Proposed section 482 regulations.
On January 24, 1992, the Internal Revenue Service issued proposed regulations under section 482 of the Internal Revenue Code, providing rules for intercompany transfer pricing and cost sharing. The proposed regulations (INTL-372-88 and INTL-401-88) were published in the Federal Register on January 30, 1992 (57 Fed. Reg. 3571), and in the February 24, 1992, issue of the Internal Revenue Bulletin (1992-8 I.R.B. 23).(1*)
Tax Executives Institute (TEI) is the principal association of corporate tax executives in North America. Our approximately 4,700 members are employed by more than 2,000 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and the government alike.
As a professional association, TEI is firmly committed to maintaining a tax system that works - one that is consistent with sound tax policy, one that taxpayers can comply with, and one in which the Internal Revenue Service can effectively perform it;s examination function. Many of TEI's members work for multinational enterprises for which the transfer pricing and cost sharing rules issued under section 482 have a substantial impact. They know first-hand the counterproductive effect of lengthy controversies with the IRS and foreign revenue authorities over transfer pricing issues. They also know first-hand of the need for certainty in an area fraught with disagreement. Thus, TEI brings an informed perspective to bear on the proposed transfer pricing and cost sharing regulations under section 482.
The Tax Reform Act of 1986 amended section 482 to require that consideration for intangible property transferred to related parties be commensurate with the income attributable to the intangible. The Conference Report on the 1986 Act recommended that the IRS conduct a comprehensive study of intercompany pricing rules and consider whether the regulations under section 482 should be modified.(2) The Treasury Department and IRS issued the study of intercompany transfer pricing (hereinafter "the White Paper") on October 18, 1988.(3) Many of the concepts enunciated in the White Paper have been incorporated into the proposed regulations. If adopted, the proposed regulations will fundamentally change how multinational companies determine their intercompany pricing for transfers of both tangible and intangible property. Moreover, the proposed regulations deviate substantially from the internationally accepted definition of the arm's-length standard (notwithstanding the assertion to the contrary contained in the recent report to Congress by the Treasury Department and IRS concerning the administration of section 482).(4)
III. Summary of Comments
The Tax Reform Act of 1986 added one 36-word sentence to section 482. The legislative history of the change manifested congressional concern about transfers of "high-profit intangibles" to related foreign entities in low-tax jurisdictions.(5) The IRS, however, has seized upon a specifically targeted statutory amendment to revisit every facet of the section 482 regulations and to overturn every taxpayer-favorable court decision that it perceives as encroaching on the IRS's power to allocate income or deductions under section 482. TEI submits that this attempt to vitiate existing precedent not only exceeds Congress's expressed concerns but it will inevitably and unnecessarily lead to controversy in many situations that could prudently be resolved under the existing regulations.
The proposed regulations proceed on the theory that they should be used to establish transfer prices between related entities. Hence, the IRS "anticipates that taxpayers win use these regulations to establish transfer prices for controlled transactions using the best available data, and that [taxpayers] will provide the data as early as is practicable in the course of an examination by the [IRS]."(6) Such a view, which infects the core of the proposed regulations, misapprehends the purpose of section 482. The statute authorizes the IRS to redetermine income between related parties only if such a redetermination is "necessary" to prevent the evasion of taxes or to clearly reflect income. In other words, section 482 mandates such adjustments only where the taxpayer's method produces an unreasonable result. TEI believes the regulations under section 482 should not be used to mandate intercompany pricing methodologies, but rather to provide guidance on whether a taxpayer's actual pricing results will be found to be reasonable.
Notwithstanding TEI's specific concerns regarding the practical implementation of the proposed regulations, the Institute applauds the proposed regulations insofar as they acknowledge that the arm's-length standard will produce a range of acceptable prices and results. Although taxpayers and the government must ultimately settle on a single price in evaluating a particular set of transactions, the comparable profit interval (CPI) concept efficaciously shifts the focus to the range that surrounds any particular price. It thus increases the area within which agreement between taxpayers and the government may be reached - preferably at the earliest stages of examination.
The CPI regime should not, however, supplant other internationally accepted measures of arm's-length pricing, such as the comparable uncontrolled price (CUP), resale-price, and cost-plus methods. If the other pricing methods sanctioned by the existing Treasury regulations are constricted in application (or de-emphasized to the point of irrelevance), the CPI concept will not serve its intended purpose - reducing controversy and disagreement - but rather will create uncertainty and provoke protracted litigation to define the boundaries of the application of CPI and the myriad new terms introduced.
The elevation of CPI, in effect, as the principal method of determining arm's-length consideration - whether for intangible property or tangible property with significant embedded intangibles - raises the potential for unresolved disputes with U.S. treaty partners and concomitant double taxation. We believe that foreign governments will find the restrictions on the use of the internationally accepted methods - CUP, resale-price, cost-plus, etc. - so onerous and the results under CPI so overreaching that they may retaliate by increasing the number of transfer pricing issues raised against the local affiliates of U.S.-based multinationals. Furthermore, the mandatory imposition of CPI as a pricing method (or validation procedure) in all but the few cases that meet the constricted matching transaction method (MTM) and CUP standards will significantly increase the number of competent authority cases sought by U.S. taxpayers. This is unfortunate, for the competent authority process should not be viewed as the forum for resolving a vast number of pricing disputes. We further believe that a large increase in the magnitude of income adjustments and number of transfer pricing cases will lead to a profusion of unagreed competent authority cases. In anticipation of these results, TEI recommends that treaty negotiation procedures be revised to seek a provision for the mandatory use of arbitration where the competent authorities are unable to agree.
The best way to assuage concerns of taxpayers and foreign governments alike and to reduce the number of competent authority cases is to promulgate safe-harbor rules under the regulations. Thus, TEI recommends that CPI be applied as a safe harbor rather than as a mandatory pricing method (or validation process). In addition, TEI proposes other safe harbors or rebuttable presumptions that may be employed to reduce the number of pricing disputes. If CPI is to become the predominant method for setting transfer prices (rather than the safe harbor TEI recommends), it is essential that taxpayers be afforded the opportunity to establish why - under their facts and circumstances - the prices are arm's length and properly diverge from a mechanical CPI-based income adjustment.
Prop. Reg. [section] 1.482-2(g) sets forth rules for qualified cost-sharing arrangements. Cost-sharing arrangements are agreements containing objective formulae to share the risks and rewards of collaborative research and development activity. The proposed regulations respond positively to many of the criticisms directed at the White Paper's treatment of cost sharing. In general, the rules provide a foundation upon which a workable regulatory framework may be constructed. There are some areas, however, that require clarification and comment. In particular, the proposed regulations create a new test against which the operating results of the cost-sharing participants must be measured to determine whether the arrangement is reasonable. Where a cost-sharing agreement fails to allocate costs in accordance with the proportionality required by the proposed "cost/income" test, the regulations empower the IRS to make various levels of adjustment. In TEI's view, the test is broad, imprecise, and not reflective of the manner in which unrelated participants in a long-term, joint enterprise respond to imbalances in the costs and benefits arising from a cost-sharing agreement.
TEI submits that cost-sharing arrangements should be encouraged by flexible regulations rather than impeded by barriers to their use. Disputes with the IRS and, indeed, foreign governments may be avoided through the operation of fairly structured cost-sharing agreements. Thus, TEI believes it is wrong to burden cost-sharing agreements with an inflexible, mathematical test of "reasonableness." The reasonableness of a cost-sharing agreement depends upon the exercise of judgment tempered by experience based upon all the relevant facts and circumstances. There are many factors beyond the control of the parties to a bona-fide cost-sharing agreement that influence the profitability of intangibles of various participants to the agreement. Therefore, TEI recommends that the cost/income ratio be eliminated as a presumptive test of the reasonableness of a cost-sharing agreement. At most, the cost/income test should be regarded as only one factor to be considered in evaluating the reasonableness of the allocation of the costs and benefits of a cost-sharing agreement.
The Tax Reform Act of 1986 added the following sentence to section 482:
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.
The legislative history of the change expresses congressional concern about transfers of "high-profit intangibles" to related foreign entities in low-tax jurisdictions.(7) Curiously, the proposed regulations fail to provide general principles or guidance on the new, key statutory phrase "income attributable to the intangible" and the "commensurate" standard. Significant changes are proposed, however, to the rules for sales of tangible property generally and for tangible property that incorporates intangibles particularly. In addition, the IRS requests comments on how Treas. Reg. [section] 1.482-2(b), relating to services, should incorporate the commensurate-with-income standard.(8) TEI submits that any modification of the existing regulations to extend the commensurate-with-income standard to tangible property or services is unsupported by the statutory amendment and legislative history of the 1986 Act.(9)
A. Industry Averages and
The commensurate-with-income standard was added to section 482 because of a perception that incentives existed for taxpayers to transfer intangibles to a related foreign entity in a low-tax jurisdiction, "particularly when the intangible has a high value relative to manufacturing or assembly costs."(10) Furthermore, Congress expressed dissatisfaction with the use of industry norms and averages for transfers of "high-profit intangibles" where there was a pattern of transfers to U.S. possessions or low-tax jurisdictions.(11) In an ironic twist, however, the center-piece of the proposed regulations, the comparable profit interval (CPI), sanctions an approach to transfer pricing that depends upon the construction of industry operating income intervals based on profit-level indicators drawn from broad government or commercial data bases. Prior to 1986, the IRS resisted taxpayer attempts to use industry data as evidence of compliance with section 482. With the implementation of the 1986 Act changes, the transfer pricing debate has apparently come full circle with the IRS now proposing the use of industry data for the "tested party" as the generally applicable section 482 standard.
The legislative directive to the IRS was to develop a commensurate-with-income standard for high-profit intangibles. To the extent the proposed regulations impose a substantial, new burden on transfers of "ordinary" intangibles and on transfers of tangible personal property, the statute has been exceeded. TEI recommends that the IRS narrow its focus and propose rules limited to the legislatively identified problem of high-profit intangibles. This would eliminate a substantial burden on taxpayers not having "super" products and reduce the burden imposed on taxpayers with few high-profit intangibles.
B. Tangible Personal
Clearly, the 1986 amendment was aimed at the transfer of high-profit intangible property. The statute specifically provides that the new standard is applicable to any transfer of intangible property within the meaning of section 936(H)(3)(B). Nowhere did Congress evidence an intent to reach tangible property transfers. Nonetheless, the preamble avers that the change is necessary because the application of CPI solely to transfers of intangibles would create an artificial and unwarranted distinction between tangible and intangible property, and would lead to disputes in cases involving tangible property incorporating an intangible. TEI believes, however, the proffered "solution" to the "problem" of transfers of tangible property with significant embedded intangibles is overbroad. Congress focused on "high-profit" intangibles, whereas the proposed regulations extend to transfers of "material" intangibles - either as such or as a part of tangible property. The existing regulations would seem to provide sufficient guidance for most transfers of tangible personal property and ordinary intangible property that lacks considerable value. Furthermore, overlaying the CPI concept on the resale-price, cost-plus, and other fourth methods applicable to tangible property sales is simply inconsistent with the international norms for transfers of tangible property.
The 1986 Act amended section 482 to impose the commensurate-with-income standard on transfers of intangible property, which is defined by reference to section 936(H)(3)(B). The latter subparagraph provides an extended list of intangible property "which has substantial value independent of the services of any individual." TEI believes that rules for services and the rules for intangible property are mutually exclusive because intangibles are property rights having value independent of the services of any individual.(12) Any attempt to bootstrap services into the commensurate-with-income standard contravenes the express language of section 482. Thus, there is no need to amend the rules of Treas. Reg. [section] 1.482-2(b) to incorporate the commensurate-with-income standard.
V. Resolution of Section 482
The proposed regulations are intended to facilitate transfer pricing by taxpayers in ways that reduce controversies with the IRS.(13) Concededly, if one accepts the premises that (1) the government should establish a range of transfer prices for taxpayers(14) and (2) the government's litigating positions (which were rejected in a number of court decisions(15)) are extensions of the power to issue regulations under section 482, then there will be less controversy because there is no subjective judgment to exercise nor anything left to dispute: whatever the government says the price should be - it is!
Some view the proposed regulations as mandating the price to be charged in all transfers of tangible and intangible property to related parties.(16) TEI believes that assessment is close to the mark. We also believe that using the proposed regulations to overturn court decisions with which the IRS disagrees will not reduce controversy. Indeed, we question whether Congress ever intended for the IRS to engage in a wholesale redraft of the existing regulations to overturn unilaterally the cumulative buy of section 482 precedent.(17) In fact, we believe that taxpayers' energies will - initially, at least - be directed at testing the government's attempt to supersede important judicial interpretations of section 482. To the extent this occurs, the proposed regulations will spawn - not decrease - conflicts. Furthermore, there are a number of new definitions and terms that will inevitably lead to disputes as the boundaries of the proposed regulations are explored. Thus, litigation engendered under section 482 will certainly change its focus if not its scope if the proposed rules are promulgated in final form.
