In theory, it is possible to treat the entire multinational as a single entity and either tax it on a consolidated basis (with the parent paying the entire tax but with a credit for foreign taxes on the subsidiaries) or apportion the group’s income among different jurisdictions by a formula, which essentially ignores the separate status of the various corporations within the group. The first way was briefly used by the US in 1921–24, and the second (formulary apportionment) is used by US states and Canadian provinces for intra-national purposes, and has been proposed for internal use within the EU. However, since 1924 the dominant method of allocating income among members of a corporate group has been to treat each company as a separate taxpayer and to determine the correct transfer prices for sales of goods or services among the group members on the basis of the arm’s length standard (ALS). The ALS, which is embodied in every tax treaty, states that the division of income among companies within a commonly controlled group should be based on estimates of how the income would be divided if the commonly controlled companies were instead unrelated companies, acting with respect to one another at arm’s length.
The transfer pricing problem can be illustrated with the following simple example. Parent Corporation P owns 100 percent of a single subsidiary S. P manufactures widgets at a cost of 20 and sells them to S, which incurs distribution costs of 20....
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