The IRS regulations and OECD Guidelines discuss the need to for taxpayers to consider “reasonable alternatives” in determining whether their transfer prices are arm’s length. As a matter of first impression, this seems reasonable. When applied to arm’s length prices, the question is whether a price that is observed in the third party transaction can be used even when there is convincing evidence that either the seller would not sell at such a price or that the buyer would not be willing to pay such a price.

This was an issue in the Bausch & Lomb Tax Court case. In this case, there were a substantial number of transactions that supported a price of $7.50 for a contact lens. However, Bausch & Lomb US could produce contact lenses at its US manufacturing facilities for perhaps $2.00 per lens. Therefore, even accepting the $7.50 price as arm’s length, the IRS raised the question of whether, at arm’s length, Bausch & Lomb US would have agreed to buy lenses from Ireland at a price of $7.50 when it could have produced them for $2.00? Or would it only have cut production at its US facilities if it was able to secure a price that was linked to its costs rather than the market price?

The introduction of the concept of reasonable alternatives introduces the question of whether, and how, corporate decision-making should be factored into an analysis of what is or is not arm’s length. Does the application of the arm’s length standard simply require that the prices charged in a transaction be set at the same level as the prices charged in a “comparable” transaction among unrelated third parties, or does it also require that the price be set at a level that would induce the two parties to agree to enter into the transaction? Including the latter consideration as part of an arm’s length analysis necessarily involves examining whether the decisions made by the two controlled taxpayers are ones that would be made at arm’s length.

One approach to incorporating reasonable alternatives into a transfer pricing analysis is to continue to focus on price, and treat reasonable alternatives as one of the factors that affects the selection and application of transfer pricing methods. The Bausch & Lomb fact pattern outlined above implies that there is some barrier to entry that prevented other suppliers from producing contact lenses at the same low costs as were incurred by Bausch & Lomb US. Therefore, the key issue may not be the price of the contact lenses per se, but how to address the issues raised by the barrier to entry. In the Bausch & Lomb case, this essentially involved determining an appropriate arm’s length value of the proprietary spin-cast technology owned by Bausch & Lomb US. Bausch & Lomb argued that the price of the spin-casting technology should also be determined based on third party comparables, with a royalty rate set at 5% of sales. A royalty rate at this level would generate income of only 0.05 * $7.50 = $0.375 per lens, far too little to offset the $5.50 difference between the observed price of $7.50 and Bausch & Lomb’s US production costs of $2.00. A reasonable alternatives argument would be that Bausch & Lomb US would not have been willing to pay a price of $7.50 under such circumstances, and that the CUP prices should therefore be rejected. A shift to the use of the CPM/TNMM method to either determine the price of lenses or the royalty rate for the spin-cast technology, however, would have eliminated the disparity and therefore generated prices that would be acceptable to Bausch and Lomb US. Under this reasoning, a reasonable alternatives analysis would suggest that the CPM/TNMM was a more reliable pricing method than the CUP/CUT.

A reasonable alternatives analysis, however, is much better at showing that a price is wrong, in that it would clearly be unacceptable to one of the two parties, than in showing that a particular price is right. Keeping with the Bausch & Lomb example, assume that Bausch & Lomb can produce lenses for $2.00, including earning a routine profit. Europe Lenses is paying its existing suppliers a price of $7.50 per lens, and is also earning a routine profit. Bausch & Lomb can generate increased revenues and earn routine profits on such increased revenues at any price over $2.00 per lens. Similarly, Europe Lenses can afford to pay any price up to $7.50 per lens and earn routine profits. A simple reasonable alternatives analysis can be used to say that the price will not go below $2.00 per lens and will not go above $7.50 per lens, but cannot say anything more than this without additional factual and economic analyses, which are often speculative and subject to substantial disagreement between the taxpayer and tax authorities.

Thus, in many cases a reasonable alternatives analysis will at most lead to a range rather than a specific price. A higher price is always in the best interest of the seller, and a lower price is always in the best interests of the buyer. But a higher price is only a reasonable alternative if the buyer must accept it; a lower price is a reasonable alternative only if the seller must accept it. However, there are many cases in which the buyer would be willing to pay a price that it greater than the lowest price that the seller would accept, and conversely the seller is willing to accept a lower price that the buyer would be willing to pay. This implies that at best a reasonable alternatives approach can establish a range, and not pick the right point within the range. This is at the heart of frequent disputes over who should realize the benefits of volume discounts, location savings, market specific attributes, the effect of implied guarantees on interest rates.

In other cases, a reasonable alternative analysis may suggest that there is no price at which the transaction would take place – the lowest price that is acceptable to the seller is greater than the highest price that is acceptable to the buyer. This issue is at the heart of a number of cases involving the allocation of administrative and IT services, where the tax authorities of the headquarters company expect all costs to be allocated out, while the tax authorities of the recipients of the services believe that they could be purchased more cheaply in the local market, often due to lower labor costs.

The issues associated with using a reasonable alternatives analysis are compounded when the analysis is applied to decisions that may affect profits, but not necessarily prices. (Indeed, it is possible that there are not intercompany transactions, simply investment decisions.) Take the situation in which an MNE makes incurs losses on small cars, but more than offsets these losses with profits on large cars. Such economics are driven by the nature of the market, and not by non-arm’s length pricing. The MNE can clearly engage in tax planning by producing small cars in a high tax jurisdiction and large cars in a low tax jurisdiction. Given this, is the MNE free to source (unprofitable) small cars from the high tax jurisdiction and (profitable) large cars from the low tax jurisdiction? Or does the need for arm’s length transfer pricing require the MNE to structure its transactions in a way that ensures that the producer of small cars is likely to earn a profit (e.g., through a contract manufacturing arrangement)? And which legal entity is responsible for providing this guarantee – the parent company, the manufacturer of large cars, or the marketing company that sells both large and small cars?

At one level, such a constraint on the business arrangements of the MNE appears to be “reasonable” in that the losses on small care are presumably incurred to bring customers to the brand of cars offered by the manufacturer and therefore to generate future sales of the profitable large cars. (This is even more true in classic “blade and razor” fact patterns.) However, if I substitute “fuel efficient” cars for small cars and “luxury gas guzzlers” for large cars, the former are likely to have high sales and high profits when gas prices are high but losses when gas prices are low, with the reverse occurring for the luxury gas guzzlers. Under such circumstances, the MNE may expect equal profits on both fuel efficient cars and gas guzzlers at the time when the factories to produce these cars are built, but there will be some years in which fuel efficient cars realize high profits while gas guzzler experience losses, and vice versa. Under such circumstances, does the proper interpretation of the arm’s length standard allow tax authorities to argue that this type of risks should not be placed on the local legal entity producing these vehicles?

Once again, we have a blurring of the lines between transfer pricing and investment decisions.

Blog Posts in this Series:

Evolution of the Arm’s Length Standard: Introduction

Evolution of the Arm’s Length Standard: Part 2 – Entering a Market Through Sales v Investment

Evolution of the Arm’s Length Standard: Part 3 – The Introduction of Profit-Based Methods

Evolution of the Arm’s Length Standard: Part 4 – Reasonable Alternatives

Evolution of the Arm’s Length Standard: Part 5 – An Increasing Focus on the Location of Decision-Makers


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