VI. Arm's-Length Standard
A. International Standard
Prop. Reg. [section] 1.482-1(b)(1) explains the scope and purpose of the new regulations. That section also "clarifies" the general meaning of the arm's-length standard by providing that, as revised, the test is whether uncontrolled taxpayers, exercising sound business judgment on the basis of reasonable levels of experience (or, if greater, the actual level of experience the controlled taxpayer) within the relevant industry and with full knowledge of the relevant facts, would have agreed to the same contractual terms under the same economic conditions and circumstances. The revised standard suggests that the IRS can second guess the business judgment or experience of uncontrolled parties that enter into comparable transactions. In contrast, the current Treasury Regulations focus on observable, comparable transactions as the principal standard for judging intercompany pricing. Indeed, the current regulations served as the model for the 1979 Report of the Organisation for Economic Co-operation and Development (OECD) on transfer pricing.(18) The OECD guidelines, in turn, have become the international norm.
TEI believes that to be acceptable as an international standard, intercompany pricing regulations 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 for compliant taxpayers. We regretfully conclude that the proposed regulations are deficient when measured against these standards.
The proposed regulations set an exceedingly high hurdle to use MTM for transfers of intangibles. The availability of MTM as a pricing method is, thus, as constricted as the CUP method for tangible property transfers. More important, the Comparable Adjustable Transactions (CAT) method for intangible property transfers is excessively restricted because the pricing result is subject to confirmation under the CPI regime. Furthermore, the proposed regulations subject the internationally accepted resale-price and cost-plus methods for transfers of tangible personal property to validation under CPI. Thus, the proposed regulations accord supreme importance to the radically new CPI concept as the core measure of whether prices meet the arm's-length standard.
TEI believes the emphasis of the proposed regulations on CPI is at odds with the international arm's-length standard for several reasons. First, the focus within CPI on profits earned rather than the price charged is per se incompatible with the manner in which uncontrolled parties arrive at arm's-length prices. Second, any method subject to CPI validation is no longer an independent method. Thus, foreign governments (including U.S. treaty partners) will likely reject the imposition of CPI on the internationally accepted resale-price and cost-plus methods, leading to a considerable increase in double taxation. Third, foreign governments may be reluctant to accept the higher standard of comparability seemingly imposed by the proposed regulations because those countries tend to allow a greater range of permissible adjustments to find a comparable transaction - particularly for intangible property. Thus, to better conform the proposed regulations to international standards, we recommend that the IRS consider, at a minimum, eliminating the application of CPI to CAT and the cost-plus and resale-price methods.
A number of foreign governments commented upon the White Paper and can be expected to comment upon these proposed regulations. Representatives of the governments of Japan and Germany have already remarked in public forums that the proposed regulations do not conform to the international norms.(19) The actions of U.S. treaty partners in specific cases will likely be more pointed and critical. Indeed, TEI believes that if the CPI concept is applied widely and mechanically, foreign governments may retaliate by raising more transfer pricing issues for U.S.-based multinational companies.(20) Thus, widespread use of the CPI concept may even cause a revenue loss to the U.S. fisc if increased enforcement activities in non-tax-haven countries result in correlative adjustments being granted by the United States pursuant to competent authority proceedings.
In our view, the proposed regulations will likely result in more competent authority cases with U.S. treaty partners. Resolution of competent authority issues is time consuming, expensive, and frequently frustrating for taxpayers and the government.(21) The regulations under section 482 should be aimed at resolving controversy before reaching the level of competent authority, for the use of that process should be the exception rather than the norm. Thus, our recommended changes are intended to reduce the referrals to competent authority. Furthermore, to avoid the double taxation that arises from unagreed competent authority cases, TEI recommends that U.S. treaty negotiations seek a provision requiring the use of arbitration where the competent authorities are unable to agree.(22) Inclusion of such a provision will at least assure resolution of the issues - although regrettably at the end of a long and arduous process.
B. Roundtrip Transactions
Under Prop. Reg. [section] 1.482-1(b)(1), the combined effect of all transactions of a controlled taxpayer with other members of the group and with uncontrolled parties before, during, and after the taxable year under review is to be considered in applying the arm's-length standard. This proposed rule departs from the international norm and clearly overrules certain aspects of Bausch & Lomb and Sundstrand concerning the segregation of transactions.(23) The aggregation rule is unfortunately quite broad and may be invoked whenever and however the government deems necessary. If such a rule is necessary to curb perceived abuses, taxpayers deserve some certainty that ordinary non-abusive business transactions will not be restructured. As now crafted, the rule is so broad that it is unworkable.
C. Disregard of Contractual
Prop. Reg. [section] 1.482-1(b)(1) authorizes the IRS to disregard express contractual arrangements between controlled parties.(24) The IRS may also deem an arrangement to constitute a contract where none exists. To the extent the provision empowers the IRS to disregard form in favor of the substance of a transaction, it is unremarkable and likely unnecessary. Where a contractual arrangement reflects a bona-fide distribution of economic risks, however, the IRS should continue to respect the terms of an agreement between related parties.(25)
VII. Prop. Reg. [section] 1.482-2(d):
The proposed regulations replace the current rules applicable to intangible property transfers with a hierarchy of methods to establish whether a transfer of intangible property occurs at an arm's-length price. In particular, Prop. Reg. [section] 1.482-2(d)(2)(iii) prescribes the priority of methods for determining an arm's-length consideration. The proposed regulations reflect the view that the method relying on the most complete data and requiring the fewest adjustments will most accurately reflect the amount of consideration that an unrelated taxpayer would have charged for the same intangible under similar circumstances.(26)
The proposed regulations adopt the conceptual approach (if not the terminology) of the White Paper. Specifically, the proposed regulations establish three methods for determining arm's-length prices for intangibles, which are to be applied in the following order of priority: (1) the matching transaction method (MTM) (similar to the White Paper's exact comparables), (2) the comparable adjustable transaction (CAT) method (similar to the White Paper's inexact comparables method), and (3) the comparable profit method (CPM), which is based on the new CPI method for determining arm's-length returns (similar in part to the White Paper's basic arm's-length return method (BALRM)). While the proposed regulations purport to set forth three distinct methods, the application of the rules in most circumstances would result in the comparison of a controlled party's operating results with an uncontrolled party's operating results using CPI.
Under Prop. Reg. [section 1.482-2(d)(3), a matching transaction is an uncontrolled transfer of the same intangible under the same or substantially similar economic conditions and contractual terms. Prop. Reg. [sub-section] 1.482-2(d)(3)(iii) and (iv) list factors to consider in determining whether the economic circumstances and the contractual terms in the controlled and uncontrolled transfers are substantially similar. The standards set by the proposed regulations are so strict that a transfer of an intangible to a controlled party will rarely qualify for MTM. This is because the property, protected interest, or body of knowledge (together with the stage of development) must be identical.(27) A limited number of adjustments to compensate for differences in economic conditions and contractual terms is permitted, but the economic effect of the differences on the price must be susceptible of very precise determination.(28) Because MTM requires a virtual identity of property, terms, and conditions, it will prove extremely difficult, if not impossible, to use.
Prop. Reg. [section] 1.482-2(d)(4) describes the CAT method. Under this method, an arm's-length consideration is determined with reference to the amount of consideration charged in an uncontrolled transfer of the same or a similar intangible. Similar to MTM, adjustments are to be made for material differences in the contractual terms and economic conditions under which the transfer is made. Unfortunately, the CAT method is subject to validation under the CPI concept of Prop. Reg. [section] 1.482-2(f). Thus, the opportunity to use inexact comparables as a basis for intercompany pricing is severely restricted.
Prop. Reg. [section] 1.482-2(d)(5) describes CPM, which must be employed when the requirements of neither MTM nor CAT are met. This method requires a comparison of the operating income that results from the consideration charged in the controlled transfer with the operating incomes of similar, uncontrolled parties. The consideration charged in the controlled transfer will be considered arm's-length when the reported operating income falls within the CPI. If the "tested party's" operating income for the controlled transfer falls outside of the CPI, the consideration for the transfer will be adjusted. Ordinarily, the adjustment will be made to place the operating income at "the most appropriate point" in the interval. Where the controlled taxpayer's operating income is just outside of the interval, a special rule permits the adjustment to be reduced to place the controlled party's income just inside the interval.
Notwithstanding the avowed purpose of the proposed regulations to reduce controversy, TEI iii greatly concerned that CPI will be employed broadly and routinely by revenue agents as an examination template to propose adjustments for intangible (and tangible) property transfers. The conditions placed upon the use of MTM and subjecting the CAT method (as well as other methods) to validation under CPI effectively reduce the universe of arm's-length methods to a severely restricted MTM and CPI. CPI, however, is such a mechanical, formulary approach to pricing that it will likely be rejected by many of our treaty partners as deviating from the internationally accepted definition of arm's length.
TEI recommends that the IRS change the status of CPM to a safe harbor. Thus, if a taxpayer's results fall within the CPI, the transfer price should ordinarily be respected. Where a controlled party's results fall outside of the range of results prescribed by CPM, the taxpayer should be given the opportunity to provide evidence that the results occur for reasons other than non-arm's-length pricing. Thus, although CPM may be acceptable as a transfer pricing method, it should not be elevated to the paramount status accorded it in the proposed regulations.
Prop. Reg. [section] 1.482-2(d)(6) provides a general rule that the arm's-length character of consideration must be tested annually to conform to the commensurate-with-income standard. Exceptions to the annual adjustment rule are set forth at Prop. Reg. [section] 1.482-2(d)(6)(ii), but they are crafted so narrowly that few taxpayers will be able to obtain meaningful relief.
We recognize that, in imposing the commensurate-with-income standard, Congress may have intended a periodic review of and adjustment to long-term agreements. An annual adjustment, however, is clearly not required under section 482, nor did Congress suggest such a requirement be imposed when it amended section 482. A less burdensome and preferred approach would be to authorize periodic adjustments, generally not more frequently than every three years. Furthermore, the IRS should clarify that adjustments may reduce as well as increase U.S. taxable income.
We note that any periodic adjustment rule is likely to be controversial, if not rejected altogether, by foreign jurisdictions. TEI believes that arm's-length principles require royalty payments to be consistent with both U.S. and foreign law. In many cases, contracts must be registered with a foreign government agency to obtain approval for remittances. Revisions that decrease foreign jurisdiction revenues may not be approved. Thus, an additional exception should be crafted to Prop. Reg. [section] 1.482-2(d)(6)(ii) to the effect that periodic adjustments will not be required where the foreign government expressly disapproves the revision. At a minimum, the regulations should address the effect of foreign law restrictions on both the determination of an arm's-length royalty rate and periodic adjustments of the rate.
VIII. Prop. Reg. [section] 1.482-2(e):
Transfers of Tangible
Prop. Reg. [section] 1.482-2(e)(1) modifies the rules applicable to sales of tangible personal property. According to the preamble, the changes are necessary to implement the commensurate-with-income standard because "applying the comparable profit interval solely to transfers of intangibles would create an artificial and unwarranted distinction between the treatment of tangible and intangible property, and would lead to disputes in cases involving tangible property incorporating an intangible."(29) The proposed regulations also modify the priority of the pricing methods. In particular, CUP retains its premier position, but the resale-price and cost-plus methods are made equivalent to each other and subject to validation under the CPI concept. Other, so-called fourth methods may be employed, but they are deemed inferior to the resale-price and cost-plus methods and must also be tested under the CPI concept. TEI believes that the regulations should eliminate the gloss of CPI validation from the internationally accepted resale-price and cost-plus methods.
Prop. Reg. [section] 1.482-2(e)(2)(ii) adds three items to the existing list of facts or circumstances that may affect price comparability under the CUP method. One of the new factors is sales volume.(30) The other new items are inventory turnover rate and advertising and warranty practices. The proposed regulations also add a new example (Example (5)) to illustrate how volume may affect price and explain how the price charged in the controlled sales transaction must be adjusted. Under Prop. Reg. [section] 1.482-2(e)(2)(ii), unless the volume of property changing hands in an uncontrolled sale is virtually the same as the volume of property changing hands in a controlled sale, the controlled and uncontrolled sales will not, in the absence of a definite and reasonably ascertainable volume discount adjustment, be considered comparable. Although this rule is proper in cases where the volume affects the price, it clearly should not apply in all cases. Such a result is inconsistent with prevailing practice.
Many products - particularly commodities - are sold at prices unaffected by the volume of product that changes hands in a particular transaction.(31) In such cases, volume does not affect the price at which the commodity is sold irrespective of whether the sale is made to a controlled entity or a third party. Indeed, commodity pricing is inherently arm's length where it is based on commodity exchange transactions between unrelated parties in recognized markets. Thus, TEI believes it is unreasonable to require that a volume discount adjustment be made merely because the volume involved exceeds the volume sold in an uncontrolled sale. To recognize market reality, the proposed regulations should be modified to state that volume discount adjustments are not required where accepted trade practice ignores volume. Even in those instances where trade practice does not provide for a volume discount, the use of a comparable price with a volume discount will lead to a more accurate result than will CPI.(32)
IX. Prop. Reg. [section] 1.482-2(f):
Comparable Profit Interval
Prop. Reg. [section] 1.482-2(f) radically departs from the current regulations in prescribing the comparable profit interval concept. In general, CPI is a range of hypothetical operating incomes that a "tested party" would have earned if objective measures of profitability - known as profit level indicators (PLIs) - had been equivalent to those of uncontrolled taxpayers performing similar functions. Prop. Reg. [section] 1.482(f)(3) provides a four-step process to construct a CPI. Step one is to select the "tested party," generally the party to the controlled transaction whose operating income can be verified using the most reliable data with the fewest and most accurately quantifiable adjustments.(33) Step two of CPI is to determine under Prop. Reg. [section] 1.482-2(f)(5) the applicable business classification of the tested party to identify the applicable financial data of uncontrolled taxpayers used to construct the CPI. Step three is to compute the constructive operating incomes of the tested party by applying PLIs (essentially financial ratios) from uncontrolled taxpayers to the financial data of the tested party.(34) Step four is to select, from the various constructive operating incomes determined in the third step, those incomes that converge to form an interval that is reasonably restricted in size.
