Consulting fees are currently deductible.

The IRS National Office has ruled that a company may deduct consulting fees incurred in developing a transfer pricing methodology (TPM) and negotiating an advance pricing agreement (APA). In Letter Ruling (TAM) 9929038, the IRS ruled that the fees were tax compliance costs that did not create a separate and distinct asset or provide significant future benefits. The ruling is consistent with the Service's position that INDOPCO, Inc., 503 US 79 (1992), does not support capitalization when the only future benefit is a reduction in future costs.

Business Purpose for TPM

During its Year 1 tax year, the company considered whether to apply to the Service for an APA for transactions in two different countries. At the time, the IRS was considering the proposal of significant transfer pricing adjustments under Sec. 482 for transactions for tax years beginning in Year 2, and had already proposed such adjustments for Years 3 and 4. The company reasoned that the APA could be a vehicle for developing a TPM agreeable to the Service, as well as to the tax authorities in the two countries. In addition, the TPM could serve as a basis for resolving all actual and potential disputes with the IRS for prior tax years and for avoiding such disputes in future years. In Year 5, the company filed for an APA to cover Years 5 and 6. While the application was pending, the IRS Examinations Division suspended its consideration of transfer pricing adjustments for the tax years under audit, and the Appeals division suspended its consideration of proposed transfer pricing adjustments for prior tax years.

To help the company develop a TPM, its attorney hired an economic consulting firm. The firm developed a TPM that was proposed as part of the APA application; the firm then consulted with the company and the Service over the next several years, making modifications to the TPM as negotiations proceeded. The company currently deducted amounts paid to the consulting firm. It also began using a version of the TPM for internal pricing purposes in Year 7 and reported operating results based on these prices for both tax and financial accounting purposes.

IRS Proposes Capitalization

As part of the examination of the company's returns for Years 8 and 9, the examining agent proposed to capitalize the consulting fees under Sec. 263. During the years at issue, the fees were incurred for the development of the TPM and assistance with APA negotiations with the Service. These activities resulted in the adoption of the APA for Years 5 and 6 and the use of the TPM to resolve transfer pricing issues for Years 3-8. The examining agent maintained that the fees should be capitalized, because the TPM and the APA provided the company with a significant future benefit (i.e., the potential reduction of future tax compliance costs).

The National Office disagreed, ruling that the reduction of future costs, without more, is not a sufficient ground for capitalization. The National Office cited T.J. Enterprises, Inc., 101 TC 581 (1993) (amounts paid to a majority shareholder to prevent her from causing an increase in royalty rates were currently deductible), Rev. Rul. 95-32 (expenditures that reduced a utility's future production costs were deductible) and Rev. Rul. 94-77 (severance payments made to employees in connection with a business down-sizing were deductible even though they might produce some future benefits, such as reducing future operating costs and increasing operating efficiencies).

The National Office also noted that neither the TPM nor the APA constituted a separate and distinct asset as contemplated by Sec. 263(a). Thus, the company did not derive a significant future benefit from the consulting fee expenditures, and the costs were "merely tax compliance costs"

FROM DIANE HERNDON AND JANE ROHRS, WASHINGTON, DC