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Procter & Gamble and beyond.


In Procter & Gamble Co. v. Commissioner, 95 T.C. No. 23 (Sept. 18, 1990),(1) the Tax Court dealt the Internal Revenue Service another setback in its long-standing attempt to mitigate the damage from its major defeat in Commissioner u. First Security Bank of Utah, 405 U.S. 394 (1972). In First Security Bank, the Supreme Court held that the IRS could not make a section 482 adjustment to tax insurance commissions to a bank from a related insurance company where federal banking laws prohibited the bank from receiving the insurance commission income. The Supreme Court reasoned that, where the failure to charge the income in question arose from a legal prohibition (as opposed to the artificial shifting of income by the exercise of control by related parties), section 482 cannot apply.

In an attempt to mitigate the damage it perceived from First Security Bank, the IRS first asserted that the law prohibiting receipt of the income must be federal law. In Salyersville National Bank v. United States, 613 F.2d 650 (6th Cir. 1980), the Sixth Circuit held that provisions of state law can similarly prevent a section 482 adjustment. Licking its wounds, the IRS next urged that foreign law certainly could not preclude section 482 adjustments.(2) In Procter & Gamble, the Tax Court handed the IRS yet another defeat in the IRS's attempts at damage control.

This article addresses the ramifications of Procter & Gamble in today's economic and tax environment. This article does not address in detail the merits of the Tax Court's holding in Procter & Gamble, for the fatal defect in the IRS's case becomes manifest by simply stating the issue: Whether there is any difference material to section 482 between domestic law prohibitions and foreign law prohibitions? The answer to the question is so obvious that the question of a reversal turns upon the Supreme Court's willingness to reconsider and overrule, directly or in principle, its seminal holding in First Security Bank.

In this article, the authors first summarize the decision in Procter & Gamble and then consider why it is unlikely the Supreme Court will reconsider or limit its holding in First Security Bank. Next, the prospects for a legislative or administrative solution to the IRS's perceived horrors in this area will be explored. Finally, the authors address areas in which the holding in Procter & Gamble offers planning opportunities.


Procter & Gamble involved a technology and intangible sub-licensing agreement between a U.S. Parent's ("P&G's") second-tier Spanish subsidiary ("Espana") and P&G's firsttier Swiss subsidiary ("AG"). AG had first obtained the technology and intangibles from P&G, pursuant to a licensing agreement. Under its licensing agreement with P&G, AG paid P&G royalties with respect to the exploitation of the intangibles by AG's sublicensees. AG then sublicensed the technology to related parties who directly exploited the technology in various geographical areas. Among these sublicensees was Espana which exploited the technology in Spain. Under this sublicensing agreement, AG did not receive royalties because, as P&G has maintained throughout the litigation, Espana was prohibited by Spanish law from paying royalties for such licenses to a related company.(3)

P&G included in its U.S. taxable income the royalties accruing to P&G under the license agreement with AG. AG, as a controlled foreign corporation (CFC), deducted the royalties paid to its parent in computing its Subpart F income but included no income from Espana as royalty income on the sub-license. Since AG's Subpart F income was included on P&G's U.S. return under the Subpart F rules, AG's deduction for royalties paid P&G offset exactly P&G's income from those same royalties, and no net amount was included on P&G's return to reflect a royalty for Espana's exploitation of the intangibles in Spain.

The IRS determined a deficiency based upon a section 482 adjustment to the licensing between AG and Espana. P&G petitioned the for redetermination of the deficiency. The Tax Court rejected the IRS's attempt to apply section 482, reasoning that AG's failure to charge Espana the royalties and thus include Espana's royalty payments in AG's Subpart F income resulted from a legal prohibition of Spanish law rather than the exercise of control between related parties.

The Tax Court's logic, of course, was the same as the Supreme Court's reasoning in First Security Bank. Consequently, the Tax Court was constrained to reach the same conclusion: Section 482 could not apply. The Tax Court did, however, caution taxpayers that section 482 might apply if there were no legitimate business purpose for the taxpayer to subject itself to the legal prohibition against paying or receiving income. On rehearing, the Tax Court rejected the IRS's belated attempt to to assert three alternative theories: (1) a section 482 allocation to Espana of AG's deductions for royalty payments to P&G under section 482, (2) a general disallowance theory, and (3) a general section 61 assignment-of-income theory.


