30.5 TRANSFER PRICING. Internal Revenue Code Section 482 authorizes the Com-
missioner of Internal Revenue to distribute, apportion, or allocate gross income, de-
ductions, or allowances between or among related taxpayers. These rules are dis-
cussed in detail in the prior chapter. The effect of this Internal Revenue Service
power is applied before all the other rules discussed in this chapter are applied. The
purpose is to prevent the evasion of taxes by such devices as shifting of profits, the
making of fictitious sales, and other methods frequently adopted for the purposes of
“milking.” This section prevents the arbitrary shifting of income and deductions
among controlled corporations and places such corporations on a tax parity with un-
controlled corporations.
Section 482 applies when there are two or more organizations, trades, or businesses
owned or controlled by the same interest. It becomes operative when the activities re-
sult in either evasion of taxes or a failure to reflect income clearly. To determine own-
ership or control by the same interest, the regulations look to the reality of the control.
The regulations find that a presumption of control arises if income or deductions have
been arbitrarily shifted. The evasion of taxes or the failure to reflect clearly income
may be intentional or unintentional. Transactions between or among related parties are
subject to special scrutiny to see if there was a failure to reflect income clearly. If there
was such a failure, income or deductions can be shifted by the IRS from one entity to
another. The theme of the regulations is to require related parties to deal with each
other at arm’s length, that is, as they would with unrelated parties. The regulations de-
scribe what is meant by “arm’s length” in five types of transactions: loans or advances,
performance of personal services, use of tangible property, transfers of, or the use of,
intangible property, and sale of tangible property. In some of these specific types of
transactions, the regulations provide safe havens or safe-haven rules. A taxpayer that
conforms to these safe-haven rules automatically has a defense against a Section 482
allocation, since the transaction is deemed to be at arm’s length.
(a) Specific Transactions
(i) Loans. The Section 482 regulations provide safe-haven interest rates that apply
to U.S. dollar loans. For loans or advances entered into after May 8, 1986, the safe-
haven rates are provided by the Internal Revenue Service on a monthly basis and are
known as the applicable federal rate. The AFR varies, depending upon whether the
loan is short term, medium term or long term, and whether interest is paid monthly,
quarterly, semiannually, or annually. The AFR in effect at the time the loan is entered
into applies. The safe-haven range is 100% of the AFR (lower limit) to 130% of the
AFR (upper limit). If the rate charged is less than the lower limit, then the IRS may
raise the rates to the lower limit. If the rate charged is higher than the upper limit,
then the IRS may lower it to the upper limit. If the rate charged is within this range,
the IRS must accept it.
The interest period begins on the date the indebtedness arises. However, for in-
debtedness arising in the ordinary course of business from sales, leases, or the rendi-
tion of services, or any other similar extension of credit that is not evidenced by a
written instrument requiring payment of interest, the interest period is not required to
begin until the first day of the third calendar month (fourth calendar month if debtor
is located outside the United States) following the month in which the trade receiv-
able arises. unless the taxpayer can demonstrate that regular trade practice permits a
30 • 14 INTERNATIONAL TAXATION