Bloomberg has an amazing overview on transfer pricing, via an upcoming paper by Economist Kimberly Clausing. It is estimated $60 billion dollars in corporate taxes are avoided through this technique and $1 trillion dollars in profits are parked offshore, much of which is to avoid paying taxes.

The nutshell of the technique is to attribute sales in one country to profits in another.

The system allows for creating paper transactions between subsidiaries of the same company to allocate expenses and profits to selected countries. For instance, when technology firms license their patents to offshore subsidiaries in low-tax countries, profits from sales overseas are booked to the foreign units, not the U.S. parents. The tax savings add to profits.

U.S. tax laws have sought to regulate transfer pricing in various forms since 1921. Treasury Department regulations in 1968 created standards for pricing inter-company transactions. Thousands of pages of rules have followed, and the tax code was amended in 1986 because of concerns that companies were shifting profits from the U.S.

For U.S. regulators, the key questions in transfer pricing are whether the parent pays too much to its offshore subsidiary or whether the subsidiary pays too little to its U.S. parent. Treasury Department regulations require “arm’s length” prices, or the amounts that would be paid between unrelated parties.

Those rules are “based on a fiction,” said Michael C. Durst, special counsel at Steptoe & Johnson LLP, in Washington, who advised companies on transfer pricing for 15 years and has emerged as a leading critic of the system.

Many of the transfer pricing transactions between a U.S. parent and its offshore units would never take place between unrelated parties, Durst said. So it’s often impossible to compare the prices paid in those deals to prices in real-world transactions between separate companies, he said.

The article has examples as well as an interactive graphic, to illustrate how transfer pricing works.

For more details on transfer pricing read full spectrum inequality.