A. The IRS's Concerns

The IRS has vocally argued that the Procter & Gamble decision represents a large and intolerable raid on the Treasury.(4) The IRS is concerned that U.S. multinationals will play games with foreign authorities to "create" the appearance or reality of a legal prohibition where none would have existed absent the opportunity to save U.S. tax. U.S. multinationals may thus conduct their business in order to be subject to such limitations of foreign law rather than in an alternative manner whereby such limitations might be avoided, and may even collaborate with foreign bureaucrats and politicians to create such limitations.(5)

We submit that these concerns are hyperbolic and reflect more than just a bit of bureaucratic paronoia. Indeed, the IRS's comments betray an outdated view of foreign governments as puppets of U.S. multinationals. Such a view may have been appropriate at one time in some situations, but is scarcely true today on a broad basis. Foreign governments are more often than not quite sensitive to avoid any appearance of being influenced by U.S. interests, and in some situations foreign governments may even harbor strong anti-American attitudes.

The point is simply this: The phenomenon that gives the IRS so much concern may be so much the exception in today's world that to formulate a rule universally applicable to foreign law prohibitions based on that phenomenon without regard to whether there was improper collaboration seems to be overkill and certainly not required by section 482.

We question whether the U.S. tax administrators should use section 482 to sit in judgment over the bona fides of sister governments. Suppose a country has a program to provide incentives to foreign corporations to invest in business operations in the country. The country's law provides that the incentives can be offered only upon extraction of economic commitments from the multinational seeking the incentives. Among the smorgasbord of economic commitments the multinational must give is the commitment to operate through a corporation incorporated in that country and to re-invest in that country all profits from operations (including those profits that might normally be payable as royalties to the U.S. parent). The foreign law provides that these limitations be incorporated into the corporation's articles of incorporation and that the commitments be subject to various civil and criminal penalties. In such a case, there is a real governmental imperative for the legal limitation and there is a real business reason for the taxpayer to subject itself to the legal limitation. Accordingly, it should withstand section 482 scrutiny if First Security Bank is not overruled.

Suppose, however, there is no real foreign government interest in the limitation (i.e., it imposes the limitation as an accommodation to the U.S. multinational), or that the foreign government really does not enforce the limitation, or that the taxpayer has no real business reason for subjecting itself to the limitation because equally advantageous alternatives were available to it. Alternatively, suppose there is only a marginal real foreign government interest in the limitation. In such situations, resolution of the U.S. tax dispute will turn on whether the limitation really represents "law" in the sense section 482 requires and, as a subset of that inquiry, whether there is a real business purpose in the taxpayer purportedly subjecting itself to the limitation. Obviously, as the Tax Court warned in Procter & Gamble, where the limitation is devoid of any real business and governmental purpose, the limitation should not be honored. The tax law is imbued with principles or doctrines that permit and even require that gossamer structures be ignored. See, e.g., Gregory v. Helvering, 293 U.S. 465 (1935).

Finally, suppose (and this presents the tough case) that the foreign government has a real and not a sham governmental interest in the prohibition. The question is whether the IRS and the courts should arrogate to themselves a license to make a qualitative review of the foreign government's interests reflected in the prohibition. Should they determine in some cases that the foreign government's interest is not sufficiently weighty to override the U.S. government's interests as reflected in section 482? These inquiries will involve the IRS and the U.S. courts in the morass of foreign law interpretation and administration as well as in the balancing of potentially sensitive issues of comity and diplomacy. Except in the purely sham situation, it would be a dangerous and slippery slope for the IRS and then the courts to determine issues of foreign government bona fides and relative merits of foreign government action. The authors believe that the problem -- if indeed it is a real problem at all -- requires a neutral legislative solution and not a judicial solution.

In addition to concerns where the law or governmental practice actually imposes the limitation, the IRS is concerned that limitations in the nature of economic contractual limitations subject to foreign law could be used as a bar to section 482 allocations. The "Aramco Advantage" cases discussed below raise this concern. There, the facts might be characterized as an economic arrangement in which one contracting party -- because of its bargaining position -- imposed a limitation upon the other party, thereby raising the issue whether such a limitation should be honored when the limitation permits economic distortions within one of the parties' corporate group. The IRS is concerned that the contractual limitation, enforceable under foreign law, could be invoked by U.S. multinationals to manipulate their U.S. tax liability.

These potential problems are present in purely domestic arrangements (i.e., transactions between related domestic corporations), but the IRS apparently is less concerned about purely domestic arrangements. The reason is two-fold. First, domestic arrangements are not only more easily policed for blatant abuses but the IRS is probably also more comfortable that domestic law limitations are less likely to be artificial. Second, domestic arrangements fall squarely within the purview of Supreme Court precedent, First Security Bank. The IRS may hope, however, to establish that foreign law prohibitions are different from domestic law prohibitions and then use that finding as a beachhead to storm the bastion of First Security Bank. It is true that the IRS would be pleased with a victory if only in the foreign law arena, for it perceives particular abuse in that arena; the frosting on the cake, however, would be for a victory in Procter & Gamble to presage ultimate reversal of First Security Bank, either by direct reversal by the Supreme Court or by a decision eroding the underpinnings of First Security Bank.

