fruitless inquiry." Therefore, the one above, and taxpayers are entitledperiodic adjustments must be made the to fear that, like Eliza Doolittle's dad, whengeneral rule. temptation comes along the IRS will give

There is one way in which the frame- right in. Providing taxpayers with a rightwork presented above can be used to mit- to multi-year set-offs would solve thisigate this harsh result. For example, con- problem. If administrative difficulties aresider a project that is expected to the concern, perhaps this right should beexperience losses in the early years, then restricted to situations in which the tax-a period of high profits, then a decline in payers has an ex ante, adequately docu-profits as the product becomes obsolete."' mented set of projections or other descrip-If an NPV analysis is used, there is no tion of his transfer-pricing methodology,reason to require the related-party roy- and wants to use facts from multiple yearsalties to vary over time in the same pat- to show that this analysis is still valid.tem, because NPV can easily check theoverall consistency of the royalties no

Conclusionmatter how their time profile differs fromthat of cash flow earnings. If the middle The White Paper suggests BALRM foryears of the project turn out as expected, situations in which a parent licenses orthe royalties will appear to be inadequate otherwise transfers a uniquely valuablein comparison to contemporaneous earn- intangible to an affiliate which performsings. However, periodic adjustments one or a few functions and does not em-clearly should not be required. Instead, the ploy significant intangible assets of itstaxpayer should be allowed to show that own. This paper discusses some of thethe project is still on the path relative to criticisms of this suggestion and decideswhich the royalties are appropriate. that, contrary to some of the comments,

In effect, the cash-flow projections con- the White Paper is correct in concludingtain a complete summary of the relevant that a new method is needed in these cir-expectations. Therefore, they allow the cumstances.inquiry into the taxpayer's original This paper then suggests that the newknowledge to be a little less fruitless. At method be based on a standard businessleast the taxpayer should be allowed to use school analysis of investment decisions.them to prove to the IRS that his original Specifically, transfer prices should beexpectations, thus the original royalty rate, analyzed by calculating net present valueis still valid. Of course, an affiliate's ac- (NPV), using projections of the affiliate'stual experiences may depart significantly cash flows and a discount rate that re-from the projections. If so, a periodic ad- flects both the time value of money andjustment would still be required. Specif- the costs of bearing the risks inherent inically, it would be necessary to conduct a the affiliate's activities. Once initial in-new NPV analysis based on new projec- vestment or market value is subtracted,tions that are consistent with the affili- NPV should be approximately zero. Thisate's actual experiences. This analysis will is because an unrelated party would notindicate whether the royalty rate should accept the arrangement if N-PV is less thanbe adjusted and by how much. zero; an NPV significantly larger than zero

To implement this approach to periodic implies that the affiliate is earning moreadjustments, the regulations may have to than it would at arm's length. In eithermodify one result reached in the White case, the royalty rate or other transferPaper. The White Paper considers multi- price should be adjusted.year set-offs and, although acknowledg- Among the virtues of this approach ising the theoretical arguments for them (p. that many of BALRM's methodological is-102), rejects them for administrative rea- sues can be resolved by referring to the

270 NATIONAL TAX JOURNAL [Vol. XLII

textbooks'extensive discussion of NPV and unrelated parties, so that comparables should be

how to apply it. Further, the textbook available. There seems to be confusion as to whetherboth BALRM and the mexact comparable method must

analysis contains a powerful yet rela- be applied in this situation. It seems to have beentively straightforward framework for caused by the passage, ". . . it is inappropriate to de-analyzing risk and factoring it into the terrnine transfer prices solely on the basis of inexact

calculation. comparables." (WP P. 91.) Some observers seem to readthis sentence as ". . . it is inappropriate to determine

Finally, the paper suggests two changes any transfer price. . . ." However, the second para-to the White Paper's conclusions on graph on p. 103 and Examples 3 and 4 in AppendixBALRM. First, the discussion of discount E show that the correct reading is it is inap-

rates suggests that the reasonable range propnate to determineeverytransferprice Thus,the White Paper clearly does contemplate.that many

may be sufficiently small, in terms Of ef- (but not all) transfer-pricing issues will be resolvedfects on allocations of income, that a safe solely on the basis of inexact comparables.harbor is appropriate-specifically, the 6Examples which predate the White Paper include

