Collateral consequences of U.S. transfer pricing adjustments.

March 18, 1999

On March 18, 1999, Tax Executives Institute submitted the following comments concerning the proposed revisions of Rev. Proc. 65-17, which relates to the collateral consequences of U.S. transfer pricing adjustments. The Institute's comments, submitted in the form of a letter from TEI President Lester D. Ezrati of Hewlett-Packard Company to IRS Associatel Chief Counsel (International) Michael Danilack, were prepared under the aegis of TEI's International Tax Committee, whose chair is Michael P. Boyle of Microsoft Corporation. G. Richard Eigenbrode of Applied Materials, Inc., a member of the Santa Clara Valley Chapter, contributed materially to the development of the Institute's comments.

On December 21, 1998, the Internal Revenue Service issued Announcement 99-1, which proposes to revise Revenue Procedure 65-17(1) relating to the collateral consequences of U.S. transfer pricing adjustments. The announcement was published in the January 11, 1999, issue of the Internal Revenue Bulletin (1999-2 I.R.B. 41). In January 1996 and July 1998, Tax Executives Institute filed comments on the proposed revision of Rev. Proc. 65-17. The Institute is pleased that many of its recommendations were incorporated in the announcement and offer the following comments on the formal proposal to revise the revenue procedure.

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our more than 5,000 members represent 2,800 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises and to transfer pricing issues in particular. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the proposed revision of Rev. Proc. 65-17.

Rev. Proc. 65-17 addresses the collateral consequences of U.S. transfer pricing adjustments. Specifically, the procedure permits a qualifying U.S. taxpayer, whose taxable income has been increased by reason of an allocation under section 482 of the Internal Revenue Code, to receive payment from the related entity from (or to) which the allocation of income (or deduction) was made, without having the receipt of such payment considered a taxable distribution (or contribution) for federal income tax purposes.

The procedure essentially adopts the theory that section 482 adjustments will be treated as a loan -- from the entity to which the income properly belonged -- to the entity that received the income. This treatment occurs whether the adjustment increases or decreases the taxpayer's reported U.S. taxable income. Moreover, taxpayers may elect to establish "loan" accounts under prescribed IRS procedures. If such an election is not made, or if requests for relief are denied, then the taxpayer may face constructive dividend (or capital) treatment.

Rev. Proc. 65-17 provides the mechanism for U.S. parent companies to establish and receive payment of the "loan" from a foreign subsidiary. The procedure addresses the situation in which a U.S. parent company was subject to a section 482 adjustment that increased its taxable income from a foreign subsidiary. Relief was provided not only to mitigate double taxation, but also to encourage future settlements of section 482 issues.

Rev. Proc. 65-17 currently provides the option of either offsetting dividends or repatriating cash to satisfy the receivable created by the section 482 adjustment. If Rev. Proc. 6517 relief is granted, any original transaction that was adjusted is treated as if the correct amount had been paid. An example notes that where a U.S. subsidiary has paid more for services than an arm's-length amount, the foreign parent will not be considered to have received a dividend to the extent of the excess amount, and the withholding tax provisions of sections 881 and 1442 will not be applied.

In Announcement 99-1, the IRS proposes to modify the procedure by making four major changes:

* The requirement of a finding by the IRS that the related-party transaction not have as a principal purpose the avoidance of federal income tax is eliminated. The proposal requires only that the taxpayer not be subject to a penalty under section 6662(e)(1)(B) or section 6662(h) of the Code by reason of the primary adjustment.

* Cash repatriation treatment is extended to adjustments initiated by the taxpayer under Treas. Reg. [sections] 1.4821(a)(3), including downward as well as upward adjustments.

* Dividend offset treatment is eliminated.

* The proposal clarifies that foreign tax credit is allowed for any foreign withholding tax with respect to the repayment of the principal or interest on a cash repatriation account to the extent and subject to the limitations of section 901 of the Code.

TEI generally supports the relief provisions set forth in Rev. Proc. 65-17 and believes that, with one exception -- relating to the dividend offset rule -- the proposed changes will further the goal of minimizing double taxation.

Hence, the elimination of the required finding of a tax-avoidance purpose recognizes that the law has changed considerably since the procedure was first issued. The section 6662(e) penalty clearly holds the taxpayer to a higher standard, eliminating the need for a finding of no-tax-avoidance purpose. Moreover, Rev. Proc. 65-17 currently fails to address the potential tax treatment of cash payments in the foreign jurisdiction and we are pleased that the proposed procedure would clarify that the foreign tax credit is available for withholding taxes paid in respect of such payments. Other changes -- such as permitting cash repatriation treatment for taxpayer-initiated adjustments and expansion of the procedure to include adjustments under section 61 or 162 of the Code -- are also needed. We commend the IRS for proposing these revisions.

The Institute is disappointed, however, with the proposed elimination of the dividend offset procedure. We believe that this option is still needed in the post-section 6662(e) world and urge the IRS to reconsider its elimination.