B. Judicial Solutions

1. Appeal in Procter & Gamble

On April 24, 1991, the IRS filed a notice of appeal in Procter & Gamble to the United States Court of Appeals for the Sixth Circuit. The briefs in the case have been filed, and the matter is awaiting assignment for oral argument. The case will probably be argued in early 1992 and an appellate decision may be forthcoming by the fall.

The authors predict that the Sixth Circuit will reach the same conclusion as the Tax Court -- that there is no reason to distinguish between foreign law prohibitions and domestic law prohibitions. In other words, the Supreme Court holding in First Security Bank and Sixth Circuit's prior holding in Salyersville National Bank should be dispositive.(6)

If this prediction holds, the question will become whether the Solicitor General will use a Sixth Circuit defeat to request the Supreme Court to reconsider First Security Bank. Informal discussions with government personnel, some of whom could speak with knowledge but not with the ultimate authority reserved to the Solicitor General, suggest that the decision has not yet been made. It is thus possible that the government could accept defeat in Procter & Gamble and wait for a more favorable case (e.g., the Aramco Advantage cases) in another circuit where the court of appeals will not be constrained by the Sixth Circuit's decision in Salyersville National Bank. (An IRS victory in another circuit would create a conflict, one of the principal grounds for the Supreme Court to agree to hear a case.)

Would the Supreme Court accept Procter & Gamble if asked? Would the Supreme Court overrule First Security Bank if it heard the case? If not, would the Supreme Court distinguish that case and hold for the IRS solely on the grounds, that for section 482 purposes, foreign law is different from domestic law?

Although the answers are now unknown, we can make some informed observations about the possible outcome. The first observation is based on the principle of stare decisis. Once tax issues are decided by the Supreme Court, the imperatives of certainty and predictability militate heavily in favor of changes being made by Congress and not by the courts. This does not mean, however, that the Supreme Court should not ever and will not ever overrule its precedents; it simply means that the occasion for doing so must be compelling.(7)

The role and importance of stare decisis, particularly in economic relationships such as this tax issue, may be particularly persuasive at this time. Many observers of the Supreme Court have speculated that the Court is poised to overrule many precedents. Much debate has been generated over whether the uncertainty generated by the "new" Court's perceived willingness to review previously settled law is a good thing. Given the debate, we believe the Court will reserve its overruling of past precedent to matters particularly important to the constituencies that created the "new" Court. Nothing emanating from the White House or any constituency supporting the "new" Court has related generally to tax issues or to section 482 or the scope or propriety of First Security Bank in particular.

The second observation is that there is no substantial feeling that First Security Bank was incorrectly decided. The government's argument in First Security Bank was essentially that income that in some economic sense might be viewed as attributable to an activity performed by another member of the group ought to be attributed to the member performing the services. But section 482 requires more than just an economic analysis to determine who in an economic sense is the true earner of the income: it requires that the putative misallocation of income be attributable to the exercise of control. Where the putative misallocation occurs as a result of prohibitions - legal or contractual - beyond the taxpayers' control, section 482 by its terms should not apply. It would be a dangerous step indeed to turn the Internal Revenue Code into a playing field where the referees are economists making calls based on economic notions that are at once imperfect and imprecise. Section 482 rightly applies only in those cases where the putative distortion arises form the exercise of control by the related taxpayers and not from forces beyond the control of the related taxpayers.

We doubt that the IRS could mount a sufficiently weighty argument to persuade the Supreme Court to reassess First Security Bank. Concededly, some observers believe that the theoretical underpinnings of First Security Bank have been eroded, in particular by United States v. Basye, 410 U.S. 441 (1973). Basye, however, has not been relied upon to date by the IRS in Procter & Gamble. Certainly, the IRS would have relied upon this authority had it perceived it as the herald of a new day in section 482 jurisprudence. On the other hand, since Basye did not overrule or even question First Security Bank, the argument that Basye undermines the holding of First Security Bank should be addressed to the Supreme Court in asking it to overrule First Security Bank. We nevertheless consider it unlikely that the Court will consider these cases as sufficiently on point to cause them to reconsider First Security Bank.(8)

2. The Aramco Advantage Cases

The Aramco Advantage cases offer the IRS another opportunity to seek a judicial solution to the problem it perceives. In the Aramco Advantage cases, affiliates of Texaco and Exxon purchased oil from Saudi Arabia at substantially below the world fair market price, the differential being the "Aramco advantage" these corporations had over their competitors. Allegedly to meet Saudi policies reflected in decrees of the Saudi oil minister, the purchasing affiliates were precluded from selling the oil other than at the below-market price at which they purchased it, plus costs and a reasonable profit -- i.e., a sales price substantially below the world market price. Since the bulk of the oil was sold by each corporation to and through one or more related corporations that refined the oil and marketed the refined product at world market prices, the profit inherent in the oil when it first entered the Texaco or Exxon family was pushed to other corporations in their respective families that allegedly could take better advantage of the deferral opportunities the U.S. tax law allowed foreign corporations. The net result was that the economic benefit of the Aramco advantage achieved deferral of taxation through artificially low sales prices dictated by the Saudi oil minister for reasons of Saudi policy.

