United States: Transfer Pricing Audits: Flipping The Tested Party

In some recent transfer pricing audits, the Internal Revenue Service (IRS) "flipped the tested party" after examining transactions between related U.S. and foreign companies. Typically, this practice results in the attribution of a larger portion of profit from the relevant business activity to the United States. On its face, the expression "flipping (or switching) the tested party" suggests that the IRS and the taxpayer have essentially similar views of the transactions (and the entities involved), but have approached the pricing from different angles: The taxpayer priced the transaction by comparing the profits of one party (usually the U.S. entity) to those of comparable unrelated parties, whereas the IRS priced the transaction by comparing the profits of the other party (usually the foreign entity) to those of comparable unrelated parties. In some cases, however, it appears that in purporting to flip the tested party, the IRS may in fact have misconstrued the substance and/or form of the actual transaction and disregarded the taxpayer's use of an appropriate and more reliable transfer pricing method (TPM). As these cases reveal, taxpayers can effectively respond to — and successfully quash — IRS attempts to flip the tested party when those attempts reflect methodologically unsound approaches. This alert suggests potential challenge.


The Internal Revenue Code and Treasury Regulations oblige related parties to price an intercompany transaction such that its results are consistent with those that would have been realized had unrelated parties engaged in the same transaction—that is, the price charged between related parties must be an arm's length price. To arrive at the arm's length price, a taxpayer must apply a TPM, but not just any TPM. Under the Best Method Rule, the taxpayer must select the TPM that provides the most reliable measure of an arm's length result.

The Regulations allow a taxpayer to use whichever method is best in light of the taxpayer's facts and circumstances, and they specifically define several TPMs that should be considered. For example, the comparable uncontrolled price (CUP) method for tangible goods, the comparable uncontrolled services price (CUSP) method for services, and the comparable uncontrolled transaction (CUT) method for intangibles all determine the arm's length price by first identifying comparable transactions between unrelated parties and then computing the interquartile range of prices observed in those "uncontrolled" transactions. The taxpayer's intercompany transaction price typically must fall within this "arm's length range."

The CUP, CUSP, and CUT methods rely on direct observations of market prices. In contrast, the comparable profits method (CPM) arrives at the arm's length price indirectly. To apply the CPM, a taxpayer must choose one of the two parties to its intercompany transaction to serve as the tested party. The CPM first determines the tested party's arm's length profitability on the basis of the profitability of comparable uncontrolled taxpayers, and then uses that profitability measure to demonstrate that the prices charged are arm's length.

Whether a direct method, such as the CUT method, or an indirect method, such as the CPM, is the "best" method for pricing a given transaction primarily depends upon two factors: (1) the quality of the data and assumptions used in the analysis and (2) the degree of comparability between the controlled transaction (or under the CPM, the tested party) and any uncontrolled comparables. The Regulations detail the factors relevant to evaluating comparability. For the CUP, CUSP, and CUT methods, the most important factor is the similarity of the products or services that are the subject of the transactions. For the CPM, it is most important that the tested party and uncontrolled comparables perform similar functions, assume similar risks, and invest similar resources. To help ensure a high degree of similarity on these points, the Regulations provide that the tested party should generally be the least complex of the two related parties and the one that does not own unique or valuable intangibles.


Ongoing and recently-concluded transfer pricing disputes illustrate a troubling trend. In these cases, the IRS has adopted views of the transactions' substance very different from those of the taxpayer and may consequently have applied the CPM to an inappropriate tested party:

1. Abbott Laboratories v. Commissioner, U.S. Tax Court Dkt. No. 29307-11

A Tax Court petition filed by Abbott Laboratories (Abbott) suggests that, in Abbott's view, the IRS has mischaracterized the role of its Bermudan subsidiary, Abbott Ireland, in transactions between Abbott Ireland and Abbott Cardiovascular Systems (ACS), a U.S. subsidiary of Abbott. Abbott Ireland licensed intangibles from ACS and used these intangibles in manufacturing drug-eluting stents and other vascular intervention devices, at least some of which it then sold to ACS for distribution. According to the petition, ACS and Abbott Ireland determined the royalty rate for the intangibles license using the CUT method. They set the transfer price for the finished devices sold to ACS using the CPM, and because in the sale of goods transaction ACS was a mere distributor while Abbott Ireland manufactured highly complex, heavily regulated products, they chose ACS as the tested party.