IRS should allow a discount rate of 20 Musgrave [19871, pp. 202-203, and Langbein [19861,Stoffregen et al. [19891 apply this view to BALRM and

percent per annum to be used in NPV cal- ,uogests a replacement that is effectively a one-factorculations unless the taxpayer wishes to, formula apportionment system, the factor being as-and can, justify a different number. The sets p-periy defined to include the value of intan-

second change is to provide taxpayers with gibl,,*6Rollinson and Frisch [19881 discuss these points in

the right to multi-year set-offs, at least in greater detail than the White Paper's chapter 10.some form. At a minimum, taxpayers "'In making this change [to section 4821, the com-should have the right to prove that an af- mittee intends to make clear that industry norms or

filiate's activities are still consistent with other unrelated party transactions do not provide a. . safe-harbor minimum payment for related-paity in-

the projections in an analysis that justi- tangibles transfers." House of Representatives (19851,fies the royalty rate or other transfer price. p. 425.If the taxpayer can do so, no adjustment 8A recent decision in an important Tax Court case

should be required.contains an illustration of this school. According tothe Judge's opinion, the taxpayer's expert witness es-poused exactly this view. See Bausch & Lomb [19891,

ENDNOTES p. 123."'There is nothing inherently wrong with a tax-

**I would like to thank Thomas Horst and Barbara payer establishing its affairs in a manner that min-Rollinson for helpful comments. Any errors or opin- imizer, its tax by placing risk in a manufacturing af-ions expressed in this paper are, however, mine alone. filiate." Fuller [19881 p. 661.

'Some readers may know that I was a member of IoAbramowitz and Allen [19891 is an excellentthe Study Group that wrote the White Paper, and may analysis of these "Carnatiore' cases. The issue iswonder whether the Study Group considered the ideas whether a wholly owned insurance subsidiary shouldexpressed in this essay. R did not, because these ideas be considered as bearing its parent's risks. (If not, theare the result of research done since the White Pa- subsidiary is not considered an insurance enterprisepees release. (Specifically, the starting point was the and thus is not allowed to use certain favorable taxuse of projections and present values in the Bausch code provisions.) They agree that nothing of sub-and Lomb opinion; see Frisch and Horst [19891.) Thus, stance happens in a situation in which a wholly ownednothing in this paper should be taken as criticism of subsidiary bears only its parentr, risks; however, theythe Study Group's decisions; instead, the paper is in- disagree with the IRS in a situation in which the af-tended as elaboration and ftuther development of them. filiate insures both its parent and unrelated parties,

'The Tax Reform Act of 1986 added the sentence, because then something of substance, namely risk"In the caseof any transfer (or license) of intangible pooling, does occur.property (within the meaning of section 936(h) (3) (B)), "Bischel [19881 seems to be an example:the income with respect to such transfer or license shall "Once it is determined what risks are appro-be commensurate with the income attributable to the priately assumed by the related parties, de-intangible." This was the first significant change in pending on the functions each performs, it issection 482 since the Revenue Act of 1928. essential to, in turn, determine what an un-

'An example is Fuller [19881 which disapproves related party would require, as a portion of netsharply of BALRM but emphasizes the usefulness of profit, to assume such risks." (p. 1102)profit splits. 12 Technically, the simple formula applies only when

"If the intangible is not unique and the affiliate riskiness is thought to be constant through the life ofperforms complex functions or uses its own signifi- the project. If risk varies with time, a more compli-cant intangibles, BALRM should not be used. In- cated formula containing a p for each time period muststead, the White Paper states that the "inexact com- be used. For example, a project may be risky chieflyparables" method will probably be appropriate (WP because of something that will become known in thep. 103). This is because it is likely that a non-unique near future, such as whether FDA approval can beintangible will have competitors that were licensed to obtained; if and when this hurdle is overcome, the

No. 31 DANIEL J. FRISCH 271

project then may be relatively riskless. In this situ- proach is consistent with the eighteenth centuryation, the simple formula can be extended by using teachings of the founding father of modern econom-it in a "decision tree" framework; see B&M pp. 191- ics.196 and 220-228. 181am grateful to Paul Oosterhuis for allowing me

"Wall Street Journal, May 3, 1989, p. C17. Due to to see unpublished materials from which this exam-the Fe&s macroeconomic policies, short term interest ple is taken.rates are thought to be exceptionally high at present,especially in relation to long-term rates. The range oftypical discount rates discussed below may be high,therefore. REFERENCES