The IRS proposed massive deficiencies against two of the Aramco "partners," Exxon and Texaco, and is reported to be asserting similar adjustments in respect of the two other U.S. multinationals involved, Chevron and Mobil.

The Exxon and Texaco cases were filed in the Tax Court. Those taxpayers' forum-choice analysis is not publicly available, but two factors may have weighed heavily on the taxpayer. First, the cash flow consideration involved in such massive deficiency assertions is apparent; there is no requirement that a taxpayer prepay a deficiency in order to go to Tax Court, whereas payment must precede litigation in the Claims Court or the District Court. Second, the Tax Court is generally considered a more tax-proficient court and, therefore, might more readily regard as disingenuous the IRS's attempt to distinguish foreign law from domestic law in applying First Security Bank. (Certainly, in this latter respect, the Tax Court is no worse a forum than the Claims Court.)

In the Tax Court, the case was assigned to Judge Whitaker. After much pre-trial sparring, Judge Whitaker decided on a two-prong approach. The first phase of the trial was to determine the nature of the legal limitation involved and whether that limitation per se precluded application of section 482 under First Security Bank and its progeny. If that phase of the trial is resolved in the taxpayers' favor, the taxpayers will win the case without further ado; if that phase is resolved in the IRS's favor, the second phase will address the appropriate transfer price under section 482.

The first phase of the hearing has been concluded. The parties are briefing the issues raised in the first hearing. These issues run the gamut, from evidentiary and procedural issues to the merits of the legal arguments.

Forecasting a result in the Aramco Advantage cases is difficult. On the one hand, the Aramco Advantage cases are significantly different from Procter & Gamble. The legal prohibition in the Aramco Advantage cases appears to have arisen from Saudi pricing policies for a commodity that it sold into the world market. One can argue, therefore, that the prohibition in question is more like the type of economic decision that any large supplier of any relatively scarce product might make. In other words, the decision was arguably more economic than governmental. On the other hand, the governmental action did relate to government-owned resources. Nations, including the United States, have historically viewed exploitation of government-owned resources as a legitimate governmental function. More important, there was no hint of collusion between the Saudi government and the Aramco partners. The Saudi government was not indifferent to whether it would adopt the policy or not adopt the policy and it did not adopt the position simply to accommodate the Aramco partners' U.S. tax goals. Rather, the policy was adopted for reasons dictated by the Saudi's perception of the Saudi government's best interests. For this reason, it appears that the Aramco Advantage cases should be decided in favor of the taxpayers.

The IRS's best argument in the Aramco Advantage cases is that the Saudi government was not acting in its capacity as a government but in its capacity as a vendor of a product. We believe that position is ill-founded, given the historical relationship of governments and natural resources. Even if the Saudi government were acting like a private vendor, however, the legal prohibition should still prevent the section 482 adjustment. The issue, properly framed, is whether a contractual limitation on one party may be overridden by the IRS under section 482 where the contract is a result of a negotiated arrangement between unrelated parties and the prohibition limiting the actions of one party is based on real or perceived business imperatives of the other party and is not the result of "control" exercised by the party limited by the prohibition.

Assume that a franchisor of quick-serve hamburgers imposes the requirement that a corporate franchisee may pay to a management company, related or unrelated, no more than one percent of sales. The franchisor's purpose is to provide for a fair management fee, but to ensure that costs are kept to a minimum so the franchisee will have sufficient funds to make necessary quality improvements. Assume further that the IRS can demonstrate that, based on the kind and quality of services performed by the related management company, an arm's-length fee in the absence of the limitation would be two percent. The issue is whether the government can impose that fee under section 482. The answer to that question must be no.(9)

The purpose of section 482 is to prevent the artificial shifting of income.(10) As the Supreme Court in First Security Bank noted, section 482 may apply when the exercise of the common control is the reason for pricing distortions. Where, as in the posited case and in the Aramco Advantage cases (if one accepts this private vendor construct), the alleged pricing distortion results not from the exercise of common control but because of restrictions imposed by a third party who has both the power and the real interest to impose the limitation, then section 482 cannot apply.(11)

Although the courts and the IRS should proceed carefully and sensitively in questioning prohibitions imposed by other countries, a section 482 adjustment may be appropriate where the prohibition was "imposed" solely as an accommodation to the U.S. taxpayer. Traditional principles of tax law, however, are sufficient to deal with these situations.(12) The same would be true in the case of sham contractual prohibitions imposed by third parties in purely nongovernmental business arrangements. In other words, it would be an intolerable interference with the market place for the IRS -- which cannot claim any unique insight into the imperatives of the market place -- to second-guess the terms of business deals. It is one thing to upset arrangements if they are void of substance; it is quite another to hold out the possibility that the IRS will upset legitimate business deals solely because the IRS feels they could have been structured to produce more tax revenue.

