Revision of Rev. Proc. 65-17: adjustments required after a section 482 adjustment.

On June 27, 1998, Tax Executives Institute submitted the following comments on Rev. Proc. 65-17, relating to the adjustments required after a section 482 adjustment is made. TEI's comments took the form of a letter from TEI President Paul Cherecwich, Jr. of Cordant Technologies Inc. to Michael Danilack, Associate Chief Counsel (International) of the Internal Revenue Service. The comments were prepared under the aegis of the Institute's International Tax Committee, whose chair is Joseph S. Tann of Ameritech Corporation. Contributing materially to the submission were committee vice chair Joseph E. Bernot of NCR Corporation, Thomas R. Blythe of Baxter International, Inc., David A. Gellatly of Reynolds Metals Co., Margaret A. Osborne of Medtronic, Inc., Peter M. White of Eastman Kodak Co., and Terilea J. Wielenga of QAD, Inc.

Earlier this year, you gave a speech on proposed changes the Internal Revenue Service is considering to Rev. Proc. 65-17, relating to the adjustments required after a section 482 adjustment is made. You indicated that the IRS is considering the elimination of the dividend offset provision in that procedure and invited comments. Tax Executives Institute believes that the dividend offset provision affords taxpayers and the government with another form of alternative dispute resolution and urges the IRS to retain it.

Background

Revenue Procedure 65-171 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 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 provides the option of either offsetting dividends or repatriating cash to satisfy the receivable created by the section 482 adjustment.(2) If Rev. Proc. 65-17 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. G.C.M. 38676 explains that any difference between the arm's-length charge and the amount actually transferred is to be established as an account receivable from the parent, pursuant to the general principles of Rev. Proc. 65-17.

Section 4.01 of the procedure 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. 19642,

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.

The Dividend Offset Option Should Be Retained

The proposed elimination of the dividend offset option seems to stem from a belief that recent changes in transfer pricing documentation requirements will soon eliminate the need for section 482 adjustments. This is unfortunately not true. 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.

In many ways, the establishment of a transfer pricing policy is as much an art as 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 2 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.

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 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 filing a request for an APA and its completion. 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 recent documentation requirements and APA procedure may have reduced the likelihood of a section 482 adjustment, they are not a complete cure; the mechanics of coping with an adjustment remain important, especially in the absence of more current audits.

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 simpler and less disruptive than the alternative that will apparently be retained in the revised revenue procedure -- the repatriation of cash to satisfy the account receivable. At a time when the IRS is under fire to settle 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.

Conclusion

Because Rev. Proc. 65-17 is not available in respect of abusive transactions, we see no reason to eliminate the dividend offset provision. TEI therefore recommends that the provision be retained for taxpayers that in good faith attempt to comply with the transfer pricing rules.

Tax Executives Institute appreciates this opportunity to present our views on the possible elimination of the dividend offset provision of Rev. Proc. 65-17. If you have any questions, please do not hesitate to call Joseph S. Tann, Jr., chair of TEI's International Tax Committee, at [phone], or Mary L. Fahey of the Institute's professional staff at [phone].(3)

(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").

(2) The only limitation on obtaining Rev. Proc. 65-17 relief is that a taxpayer have no tax-avoidance motive. In Rev. Rul. 82-80, 1982-1 C.B. 89, relief was extended to foreign-owned U.S. subsidiaries.

(3) In January 1996, the Institute filed extensive comments on Rev. Proc. 65-17 -- including the need to clarify and expand the dividend offset. [Editor's note: These comments appeared in the January-February 1996 issue of The Tax Executive.]