The four-step CPI process is used in other portions of the proposed regulations to validate the transfer prices established under other methodologies. In particular, the cost-plus and resale-price methods for odes of tangible personal property and the CAT method for intangible transfers are subjected to validation under the CPI concept. If the tested party's operating income is within the interval established by the CPI, the transfer price is valid. If the pricing method results in operating incomes outside of CPI, the transfer pricing method is invalid and must be redetermined - most likely under the CPI transfer price method.
Where CPI is used as a transfer price method (as opposed to a validity test), two additional steps are undertaken. Step five is to determine "the most appropriate point in the interval." The final step is to determine the transfer price for the controlled transaction. Actual transfer prices are adjusted to render the operating income of the tested party equal to the constructive operating income at the most appropriate point in the CPI interval.
a. The CPI concept inherently acknowledges that unrelated parties may negotiate a broad range of possible arm's-length prices. The concept's utility in narrowing the range of controversy on pricing issues by modifying both IRS and taxpayer behavior, however, is undermined by the concept of "the most appropriate point in the interval." Whether a taxpayer missed the range by an inch or a mile, the concept suggests that the adjustment should be whatever is necessary to bring the taxpayer within the range. Any further income adjustment within the range exacts a non-penalty penalty.
CPI is presented as a concept that will produce irrefutably precise results. It rests, however, on a foundation of highly subjective assumptions and its precision is therefore illusory. CPI is premised on the idea that if the income of a controlled taxpayer is adjusted by reference to the level of income of comparable uncontrolled taxpayers, and the controlled transaction price is adjusted to produce that level of income, then the resulting adjusted price is the one that would have been agreed to by an uncontrolled taxpayer dealing at arm's length. When the taxpayer is unable to use the CUP or MTM methods to establish arm's-length prices, the proposed regulations provide no escape from the pervasive CPI concept - requiring either validation under CPI or the use of CPI (or CPM) as a method.
TEI submits that elevating CPI to be the paramount method (in practice, if not hierarchically) is a mistake. Company income levels vary for any number of reasons unrelated to pricing decisions including (1) efficiency of operations; (2) market share and market size (which influence the degree to which the firm can act as price setter or price follower); (3) the product market (growing, mature, declining); (4) the degree to which a firm is established in a market (e.g., if the firm is new to a market, price cutting or promotions will undercut prices and profitability); (5) business strategy (product developer with high research and development, active or passive distributor, etc.); (6) cost controls; and (7) organization and productivity of the workforce.(35) More important, the operating incomes used to construct the interval include profits and losses of non-comparable transactions. In summary, there are a host of external market and internal operating factors that contribute to higher (or lower) than average returns. Indeed, in most cases, such factors, either singularly or in combination will have a greater effect on financial (and taxable) income than transfer pricing. Widely employed, CPI will produce hypothetical results that bear little or no relationship to arm's-length prices. Thus, while appearing to produce scientifically precise results (e.g., the concept of most appropriate point in the interval), CPI rests on judgments based on imprecise or unavailable data.
b. TEI believes that the CPI concept can operate to achieve the IRS's underlying purpose of reducing controversy in transfer price cases if it is framed as a safe harbor. Where operating results fall within an acceptable interval, no further issue should be raised concerning the arm's-length nature of the pricing that produces the results. Where operating results fall outside a prescribed interval determined under Prop. Reg. [section] 1.482-2(f), however, taxpayers should be given the opportunity to demonstrate that their pricing meets the requirements of another method such as resale-price or cost-plus without resorting to CPI validation.(36)
Furthermore, taxpayers should be able to demonstrate that their facto and circumstances are the reasons that their results are atypical of the CPI range. That is to say, no adverse inference should arise from having results outside CPI. CPI is constructed by eliminating certain "comparable" companies whose results did not produce a convergence of operating incomes. The most comparable company for the tested party may, indeed, have been one or more of the companies eliminated to produce a convergent range for CPI. The inherent limitation of an average is that some companies will be at the top and bottom of the range. A mechanical application of CPI to the companies with superior or inferior results will invariably lead to inappropriate adjustments.(37)
Also, even though it is unable to establish a comparable under other methods - possibly for a lack of relevant data - a taxpayer should be permitted to demonstrate that its tested party's income fell outside of CPI because of clearly identifiable circumstances that either inflated or depressed operating income for the period. Appropriate adjustments should be permitted to the taxpayer's financial results to exclude non-recurring or isolated events such as product recalls, strikes, or extraordinary litigation proceeds or losses.
Finally, TEI challenges the presumption underlying the use of CPI as a validation of the other arm's-length pricing methods. TEI believes that the other methods such as CAT, resale-price, or cost-plus, will often yield more accurate gauges of arm's-length prices than CPI because those methods are measures of gross profit and, therefore, are a closer approximation of prices. As noted previously, operating income will depend upon many economic factors that neither bear upon nor result from pricing decisions. Thus, CPI is flawed as a check on other, arguably superior pricing methods.
B. Tested Party Operations
Identifying who is the tested party is the first step in developing the CPI. Next, the relevant operations of the tested party are segregated for comparison to uncontrolled operations. TEI foresees numerous disputes arising over which party and which operations are to be tested under CPI. Even if agreement is reached for a particular year, disputes may arise in subsequent years as the facto and circumstances change. TEI recommends that the regulations provide general rules or a list of factors to determine who is the tested party. Such guidance is especially important where there are multiple related party transactions that contribute to the development of a finished product.
To provide balance, an additional example should be developed indicating that a controlled foreign corporation (CFC) is generally entitled to a return on marketing intangibles for which the CFC incurred the cost of development. With respect to an "inbound" distributor, one example clearly provides that a U.S.-based distributor that makes expenditures to develop a market in the United States (and thus develops a valuable marketing intangible) is entitled to a return commensurate with the intangible developed.(38) The regulations should expressly state that a similar rule obtains for "outbound" companies.
C. Data Availability
To construct CPI, the best available data and PLIs must be used. Step two of the process of constructing CPI is to determine the applicable business classification of the taxpayer, which turns on identifying the products, services, functions, and business risks of a controlled party and comparing this with similar indicia of uncontrolled parties. If reliable financial data cannot be found for business classifications that closely correspond to the tested party's operations, the scope of the business classification must be broadened until data are found.
The proposed regulations create a dilemma for taxpayers: the most reliable data will be the narrowest grouping of products or services that correspond to the tested operations, but such data will likely be proprietary and, therefore, unavailable.(39) As the relevant business classification expands to encompass "comparable" companies, the reliability, accuracy, and comparability of the data will decline as more and more non-germane products or services (and expenses) are swept into the financial data being compared. Thus, the reliability of financial data is inversely related to its availability. TEI foresees innumerable controversies over the relevance and reliability of business classifications.(40)
Among the financial ratios cited as appropriate PLIs, the proposed regulations evince a preference for return on assets (ROA). The proposed regulations blithely assume that this measure is widely kept by all companies as a key management measure of profitability. Anecdotal evidence suggests, however, that this is an erroneous assumption. Indeed, TEI understands that few companies segregate assets on product-line or even divisional bases.(41)
TEI believes it is wholly inappropriate to use the ROA of broadly diversified companies as a measure of profitability of a more narrowly focused company and vice-versa. Furthermore, TEI believes that ROA information for public companies will prove nearly us& less because ROA will only be available for the company as a whole, thus reducing the reliability and relevance of the comparison.
Finally, TEI questions the use of financial statement data (to the extent such data exists and are generally available) to derive PLIs that will be used to adjust taxable income. Significant financial statement and tax differences will arise from differences in the mode of business operations between competitors, as well as from the different measurement of financial and tax accounting. For example, a company that derives a substantial portion of its revenues from operating leases and sales of the same product may have considerable difficulty adjusting the financial statements of direct competitors that also sell or lease the same product because of differences in timing of revenue recognition and depreciation methods applicable to the leased products.
D. Retrospective vs.
Taxpayers desire, and are entitled as a vital principle of sound tax administration to know with certainty the tax results of their transactions. A fundamental flaw of the CPI approach is that it requires taxpayers to use data from a subsequent year's transactions to evaluate the propriety of their pricing. Prop. Reg. [section] 1.482-2(f)(2) requires taxpayers to use data from the previous year, the current year, and the year subsequent to the year under scrutiny to evaluate the arm's-length nature of their pricing. The proposed regulations thus betray a bias in favor of using the examination function of the IRS to evaluate prices. The approach is fundamentally at odds with the philosophy of the IRS's Compliance 2000 initiative of providing timely guidance and thereby enabling taxpayers to file accurate and complete returns. Taxpayers deserve a transfer pricing approach that will assist them in complying with the tax law, preferably before entering into a transaction and assuredly before filing their tax returns. The proposed regulations fail this fundamental test of fairness since the data required to be used to evaluate a particular year's pricing (using the CPI validation approach) will not be available until the year after the filing of a return.
E. Most Appropriate Point
in the Interval
An adjustment to a taxpayer's transfer prices will ordinarily not be made where the reported operating income of the tested party is within the CPI. If the reported operating income of the tested party is outside the CPI, an adjustment (with certain exceptions) must be made to bring the operating income of the tested party to the most appropriate point within the CPI, unless the reported operating income is not significantly outside the CPI. Under Prop. Reg. [section] 1.482-2(d)(5)(iii)(B), if the reported operating income is not significantly outside the CPI, the district director may take into account the deviation between the CPI and the reported operating income and reduce the adjustment accordingly. Similarly, in the case of tangible property transfers under Prop. Reg. [section] 1.482-2(e) (assuming the CUP method does not apply), the use of either the resale-price or cost-plus method will be acceptable only if it produces a level of reported operating income for the tested party that is within the CPI. If a "fourth method" is used (because the resale-price or cost-plus methods do not produce a level of reported operating income within the CPI), the best fourth method is that resulting in operating income for the tested party at the most appropriate point within the interval; this is the case even where other "fourth methods" produce results that are within the CPI. Prop. Reg. [section] 1.482-2(e) does not contain a provision that limits adjustments on tangible property transfers in a manner similar to Prop. Reg. [section] 1.482-2(d)(5)(iii)(B).
TEI objects to the concept of "the most appropriate point in the interval." An adjustment to the most appropriate point of the CPI operates as a "penalty" in those cases where the tested party's reported operating income is not within the CPI (in the case of tangible property transferred under the resale-price or cost-plus methods) or is far beyond the CPI (in the case of intangible property). The provision is intended to encourage taxpayers to exercise proper care in establishing intercompany prices - to "get it right the first time." Some form of inducement may be proper, but as set forth in the proposed regulations the penalty should be eliminated because penalty provisions for substantial adjustments already exist under section 6662. TEI recommends, at a minimum, that the regulations provide the taxpayer an opportunity to reduce the amount of the adjustment to an amount closer to the outer limit of the CPI range by demonstrating that a reasonable attempt was made to assure that proper care was taken in initially establishing intercompany transfer prices. In addition, we recommend that the rule set forth in Prop. Reg. [section] 1.482-2(d)(5)(iii)(B), which limits the amount of a proposed adjustment on an intangible transfer where reported operating income is not significantly outside the CPI, be extended to transfers of tangible property. The resale-price or cost-plus methods should thus be available to taxpayers as transfer price methods where the reported operating income is not significantly outside the CPI. Furthermore, adjustments to taxpayer's reported incomes should be reduced to take into account relatively minimal deviations between the CPI and reported operating income.
Within the CPI regime, there are a number of areas where disputes between taxpayers and the IRS will arise. As previously discussed, determining the tested operations and applicable business classification will likely be highly contentious. Identification of comparable uncontrolled taxpayers and the appropriate PLIs will also be problematic. Thus, CPI used by a taxpayer to set its prices may differ significantly from CPI computed by the IRS, and the reported operating income of the tested party could fall well outside the CPI range as determined by the IRS, even though the taxpayer has exercised reasonable care and good faith,in establishing its intercompany prices.
Unless the rule contained in Prop. Reg. [section] 1.482-2(d)(5)(iii)(B) is extended to tangible property transfers, inequitable results may occur. For example, assume in connection with a tangible property transfer in which the resale price or cost-plus method is used, the CPI range is between $100,000 and $200,000, and the most appropriate point is $150,000. If the tested party's reported operating income is $199,000, no adjustment will be made. On the other hand, if the tested party's operating income is $201,000, the resale-price or cost-plus method will not be available, and an adjustment of $51,000 win likely be made, effectively a "penalty" of $49,000. The rules, thus, operate ujustifiably in cliff-like fashion.
