November 1, 2023
Corporate Taxation: Profit Shifting, Transfer Pricing, and Cost
Sharing

Recent events have highlighted the issue of corporate profit
best method for achieving arms-length prices is through
shifting using transfer pricing and cost sharing methods. In
prices in comparable uncontrolled transactions. For some
its October 11, 2023, 8-K filing with the Securities and
goods and services, and particularly for intangible assets,
Exchange Commission, Microsoft indicated that it had
such comparable prices are not available because of the
received a notice of a $28.9 billion deficiency from the
unique nature of the commodity. Examples of intangibles
Internal Revenue Service (IRS). Microsoft communications
likely to confront this problem are drug formulas and digital
indicated that the deficiency is related to the allocation of
assets such as software.
profits among countries using a transfer pricing method
referred to as cost sharing. This deficiency refers to taxes
Treasury regulations outline the basic methods for setting
during the 2004 to 2013 period. In a separate development,
transfer prices for tangible property, intangible property,
on October 20, 2023, the IRS announced a number of new
loans, and services. In the case of intangibles there are three
initiatives, including a focus on large corporations’ cross-
methods:
border transactions and transfer pricing methods of U.S.
subsidiaries of foreign corporations. Senator Ron Wyden,
• The comparable uncontrolled transactions method
chairman of the Senate Finance Committee, has also
compares the payments between unrelated businesses to
proposed legislative changes to address transfer pricing
determine the transfer price (similar to comparison of
following an investigation of multinational pharmaceutical
sales prices for tangible goods).
companies by the committee.
• The comparable profits method, where profits of
This In Focus explains how transfer pricing, and
comparable firms as a share of assets, sales, or operating
specifically the cost sharing method, can be used to allocate
costs are used to determine the transfer price.
profits from intangible assets out of the United States and
into low-taxed jurisdictions.
• The split-profits method, where profits are allocated
based on the contribution of each firm (including
What Is Transfer Pricing?
functions performed, resources invested, and risks
Transfer pricing is one of the two main methods, along with
assumed). When a firm has ongoing research and
the allocation of debt, that affects how multinationals report
development, the allocations are often determined by the
profits across different countries. In general, profits are
split-profits method with cost sharing. A variation of the
attributed to the country where the asset generating the
split-profits method is the residual split-profits method,
profits is produced or acquired. When sales of goods or
where an amount of profit is assigned for routine
assets occur between related corporations, such as a U.S.
functions and the residual is split between the
parent and its foreign subsidiary, transfer pricing rules
corporations.
generally require that the transaction occur at arms-length
prices, that is, prices that would occur between unrelated
Cost Sharing Agreements and the Split-
parties.
Profits Method
Cost sharing agreements (CSAs) are a common way to
The Internal Revenue Code (IRC) section that governs
allocate profits derived from intangible assets between a
transfer pricing, Section 482, is a brief section, general in
parent and its subsidiary, usually by payments to the parent
nature, which consists of three sentences. The first
for the rights to exploit the intangible in a particular
sentence, which is long-standing in the tax code, allows the
geographic area. Under a cost sharing arrangement there is
Secretary of the Treasury to adjust tax items to address tax
an initial buy-in payment (sometimes called a platform
evasion or to properly reflect income. The second sentence,
contribution) to acquire a share of the existing intangible.
added by the Tax Reform Act of 1986 (P.L. 99-514),
After that point, the subsidiary firm makes a cost
provides that in the case of intangibles the payment for the
contribution to reflect its share of any ongoing profits from
transfer or license of an intangible must be commensurate
the original intangible. The buy-in payment could be an
with the income received from the intangible. The third
ongoing royalty that reflects the increased earnings due to
sentence, added by a law commonly referred to as the Tax
the intangible or an upfront payment that would reflect the
Cuts and Jobs Act of 2017 (P.L. 115-141), provides that
present value of those increased earnings. The buy-in
intangible assets can be aggregated to determine valuation.
payment is deductible to the subsidiary and is taxable to the
parent.
The details of rules regarding transfer pricing are contained
in the Treasury regulations under Section 482, which are
After this initial buy-in payment, profits are divided based
generally designed to reflect the arms-length standard. The
on cost sharing payments by the subsidiary to the parent,
https://crsreports.congress.gov

