The fact of the matter is that businesses may be making transfer pricing decisions
for other reasons than worldwide tax minimization. Tax issues, though clearly im-
portant, have declined in comparative importance as tax rates have declined during
the 1990s and beyond.
For example, the transfer pricing regulations fail to recognize that many multina-
tional businesses operate on a two-tier system, an official intercompany transfer price
and an informal intracompany transfer pricing system. This two-tier system occurs
most often in the context of work-in-process goods, as there is often no true market
for these goods.
The transfer pricing regulations fail to address intermediate goods, such as work-
in-process inventories. At the present time, the taxpayers and the IRS have been ret-
icent in seeking and applying this intracompany data because the transfer pricing reg-
ulations do not address this product area.
29.8 COST ISSUES, EXCESS CAPACITY, AND COST STRUCTURES OVERSEAS. Many
multinational businesses transfer their products among affiliated enterprises by using
a full standard cost system or by using a full actual cost system.^3 As a practical mat-
ter, manufacturers both inside and outside the United States have to address excess
production capacity issues from a cost accounting perspective, for addressing alloca-
tion and apportionment considerations, and for addressing transfer pricing consider-
ations. The treatment of excess capacity is likely to be an allocation and apportion-
ment issue under Regulation Section 1.861-8 when the excess capacity takes place
within the United States and as a transfer pricing issue when excess capacity takes
place in a foreign facility, thus creating nonparallel treatment.
Our concern is that such intercompany transfers produce a significant level of con-
temporaneous documentation, but the IRS rarely takes the opportunity to analyze this
data, and, as a result, the data is ignored or lost. Consider the following two examples.
(a) Example. X Corporation is a manufacturer in Country X. X’s factory has the ca-
pacity of producing 10,000 widgets per year. X produces and sells 4,000 units for sale
in the United States and produces and sells 4,000 units for sale in Country X during
year 1. The remaining 2,000 units are not produced and became excess capacity for
year 1. The variable cost of production is $1,000 per unit. Overhead is $5 million. X
Corporation sells the widgets to its U.S. affiliate for $1,800 each. The U.S. affiliate
makes use of extensive marketing intangibles and sells the widgets to ultimate cus-
tomers for $2,000 each.
Assume that X Corporation treats excess capacity costs as attributable to X’s ex-
ports under local law and pursuant to the transfer pricing rules of Country X. Exports
to the United States would bear 60% of the overhead costs (4,000 export units plus
2,000 excess capacity units divided by 10,000 units) or $3 million (60% ×$5 mil-
lion). The $3 million would be divided by the 4,000 export units, or $750 per unit.
Total costs would be $1,750 ($1,000 in variable costs plus $750 for overhead.) Cor-
poration X would show profits of $200,000 ($50 ×4,000 units) for its U.S sales.
In contrast, domestic sales in Country X would bear 40% of the overhead costs
(4,000 domestic units divided by 10,000 units) or $2 million (40% ×$5 million). The
29 • 14 TRANSFER PRICING FOR INTERCOMPANY TRANSACTIONS(^3) Robert Feinschreiber, “Business Facets of Transfer Pricing,” Transfer Pricing Handbook#1, 3rd ed.,
edited by R. Feinschreiber (New York: John Wiley & Sons, 2001): Section 1.13.