C. Legislative Solutions

In this era where bureaucrats and politicians are prone to foreign-country bashing, it is not inconceivable that there would be attempts at legislation designed to prevent any possibility (however remote in the real world) of foreign-country manipulation of U.S. tax consequences in the manner that concerns the IRS. In order to do so, however, Congress would almost certainly have to adopt a sweeping and neutral rule, one that would necessarily throw out the baby with the bath water. The tax law is robust enough to police the clearly abusive situation where the foreign law prohibition -- whether in a governmental or contractual setting -- is a sham or pure accommodation to the U.S. taxpayer. Broader permission to upset these arrangements would, however, necessarily encroach on legitimate foreign government and business imperatives.

Congress could, of course, fix the perceived problem in the foreign arena in a neutral way by requiring some form of consolidation of foreign income for U.S. tax purposes. This change would not resolve the perception of abuse from arrangements between and among related domestic taxpayers (such as involved in First Security Bank and Salyersville National Bank), and would thus provide only a partial solution to the larger problem confronting the IRS since its defeat in First Security Bank. More significantly, eliminating deferral would be a radical change in the treatment of income earned by foreign affiliates of U.S. multinationals, and it is unlikely Congress would find the political will to tinker in such a major way with the substantive provisions of the Internal Revenue Code's foreign provisions.

An international tax specialist with the staff of the Joint Committee on Taxation has recently included the Procter & Gamble problem on a list of items that, in his (and not necessarily the Committee's) view, might require legislative change.(13) The specialist cited no specific solution, but suggested that a stronger requirement on the taxpayer to demonstrate that the IRS abused its discretion in making the adjustment, citing the recently enacted recordkeeping requirements under section 6038A. Of course, the taxpayer already has the burden of establishing that the Commissioner's section 482 determination is arbitrary, capricious, and unreasonable and that the IRS abused its discretion.(14) Given this burden, it is questionable how a "super-burden" would affect the outcome of many cases. Thus, the court must currently be firmly convinced that the taxpayer's position is correct; it is unlikely that the court would apply an even more stringently articulated burden to hold for the IRS where it was firmly convinced the IRS is wrong and the taxpayer is right.(15)

We question whether a broader legislative solution dealing only with the foreign law side of the question is feasible. Certainly, foreign countries (including our treaty partners) would object to such a one-side solution that, in the final analysis, may be another slur upon their character because the IRS's real concern is probably a belief that foreign countries are willing to play games in this area to the detriment of the U.S. fisc. We question whether Congress again wants to undertake such one-sided legislation after the concerns that have been raised about analogous one-sided legislation (e.g., the "super-royalty"(l6) provisions and the recordkeeping requirements of sections 6038A and 6038C).

D. Administrative Solutions

Reportedly, new section 482 regulations will be issued shortly after the end of 1991.(17) Although there have been no indications that the regulations will attempt to deal with the Procter & Gamble issue, the question does deal whether the IRS might attempt a pre-emptive strike in this area.

The current blocked income rules in Treas. Reg. [sections] 1.482-1(d)(6) provide that, if payments are prohibited, the taxpayer can elect to defer the income arising from the allocation by adopting a method of accounting that would also defer any deductions related directly or indirectly to the deferred income. In Procter & Gamble, the Tax Court held that the blocked income regulations had no application because the regulations required the ability in the first instance to make a section 482 adjustment and First Security Bank precluded a section 482 adjustment. Certainly, the IRS must have the power before it can offer the taxpayer the opportunity to avoid the exercise of the power in exchange for the taxpayer's agreeing to defer deductions. If the Tax Court's holding in Procter & Gamble is sustained on this issue, we doubt that the IRS could devise valid regulations, for the holding goes to the very threshold issue whether section 482 can be read to permit an adjustment ab initio. The IRS might, however, endeavor to affect this issue by proposing regulations having the practical effect of adopting its position. Although we question whether valid regulations could be proposed, during the period before the regulations were held invalid such proposed regulations could have a powerful deterrent effect to exploiting the potential inherent in Procter & Gamble.


