Speculation as to the Transfer Pricing Battle Between Western Digital and the IRS

July 11, 2022 by Harold McClure
About the Author
Harold McClure
Harold McClure
is an economist with over 25 years of transfer pricing and valuation experience.
Dr. McClure began his transfer pricing career at the IRS and went on to work at several Big 4 accounting firms before becoming the lead economist in Thomson Reuters’ transfer pricing practice. Dr. McClure received his Ph.D. in economics from Vanderbilt University in 1983.
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Western Digital Corporation (WDC) announced in its 10-Q filing for the period ending April 1, 2022 that it has resolved a long-standing transfer pricing dispute with the United States Internal Revenue Service (IRS). WDC may pay an additional $700 million in income taxes. The dispute eventually covered the period from July 1, 2007 to June 30, 2015. The original transfer pricing adjustment for the first two years would have resulted in over $500 million in taxes, with a subsequent proposed adjustment for the period through June 30, 2012 exceeding $1.25 billion or $250 million in taxes per year.

This discussion will speculate on what the transfer pricing issues were based on information provided in WDC’s 10-K filing for fiscal year ended July 2, 2010.

WDC designs and manufactures computer hard drives selling them to original equipment manufacturers and original design manufacturers. For the three-year period covered in this 10-K:

  1. Annual sales averaged approximately $8.5 billion per year;
  2. Consolidated operating profits represented 12.65% of sales;
  3. Cost of production represented 78.4% of sales;
  4. R&D expenses represented 6.25% of sales; and
  5. Selling expenses represented 2.7% of sales.

US sales represented only 20% of sales, with the remaining sales occurring in Europe and Asia. Production was performed by its Asian affiliates in Malaysia, the Philippines, and Thailand. One of the transfer pricing concerns was the extent of profits accruing to a newly formed Irish affiliate.

The effective tax rate for this period was approximately 9%, as only 10% of worldwide profits were allocated to the US parent under the transfer pricing policies. The Asian affiliates enjoyed tax holidays while the Irish affiliate likely enjoyed a low tax rate. The IRS’ primary concern was that too much profits were allocated to the Irish affiliate, but the profitability of the Asian manufacturing affiliates may have been an additional concern.

The following table presents a simplified model of transfer pricing between the various distribution affiliates of WDC and its manufacturer affiliates, and a highly simplified variation of an intangible holding affiliate. Our highly simplified variation assumes that this intangible holding affiliate owns all product and process intangibles. We later relax this potentially unrealistic assumption.

Initial Transfer Pricing Model (in Millions)

 

Manufacturers

Principle

Distributors

Sales

$0.00

$0.00

$8500.00

I/C Price 2 (Outbound)

$0.00

$8219.50

$8219.50

I/C Price 1 (Inbound)

$6885.00

$6885.00

$0.00

Gross Profits

$6885.00

$1334.50

$280.50

Expenses

$6664.00

$531.25

$229.50

Net Profits

$221.00

$803.25

$51.00

 

Our model assumes that for every $100 of disk drives sold, the manufacturing affiliates are paid $81 by the principle (I/C price 1) and the distributor affiliates are charged $96.7 by the principle (I/C price 2). The manufacturing affiliates receive a routine return to their activities, which our table assumes represents a 3.32% markup over production costs. The distributor affiliates retain a 3.3 gross margin so its net profits represent a 0.6% return to sales, which is equivalent to a 22.22% markup over expenses.

The principle in our initial model captures 74.7% of consolidated profits with the manufacturing affiliates capturing 20.55% of profits leaving the distribution affiliates with only 4.75% of profits. We noted that the US parent was allocated 10% of consolidated profits with less than 1% of this allocation coming from its distribution function. The US parent also captured just over 12% of residual profits.

The IRS likely argued that the US parent deserved a higher proportion of these residual profits as compensation for incurring prior R&D expenses related to the development of the product intangibles. The discussion of intangible assets in WDC’s 10-K filing, however, hinted at the existence of significant process intangibles in addition to product intangibles:

We believe that we have significant know-how, unique product manufacturing processes, execution skills and human resources to continue to be successful and have the ability to grow, as necessary, our manufacturing operations … Hard drive manufacturing is a complex process involving the assembly of precision components with narrow tolerances and thorough testing … We continually evaluate our manufacturing processes in an effort to increase productivity, sustain and improve quality and decrease manufacturing costs. We continually evaluate which steps in the manufacturing process would benefit from automation and how automated manufacturing processes can improve productivity and reduce manufacturing costs.

If the Asian manufacturing affiliates owns valuable process intangibles, then the tax authorities in Asia could likely argue for a transfer price higher than 81% of sales. As such, the manufacturing affiliate would deserve higher profits under the arm’s length standard.

The profits attributable to the product intangibles would therefore be less than the $803.25 million per year assumed in our table. The appropriate allocation of residual profits between the process intangibles owned by the Asian manufacturing affiliates versus the product intangibles from US pre-existing intangibles and the product intangibles created by ongoing R&D efforts would depend on a profit split analysis.

 

References

Western Digital. Corp., 10-Q: Quarterly Report for the Quarterly Period Ended April 1, 2022, Filed May 4, 2022.

Western Digital, Corp., 10-K: Annual Report for For the Fiscal Year Ended July 2, 2010, FIled August 13, 2022.

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