The petition alleges that, after examining the group's consolidated U.S. income tax return, the IRS adjusted the transfer prices for both transactions to attribute more income to ACS. First, the IRS applied the resale price method in lieu of the parties' chosen CPM to the finished devices sales and concluded that ACS should earn a margin 11 times higher than what it reported, thus decreasing the transfer price and Abbott Ireland's income. Second, in contrast to the parties' use of a CUT for the intangibles license, the IRS applied the CPM. It chose Abbott Ireland (the licensee) as the tested party and concluded that Abbott Ireland was too profitable and so should be paying a higher royalty rate to ACS.

In the petition, Abbott explains in detail the functions performed and risks borne by Abbott Ireland in manufacturing medical devices. The petition emphasizes, for example, Abbott Ireland's assumption of substantial product liability and regulatory risks and its engineers' role in process research and development. Reading between the lines, it appears that the IRS adjustments rest upon characterization of Abbott Ireland as akin to a risk-stripped contract manufacturer rather than an independent, risk-bearing manufacturer. Moreover, the petition does not reveal what flaws, if any, the IRS identified with the taxpayer's methodology or selected comparables. Thus, the petition illustrates both challenges posed by the IRS practice of flipping the tested party: possible mischaracterization of the transaction's substance (in particular, the tested party's functions, assets, and risks) and apparent disregard of a potentially more reliable TPM.

Despite its advanced age—the petition was filed December 22, 2011—the case has not yet been set for trial.

2. Medtronic Inc. v. Commissioner, U.S. Tax Court Dkt. No. 6944-11.

Another long-pending Tax Court petition—filed by Medtronic, Inc. (Medtronic) on March 23, 2011—tells a similar story. Medtronic licensed intangibles to its non-U.S. subsidiary, Medtronic Puerto Rico Operation Co. (Med PR). Med PR used the intangibles to manufacture pulse generators and medical therapy delivery devices, which Med PR then sold to a U.S. distribution affiliate. Med PR also used some of the intangibles licensed from Medtronic to manufacture spinal screws and sold the screws to yet another U.S. subsidiary.

According to the petition, Medtronic determined the royalty rate it received from Med PR using the CUT method, supporting that conclusion with the profit split method, and used the CPM for the other intercompany transactions. The petition does not disclose which party Medtronic selected as the tested party in the transactions for which it used the CPM but strongly suggests that it did not choose Med PR: In the petition, Medtronic repeatedly asserts that Med PR was "an entrepreneurial, risk-bearing, and functionally autonomous licensed manufacturer" and recites at length the substantial risks Med PR assumed and the extreme complexity of the manufacturing it performed. Med PR, in other words, would generally not be the least complex party to the intercompany transactions.

The IRS apparently took a very different view. According to the petition, it disregarded Medtronic's CUT and instead applied the CPM to the Medtronic-Med PR license, with Med PR as the tested party. It did the same with respect to Med PR's sales of spinal screws to a U.S. distribution affiliate. For both transactions, the IRS analysis produced a transfer price that increased the Medtronic group's U.S. income. The IRS position, Medtronic contends, is "based on how [it] believes Medtronic should have, could have, or might have structured its business operations . . . not . . . on how Medtronic, in fact, structured its business operations." As in the Abbott petition, Medtronic's petition alleges that the IRS rejected a CUT and applied the CPM using inappropriate comparables based on a mischaracterization of the tested party's role. The petition suggests that the IRS views Med PR as a contract manufacturer, not as an "entrepreneurial, risk-bearing, and functionally autonomous manufacturer" that would, at arm's length, negotiate a lower royalty rate and insist on retaining a larger share of the final price for the goods it manufactures. Thus, at least from the taxpayer's point of view, the case exemplifies both potential methodological errors raised by the practice of flipping the tested party: The IRS disregarded the substance of the taxpayer's transactions and inexplicably rejected use of a potentially more reliable TPM.

Judge Kathleen Kerrigan tried Medtronic's case in February and March 2015 and set a briefing schedule that concludes in October. Depending on the proof presented at the non-public trial, her decision, expected in 2016, may address the potential issues raised by flipping the tested party.

3. Guidant LLC, formerly Guidant Corporation v. Commissioner, U.S. Tax Court Dkt. No. 989-11.

On March 11, 2011, Guidant LLC (Guidant) filed a Tax Court petition that raises issues similar to those in the cases discussed above. It licensed intangibles to two foreign subsidiaries, Guidant Puerto Rico B.V. (Guidant PR), which operated a manufacturing branch in Puerto Rico, and Guidant Luxembourg SARL (Guidant Ireland), which operated a manufacturing branch in Ireland. Both subsidiaries used the intangibles in manufacturing complex medical devices which they sold to other related parties.