A. Take Advantage of Foreign Law

The IRS's concerns about the ramifications of Procter & Gamble suggest that the planning opportunities in this area exist, as long as the threshold tax requirement of real substance is met. Merely understanding the IRS's concerns should give the creative tax adviser ample ideas that, in an international business setting, can be utilized to ensure that his or her client or company does not pay more tax than the law requires. Judge Hand's famous quotation in Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), aff'd, 293 U.S. 465 (1935), is particularly apropos here: any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose the pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes.

B. Super-Royalty Provisions

Another area of potential advantage to the U.S. multinational is the so-called "super-royalty" provisions, which were added to section 482 in 1986. Specifically, section 482 was amended to include the following:

In the case of any transfer (or license) of intangible

property (within the meaning of section 936(h)(3)(B)),

the income with respect to such transfer or license

shall be commensurate with the income attributable

to the intangible.

A similar provision was previously included in section 367(d).

The question is whether the First Security Bank analysis as applied in Procter & Gamble precludes the application of the super-royalty provisions on the grounds that First Security Bank goes to the threshold issue whether section 482 applies. If section 482 cannot apply because of a legal limitation on the payment or receipt of income, then the super-royalty provision arguably would not apply.

This analysis might also extend to section 367(d), which applies to nonrecognition transfers, on the theory that if First Security Bank prohibits a section 482 adjustment to a licensing transaction when, under foreign law, the licensee cannot pay a royalty, then there can be no constructive licensing arrangement under section 367(d) requiring the same effect if the outbound transfer is a nonrecognition transaction. In other words, since the purpose of section 367(d) is to transform an outbound transfer into the tax equivalent of a licensing arrangement, the taxpayer should be no worse off than if it had entered a straightforward licensing arrangement where First Security Bank would preclude a section 482 adjustment.

C. Information Provisions

As previously observed, Congress has passed stringent information and recordkeeping provisions in section 6038A (pertaining to related domestic and foreign corporations), which are mirrored in section 6038C (pertaining to foreign corporations with U.S. trade or business). These provisions impose major information and recordkeeping requirements, with substantial in terrorem penalties for failure to comply in the form of significant dollar penalties and, perhaps worse, a stiffer burden of proof to overcome section 482 adjustments. The legislative history suggests that the information requirements are not to be overridden by foreign laws prohibiting the disclosure of information.

Some commentators have expressed concern that the new provisions conflict with certain treaty provisions requiring confidentiality of "trade, business, industrial, commercial, or professional secret or trade processes" and requiring nondiscrimination between foreign corporations and domestic corporations.(18) These concerns may be accentuated by Procter & Gamble's deference to foreign law. Given the legislative history, however, we doubt that a court will extend Procter & Gamble and its reasoning to defeat the clear congregssional purpose for sections 6038A and 6038C.

D. Section 482 Accuracy-Related Penalty

Congress recently enacted an accuracy-related penalty for section 482 adjustments. Section 6662(b)(3) imposes a 20-percent penalty for the portion of tax due to a "substantial valuation misatatement." The adjustment is a "substantial valuation misstatement" if either (1) the adjustment results from a correct amount of 200 percent or more (or 50 percent or less) of the amount claimed by the taxpayer in reporting the transaction or (2) the net section 482 adjustment exceeds $10,000,000. I.R.C. [sections] 6662(e)(1)(b). The penalty, regularly 20 percent, is doubled to 40 percent in the case of gross evaluation misstatements, defined by making the following changes: 200 percent is 400 percent, 50 percent is 25 percent, and $10,000,000 [sections] $20,000,000. In determining the $10,000,000 threshold adjustment ($20,000,000 in the case of a gross valuation misstatement), however, adjustments increasing taxable income are excluded if the taxpayer shows "that there was reasonable cause for the taxpayer's determination of such price and that the taxpayer acted in good faith with respect to such price." I.R.C. [sections] 6662(e)(3)(B)(i).

Although excluded in making the dollar threshold determination, once that threshold is reached on the basis of adjustments not subject to the reasonable cause and good faith exception, the entire amount of the section 482 adjustment is subject to the penalty. Significantly, there is an escape from the penalty on any portion of the underpayment of tax if it is shown that there was a reasonable cause for that portion of the understatement and the taxpayer acted in good faith. I.R.C. [sections] 6664(c()(1).

The uncertainty surrounding many foreign laws should give taxpayers significant opportunity to plan in this area with the reasonable assurance that, even if a section 482 adjustment is asserted and sustained, the taxpayer will be able to invoke successfully the reasonable cause and good faith exceptions. Certainly, if there is reasonable doubt on that prohibition, the taxpayer should be able to argue that, in the pursuit of its business, the better part of wisdom is to honor the apparent foreign law prohibition without being forced to test the limits of that prohibition. Given the IRS's general unhappiness with Procter & Gamble, however, the IRS may aggressively assert the penalty in the face of uncertainty.