The relative size of the CPI range will vary from case to case. Under the proposed rules for tangible property transfers, the size of the penalty will be a function of the size of the particular CPI range, rather than the good faith demonstrated by the taxpayer. For example, assume that the CPI range is relatively small, only $1.75 million to $2.25 million, with the most appropriate point being $2 million. Assume further that the reported operating income of the tested party is $4 million, or $1.75 million outside the range. The adjustment would likely be $2 million. If the CPI range were from $10 million to $20 million, with the most appropriate point $15 million, and the reported operating income of the tested party were $20.5 million (producing a result only $0.5 million outside the range), the adjustment would likely be $5.5 million. Thus, in the second case, the adjustment will be significantly greater even though the taxpayer apparently made a greater effort, in relative percentage terms, to comply with the proposed regulations. This is an inequitable result. In TEI's view, if the CPI concept truly adheres to the arm's-length standard, any adjustment within the range is arbitrary because the range demonstrates the band of operating incomes produced by arm's-length prices. Thus, we believe the concept of adjusting transfer prices to the most appropriate point in the interval should be abandoned.
X. Judgmental Profit-split
and Fourth Methods
PROP. Reg. [section] 1.482-2(f)(3) describes a CPI calculation that provides for two versions of profit-split calculations. Unfortunately, the most important part of these provisions are the limitations and restrictions on the use of profit-split and other fourth methods.(42) Where comparable uncontrolled transactions do not exist, the proposed regulations effectively require the income of the controlled party to be determined by reference to the profit levels of uncontrolled parties and the residual combined income to be derived by the controlled group is allocated to the non-tested party. The approach is flawed because it fails to provide an appropriate return on self-developed intangibles. A rate of return that fails to reflect the value of self-developed intangibles will, when applied to the assets of a manufacturing affiliate, dramatically understate the contribution of the affiliate to the group's profit. In a typical manufacturing affiliate, the expenditures to produce self-developed intangibles will be deducted (charged to expense) when incurred. Thus, there will be no return because there is no asset on the balance sheet. Furthermore, the regulations effectively allocate location savings of an offshore affiliate to the residual party.
More fundamentally, the regulations appear to under-allocate income to a tested party where the tested party owns intangibles that contribute to group profitability. By precluding a profit-split method based on judgmental evaluation of all the facto and circumstances - especially the contribution of self-developed intangibles of the tested party - the proposed regulations do not provide a proper allocation of profit to the various factors of production. To the extent the U.S. party in the controlled transaction is always the beneficiary of the over-allocation, U.S. trade partners may rightly complain that the proposed regulations overreach.
A pragmatic solution to the transfer pricing dilemma must be based on a simultaneous evaluation of all the controlled group members that contribute to the sale of a product or service to a third party. Where multiple parties to a transaction contribute valuable intangibles to the production of group profit, a true profit-split method will provide a fair return to each of the parties. TEI believes that guidelines can be developed that provide a benchmark of a range of profits expected by uncontrolled parties participating in the development, manufacture, distribution, sale, and service of the product. For example, profits could be split in proportion to relative costs incurred by each party. Alternatively, a return on tangible assets for a particular Standard Industrial Classification (SIC) code could be allocated to each party, with the residual profit allocated in proportion to either the value of the intangibles or the expenses incurred to develop the intangibles (research and development costs, advertising or sales-force compensation, etc.).
TEI believes that the regulations would be vastly improved by liberal use of profit-split methods. Thus, we recommend that the regulations provide a profit-split method as an alternative arm's-length pricing method equivalent in status to the cost-plus or resale-price methods (for sales of tangible personal property) and to the CAT method (for intangible property transfers.) Use of the profit-split method should not be precluded by the numerous restrictions contained in the proposed regulations.
XI. Safe Harbors
The proposed regulations fail to provide safe harbors with respect to transfers of either tangible or intangible property. The IRS, however, solicits taxpayer comment on whether safe harbors should be provided in the regulations.(43) As the prescient trial court stated in 1978 in E.L DuPont de Nemours & Co. v. United States,(44) "universally acceptable safe haven criteria to facilitate the administration of section 482 may now be both entirely feasible and eminently proper."
TEI believes that safe harbors are especially appropriate now because they promote certainty and ease of administration in an area fraught with complex factual determinations. The advantage of certainty of result often outweighs the income tax detriment taxpayers may incur by following a safe harbor. Conversely, voluntary taxpayer 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.
As previously discussed, TEI believes that CPI should be used as a safe harbor where the taxpayer establishes that its operating income falls within the range of CPI. If operating income is not within the CPI range, however, no adverse inference should arise; rather, the taxpayer should be permitted to establish that its pricing is arm's length under other standards such as resale-price, cost-plus, and other criteria including that set forth in the existing regulations.
In addition to recasting CPI as a safe harbor, TEI recommends adoption of certain safe harbors that would preclude adjustments under section 482.(45) No adverse presumption, however, should be drawn from falling outside of the suggested safe harbors. In addition to the suggested safe harbors which follow, TEI makes certain other recommendations for adopting rebuttable presumptions and exceptions to the application of CPI.
A. High-tax Jurisdictions
The legislative history of the 1986 amendment confirms that Congress was primarily concerned with the transfer of high-profit intangibles to foreign affiliates operating in low-tax countries.(46) Consequently, a safe harbor recognizing that taxpayers receive little or no tax benefit from operating in high-tax jurisdictions should be considered. Thus, TEI recommends that safe harbor be available if the rate of tax in the foreign jurisdiction is more than 90 percent of the U.S. statutory rate.
B. Back-to-back Transfers
TEI recommends the adoption of a safe harbor for transfers of tangible or intangible property to or from a related party that occur within a reasonable period of time (say, one year) and on essentially the same terms as a transfer from or to an unrelated party. Transfers of property acquired from an unrelated party to a related party within a reasonable amount of time are evidence of an arm's-length consideration.(47) These transfers should be treated as satisfying section 482.(48)
C. Substantial Interest
TEI recommends the adoption of a safe harbor for transfers to entities in which an unrelated party has a substantial interest. Such an interest would exist based on the facto and circumstances, including the following factors: (i) significant third-party ownership of, say, 20 percent; (ii) public trading of the shares of the related party; (iii) an ownership interest in the related party by a foreign government; (iv) de facto control by an unrelated third party; or (v) de facto inability to control prices because of contractual constraints or provisions in joint-venture organic corporate documents, notwithstanding the taxpayer's having voting control of an entity. The White Paper noted that transfers to entities in which an unrelated party has a substantial interest can be considered arm's length.(49) TEI agrees that the existence of such an interest diminishes the control an entity may have on pricing determinations.
D. Prior IRS Examination
TEI recommends that a transfer pricing methodology employed for a period of years by a taxpayer that has been examined by the IRS be deemed an acceptable method under section 482.(50) To resolve pricing issues in advance of issues being raised on examination, the IRS is encouraging taxpayers to enter into formal Advance Pricing agreements (APA). Analogously, taxpayers and the IRS have reached agreements with respect to the treatment of pricing methodologies through the examination and appeals process. To promote the resolution of pricing controversies, the IRS should refrain from revisiting long-standing pricing methodologies that have been fully examined and accepted by government agents.(51) To subject taxpayer's pricing methodologies to additional or renewed scrutiny because it may not conform to the CPI concept is a wasteful expenditure of taxpayer and government resources.
E. Commodity Transactions
In the absence of explicit authority to use commodity exchange transactions to establish a CUP, TEI recommends a presumption be established that permits taxpayers to set transfer prices with reference to the daily range of prices on a geographically relevant market. A transfer price falling within such a range should be considered arm's length and not be subject to CPI validation. A safe harbor is appropriate for commodities traded on public exchanges because such items do not contain intangibles and valuation data are readily available and easily confirmed. An absolute presumption for commodities would satisfy both the arm's-length and commensurate-with-income standards.
F. Other Rebuttable
In addition to the foregoing safe harbors, TEI believes that certain factual circumstances warrant the creation of a rebuttable presumption that the transactions are arm's length. In such cases, the IRS would be required to establish by clear and convincing evidence that the transaction was not arm's length.
Specifically, the proposed regulations are imbued with the view that U.S.-based taxpayers purposely defer taxation of profits in foreign jurisdictions. Given the uncertainty surrounding foreign governments' acceptance of the regulations and the granting of correlative relief, TEI proposes that a rebuttable presumption be established that a transaction is at arm's length where related foreign parties repatriate at least 50 percent of operating income through royalties and management fees. This standard ensures that in most cases a U.S. taxpayer will be fairly compensated while providing some certainty for foreign affiliates attempting to comply with arm's-length pricing rules of other jurisdictions.
In the event CPI retains its status in the regulations as a validation procedure to check the results of other methods and, in effect, becomes the default method of pricing transactions invalidated by CPI, TEI recommends that an exception to its application be created based on the cost and administrative burdens imposed by its requirements. Since the issuance of the proposed regulations, economic consulting firms have been soliciting enterprises to conduct CPI studies. The quoted costs of conducting these studies range from $10,000 to $15,000 per affiliate or business unit - a substantial cost to comply particularly if required for all business units on an annual basis. Accordingly, TEI recommends that an exception to the use of CPI as a method be crafted where the level of business activity does not justify the compliance cost of calculating CPI. Taxpayers that demonstrate that the cost of calculating CPI exceeds a relative cost threshold should be deemed to be within CPI. (Taxpayers would still be subject generally to the requirements of section 482.) TEI recommends that the cost threshold be one-half of one percent of gross profit of the business unit.
XII. Prop. Reg. [section] 1.482-2(g):
TEI commends the IRS for its effort to craft a new framework for cost-sharing agreements. In many areas, the proposed cost-sharing regulations reasonably interpret legislative intent and address many concerns arising from the White Paper's over-restrictive approach.
Prefatorily, TEI believes it is important to understand the nature and role of cost-sharing agreements in a multinational context. A bona-fide cost-sharing arrangement usually will extend over a long period of time to capture all the costs and benefits of developing and enhancing intangible property.(52) It will usually employ a clear, simple, and objective formula to allocate a pool of research expenses among the participants to facilitate the conduct of research activities in many countries around the world. The formula (whether based on units, sales revenue, gross margin, etc.) will automatically allocate a larger proportion of research expenses to participants that are more successful in exploiting the intangible property. Long-term cost-sharing agreements permit taxpayers to structure transfers of intangible property in a reliable and predictable fashion that is generally acceptable to most governments of the world.(53)
Through the implementation of a sound regulatory approach that encourages adoption of cost-sharing arrangements, the IRS and taxpayers have an opportunity to reduce the number and dollar level of transfer price disputes. To achieve these goals, however, certain areas of the proposed regulations require improvement or clarification.
A. Comparable Uncontrolled
Curiously, the proposed regulations omit any reference to what uncontrolled taxpayers employing cost sharing would do in situations similar to the facts and circumstances of a controlled group.(54) TEI believes it is proper to provide a standard similar to CUP or MTM for taxpayers that employ cost sharing. A cost-sharing agreement that allocates costs in a manner similar to that of uncontrolled taxpayers would not seem to require further adjustment. TEI recommends that the regulations on cost-sharing agreements incorporate a standard similar to CUP or MTM.
B. Clarify Permissible
Measures of Benefits
for Cost Sharing
Prop. Reg. [section] 1.482-2(g) provides, in general, that if a member of a group of controlled taxpayers acquires an interest in an intangible as a result of being an eligible participant in a qualified cost-sharing arrangement, the district director may make allocations with respect to that acquisition to reflect each participant's arm's-length share of the costs and risks of developing the intangible. Prop. Reg. [section] 1.482-2(g)(2) defines the term qualified cost-sharing arrangement and requires that the arrangement (1) include two or more eligible participants; (2) be recorded in a contemporaneous, written agreement; (3) provide for a sharing of the costs incurred in developing the intangible by the participants who are to receive a specified interest in any intangible produced; (4) establish a method that reflects a reasonable effort by each eligible participant to share the costs and risks of intangible development, such that each eligible participant's share is proportionate to the benefits that each reasonably anticipates it will receive from the exploitation of intangibles developed under the arrangement; and (5) meet certain administrative requirements of Prop. Reg. [section] 1.482-2(g)(6).
Prop. Reg. [section] 1.482-2(g)(2)(ii)(A) provides that anticipated benefits may be measured by reference to anticipated units of production (where there is a uniform unit of production for all participants), anticipated sales (measured at the same level of the production or distribution process for all participants), anticipated gross or net profit, or any other measure that reasonably predicts the benefits to be shared. Prop. Reg. [section] 1.482-2(g)(2)(ii)(B) provides that a method reflects a reasonable effort to share costs in proportion to benefits only if it provides that the costs shared by each eligible participant must be adjusted (on an annual basis) to account for changes in economic conditions, the business operations and practices of the participants, and the ongoing development of intangibles under the cost-sharing arrangement.
2. Additional Guidance on
Alternative Measures of
Prop. Reg. [section] 1.482-2(g)(2)(ii)(A) provides that "[u]nder appropriate circumstances," anticipated benefits may be measured by reference to anticipated units of production, anticipated sales revenue, anticipated gross or net profit, or any other measure that reasonably predicts the benefits to be shared by the participants. The proposed regulations also provide a testing mechanism - the cost/income ratio - that is based generally on an average of the actual current and preceding two years' data.