The Dividend Offset Option Should Be Retained

Section 4.01 of Rev. Proc. 65-17 provides that if a qualifying taxpayer complies with certain requirements, that taxpayer --

   shall be permitted to exclude from his gross income all or part of any
   dividend which (1) was received from the corporation ... with which it
   engaged in the transaction or arrangement giving rise to the section 482
   allocation (the "other corporation") and (2) was included in the gross
   income of the taxpayer as a dividend ... for the year for which the
   allocation is made, provided that the amount so excluded shall not exceed
   the amount of the increase in the taxable income of such taxpayer resulting
   from the section 482 allocation from the other corporation less the amount
   of any offset which is allowed to the taxpayer under section 3 of Revenue
   Procedure 64-54, C.B. 1964-2,1008, with respect to such section 482
   allocation. To the extent that a dividend is excluded from income pursuant
   to this paragraph, it shall cease to qualify as a dividend under section
   316 of the Code or a distribution under section 963 of the Code or as a
   dividend for any Federal income tax purpose.

In proposing to eliminate the option, the IRS states that dividend off-set treatment is inconsistent with the current policy under sections 482 and 6662(e) that "taxpayers should strive upfront to price their related party transactions in compliance with the arm's-length standard." TEI disagrees.

In many ways, the establishment of a transfer pricing policy is more an art than a science. A broad range of comparables may be available. Consider, for example, a business that in good faith undertakes a comparable profits method analysis of its transfer pricing. One comparable is in the 0-to-3 percent range, while another is in the 2-to-6 percent range. In such a case, there may be a good faith divergence of as much as 3 percent in establishing the transfer price. If a section 482 adjustment were subsequently made, the resulting interest and penalties could prove onerous to the taxpayer in the absence of the dividend offset procedure.

Rev. Proc. 65-17 is an ameliorative mechanism. Its purpose is to allow taxpayers facing audit-imposed adjustments, or who self-initiate them, to make "certain adjustments to conform their accounts to reflect [al section 482 allocation." Taxpayers who "get it right" the first time do not require Rev. Proc. 65-17 relief. Allowing a section 482 adjustment to offset a dividend paid in the same year does not avoid the adjustment. And, because both parties must conform their accounts to reflect the correct transfer pricing result, the relief does not generally permit the distributing corporation's effective tax rate to remain artificially high and thereby inflate a U.S. shareholder's deemed paid foreign tax credit on future dividends.

Moreover, the elimination of the option could create financial hardship for a subsidiary that has already reduced its assets by paying a dividend. If the subsidiary is subsequently required to establish an account payable to the parent company for transfer pricing changes, it could find itself short of cash to settle that account. The recharacterization of the dividend places the entities in the same position they would have been in had the transfer pricing been correctly calculated in the beginning.

TEI acknowledges that the use of an advanced pricing agreement (APA) may mitigate the consequences of a section 482 adjustment. Not all taxpayers, however, may be able to avail themselves of the APA procedure. Indeed, the time it takes to complete an APA (sometimes two or three years) means that the taxpayer may face a section 482 adjustment for the intervening period between the time the taxpayer files a request for an APA and the time it is completed. Even taxpayers that obtain an APA may well be faced with a compensating adjustment if there is a material change in facts. In other words, although the recently revised documentation requirements and APA procedure may have reduced the likelihood of a section 482 adjustment, they do not represent not a complete cure; the mechanics of coping with an adjustment remain important, especially in the absence of more current audits.

In today's global economy, cross-border transactions are subject to ongoing scrutiny by governments. The increased scrutiny by other countries -- such as Canada, Mexico, Brazil, Argentina, the United Kingdom, and Korea -- almost guarantees that transfer pricing controversies will continue. The dividend offset provision is a reasonable and flexible approach to managing the compensating adjustments that flow from a section 482 adjustment. The procedure is less disruptive than the alternative retained in the procedure -- the repatriation of cash to satisfy the account receivable. At a time when the IRS is attempting to settle more cases without litigation, the provision provides another method of encouraging dispute resolution. Without it, the agency and the taxpayers could well face more unagreed audit issues.

Because the procedure is not available to parties subject to the section 482 penalty, there is no reason to eliminate the dividend offset provision to prevent abuse. TEI therefore recommends that the option be restored for taxpayers who in good faith attempt to comply with the transfer pricing rules.

Conclusion

Tax Executives Institute appreciates this opportunity to present our views on Announcement 99-1, relating to the revision of Rev. Proc. 65-17. If you have any questions, please do not hesitate to call Michael P. Boyle, chair of TEI's International Tax Committee, at [phone], or Mary L. Fahey of the Institute's professional staff at [phone].

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(1) 1965-1 C.B. 833, as amended by Rev. Proc. 65-17, Amendment I, 1966-2 C.B. 1211, Rev. Proc. 65-17, Amendment II, 1974-1 C.B. 411, and Rev. Proc. 96-14, 1996-3 I.R.B. 626 (Jan. 16, 1996) (hereinafter collectively referred to as "Rev. Proc. 65-17").