Nevertheless, we hope that the courts will rein in the IRS if it aggressively asserts the penalty. A position that, upon pain of penalty, forces the taxpayer to take the most aggressive position as to foreign law to maximize U.S. revenue could have serious and detrimental consequences both to foreign business operations and international relations. Our foreign neighbors would doubtless object if the United States were to encourage U.S. taxpayers doing business in their countries to ignore foreign prohibitions when there may be doubt about the application of those prohibitions. That would be bad tax policy and bad foreign policy. Accordingly, the courts should be expected to honor reasonable assertions of doubt about foreign law prohibitions in applying the reasonable cause and good faith exceptions.

Even beyond the reasonable cause/good faith exception, there is another escape from the penalty that would have applied in Procter & Gamble: the foreign-to-foreign exception. Under section 6662(e)(3)(B)(ii), this exception applies if the adjustment is made to a transaction between two foreign corporations unless the adjustment relates to U.S.-source income or income effectively connected with a U.S. business. The conference committee report on the section 482 penalty provides, as an example of this exception, a royalty paid by one CFC to another.(19) As previously noted, the receipt of royalty income would be Subpart F income includible on the U.S. parent's corporate return, but the adjustment will not give rise to this accuracy-related penalty where two foreign corporations are involved. Lesson: do risky intercompany transactions through foreign subsidiaries.(20)


Procter & Gamble confirms the existence of opportunities inherent in First Security Bank. We anticipate that those opportunities will be available until and unless there is a legislative solution. Taxpayers have the right to take advantage of these opportunities and are not even morally obligated to choose the path of the highest tax payment.