'4These betas are "asset betas." They are appropri-ate ones to use in evaluation of a firm's investment Abramowitz, George R. and Dennis L. Allen, "Rev.decisions because the effecu of financial leverage have Rul. 88-72 v. Gulf Oil-The Tax Court Should Re.been removed from them. (B&M p. 182.) affirm That Unrelated Risks Can Make A Differ-

"Frisch and Horst [19891 discuss Judge Komer's ence." Tax Notes, April 17, 1989, pp. 325-333.secondary analysis in Bausch and Lomb and modify Bausch & Lomb, Inc. and Consolidated Subsidiariesit in ways that make it resemble the analysis pre- v. Commissioner of Internal Revenue, 92 T.C. No.sented here quite closely. Exhibit 4 shows that a roy- 33, slip op. (March 23, 1989).alty rate of 33.8 percent of sales causes the Irish op- Berry, Charles H., "Economics and the Section 482erations to earn an "internal rate of return" of 27 Regulations." Tax Notes, May 8, 1989, pp. 741-749.percent. This means that NPV is zero, giken a royalty Bischel, Jon E., "White Paper Analysis: Ballroomrate of 33.8 percent, if a discount rate of 27 percent Dancing With An Intangible." Tax Notes, Decem-is used. At a discount rate of 22 percent, five points ber 5, 1988, pp. 1097-1103.lower, the royalty would have to be increased by only Brealey, Richard A. and Stewart C. Myers, Principles2 percentage points, to 35.8 percent, to restore a zero of Corporate Finance, Third Edition. New York:NPV. Thus, if 22 percent were the correct discount McGraw-Hill, 1988.rate, allowing a five percentage point addition to it Frisch, Daniel J. and Thomas Horst, "Bausch andwould make only a modest difference in the royalty Lomb and the White Paper." Tax Notes, May 8,1989.rate and, therefore, in the income allocated to the li- Fuller, James P., "The IRS Section 482 White Paper."censor. (To make an extreme comparison, consider a Tax Notes, November 7, 1988, pp. 655-664.discount rate of only 12 percent, the rate Bausch & House of Representatives, Report of the Committee onLomb used in an analysis performed prior to the case. Ways and Means on H.R. 3838 (T= Reform Act ofThe royalty would then be 39.5 percent. Thus, in- 1985). Washington, D.C.: U.S. Government Print-creasing the discount rate by 125 percent (from 12 to ing Office, December 7, 1985.27 percent) causes a decrease in the royalty rate, thus Langbein, Stanley, "The Unitary Method and the Myththe income attributed to the U.S. taxpayer, by less of Arm's Length." Tax Notes, February 17, 1986.than 15 percent (from 39.5 to 33.8 percent) in the Musgrave, Peggy B., "Interjurisdictional Coordina-Bausch & Lomb situation.) tion of Taxes on Capital Income." In S@bren Cnos-

"Some studies suggest that BALRM be used only sen, ed., Tax Coordination in the European Com-as a "screening device." There are two problems with munity. New York: Kluwer Law and Taxationthis ougpotion. First, it is unusual for regulations to Publishers, 1987.specify a method by which IRS examiners should Rollinson, Barbara L. and Daniel J. Frisch, "Recentidentify audit candidates. More seriously, this sug- Issues in Transfer Pricing," OTA Working Paper No.gestion fails to provide guidance as to how the prob- 61. Washington, D.C.: U.S. Treasury Dept., Officeleni situations should be analyzed once they are of Tax Analysis, November 1988.screened out. Stoffregen, Philip A., Harlow N. Higinbotham, David

"Berry [19891, pp. 748-9, discusses this debate. W. Asper, and Raymond P. Wexler, "The BALRMStoffregen et al. [19891 take one side. On p. 1259, it Approach to Transfer Pricing: One Step Forward,compares the rate of return approach to ". @. con- Two Steps Back." Tax Notes, March 6, 1989, pp.ventional resale price or cost plus evaluation . . ." and 1257-1262.concludes that ". . . considerations suggest a strong U.S. Treasury Department and Internal Revenue Ser-preference in favor of existing methods. . . ." Dr. Ir- vice, "A Study of Intercompany Pricing: Discussionving Plotkiii8 report on behalf of the taxpayer in Draft." October 18, 1988. (Published, with page andBausch & Lomb, "Transfer Prices, Royalties, and footnote numbers changed, in Internal RevenueAdam Smith," argues that only a rate of return ap- Bulletin, no. 1988-49 (Dec. 5, 1988), pp. 7-83.)