Supplemental comments on H.R. 5270, the Foreign Income Tax Rationalization and Simplification Act of 1992.

On September 4, 1992, Tax Executives Institute filed the following supplemental comments on H.R. 5270, the Foreign Income Tax Rationaization and Simplification Act of 1992. The comments follow up on TEI's testimony on the bill at a July 22 public hearing of the House Committee on Ways and Means, which is reprinted elsewhere in this issue. The Institute's follow-up comments were prepared under the aegis of its International Tax Committee, whose chair is Lisa Norton of the Ingersoll-Rand Company.

This letter responds to certain questions raised during the Institute's July 22 testimony before the House Ways and Means Committee on H.R. 5270, the Foreign Income Tax Rationalization and Simplification Act of 1992. During the hearing, Congressman Pickle asked for comments on the scope and function of section 482 of the Internal Revenue Code.

1. The Scope of Section 482. At the hearing Congressman Pickle questioned the feasibility of applying section 482 on other than a case-by-case basis. As you know, section 482 of the Code invests the Secretary of the Treasury with the discretion to distribute, apportion, or allocate gross income, deductions, credits, or allowances among two or more related entities if it is necessary to prevent the evasion of taxes or clearly to reflect income of any of the entities. Although the statute itself does not establish an arm's-length standard, current Treasury Regulations provide that "[t]he standard to be applied in every case is that of an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer." Treas. Reg. [section] 1.482-1(b)(1).(1)

Although section 482 applies to both domestic and foreign-owned corporations, it has its greatest application in the examination of transfer prices between domestic and foreign related parties. The statute is results-oriented: if a taxpayer can demonstrate that its transfer prices are reasonable, then those prices are not subject to re-allocation under section 482. Section 482 mandates adjustments only where the taxpayer's method produces an unreasonable result. The arm's-length standard reflects the fact that the reasonableness of intercompany pricing can be determined accurately only by taking into account facts and circumstances surrounding specific transactions.

2. Section 482 as an International Standard. At the hearing, Congressman Pickle asked whether viable alternatives are available that would permit the United States to abandon the arm's-length standard. TEI believes that to be acceptable as an international standard, intercompany pricing rules must: (1) reflect economic reality; (2) provide for symmetrical taxation of related and unrelated party transactions; (3) provide for an acceptable sharing of taxable profits among competing jurisdictions, thereby avoiding double taxation; (4) be simple enough to be comprehended and applied by taxpayers and government agents alike; and (5) provide certainty of tax results.

The arm's-length standard meets this test. By focusing on transactions, the arm's-length standard provides for taxation based on reality, and not on arbitrary rules. The use of third-party comparables ensures the proper allocation of income. When properly applied, it is a neutral standard that fairly allocates income among a company's geographical locations. The standard is widely accepted and understood by taxpayers and taxing authorities. Moreover, if reasonable safe harbors are adopted, the standard will provide certainty of results.

The United States was instrumental in establishing the arm's-length standard as the worldwide model for transfer pricing policies. Indeed, the standard provided in the current Treasury Regulations served as the model for the 1979 Report of the Organisation for Economic Co-operation and Development (OECD) on transfer pricing. The OECD guidelines, in turn, have become the international norm. See Organisation for Economic Co-operation and Development, Report of the Committee on Fiscal Affairs, Transfer Pricing and Multinational Enterprises (1979) (hereinafter referred to as "1979 OECD Report"). Use of this standard on a worldwide basis minimizes the risk of double taxation; conversely, departing from this standard would increase such a risk. U.S. General Accounting Office, International Taxation: Problems Persist in Determining Tax Effects of Intercompany Prices 60 (GAO/GGD-92-89) (June 1992) (hereinafter referred to as "GAO Report No. 92-89").

Alternatives such as the formulary approach and a minimum tax have significant disadvantages. See GAO Report No. 92-89 at 56-58. TEI does not intend to reiterate the discussion of these approaches in the GAO Report here. We must emphasize, however, that the formulary and minimum tax alternatives both suffer from the same fundamental flaw: neither alternative has been accepted as the international norm.

The arm's-length standard is central to our system of international taxation; it is the premise upon which the U.S. treaties were negotiated. To abandon the internationally accepted standard in favor of an arbitrary formulary or minimum tax approach would undermine the United States' credibility with its treaty partners and invite retaliation by other countries. See GAO Report No. 92-89 at 58 (international consensus is needed on a formulary approach to avoid double taxation and the adoption of a minimum tax may provoke retaliation by other countries). See also 1979 OECD Report at 15 (the uncoordinated use of profit allocation by tax authorities "would involve the danger that, overall, the [multinational enterprise] affected would suffer double taxation of its profits."); Charles H. Berry, David F. Bradford, & James R. Hines, Jr., Arms-Length Pricing: Some Economic Perspectives, 54 Tax Notes 731, 732, (1992) ("formula allocation could be a viable alternative only with a very radical change in worldwide tax procedures.").

The increased potential for double taxation cannot help but adversely affect the ability of U.S. multinational corporations to compete abroad. It would also signal a retreat from our commitment to the treaty system and make future treaty negotiations more difficult.

International acceptance is crucial not only to avoid double taxation, but also to minimize the administrative burden on taxpayers and the government. To the extent any alternatives "deviate or are perceived as deviating from the arm's length standard and international agreement on the alternative is not reached, the administrative burden related to the competent authority process and the corresponding need for case-by-case analysis might increase." GAO Report No. 92-89 at 94 (emphasis added).

The GAO report concludes, "[a]lthough we expect difficulties with arm's length pricing to continue, we can find no problem-free alternative that would dictate Treasury's abandoning its current course [of working to resolve the problems with the arm's length standard]." Id. at 93. The Institute agrees with this assessment.

3. The Use of Safe Harbors. At the hearing, Congressman Pickle asked whether it was possible to establish brightline tests or safe harbors in this area. TEI encourages the adoption of bright-line tests or safe harbors in the transfer pricing area. Recently, the Institute submitted comments on the IRS's proposed regulations under section 482 which were issued in January. In its comments, the Institute proposed several safe harbors or rebuttable presumptions that may be employed to reduce the number of pricing disputes. For your information, a copy of the Institute's comments is enclosed.

We believe that safe harbors are an efficient means of reducing transfer pricing controversies in the courts and in competent authority proceedings. As the trial court stated in 1978 in E.I. duPont de Nemours & Co. v. United States,(2) "universally acceptable safe haven criteria to facilitate the administration of section 482 may now be both entirely feasible and eminently proper."

Moreover, safe harbors are especially appropriate because they promote certainty and ease of administration in an area fraught with complex factual determinations. We disagree with the GAO's assumption that safe harbors are necessarily revenue losers. GAO Report No. 92-89 at 79. A properly constructed safe harbor will permit taxpayers certainty of result without harming the public fisc. In addition, voluntary compliance with safe harbors will preserve limited government resources to focus on abusive transfers. For example, the profit-split election under section 936(h) reduced the scope of controversy concerning Puerto Rico transfer pricing to the benefit of taxpayers and the government alike.

(1) The current regulations establishing the arm's-length standard are substantially identical to regulations issued in 1935. See Treas. Reg. 86, [section] 45-1 (1935). The origin of section 482 can be traced back even farther. See Treas. Reg. 41, [subsection] 77 and 78 (1921) (imposing a consolidated return requirement on affiliated domestic corporations). (2) 78-1 U.S.T.C. [paragraph] 9374, at 83910 (Cl. Ct. 1978), cert. denied, 445 U.S. 962 (1980).