(1) Rehearing denied, T.C. Memo. 1990-638 (Dec. 19, 1990), appeal to Sixth Circuit filed April 24, 1991. (2) Rev. Rul. 82-45, 1982-1 C.B. 89. (3) Spanish law was not clear on the point, but the court concluded that, on balance, the evidence of Spanish law (consisting principally of testimony of experts) was that the law was consistently applied by the Spanish administrators as imposing the limitation. (4) See, e.g., Matthews, Dolan, Pearlman Square Off Over Arm's Length v. Formula Approach, 50 Tax Notes 1336, 1337 (Mar. 25, 1991) (suggesting that Procter & Gamble is a blueprint for a massive raid on the fisc); Sheppard, The Procter & Gamble Case: Does Sec. 482 Require the Legal Ability to Receive Reallocated Income?, 49 Tax Notes 142, 145-146 (Oct. 8, 1990). (5) In his opening brief on appeal to the Sixth Circuit, the Commissioner characterized such collaborations as "tax-motivated accommodations worked out between U.S. taxpayers and compliant foreign governments." Brief at 40. (6) It is conceivable, but unlikely, that the Sixth Circuit could duck the issue by holding that Spanish law did not prohibit the payment. See note 3 supra. (7) No overwhelming fiscal imperative seems to be raised in this issue. Indeed, if there were an important fiscal imperative being abused in this arena, Congress would have previously imposed a legislative solution. In the almost 20 years since First Security Bank, Congress has scoured the terrain to curb even marginally unwarranted tax benefits and so far there has been no hint that Congress has set its sights on First Security Bank. Given this silence on the broader problem of which Procter & Gamble is only one facet, it seems unlikely that the issue is of such overwhelming importance and such dubious correctness that it need be re-examined by the Supreme Court. (8) There have been some rumblings that perhaps the Supreme Court or, perhaps, merely individual Justices are not enamored with First Security Bank. Thus, a recent article reported that Justice Powell, the author of the Firsy Security Bank opinion, had subsequently expressed dissatisfaction with it. Sheppard, The Procter & Gamble Case: Does Sec. 482 Require the Legal Ability to Receive Allocated Income?, 49 Tax Notes 142 (Oct. 8, 1990). Justice Powell is not on the Court now, but this report (if true) might influence other Justices to revisit the issue. Nevertheless, we doubt that these considerations are sufficiently weighty to cause the Court to reconsider the issue or reverse its holding in First Security Bank. (9) This raises the question whether the IRS might use section 482 to allocate the related management company's deductions to the franchisee, thereby increasing the net taxable income of the related management company in perhaps the same amount as an increase of its gross fee income would have done. The ERS's theory would be that the related management company would not have entered the relationship that would, as between unrelated parties, have earned a two-percent fee, except for the relationship. Accordingly, the theory would go, the related management company's expenses in excess of that which an unrelated management company would have incurred to earn a one-percent fee are really expenses that, but for the relationship, the related management company would not have incurred. (10) See S. Rep. No. 960, 70th Cong., 1st Sess. 24-25 (1927), which states that the purpose of the predecessor of section 482 is "to prevent evasion (by the shifting of profits, the making of fictitious sales, and other methods frequently adopted for the purpose of |milking') and in order to arrive at their true tax liability." (11) The Aramco Advantage cases are even stronger cases for avoiding any adjustment, since the IRS might allocate deductions rather than income and achieve much the same effect. In these cases, however, there is no similar colorable arguments to achieve the same or close to the same net effect by deduction allocations. (12) E.g., Gregory v. Helvering, 293 U.S. 465 (1935). (13) Matthews, Dolan, Pearlman Square Off Over Arm's Length v. Formula Approach, 50 Tax Notes 1336, 1339 (Mar. 25, 1991). (14) E.g., Sundstrand Corp. v. Commissioner, 96 T.C. No. 12 (1991). (15) There has been some criticism that, perhaps, despite the heavy burden in section 482 cases, the courts might not really be applying a heavy burden at all. See H.R. Rep. No. 101-386, 101st Cong., 1st Sess. (1989) Conference Report on Omnibus Budget Reconciliation Act of 1989), reprinted in R.I.A. Supplement at 104 (dated Nov. 27, 1989)(discussing the foreign-reporting provisions). Judge Nims, Chief Judge of the Tax Court, recently responded to this criticism by noting that the Tax Court does not routinely substitute its judgment for the Commissioner in this area, but has to decide a real case on the basis of the record before it. When the record confirms that there is something wrong with the IRS's determination, the court cannot allow that determination to stand. Matthews, IFA Conferees Hear Gideon's Views on Info Reporting. Nims Addresses Transfer Pricing Litigation, 50 Tax Notes 1056,1058 (Mar. 11, 1991); see, e.g., Eli Lilly & Co. v. Commissioner, 856 F.2d (7th Cir. 1988), for an interesting application of burden-of-proof principles in this context. (16) In its "Section 482 White Paper," the IRS downplayed the enactment of the super-royalty provision as representing a change in section 482 in an attempt give it the appearance of conforming to the international arm's-length standard. See Notice 88-123,"A Study of Intercompany Pricing under Section 482 of the Code," 1988-2 C.B. 472-4766; Carlson, Fogarasi & Gordon, The Section 482 White Paper: Highlights and Implications, 41 Tax Notes 547 (Oct. 31,1988). Moreover, although the super-royalty provision in section 367(d) is one-sided (capturing only outbound transactions), the super-royalty provision in section 482 appears to be two-sided. The permutations of the super-royalty provisions are beyond the scope of this paper, but it is fair to say that they represent, on balance, a one-sided approach that is negatively viewed by foreign countries. (17) Turro, ALI-ABA Conference Centers on Transfer Pricing, Info Reporting, 51 Tax Notes 1491 (June 24, 1991). (18) See e.g., Spector, Proposed Regulations on Transfer Pricing Reporting and Recordkeeping, 50 Tax Notes 501, 515 (Feb. 4, 1991). (19) H.R. Rep. No. 101-964, 101st Cong., 2d Sess. 1076 (1990). (20) Getting intangibles to the foreign subsidiary may trigger the commensurate-with-income rule of sections 482 and 367(d), with the result being the assertion of the accuracy-related penalty. Nevertheless, because of this exception to the penalty, it is still better to interpose a foreign corporation taxable under the Subpart F regimen such as was involved in Procter & Gamble The royalties required for the parent U.S. corporation under the "commensurate with" standard should net on the U.S. parent corporation's return because of the foreign holding corporation's deduction for royalties paid or accrued to the parent corporation, thus reducing its Subpart F income taxable on the parent's return. The U.S. parent corporation will thus have tax consequences from section 482 adjustment with respect to royalties that should have been paid by the operating foreign corporation only if there is an adjustment between the holding foreign corporation (AG in Procter & Gamble) and the operating foreign corporation (Espana in Procter & Gamble). That adjustment will be between foreign corporations, thus invoking this exception to the penalty. The planning to use foreign law as a basis for avoiding payment of royalty for the operating companies use of the intangibles thus becomes practically risk free -- a heads I win and tails at least I don't lose situation -- that is quite rare in the tax law. This would not be the case, of course, if the intangibles were owned by the parent U.S. corporation and the adjustment were based upon rejecting a foreign law prohibition for royalty payments made directly between the operating foreign corporation and the parent U.S. corporation. JOHN A. TOWNSEND practices tax law with Townsend & Spurgeon in Houston, Texas. He was formerly a trial and appellate attorney with the Tax Division of the U.S. Department of Justice. Mr. Townsend specializes in tax controversy practice.

SALLY A.T. SPURGEON practices tax law with Townsend & Spurgeon in Houston, Texas. She formerly worked in the international oil trading and supply industry with a multinational oil company. Ms. Spurgeon specializes in tax controversy practice.
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Author:Spurgeon, Sally A.T.
Publication:Tax Executive
Date:Jan 1, 1992
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