Corporate Taxation: Profit Shifting, Transfer Pricing, and Cost Sharing
again deductible by the subsidiary and taxable to the parent.
In an extensive article in Tax Notes discussing cost sharing
The research and development often takes place solely in
arrangements in general and Microsoft in particular, Steven
the United States and is managed by the U.S. parent.
Curtis and Reuven Avi-Yonah indicate that the IRS has not
invoked periodic adjustments but that it would be a tool to
CSAs are widely used by multinationals with intangible
enforce what they consider gaping holes in the cost-sharing
assets such as software, search algorithms, and other digital
approach.
assets, as well as large pharmaceutical companies. These
arrangements are generally with subsidiaries in tax havens
There is some debate about whether periodic adjustments
which have low or no taxes, such as Bermuda, the Cayman
conflict with the arms-length standard, which has been the
Islands, Ireland, Switzerland, Singapore, or, in the
underlying focus of regulations reflecting the first and long-
Microsoft case and others, Puerto Rico, which is not subject
standing sentence of Section 482. One issue might be
to the U.S. tax and often offers tax reductions and holidays.
whether periodic adjustments reflect the ex post realization
Puerto Rico is treated the same as a foreign country for
of profits that was not expected at the time of the buy-in or
allocating income. The arrangements can allow exploitation
whether ex post realization of profits is evidence that the
of the intangible in a particular area (such as Europe or
payments were originally understated. However, the arms-
Asia) but can also involve selling back to the United States.
length standard is a regulatory concept while the
commensurate with income measure is in the statute, with
A case can be made that cost sharing agreements are not
the latter taking precedence in defining IRS authority.
consistent with arms-length prices for several reasons.
While a wholly owned subsidiary can contribute to the cost
Other Measures to Challenge Cost
of research, it cannot assume the risk. A Government
Sharing
Accountability Office (GAO) study pointed out that any
While the periodic adjustments rule could be used to adjust
loss of the subsidiary will be reflected in the market value
transfer prices under the cost sharing method, there are
of the parent so that any loss to the subsidiary is a loss to
other parts of the tax code that might be used to challenge
the parent. Thus, related corporations do not have the same
these prices. These options are discussed in the Curtis and
ability to transfer risk as do unrelated corporations.
Avi-Yonah article on Microsoft and also in an earlier
related study by Steven Curtis and Richard Chamberlain.
Moreover, for a company whose ongoing profitability
These alternatives include treating the income as effectively
exceeds normal or competitive returns (for example,
connected with U.S. source income, or challenging the
because of its unique status in the market), a company
agreement as lacking economic substance or as a sham
would not likely contract with an unrelated corporation for
transaction.
an ongoing share of its profits based on the share of costs
contributed.
From a legislative perspective there are changes in the tax
law that could capture some of the profits allocated to tax
A University of Michigan law professor, Reuven Avi-
havens through CSAs as contained in the House version of
Yonah, has argued that the cost sharing method should be
the Build Back Better Act (H.R. 5376) in the 117th
eliminated.
Congress, and as recently proposed by Chairman Wyden.
This proposal related to the Senate Finance Committee’s
Another issue that arises with the CSA is that the buy-in
study of multinational pharmaceutical companies. Under
payment may be structured as a royalty that is relevant to
current law, a U.S. tax is imposed on foreign source income
current profits, but which declines and disappears as the
from intangibles (the tax on Global Intangible Low Taxed
technology decays. For many intangibles (e.g., the
Income, or GILTI), but the tax rate is lower than the U.S.
Microsoft Windows code), each new development is
rate and can be reduced by the use of unused foreign tax
layered on top of the existing technology so the original
credits from non-tax haven countries. These revisions
intangible has an indefinite life.
would raise the GILTI rate and apply credits against the tax
only for foreign taxes paid to the country. (See CRS In
Another issue is that CSAs allocate a disproportionate
Focus IF11943, GILTI: Proposed Changes in the Taxation
amount of profits to the subsidiary even though the
of Global Intangible Low-Taxed Income, by Jane G.
subsidiary has no active role in the management and
Gravelle for a discussion of these proposals.)
oversight of the research, which is carried out in the United
States under the complete control of the U.S. parent.
The ability to shift profits to low-tax jurisdictions could
also change if a global minimum tax (Pillar 2) proposed by
The Commensurate With Income
the OECD/G20 is widely adopted. (See CRS In Focus
Standard and Period Adjustments
IF11874, International Tax Proposals Addressing Profit
The IRS regulations include a provision to make periodic
Shifting: Pillars 1 and 2, by Jane G. Gravelle for an
adjustments to transfer prices to reflect profitability. These
explanation.) Many countries have already begun the
regulations are based on the commensurate with income
process of adopting this minimum tax.
standard for the transfer of intangibles (the second sentence
of Section 482) added by the Tax Reform Act of 1986.
Jane G. Gravelle, Senior Specialist in Economic Policy
IF12524


https://crsreports.congress.gov

Corporate Taxation: Profit Shifting, Transfer Pricing, and Cost Sharing


Disclaimer
This document was prepared by the Congressional Research Service (CRS). CRS serves as nonpartisan shared staff to
congressional committees and Members of Congress. It operates solely at the behest of and under the direction of Congress.
Information in a CRS Report should not be relied upon for purposes other than public understanding of information that has
been provided by CRS to Members of Congress in connection with CRS’s institutional role. CRS Reports, as a work of the
United States Government, are not subject to copyright protection in the United States. Any CRS Report may be
reproduced and distributed in its entirety without permission from CRS. However, as a CRS Report may include
copyrighted images or material from a third party, you may need to obtain the permission of the copyright holder if you
wish to copy or otherwise use copyrighted material.

https://crsreports.congress.gov | IF12524 · VERSION 1 · NEW