TEI recommends that the regulations provide, by way of explanatory text and examples, additional guidance concerning predictive measures of anticipated, future benefits from a cost-sharing agreement. In one example,(55) the facts assume that a more reliable measure (unit sales) of future benefit is available. Even in that example, however, the proposed cost/income test is superimposed, thereby casting doubt on the acceptability of alternative measures, such as unit sales, to predict anticipated benefits. TEI believes that the regulations should expressly provide that the cost/income ratio will not apply where there are better measures of the costs and benefits.
TEI also recommends that the regulations specifically provide that predictive measures of anticipated benefits may be determined based on existing records by reference to either (a) units of production, sales (units or revenue), or gross or net profit attributable to the current year, or (b) an average of the current and preceding two years' units of production, sales, or gross or net profit. Where actual data on the current years are readily available to taxpayers, there is no reason not to use it as a proxy for anticipated benefit to be derived from the cost-sharing agreement. Indeed, the cost/income ratio of Prop. Reg. [section] 1.482-2(g)(ii)(C) measures the allocation of anticipated benefits through a testing mechanism that relies upon actual current and prior year's data. TEI believes the proposed regulations tip the scales too far in favor of adjustments based on hindsight. A proper balance will be restored by permitting taxpayers to use actual results as predictive indicators of anticipated benefits of intangible developments.
TEI's third recommendation is that the regulations expand the list of methods contained in Prop. Reg. [section] 1.482-2(g)(2)(ii). In particular, TEI recommends that taxpayers be permitted to use amounts expended in a particular period to measure anticipated benefits. The phrase "any other measure that reasonably predicts the benefits to be shared" in Prop. Reg. [section] 1.482-2(g)(2)(ii) already suggests that a method that measures benefits by reference to amounts invested or expended in a particular period is proper, but TEI believes this alternative standard should be expressly stated. In some industries - such as natural resource extraction - such a standard may be more accurate than other measures. For example, the successful development of new drilling technology could be used on unsuccessful projects, such as a dry hole. In this situation, it is the use of the intangible that establishes its value rather than the direct outcome of its use. Investment may be a surrogate for income and better reflect actual economic activity, particularly where the investment provides the opportunity to generate income.
Many types of research activities provide benefits not measurable by income produced. For example, the benefits of pollution control research will not be measurable in terms of operating income. Cost sharing should be available for those research efforts. Thus, the regulations should provide a measurement method that permits the allocation of research expense based on investment. Ultimately, investment may prove the better standard for this measurement, and such a standard should be incorporated into the regulations to conform with expressed congressional intent and the Treasury's stated policy.(56)
TEI's final recommendation is that the regulations expressly state that self-adjusting cost-sharing formulae require no additional adjustment mechanism within the written cost-sharing agreement. In some respects, the annual adjustment requirement of Prop. Reg. [section] 1.482-2(g)(2)(ii)(B) is unrealistic. Requiring the taxpayer to adjust the terms of a cost-sharing agreement every year (with the attendant need to explain the adjustments to foreign tax auditors) creates a substantially unjustified administrative burden because unrelated parties entering long-term cost-sharing agreements do not adjust agreements on an annual basis. Instead, they rely upon the written cost-sharing formula itself to provide for automatic changes to the allocation of costs. For example, a cost-sharing formula based on the net annual sales revenue of the participants will automatically adjust for changes in economic conditions, business operations and practices of the participants, and the ongoing development of intangibles under the arrangement. TEI recommends that the regulations be clarified to provide that any formula resulting in annual changes to the proportion of costs shared by the participants reflects a reasonable effort to share costs in proportion to benefits over time.
C. Cost-Income Ratio
Prop. Reg. [section] 1.482-2(g)(2)(ii) provides that a U.S. participant's cost share must be proportionate to the benefits the participant reasonably anticipates will result from the research. Unless another method of sharing costs provides a more reliable measure of the participant's reasonably anticipated benefits over time, the district director may make allocations by reference to a comparison of the participant's cost/income ratio and the cost/income ratio of all other participants.(57) The cost/income ratio of a participant is the average of the costs of developing the intangibles borne by the participant for the current taxable year and the two preceding taxable years divided by the participant's average operating income for such years attributable to intangibles developed under the arrangement.(58) To the extent a cost-sharing agreement fails to allocate costs in proportion to benefits, the regulations provide for different levels of adjustment. Prop. Reg. [section] 1.482-2(g)(2)(ii)(C)(1) establishes a rebuttable presumption that a cost-sharing arrangement is invalid if it results in a cost/income ratio for the U.S. participant that is "grossly disproportionate" to the cost/income ratio of all other participants.(59) The ratio will be considered "substantially disproportionate" where the U.S. participant's cost/income ratio is more than two times the cost/income ratio of all other eligible participants. If the cost/income ratio is substantially disproportionate, the cost-sharing agreement may be valid, but the district director nevertheless is empowered to invoke the "buy-in and buy-out" rules of Prop. Reg. [section] 1.482-2(g)(4)(iv)(A) to subject a portion of the intangible costs to the rules under Prop. Reg. [section] 1.482-2(d). Where the U.S. participant's cost/income ratio is not substantially disproportionate, adjustments will be limited to a reallocation of costs among the participants.
2. General Reaction
The proposed regulations appear to permit taxpayers to adopt any reasonable method for sharing costs. The imposition of a rigid cost/income ratio to test whether the method employed achieves a reasonable sharing of costs, however, undercuts the utility of the regulations. TEI believes that any allocation method that reasonably anticipates the benefits to be derived over time should not be subject to the cost/income ratio test. The rebuttable presumption in the regulations may encourage revenue agents to apply the mechanical operating income test before considering whether the cost-sharing agreement contains a reasonable method for allocating costs. Furthermore, the rebuttable presumption may, in effect, propel cautious taxpayers to adopt the cost/income ratio test as their allocation method. In TEI's view, the imposition of the cost/income ratio is incorrect where other methods of anticipating benefits and sharing costs are dictated by the underlying business and economic circumstances.
TEI's view flows from the fundamental difference in approach between transfer pricing transactions and cost-sharing agreements. For transfers subject to transfer pricing, the taxpayer has an existing asset and is attempting to determine the asset's fair value, regardless of whether the transfer is to a related or unrelated party. In a cost-sharing arrangement, however, the participants enter the agreement in anticipation of developing an asset. The participants may be unsuccessful or untimely in developing the property. When the development is successful, the participants have ownership of, and the right to use, an asset without a subsequent transfer.
To illustrate the difference, assume party A is unwilling to spend $3 million in a cost-sharing arrangement with unrelated party B to develop an intangible that it could use in its trade or business. Party A might be willing to pay $5 million for a developed intangible, but perceives a substantial risk of losing its entire $3 million should the cost-sharing arrangement prove unsuccessful. By paying an additional $2 million, party A would be able to purchase a fully developed asset. In economic terms, party A is paying a $2 million premium to shed the risk of unsuccessful or untimely development. On the basis of a risk/reward analysis, then, the parties to a cost-sharing arrangement should pay less for successfully developed intangibles (and, consequently, have a greater reward on their exploitation) since they bear the risk of unsuccessful or untimely development as well all the market risk of exploiting a developed intangible.
The sharing of the risk of unsuccessful (or untimely) development is the key economic factor in cost-sharing arrangements that distinguishes them from transfer pricing situations. The application of a mechanical income test to determine the validity of a cost-sharing arrangement during most stages of an undeveloped or incomplete intangible is improper because the results of the arrangement remain highly speculative. Thus, TEI objects to the pre-eminent position of the cost/income ratio in evaluating a cost-sharing arrangement. The rebuttable presumption status accorded to the cost/income ratio is a flawed approach and should be abandoned. At most, the cost/income ratio should be only one factor to validate the reasonableness of allocation methods used by the participants.
3. Specific Comments
Application of the cost/income ratio presents a number of problems. Any annual (or other short-term) analysis of the income of the participants in a cost-sharing agreement will distort results. Over time, a bona-fide arrangement will result in proportionately more research expense being charged to a party that derives proportionately more benefit. The cost/income test (or any other snapshot calculation) should not enjoy a procedural burden of proof. Taxpayers should be able to establish the validity of their cost-sharing arrangement on the basis of their own facto and circumstances. A cost-sharing arrangement that is structured fairly, applied consistently, and, most important, stands the test of time in capturing and allocating research costs should be recognized as an arm's-length arrangement. In a long-term cost-sharing arrangement, the parties obtain what they bargain for. Applying rules that do not properly account for the long-term nature of such arrangements is akin to taking a single frame from a motion picture to represent the entire film. In some instances, the snapshot will be an accurate representation, but in most cases the perception is inaccurate.
The commensurate-with-income standard may support a requirement that the parties to a cost-sharing agreement amend the terms of their agreement periodically to ensure that the party deriving proportionately more benefit is in fact bearing proportionately more costs. To be consistent with uncontrolled arrangements, however, the amendments should be applied prospectively. Uncontrolled parties to a cost-sharing agreement would not reallocate costs for prior years. TEI believes that foreign jurisdictions will not look favorably on attempts by the IRS to impose retroactive charges on foreign participants in a U.S.-based multinational cost-sharing arrangement.
a. Operating Income. Prop. Reg. [section] 1.482-2(g)(3) defines the numerator of the cost/income ratio - operating income attributable to intangibles - as all operating income that is directly or indirectly attributable to the intangible development area. This definition is unduly broad. As a matter of economic theory, it may be possible to segregate and assign income to various factors responsible for producing profits. As a practical matter, however, the burden of segregating income streams attributable to many sources will prove extremely difficult, especially in industries that employ process technologies. In many circumstances, the proposed regulations will deem the entire net operating income of a taxpayer "attributable" directly or indirectly to the intangible development area. Furthermore, there may be innumerable intangible areas - some developed before the effective date of the 1986 Act - that overlap.
b. Profitability Affected by Numerous Factors. There are a host of factors, apart from the "income attributable to intangibles," that affect operating income including market share and size, labor costs, governmental costs including taxes and regulatory restrictions, business conditions, and management acumen.(60) For example, one participant to a cost-sharing agreement may wish to enter a highly competitive market where it may take longer than three years to produce operating income proportionate with other members of the cost-sharing agreement. Likewise, the business conditions in one participant's market may be in recession while other participants are in a fast-growth mode. Differences in fundamental business organization and objectives will similarly affect the profitability of the participants. For example, one participant may conduct a full range of business functions - from research and development to manufacturing to marketing and distribution - while another member of the same group may be a high-volume distributor providing products to related or unrelated marketing and selling companies. In such cases, the cost/income ratio will not properly measure the participants' reasonable efforts to anticipate benefits and allocate the costs.(61) In summary, TEI believes that the relationship between costs and income from intangibles is so attenuated that the cost/income ratio is a flawed measure of proportionate sharing of costs and benefits under a cost-sharing agreement.
c. Disparate Benefits to Participants. For reasons beyond the control of the participants to a cost-sharing agreement, a research project may result in the serendipitous development of an intangible that is uniquely suitable to market exploitation by one or another of the participants, but not by all participants equally. Indeed, the project may have been unsuccessful as measured by its original conception, yet highly successful in unanticipated ways. The proposed regulations - through the cost/income ratio and other provisions - assume that in such a situation uncontrolled parties would amend the terms of the original cost-sharing agreement to redistribute the profit from the intangible. Thus, assume two parties to a cost-sharing agreement, A in Japan and B in the United States, set out to develop a pharmaceutical treatment for cancer. Instead, the parties create a drug that treats diseases caused by a diet rich in seaweed. Owing to dietary customs, exploitation of the drug technology may produce disproportionate benefits to the Japanese participant. The proposed regulations (in particular, the cost/income ratio) seemingly empower the IRS to disregard the terms of the cost-sharing agreement should A and B be related parties. Other examples of disproportionate, serendipitous benefits arising from research and development can be imagined for any products that have unique applications because of geographic, cultural, physical, legal, environmental, or other conditions within a market. TEI believes that any cost-sharing agreement that purposely attempts to exploit these market differentiating conditions may be adjusted through other means. Likely, the cost/income ratio would cause adjustments where none should be made.
d. Undefined Standard. The term "grossly disproportionate" is not defined in the proposed regulations. In Example 5(iii) of Prop. Reg. [section] 1.482-2(g)(4)(ii)(E), a 0.65 cost/income ratio is determined to be "grossly disproportionate" to a ratio of 0.12 (a multiple of 5.4 times). In contrast, a "substantially disproportionate" allocation occurs where the U.S. participant's ratio is more than twice the other participants' ratio. TEI wonders where - on the range of 2 to 5.4 times - a cost/income ratio comparison crosses the line from "substantially" "grossly" disproportionate. If the cost/income ratio is to be retained, the draconian consequence attached to "grossly disproportionate" cost allocations requires that it should not be the standard to disqualify a cost-sharing agreement.(62) Cost-sharing agreements should not be disqualified unless clear and convincing evidence shows that the parties had a tax-avoidance purpose in allocating the costs disproportionately. One persuasive element (though not a presumptive burden) of such evidence would include a showing by the IRS that the cost/income ratio of the U.S. participant exceeds five times the other participants' ratio for each of three consecutive years and a net worldwide tax benefit arises from the allocation. Furthermore, a taxpayer should be permitted to provide credible rebuttal evidence (the existence of adverse business conditions, poor management, strikes, etc.) that skew the purely arithmetic ratio. For example, if a U.S. participant to a cost-sharing agreement incurs a net operating loss over a particular three-year period (or more), the participant should be able to provide the requisite evidence that no tax-avoidance purpose is present. The cost/income ratio test automatically disqualifies a cost-sharing arrangement in these circumstances. TEI believes this result illustrates why the cost/income ratio test does not work and should be deleted.
e. Testing Period. The examples in the proposed regulations suggest that taxpayers will be subject to adjustments for cost reallocations in any testing period where the cost/income ratios of the parties are not exactly 1:1. The apparent assumption of the proposed regulations is that there is a relatively short lead time between the development of the intangibles and their exploitation. Within the framework of a long-term agreement, it is impossible to arrange exactly proportionate matching at any particular point in time. Thus, the strict 1:1 ratio between U.S. and non-U.S. participants is unduly stringent. If the cost/income test is to be retained, disproportionate sharing should be permitted within a certain range. For example, no adjustment to shared costs should be required where the U.S. participant's ratio is no more than 125 percent of the other participant's ratio in any one year.