According to the petition, Guidant established the royalty rate charged to Guidant PR and Guidant Ireland using the CUT method, an unspecified method, or a profit-split method and used CPM to price the two subsidiaries' sales of finished products. The IRS used the CPM to reprice all of the intercompany transactions and, the petition contends, failed to select the least complex party as the tested party. The petition strongly suggests that the IRS chose Guidant PR or Guidant Ireland as the tested party for each transaction: It characterizes the two subsidiaries as "risk-bearing entrepreneurial manufacturer[s] and developers[s]" that bear significant regulatory and product liability risks and that participate with Guidant in product research and development. One can presume that in applying the CPM to the finished goods sales, Guidant treated the purchasers, not Guidant PR and Guidant Ireland, as the tested parties. Hence, in addition to the issues of disregard for substance and the best method raised by the petitions described above, Guidant's petition presents a pure example of the IRS flipping the tested party.

No trial date has yet been set in the case. The employer aggregation rules to be applied when identifying:


The pending Tax Court petitions summarized above suggest that the IRS may, in flipping the tested party, mischaracterize the parties' roles in related party transactions, reflexively apply the CPM even when a reliable CUT is available, and misapply the CPM by selecting the more complex party as the tested party. Taxpayers have tools to respond to IRS auditors' attempts to inappropriately flip the tested party:

1. Rely on the Regulations:

  • The Best Method Rule prescribes adoption of the TPM for which available uncontrolled comparables exhibit the greatest degree of comparability to the controlled transaction (or taxpayer), taking into account the quality of the data and assumptions.
  • The Regulations require evaluation of comparability in light of "all factors that could affect prices or profits in arm's length dealings," but they emphasize the importance of certain factors to certain TPMs. For the CPM, the most important factors are the tested party's functions performed, risks assumed, and resources invested. A thorough analysis of those factors with respect to the tested party is thus a necessary predicate to the selection of uncontrolled comparables, and the CPM will yield a reliable measure of the arm's length result only if the selected comparables are genuinely similar to the tested party.
  • The Regulations state that "in most cases the tested party will be the least complex of the controlled taxpayers and will not own any valuable intangible property or unique assets that distinguish it from potential uncontrolled comparables." In other words, as the tested party becomes more complex, the pool of potential uncontrolled comparables shrinks, and the analysis becomes less reliable.

2. Prove Up Your Functional Analysis.

Taxpayers should be prepared to prove the accuracy of their functional analyses. Rather than simply reciting what a party does and what risks it bears, a taxpayer should be able to present witness testimony and documentary evidence consistent with its representations. If the IRS mistakenly assumes that a limited-risk distributor enjoys a high degree of independence, the taxpayer should be prepared to show—not merely state—that the distributor in fact exercises little autonomy, performs few functions, and bears few risks. Note the number of pages devoted to descriptions of functions and risks in the Abbott, Guidant, and Medtronic petitions.

3. Defend Your Chosen TPM.

Taxpayers must always be prepared to support their chosen comparables with factual analysis, but where high-quality, reliable uncontrolled comparables data for a CUP, CUSP, or CUT are available, those methods will necessarily be superior to other methods because they rest upon direct observations of market prices. The Regulations do not incorporate this self-evident proposition, but perhaps because it seems self-evident, it bears remembering—and reminding.

4. Consider Profitability Down the Value Chain.

A taxpayer always makes the initial choice of a TPM and, if applicable, tested party. As the cases described above illustrate, however, the IRS may challenge those choices, and foreign tax administrations may do the same. Taxpayers should thus examine, and be prepared to explain, how the profitability of each participant in the chain of related-party transactions aligns with its functions, risks, and assets.

This article is designed to give general information on the developments covered, not to serve as legal advice related to specific situations or as a legal opinion. Counsel should be consulted for legal advice.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

In association with
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:
  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.
  • Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.
    If you do not want us to provide your name and email address you may opt out by clicking here
    If you do not wish to receive any future announcements of products and services offered by Mondaq you may opt out by clicking here

    Terms & Conditions and Privacy Statement

    Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

    Use of www.mondaq.com

    You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


    Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

    The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


    Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

    • To allow you to personalize the Mondaq websites you are visiting.
    • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
    • To produce demographic feedback for our information providers who provide information free for your use.

    Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

    Information Collection and Use

    We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

    We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

    Mondaq News Alerts

    In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


    A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

    Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

    Log Files

    We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


    This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

    Surveys & Contests

    From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


    If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


    From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

    *** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .


    This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

    Correcting/Updating Personal Information

    If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

    Notification of Changes

    If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

    How to contact Mondaq

    You can contact us with comments or queries at enquiries@mondaq.com.

    If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.

    By clicking Register you state you have read and agree to our Terms and Conditions