Petitioner Compaq Computer Corporation manufactures personal computers (PCs). Printed circuit assemblies (PCAs) are the electronic circuitry inside a PC's central processing unit that allows the PC to operate. Compaq set up a PCA manufacturing subsidiary in Singapore. The petitioner purchased PCAs from its Singapore subsidiary at actual market prices based on purchases of similar PCAs from unrelated subcontractors that were primarily located in the United States, with a "turnkey equivalent" adjustment based not on actual transactions, but on industry practice. The IRS took the position that such pricing resulted in too much profit being left in low-tax Singapore. The IRS argued that a "cost-plus" approach should have been used and declared a deficiency in Compaq's consolidated returns. Compaq appealed to the Tax Court.
1. What standard does a taxpayer have to meet in order to overcome the IRS determination that the transfer prices were not arm's-length? Does this give the IRS the great benefit of the doubt?
2. Why was the IRS unable to show that its ruling against Compaq was not "arbitrary and capricious"?
3. What does this tell the U.S. investor about playing games with inter-affiliate transfer pricing to avoid taxes?