Furthermore, there should be flexibility in the use of a three-year period for determining the proportionality of costs shared. The use of a strict three-year period is particularly inappropriate in respect of start-up ventures that may not generate revenues - let alone operating profits - for several years. Such arrangements should be excluded from any mathematical test until they show consistent profits. Furthermore, taxpayers should be permitted to show that over time - rather than within a single testing period no matter how long its duration - costs and benefits are shared in an approximately proportional manner. Again, we suggest that no adjustment to costs should be required where the U.S. participant's ratio does not exceed 125 percent of the other participants' ratio.
f. Records. The proposed regulations do not specify at what level of detail the cost/income ratio is to be computed. If the computations are required on a product-by-product basis, the administrative burden would be horrendous and would not contribute appreciably to the accuracy of the results. TEI recommends that taxpayers be permitted to select the business unit grouping (e.g., product, product line, division or company) consistent with their books and records for which the ratio is to be calculated.(63)
h. Summary. TEI believes the cost/income ratio rule should be eliminated as the principal measure of a cost-sharing agreement because it fails to provide meaningful and fair guidance to examining agents and taxpayers. In many instances, successful development and use of an intangible may not generate increased income even though the economic viability of the participants' businesses may be sustained. A cost-sharing agreement may often anticipate benefits correctly using a method other than one that relies on income. TEI believes that the use of a mechanistic cost/income ratio test is not commercially sound in all cases. Therefore, the cost/income test should be de-emphasized in importance (perhaps, treated as one factor among many), if not jettisoned entirely.
D. Buy-In and Buy-Out Rules
Prop. Reg. [section] 1.482-2(g)(4)(iv)(A) provides that when a participant in a cost-sharing arrangement transfers an intangible to another member of the controlled group, an arm's-length consideration for the transfer must be determined under Prop. Reg. [section] 1.482-2(d) - the so-called buy-in rule. Prop. Reg. [section] 1.482-2(g)(4)(iv)(C) describes the tax treatment when a participant in a qualified cost-sharing arrangement relinquishes some or all of its rights to intangibles covered by the agreement - the so-called buy-out rule. Prop. Reg. [section] 1.482-2(g)(4)(iv)(B) provides guidance on the form of the consideration on buy-ins and buy-outs.
1. Non-Tax Motivated Withdrawal
from Cost-Sharing Agreement
Prop. Reg. [section] 1.482-2(g)(4)(iv) provides that whenever a participant in a cost-sharing arrangement leaves the controlled group (or abandons the use of the intangible), that participant must be paid an amount equal to its interest in the intangible at that time. Requiring the remaining group members to make a buy-out payment to the abandoning member results in an inequitable hardship to the remaining members - particularly if no benefit (in the form of a useable intangible or more expansive rights to exploit the intangible) is conferred on the continuing members. For example, if the departing party had exclusive rights to exploit an intangible within a certain area and the other participants do not succeed to that right, no buy-out should be required. Furthermore, if a departing party assigns its interest under the agreement to another party, it is unclear whether a buy-in or buy-out would be necessary in an arm's-length transaction. Depending on the stage of development of the intangible, an unrelated assignee in such circumstance may be required to pay nothing to anyone because the intangible is so inchoate that the new party's agreement to fund the continuing research may constitute sufficient consideration.(64) If a useable intangible exists, the assignee may pay some type of royalty to the departing party. Thus, the regulations should provide that when a participant abandons a cost-sharing arrangement (or its use of an intangible developed under such arrangement) for a non-tax motivated business reason, the remaining members will not be required to make a buy-out payment to the departing (or abandoning) member. Cost-sharing agreements among unrelated parties do not continue in perpetuity. Such agreements usually terminate for business reasons and without provision for a buy-out, especially where no benefit accrues to the parties who continue the agreement. Indeed, many uncontrolled cost-sharing agreements terminate because one party is unwilling (or unable) to meet the financial requirements imposed by the agreement.
2. Permit Transfers in Kind with
Cash Payments to Equalize
Net Contributed Values
Prop. Reg. [section] 1.482-2(g)(4)(iv) provides that a payment must be made to a new member of a cost-sharing arrangement for the value of the intangibles that the new member contributed to the group. In addition, a buy-in payment must be made by the new member to the existing members in exchange for the rights that the new member acquires in the existing group intangibles. TEI recommends that the regulations provide for an offset of the respective values of the interest acquired by the new member in the existing intangibles of the group and any intangibles contributed by a new member, so that only one payment by one party of the net difference between the two aggregate values need be made.
3. Time to Apply the
Buy-in or Buy-out Rules
The regulations should specifically state that the adequacy of the consideration is to be tested at the time of the buy-in or buy-out. Thus, the IRS should abjure a retrospective rule because of the key economic element of the risk of unsuccessful or untimely development that is inherent in a cost-sharing arrangement.
In addition, the regulations should confirm that in appropriate circumstances an arm's-length consideration will be the costs incurred prior to the buy-in or buy-out (discounted by an appropriate interest factor). The application of any commensurate-with-income concept to various stages of an undeveloped or incomplete intangible would be extraordinarily difficult.
4. Effect of Failure to
Apply Buy-In or Buy-Out
The proposed regulations are silent concerning the effect of failing to apply the buy-in and buy-out rules. TEI believes it improper to disqualify a cost-sharing arrangement entirely where the taxpayer fails to abide by the buy-in or buy-out rules. The regulations should clarify that a taxpayer's failure to apply the buy-in and buy-out rules will not disqualify the cost-sharing arrangement. In such instances, the taxpayer should be subject to the rules on transfers of intangible property contained in Prop. Reg. [section] 1.482-2(d).
5. Post Buy-Out Events
The proposed regulations provide that the amount of a buy-out payment may be adjusted if events or transactions occur within a short time after the buy-out that could have some bearing on the magnitude of the buy-out payment.(65) To provide certainty to taxpayers that their buy-out amounts will not be subject to adjustment upon examination, the IRS should establish a rebuttable presumption that, in the absence of clear and convincing evidence to the contrary, an event or transaction that occurs more than two years after the buy-out will not be grounds for an adjustment to the buy-out amount.
6. Exceptions to the
As a policy matter, the buy-in rule may have ample justification. TEI believes, however, that there are circumstances that clearly warrant exceptions. For example, TEI believes it may be improper to apply a buy-in rule to basic research costs that precede the formation of a cost-sharing group or the entry of a new participant. Basic research by definition may not lead to the development of an intangible that may be transferred or for which a buy-in value may be determined. Even outside of the basic research area, expenses incurred to a certain point on many projects may have no ascertainable value and thus should not trigger the buy-in provisions.
Another area where the application of the buy-in rules may be improper is the effect of corporate acquisitions, mergers, and liquidations. Consider, for example, a cost-sharing arrangement between a foreign parent corporation (which is organized, say, under the laws of the United Kingdom) and its U.S. subsidiary. If the U.S. subsidiary utilizes intangibles developed under the cost-sharing arrangement in a new business in the United States and conducts the new business as a division of the subsidiary, the new buy-in rule would not be applicable. If, on the other hand, the U.S. subsidiary decides to operate the new business as a newly organized domestic (U.S.) corporation, the new corporation will be required to make a buy-in payment to the ultimate foreign parent corporation and the immediate U.S. parent. In either case, the commercial arrangement is the same, yet the proposed regulations provide a different tax result simply because the U.S. subsidiary - for legitimate, non-tax business reasons - used a newly created entity to carry on the new business.
Similarly, the buy-in rule ought not apply to certain acquisitions. Assume, for example, the U.S. subsidiary of a foreign parent purchases all of the stock of a domestic corporation engaged in a similar business. If the newly acquired domestic corporation uses intangibles developed by the U.S. subsidiary and its foreign parent under their cost-sharing arrangement, the new subsidiary will be required to make a buy-in payment to the U.S. subsidiary and the foreign parent. If, on the other hand, the U.S. subsidiary purchases the assets of the domestic corporation or immediately liquidates the acquired company after the stock purchase, the previously developed intangibles can be freely used in the newly acquired business without making any buy-in payment. Under the proposed regulations, the form of the transaction seems to dictate unnecessarily a different result.
The White Paper suggested that a tax-free capital contribution, especially in the foreign-to-foreign context, would ameliorate this problem and accommodate some foreign legal restrictions.(66) At a minimum, the buy-in payment rule under Prop. Reg. [section] 1.482-2(g)(4)(iv)(A) should be modified in the following circumstances:
(i) where a new participant is a newly organized corporation, is incorporated under laws of the same country in which its immediate parent corporation is organized, and has as its sole shareholder (ignoring directors' qualifying shares) a corporation that is an "eligible" participant in the cost-sharing arrangement; or
(ii) where a new participant is a recently acquired corporation, is incorporated under the laws of the same country in which its immediate parent is organized, and has as its sole shareholder (ignoring directors' qualifying shares) a corporation that is an "eligible" participant in the cost-sharing arrangement.
In these two circumstances, no buy-in payment should be required. Because the proposed exceptions are limited to "same country corporations," the potential for tax avoidance is minimized.
E. Scope of Costs and
One of the principal objectives of the IRS in propounding the cost-sharing regulations is to prevent the so-called cherry-picking of research benefits - i.e., to prevent U.S. participants from bearing disproportionate costs of unsuccessful research or foreign participants deriving disproportionate benefits from successful research. Thus, there are a number of provisions, such as the definition of eligible participants, the buy-in rules, etc., that limit or restrict the ability of participants to isolate successful projects from unsuccessful projects.
Prop. Reg. [section] 1.482-2(g)(4)(i) requires that the cost-sharing agreement be broad enough to encompass "related intangible development" and narrow enough so that "products or services are of potential use to each participant." "Related intangible development" is all development, including basic research, that may reasonably be regarded as leading to the development of any product or service in the stated intangible development area and includes any activity conducted or funded by any participant relating to similar products or services, as determined by all the facts and circumstances. Prop. Reg. [section] 1.482-2(g)(4)(i)(C) provides that the arrangement must cover "costs for the development of products or services" that are of "potential use" to a participant if it "is reasonable to expect" that new products or services within the area will be used in the active conduct of that participant's trade or business in a "commercially significant" manner.
The proper scope and application of this rule is critical to taxpayers using cost sharing. It is far too important to contain imprecise phrases such as "potential use," "reasonable to expect," and "commercially significant." While we recognize that a facts-and-circumstances approach is likely necessary, TEI is concerned that IRS examiners will use such amorphous phrases to impose their judgment about whether a technology is of "potential use" in a "commercially significant" manner. To prevent ad hoc results and provide some certainty, TEI suggests that taxpayers be permitted to group their research categories by SIC code areas or trade or industry practice to meet the definition of covering all costs of "related intangible development." At a minimum, the intangible development area should be required to be no broader than the two-digit SIC category.
Furthermore, TEI recommends that the regulations carve out of covered costs an exception for basic research expenses where the intangible value is not attributable to any particular product group. TEI submits that it is frequently impossible to associate some core research expenses with any intangible development area. Such costs should be beyond the scope of a cost-sharing agreement and, more important, beyond the reach of adjustment by the IRS.(67)
F. Definition of Eligible and
Prop. Reg. [section] 1.482-2(g)(3) defines an eligible participant as a member of a controlled group of taxpayers that has a cost-sharing agreement providing that intangibles to be developed under the agreement will be used in the active conduct of a participant's trade or business.
1. Limitation to Controlled
Group of Taxpayers
TEI questions the need to limit a qualified cost-sharing agreement to a controlled group of taxpayers. The participation of an unrelated party with a bona-fide interest in a cost-sharing arrangement would seem to provide substantial evidence that the agreement contains arm's-length provisions.
