The Dairy Trade Coalition
   Saving the Spotted Cow for Generations to Come

Transfer Pricing 

Memorandum 

The Internal Revenue Service has announced on several occasions in the past five years that it is interested in stepping up enforcement actions against foreign companies doing business in the United States. This is known as she transfer pricing issue. Essentially, it revolves around the terms on which foreign corporations do business with their affiliates in the United States. It was a major campaign issue with President Clinton who estimated that 50 billion dollars could be collected by enforcement of the tax laws against foreign companies. It is believed that the New Zealand Dairy Board should be given special attention on this point with regard to its dealing with the United States subsidiaries. 

The statutory provision involved is section 482 of the Internal Revenue Code which empowers the Commissioner of Internal Revenue to reallocate items of income and deduction among entities under common control. This could apply between domestic corporations and their stockholders, between partnerships and partners and even among tax exempt entities. 

But by far the most currently visible use of the section is when it is applied to dealings between a foreign corporation and its U.S. affiliates. Since foreign parents are normally not doing business in the U.S., their income is completely free from U.S. tax. Their domestic subsidiaries, set up primarily for the purpose of performing the U.S. functions for the parent, are subject to the full U.S. tax. 

The purpose of foreign corporations in setting their transfer prices is to minimize the U.S. tax on their U.S. affiliates. It's done in a number of ways including the charging of large management fees, high interest on borrowed capital, royalties on parent technology, and the most common method, the one believed used by the New Zealand Dairy Board, is simply the setting of intercompany prices at levels where the U.S. subsidiary makes little or no profit on the sales. 

In the NZDB case we have been told that all its sales in the U.S. are made through Western Dairy and other subsidiaries. While most of the details of the arrangements are secret, we are certain that the transfer prices are such that virtually all of the income from the U.S. sales of New Zealand dairy products in the U.S. are realized in New Zealand. Very little is realized by Western on which U.S. tax is due even though Western maintains a large organization in the U.S., warehouses product and arranges the distribution of all the products, and performs indispensable functions in the sales and distribution chain. 

The basic facts supporting this conclusion are: 

• The New Zealand Dairy Board holds monopolistic power over all exports of New Zealand dairy products throughout the world. It sets prices and terms on all shipments. 
• NZDB annually sells millions of dollars of dairy products to the United States. Almost all of its sales are made to its wholly owned subsidiary, Western Dairy Products of Santa Rosa, California, which then resells the products to United States customers. While the prices prevailing between NZDB and Western are not public information it is clear that NZDB sells the product to Western at artificially inflated prices intended to attribute substantially all the profit to NZDB and very little to Western. 
• NZDB, as a non-resident company, is not required to pay income taxes in the United States on its income from its sales to the United States. Western Dairy is liable for taxes on all its income but in fact realizes very little income on the resale of products purchased from NZDB because of the inflated price it is forced to pay NZDB and, therefore, pays very little tax on a very large volume of sales. 
• The price in the United States is historically higher than the world price for the identical products. We believe that virtually all the differential between the U.S. price and the world price is retained by the NZDB when it sells products to Western. In other words Western is now paying more per pound that distributors in other countries for the same product and NZDB is getting the higher price without incurring U.S. tax on the differential; and in fact, neither NZDB nor Western pays any U.S. tax on the differential. 

Thus, the profit which is being shifted to New Zealand includes the entire premium reflecting the higher U.S. price over the world price. This entire premium is incorporated in the price that NZDB charges Western. If there ever was an item clearly allocable to United States operation and fully taxable in the United States, this is it. But NZDB retains that profit back in New Zealand and doesn't pay any United States tax. Virtually none of it is taxed here. 

The solution to the problem lies in the vigorous administration of section 482 of the Internal Revenue Code. This section empowers the Secretary of Treasury to "distribute, apportion and allocate" items of gross income and deduction between NZDB and Western and reallocate the profit to Western. In a letter dated June 29, 1994, Senators Kohl, Feingold and Wofford requested the IRS to audit Western on these transactions and to exercise the power granted to it by the 1993 Reconciliation Act transfer pricing initiative. The Committee should seek a report on that investigation. 

The Congress should consider the adoption of additional measures to insure that foreign producers like the NZDB pay their fair share of United States income taxes. The failure to pay taxes gives such producers another enormous advantage over taxpaying domestic farmers and processors.