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40% transfer pricing penalty upheld.

For the first time, the Tax Court upheld a 40% penalty against a taxpayer for substantially understating its taxable income due to a transfer pricing misstatement (DHL Corp., TC Memo 1998-461). Many practitioners believe this decision paves the way for the Service to routinely question controversial transfer pricing practices, including transfers of intangible assets outside the U.S.


DHL had developed and registered its trademark in the U.S., but its international affiliate (DHLI) had registered and defended the trademark in foreign countries. The foreign registrations had not claimed, however, that DHL was the trademark owner. The cost of developing the trademark had not been shared, and, based on written agreement and operating procedures, the parties had acknowledged that DHL owned and controlled the trademark. DHLI had not paid any consideration (payments or royalties) to DHL for using the trademark.

DHL and DHLI had recorded certain intercompany charges for services performed for each other, primarily for any imbalance between the values of shipments originating outside the U.S. that were destined for U.S. addressees and shipments originating in the U.S. destined for foreign addressees.

DHL claimed that the trademark was worth only $20 million and had apparently stonewalled the IRS after the Service issued a deficiency notice. (Ultimately, this did not help DHL's case in court.) In the absence of additional information from DHL, the IRS claimed that the tradename was worth between $500 million and $600 million (reduced to $300 million at trial).

Ownership and Value of the DHL Trademark

The court concluded that DHL, rather than the foreign affiliate, was the owner of the trademark. The court noted that, among other evidence, there existed written communications between general counsels for DHL and DHLI, in which the former stated that the trademark could not be sold to a foreign purchaser without the consent of DHL and its board of directors.

The court held that DHL's position on the $20 million value of the trademark had been based on a "friendly" appraisal by an outside firm. Using other valuation evidence, the court concluded that the total intangible assets of the parties were worth approximately $300 million, which it divided equally between the trademark and the parties' operating systems, quality control guidelines and operating procedures. By applying a marketability discount, the court determined that the trademark's $150 million value should be reduced to $100 million, because an arm's-length purchaser would have to incur costs to perfect trademark ownership in foreign jurisdictions.

Sec. 6662 Penalties

In the Sec. 482 context, there are two different levels of Sec. 6662 penalties for inaccuracies--(1) substantial valuation misstatements (the 20% penalty) and (2) gross valuation misstatements (the 40% penalty).

Specifically, a 20% accuracy-related penalty is imposed on any portion of an underpayment resulting from any substantial income tax valuation misstatement; such misstatement occurs if the price of any property or its use in connection with any transaction between related persons described in Sec. 482 is 200% or more (or 50% or less) of the correct Sec. 482 valuation, or the transfer pricing adjustment exceeds the lesser of $5 million or 10% of the taxpayer's gross receipts. The penalty is doubled to 40% if the price claimed is 400% or more (or 25% or less) of the correct Sec. 482 valuation, or the transfer pricing adjustment exceeds the lesser of $20 million or 20% of the taxpayer's gross receipts.

The court found that DHLI should have paid DHL a 0.75% royalty rate, and applied the 20% substantial valuation penalty to forgone royalties. The court considered the trademark valuation misstatement a gross valuation misstatement, and applied the 40% penalty to this item. The tax deficiencies for the 1990, 1991 and 1992 tax years were $194.5 million, $14 million and $216 million, respectively; the court imposed Sec. 6662 penalties of $75 million, $3 million and $84.5 million, respectively--a total of $162.5 million in penalties--for these years.

As key facts, the Court noted the intransigence of the parties during the administrative and trial proceedings and the lack of independence on the part of the appraiser who reached the $20 million trademark valuation on which DHL relied. It is no surprise that the court commented, "As this trial has again demonstrated, parties can find experts who will advance and support values that favor the position of the person or entity that hired them."


The holding in DHL reaffirms the fact that the IRS will carefully scrutinize situations involving transfers of intangible assets from U.S. to related foreign parties. The holding also suggests that courts will be willing to uphold the assessment of the 20%/40% penalties in appropriate situations. Accordingly, taxpayers should plan to properly document and defend the pricing of transactions with controlled parties.

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Article Details
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Title Annotation:taxation
Author:Major, Bill
Publication:The Tax Adviser
Geographic Code:1USA
Date:Apr 1, 1999
Previous Article:Final loss allocation regs. result in increased FTC limitations.
Next Article:Variable annuities and current tax law.

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