2. Treat Affiliated Group
as a Single Taxpayer
The requirement that each participant use the intangibles to be developed in the active conduct of a trade or business is too restrictive. Multinational groups often concentrate research and development activities within a single legal entity - either the parent corporation or a special-purpose subsidiary. The fruits of research activity should be freely available within an affiliated group filing a consolidated tax return without meeting the requirements of a cost-sharing subgroup under Prop. Reg. [section] 1.482-2(g)(3)(v)(B)(2). In addition, where there is a research affiliate within a group that does not engage in other commercial activities (such as selling or manufacturing), the research affiliate should be an eligible participant of the cost-sharing arrangement.
3. Accommodate Foreign
The requirement that each eligible participant use either at present or in the future intangibles developed under the arrangement in the active conduct of its trade or business presents difficulties in some foreign jurisdictions. Some foreign countries place restrictions on the funding or payment of research and development that is not performed within the country. Affiliates within such countries nonetheless require access to and use of the intangibles in the business. As a result, corporate groups often have one affiliate (often the immediate parent of the affiliate prevented from making the payment) pay the cost share on behalf of another affiliate. The payor affiliate may not directly use the developed technology, but it may recover the cost-sharing payment from the benefitted affiliate in various ways. Thus, the U.S. and other participants to the cost-sharing agreement are not overcharged for their respective shares. TEI recommends that IRS provide an exception for a participant that is not a direct user of the intangible but funds the cost share of another affiliate solely to comply with foreign country legal restrictions preventing direct payment of the participant's cost share.
G. Order of Application
of IRS Remedies
1. Self-Help for Taxpayers
If the cost/income ratio test is to be retained, the regulations should allow a taxpayer at least a one-year period from the year in which a disproportionate allocation arises in order to cure the defect.(68) If there are different profitability factors in various jurisdictions, a self-help cure will alleviate some of the problems of using a mechanical test.
2. Revise Priority of
TEI believes that the principal remedy for a disproportionate allocation should be an adjustment of costs rather than application of the buy-in and buy-out provisions. The regulations should reserve the buy-in and buy-out provisions for limited situations where there is a transfer of a successfully developed intangible that has an immediate application in the transferee's trade or business.
TEI also recommends that the regulations state that the disqualification of a cost-sharing agreement is reserved for clearly abusive situations involving a consistent pattern of disproportionate allocations over time. The mere failure of a mechanical test in one year (regardless of how disproportionate the ratio) should not, in itself, disqualify an agreement.
H. Accounting for Costs
The IRS invites comments on the appropriate accounting principles to employ in determining the shared costs of intangibles.(69) To minimize the administrative burdens that the regulations place on taxpayers, TEI recommends that the development costs subject to a cost-sharing arrangement be determined by applying generally accepted accounting principles (GAAP) rather than tax accounting principles. Furthermore, in the context of a controlled group comprised of companies in many countries, we believe that GAAP principles used for financial accounting reports of the parent corporation should be employed.(70) In any event, TEI believes that the imposition of U.S. tax accounting principles would be extremely burdensome.(71) For example, if U.S. tax accounting rules were used, cost-sharing participants in other countries would be required to compute depreciation related to assets used to produce the intangibles under U.S. tax depreciation rules. In addition, indirect costs presumably may need to be computed using the complex uniform capitalization rules of section 263A.(72) We believe the consistent use of GAAP over the period of years to which cost-sharing agreements generally relate will result in the appropriate determination of the costs of developing intangibles and facilitate the expeditious calculation of cost-sharing payments at or shortly after the close of the group's fiscal year. The use of tax accounting, on the other hand, win delay the final computations for an extended period and possibly necessitate numerous recomputations from amended tax returns or examination adjustments. Finally, to the extent the cost/income ratio test is retained, the use of GAAP will ensure a consistent measurement of the numerator (costs) and denominator (operating income.) Thus, TEI recommends that taxpayers be permitted to use the GAAP of the parent company to determine the costs of developing intangibles and the attendant income.
TEI recommends that any currency exchange gain or lose attendant to cost-sharing payments be separately computed by the participants outside the arrangement. There are several reasons for this recommendation. First, the parties agree to share the risk of developing intangibles, not the risk of currency fluctuation. Any risk of currency fluctuation resulting from cost-sharing payments is extraneous to the cost-sharing arrangement. Second, substantial complexity arises from the interaction of the currency rules with the administrative requirements of the section 482 regulations. Including foreign currency gain or loss in cost-sharing payments will skew the cost/income ratio because of factors unrelated to the cost-sharing agreement. For example, a political upheaval may affect the exchange rates of a currency used by one of the participants. This may ultimately burden one particular participant with artificial costs not contemplated when entering into the arrangement. Therefore, TEI suggests that any currency gain or loss should not be part of the cost-sharing payments; rather, gains and losses should be treated as separate income or expense.(73)
J. Transition Rule
The final sentence of the proposed regulations states that, for the period prior to the effective date of the regulations (taxable years beginning after December 31, 1992), the final sentence of section 482 will be applied using "any reasonable method not inconsistent with the statute." The final sentence of section 482, which was effective for taxable years beginning after December 31, 1986, states that income with respect to the transfer or license of intangible property shall be commensurate with the income attributable to the intangible. The "grandfather" rule of the proposed regulations provides that a cost-sharing arrangement will be considered a "qualified" arrangement under the new rules if the arrangement was considered a bona-fide cost-sharing agreement under the currently existing regulations, but only if the arrangement is amended where necessary to conform to the requirements of the new regulations. Such amendments are to be made within one year after publication of final, revised regulations. Since the regulations are proposed to be effective for taxable years beginning after December 31, 1992, it remains unclear, even if a "bona-fide" cost sharing agreement is modified within the required one-year period, how much protection would be afforded the agreement between the effective date of the commensurate-with-income standard (1987 for calendar-year taxpayers) and the effective date of the final regulations (1993 for calendar-year taxpayers). Therefore, TEI recommends that the transitional rule be clarified to state that if the required amendments are made within the one-year period, the cost-sharing arrangement will also be treated as a bona-fide cost-sharing arrangement under the existing regulations for taxable years beginning after the effective date of the Tax Reform Act of 1986.
K. Miscellaneous Comments
1. Disclosure of Cost-Sharing
Period for Production of
Prop. Reg. [section] 1.482-2(g)(6) prescribes certain administrative requirements for cost-sharing agreements. In particular, the material terms of the cost-sharing agreement must be summarized in an attachment to various schedules in the income tax return for each year the agreement is in effect. In addition, information and records to support the costs borne and operating income earned by each participant must be provided within 60 days of a request by the district director.
TEI believes the notification requirement should be modified to permit a one-time attachment of a summary of (or copy of) the cost-sharing agreement. A simple notice disclosing the existence of the cost-sharing agreement in subsequent year's returns should suffice. The agreement would, of course, be available upon examination.
TEI further recommends that the period within which to produce the records to support the costs and operating income of the participants be increased to 90 days. An additional period of 60 days to translate foreign language documents should also be provided.
2. De Minimis Exception for
Foreign Situs Records
TEI recommends that a de minimis rule be provided to reduce administrative burdens and costs associated with the production of foreign situs records. In particular, we recommend that the requirement to produce non-U.S. records be eliminated where total cost-sharing payments by a U.S. participant to a foreign affiliate do not exceed the lesser of $2 million or 5 percent of operating income. Certification of the relevant costs and income amounts by an independent accounting firm in lieu of production of foreign situs records should be acceptable.
XIII. Other Issues and
On October 11, 1991, TEI submitted comments on the application of the reasonable cause and good faith exceptions under section 6664 to avoid the substantial understatement penalty imposed by section 6662(e) relating to valuation misstatements applicable to net section 482 transfer price adjustments. A copy of TEI's comments is attached. Having submitted those comments in advance of issuance of the proposed regulations under section 482, several supplemental comments are in order.
First, to the extent the CPI test is retained, TEI recommends that the mathematical thresholds for imposition of the section 6662(e) penalty (ie., for net section 482 transfer pries adjustments of either $10 or $20 million) be measured from the endpoints of the calculated interval. TEI believes that the adjustment to the "most appropriate point in the interval" represents a non-penalty penalty to the extent an income adjustment is made beyond the endpoints of the interval. If the section 6662(e) penalty were to be imposed in addition to an income adjustment, an actual penalty would be stacked on the effective penalty - a result clearly at odds with penalty reform.
The automatic imposition of the section 6662(e) penalty when the statutory dollar thresholds are exceeded is, by itself, very troubling. A reasonable cause exception is particularly appropriate given the mathematical precision required by section 6662(e) and the concomitantly precise adjustments required by the cost/income ratios. Otherwise arbitrary and inequitable results will occur. Certainly, an automatically imposed 20- or 40-percent valuation misstatement penalty will not reduce the level of controversy between taxpayers and the IRS. Nor is it consistent with the IRS's Compliance 2000 initiatives and its stated desire to penalize only intentional non-compliance.
Clear descriptions of reasonable cause and good faith are necessary to avoid onerous penalties for misjudging complex factual (often contradictory) data that underlie the evaluation and setting of transfer prices. Thus, TEI believes it is critical that the IRS suspend the application of the section 6662(e) penalty rules until new, final section 482 regulations are promulgated. Furthermore, IRS should not assert any penalty under section 6662(e) in the absence of guidance on the reasonable cause and good faith exceptions.
B. Location Savings
The proposed regulations are silent regarding the allocation of location savings between related parties. Location savings, which can be defined as the incremental cost savings of doing business in a particular foreign jurisdiction, merited only a cursory footnote in the White Paper.(74) In Rev. Proc. 63-10, 1963-1 C.B. 490, the IRS recognized that location savings inure to the Puerto Rican manufacturing affiliate. While it attempts to to limit its application strictly to Puerto Rico, the revenue procedure's conclusive statement that it "properly allocates ... all income or loss" to the manufacturer is an indication that location savings should be allocated to the manufacturer in all instances. (Emphasis supplied.) The courts have agreed. In Ross Glove Co. v. Commissioner, 60 T.C. 569 (1973), the Tax Court noted that the entity that assumes manufacturing risk should have the manufacturing rewards, including location savings. More recently in Sundstrand Copporation v. Commissioner, 96 T.C. 226 (1991), the court in its discussion of location savings compared the taxpayer's costs in Singapore with hypothetical U.S. manufacturing costs. Consequently, TEI recommends that the regulations expressly address the issue of location savings and acknowledge that location savings properly accrue to a low-cost jurisdiction.
C. Cost Sharing Under
If a cost-sharing election is made under section 936(h), the Tax Reform Act of 1986 requires that the cost-sharing payment equal the greater of 110 percent of the cost of the allocated product research or the amount required by section 482 - including the commensurate-with-income standard. The proposed regulations do not address their interaction with corporations governed by section 936. Presumably, however, the regulations wih apply without exception to companies electing cost-sharing under section 936(h).
Assuming MTM is unavailable, the CPI methodology will apply to the cost-sharing possessions corporation's intangibles or to its sales of tangible property incorporating intangibles. If so, the "residual" profit could apparently be allocated to the U.S. developer of the intangible used by the possessions corporation, relegating the possessions corporation to a contract-manufacturing profit based on a return on assets. Consequently, the possessions corporation is effectively denied any return on manufacturing intangibles. This result is directly at odds with the underlying purpose of section 936(h), as well as the legislative history of the 1986 Act. Section 936 was amended substantially in 1982 to provide specific rules for the allocation of income from intangibles between the possessions corporation and a related entity that transfers intangibles to, or permits their use by, a possessions corporation. Apparently, the proposed section 482 regulations place section 936 corporations that elect cost-sharing on the so-called Dole (cost-plus) method, thereby eviscerating congressional approval of the alternatively permitted cost-sharing election.(75)
The effect of the proposed regulations is equally far-reaching with respect to non-U.S. export sales by possessions corporations. Section 936 permits a separate cost-sharing election for exports, with the intent that the cost-sharing method provides a greater return to the possessions corporation than the profit-split method. See I.R.C. [section] 936(h)(5)(F)(iii)(II). Under the proposed regulations, the permitted return on products sold under the separate export election could be restricted to a contract manufacturing return, an amount substantially less than that which would accrue under the profit-split method. Such a result vitiates the separate export product cost-sharing election permitted under the statute. When Congress was considering the 1986 Act, the Treasury Department recommended repeal of the cost-sharing election under section 936. Congress rejected this proposal, determining that cost sharing was to remain a viable option for possessions corporations. This legislative decision must not be overruled by administrative fiat. Possessions corporations should continue to realize a reasonable return on manufacturing intangibles. TEI recommends that the final section 482 regulations specifically address the substantial interaction with section 936.
Finally, on June 12, 1992, TEI submitted a letter to Assistant Treasury Secretary Goldberg urging the Treasury Department to extend the election period under Rev. Proc. 91-53, relating to taxpayers' changing their elections under section 936(h). In that letter, TEI recommended that Rev. Proc. 91-53 be extended until the first taxable year following the promulgation of final section 482 regulations addressing the effect of the 1986 Act changes on section 936 cost sharing. We now recommend that the IRS issue immediate guidance on the extension of Rev. Proc. 91-53. We also urge that the final section 482 regulations contain a transition period consistent with our recent recommendation to Assistant Secretary Goldberg so that taxpayers may make an informed decision based on the final section 482 regulations.
D. Interaction with
Prop. Reg. [section] 1.482-2(f)(2) requires that a tested party's CPI be determined by reference to information coming into existence during a three-year period which extends beyond the year under scrutiny. In the case of an importer subject to section 1059A, harsh results occur when the transfer price of tangible property brought into the United States is adjusted by reference to information unavailable at the time the property is imported.(76) There is a distinct risk that, regardless of the diligence exercised in setting a price under the resale-price or cost-plus methods, the import price may subsequently be adjusted by operation of CPI. Moreover, should that adjustment cause the transfer price to exceed the customs value of the property, the taxpayer would be unable to deduct such excess amount when determining its cost of goods sold deduction.
This problem can be addressed for those taxpayers willing to employ CPI as a safe harbor by modifying the reference period in the proposed regulations to include a period of years ending before the year in which the property is imported into the United States (as we recommend CPI be modified).
E. Interaction with
The proposed regulations under section 6038A require certain foreign-owned multinational companies to maintain and produce on demand a considerable amount of detailed records. The unstated premise of the section 6038A regulations is that non-U.S. owned companies must maintain a sufficient level of detailed records that may be examined to determine whether the United States has received its "appropriate" share of taxable income. In essence, a sufficient level of detailed records must be maintained from which a judgmental profit-split may be calculated.
In contrast, the section 482 proposed regulations reduce the application of judgmental profit split to a handful of cases. Under the proposed regulations, non-U.S. owned companies subject to section 6038A must maintain another set of detailed records to establish compliance with section 482. Thus, non-U.S. owned companies are subjected to enormous recordkeeping burdens to satisfy two disparate regulatory schemes aimed at the same perceived problem: protection of the U.S. fisc from transfer price manipulation. We believe that a principled approach to tax administration requires that the transfer pricing regulations and the concomitant enforcement of those policies be harmonized.
F. Transition Rule for
Paragraph 4 of the proposed amendments to the regulations provides that for the interregnum between the effective date of the 1986 Act (generally tax years beginning after December 31, 1986) and the effective date of the amendments to the regulations (generally tax years beginning after December 31, 1992), the commensurate-with-income standard of the statute is to be applied using any reasonable method not inconsistent with the statute. TEI believes this statement is an attempt to provide a liberal standard for compliance with commensurate-with-income standard. Unfortunately, the only example of reasonable compliance cited by the proposed regulations is the proposed regulations. TEI is concerned that without more specific guidance, revenue agents will only employ the proposed regulations as the standard for determining a "reasonable" method of compliance with the commensurate-with-income standard. TEI believes that taxpayers deserve more extensive guidance on what constitutes reasonable compliance with the final sentence of section 482. Lacking further guidance, inconsistent administration of the statute for similarly situated taxpayers is likely.
TEI is pleased to have the opportunity to present its views on the subject of the section 482 proposed regulations. These comments were prepared under the aegis of TEI's International Committee whose chair is Raymond G. Rossi. Preparation of these comments was coordinated by Lisa Norton, vice-chair of the committee, who headed a special task force to comment on the proposed regulations. If you have any questions concerning these comments, please call either Mr. Rossi of Intel Corporation at (408) 765-1193, Ms. Norton of Ingersoll-Rand Corporation at (201) 573-3200, or Jeffery P. Rasmussen of the Institute's professional tax staff at (202) 638-5601.
(1) For simplicity's sake, the proposed regulations are referred to as "the proposed regulations" and specific provisions are cited as "Prop. Reg. [section]." References to page numbers are to the proposed regulations (and preamble) as published in the Internal Revenue Bulletin. (2) H.R. Rep. No. 99-841, 99th Cong., 2d. Sess. II-639 (1986). (3) Notice 88-123, 1988-2 C.B. 458. (4) Treasury Department and Internal Revenue Service, Report on the Application and Administration of Section 482, at 1-4 (April 9, 1992). (5) See H.R. Rep. No. 99426, 99th Cong., lst Sess. 423 (1985) (hereinafter "the House Report"). (6) Preamble, 1992-8 I.R.B. at 30. (7) See House Report at 423. (8) Preamble, 1992-8 I.R.B. at 26. (9) See, e.g., Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, at 1015-1017 (1987) (hereinafter referred to as the "General Explanation"). (10) House Report at 423. (11) House Report at 425. (12) Fairly clear guidelines exist to distinguish intangible property from the offices of any individual. See generally Rev. Rul. 64-56, 1964-1 C.B. 133, as clarified by Rev. Rul. 71-564, 1971-2 C.B. 179. (13) Preamble, 1992-8 I.R.B. at 30. (14) "The Service anticipates that taxpayers will use these regulations to establish transfer prices for controlled transactions . . . ." Preamble, 1992-8 I.R.B. at 30. (15) The proposed regulations would overturn Bausch & Lamb v. Commissioner, 92 T.C. 525 (1989), aff'd, 933 F.2d 1084 (2d Cir. 1991), on whether an uncontrolled transaction is comparable, unless it can be established that the uncontrolled taxpayer would not have altered its transactions as a result of possessing the same knowledge as the controlled taxpayer. Similarly, the proposed regulations would overturn the results in Bausch & Lomb and Sundstrand Corp. v. Commissioner, 96 T.C. 226 (1991), on whether "roundtrip" transactions - i.e., transactions where a controlled affilliate, pursuant to a license agreement, uses an intangible developed by the parent company to produce products that are resold to the parent - are separate transactions that are to be independently examined under the arm's-length standard. The proposed regulations would overrule Eli Lilly v. Commissioner, 84 T.C. 996 (1985), aff'd in part, rev'd in part, and rem'd in part, 856 F.2d 855 (7th Cir. 1988), by making property contributed in a section 351 transaction subject to section 482 allocations. Contrary to the holding in R. T. French v. Commissioner, 60 T.C. 836 (1973), the proposed regulations would permit facto arising subsequent to a transaction to alter the results of the original transaction. Over-ruling Bausch & Lomb and U.S. Steel Corp. v. Commissioner, 617 F. 2d 942 (2d Cir. 1980), an example in the proposed regulations provides that where the volume in a controlled transaction is higher, a volume discount must be used if a reasonably ascertainable volume discount can be determined. In addition, the results in other cases, if not the explicit holdings, are undermined. E.g., Ciba-Geigy Corp. v. Commissioner, 85 T.C. 172 (1985), acq. 1987-2 C.B. 1. (16) See, e.g., David A. DiMuzio, An Open Letter to Corporate Tax Directors, 55 Tax Notes 127 (April 6, 1992). (17) On numerous occasions, Congress has used the legislative history to express its approval or disapproval of the outcome in specific cases, often at the IRS's behest. There was no mention of any pre-1986 cases in the legislative history. (18) Organisation for Economic Co-operation and Development, Report of the Committee on Fiscal Affairs, Transfer Pricing and Multinational Enterprises (1979). (19) At an April meeting of the OECD Working Party and Tax Committee of the Business and Industry Advisory Committee, German and Japanese officials emphasized that their countries do not accept the proposed regulations. Reports indicate that they view the regulations as departing from international standards and, more important, that competent authority resolution of transfer pricing issues arising in U.S. tax examinations will be significantly hindered by the proposed regulations. (20) Indeed, foreign governments reportedly have already stepped up examinations of U.S.-based multinationals because of a perceived revenue "grab" by the United States. That perception is based on a number of separate but cumulative actions by the U.S. government. (21) Indeed, many taxpayers currently forgo the use of competent authority procedures based on a cost-benefit analysis. (22) An arbitration provision is contained in Article 25 (and the related letter of understanding) of the U.S.-Germany Income Tax Convention. That provision, however, is deficient in TEI's view because it does not mandate (but only authorizes) the use of arbitration where the competent authorities are unable to agree. (23) We understand a "round-trip" transaction to be limited to certain facts and circumstances. Thus, a round-trip transaction consists of a license of an intangible to a related party where the licensee uses the intangible and raw materials or components purchased from other related parties to produce tangible personal property and then resells its entire output to the licensor. Application of the aggregation rule may improperly require taxpayers, or permit the IRS, to ignore comparable data. (24) The aggregation provision is intended to overrule Bausch & Lomb and Sundstrand. (25) In addition, a foreign jurisdiction will likely apply the literal provisions of a contract - especially if an interpretation supports a favorable allocation of taxable profits to that jurisdiction - thereby increasing the risk of double taxation. (26) Preamble, 1992-8 I.R.B. at 25. (27) Prop. Reg. [section] 1.482-2(d)(3)(ii). (28) Prop. Reg. [section] 1.482-2(d)(3)(v)(B). (29) Preamble, 1992-8 I.R.B. at 26. (30) The proposed regulations, thus, attempt to overturn the results in United States Steel v. Commissioner, supra, and Bausch & Lomb, supra. (31) Examples that support this view include sales of domestic iron ore, which is customarily sold at a price per ton based on the prevailing lower lake price for iron ore; crude oil, which is customarily sold at a price per barrel that exists in the geographic region where the crude oil is produced (e.g., West Texas sour); and refined metal, which is customarily sold at a price per pound based on a prevailing international market price (eg., the London Metal Exchange price). (32) The precision required to establish CUP stands in marked contrast to the generally loose standard of comparability under CPI. Under CPI, there appears to be no requirement to use comparable size companies, i.e., to make adjustments for differences in company size. A large, publicly held multinational company apparently is given the same weight in constructing a CPI as a small distributor serving a single city as long as the data exist for both and the two companies sell similar products. (33) Prop. Reg. [section] 1.482-2(f)(4)(ii). (34) Prop. Reg. [section] 1.482-2(f)(6). (35) Many of these factors were recognized in a recent report on transfer pricing practices of foreign-owned corporations prepared by the General Accounting Office. According to the report, "the data do not prove that [foreign corporations] have set improper transfer prices because other factors, such as attempts to increase market share, newness of investment, extent of leverage, fluctuating exchange rates, and managerial skills and experience, can contribute to the differences." U.S. General Accounting Office, International Taxation: Problems Persist in Determining Tax Effects of Intercompany Prices 22 (GAO/GGD-92-89) (June 1992). (36) Business people often negotiate intercompany transactions without regard for the tax consequences. While the pricing method employed may not be developed with the rigor that an economist might desire, seasoned professionals will determine a transfer price that reaches the "right" result in line with the arm's-length standard because their objective is to allocate a company's resources most efficiently. Thus, taxpayers should be able to confirm the arm's-length nature of their pricing in a fact specific and flexible manner during the examination process. (37) The IRS should provide guidance on the principles or rules to be employed to produce convergence. The examples in the proposed regulations appear to apply an "eyeball" test to eliminate some companies and include others in the CPI. TEI submits that, if this is the rule, then "convergence" like beauty lies in the eyes of the beholder. Even where statistical methods may be employed to produce convergence, there are important subjective judgments to be made. Additional guidance is required. (38) See Prop. Reg. [section] 1.482-2(d)(8)(iv), Example (4). (39) Product or product-line profit margins are generally closely guarded secrets even among public companies. If the most appropriate unrelated competitor is a private company, the comparable PLIs win be virtually impossible to ascertain. (40) For example, in a business with 10 particular products comparable to one with only 3 known products? Assuming product profit and loss statements are available, are products showing losses grouped with profitable products? Are "super" products averaged with "ordinary" products? Or what if the product mix is all within the same group, say electronic products, where Company A produces copiers and desk calculators while Company B produces copiers and mainframe computers? Factual determinations are endless in variety, yet CPI rests on the concept of ever-expanding business classifications to produce relevant comparisons. In addition, the regulations should clarify the extent of permissible groupings of both controlled affiliates (e.g., all non-tax-haven companies) and the uncontrolled parties that are similar to the tested party. (41) To the extent segment information reporting is the basis for the mistaken reliance on ROA, TEI notes that only identifiable assets are allocated in segment data. Shared assets are rarely allocated or apportioned among business segments. Even segment data, however, will include multiple product and geographic markets as well as different business functions. (42) A comparable profit split may be used only if reliable financial data are available for comparable uncontrolled taxpayers that allow a computation of combined profit for the uncontrolled parties and the determination of a profit-split percentage. Another limitation on the use of this PLI is that the functions performed by each of the uncontrolled parties must be the same as those performed by the corresponding controlled party. Furthermore, the combined rate of return of the uncontrolled parties must be very similar to the combined return on assets of the controlled parties. Finally, the intangible used by the uncontrolled parties must not differ materially from the intangibles used by the controlled parties. (43) Preamble, 1992-8 I.R.B. at 29. (44) 78-1 U.S.T.C. [paragraph] 9374, at 83,910 (Cl. Ct. 1978), aff'd, 608 F.2d 445 (Ct. Cl. 1979), cert. denied, 445 U.S. 962 (1980). (45) At a minimum, these safe harbors should operate as rebuttable presumptions in favor of the taxpayer. (46) Conference Report at II-637; House Report at 423; General Explanation at 1013-14. (47) Similarly, dispositions of property to an unrelated party within a reasonable period of time after such property is acquired from a related party are evidence of arm's length transactions. (48) CUP or MTM arguably applies in these cases, but because of the severe restrictions placed on those methods, we believe it important that the regulations address these fact patterns as safe harbors. (49) 1988-2 C.B. at 474. (50) The IRS could impose safeguards by requiring that the facts and circumstances of the transfer subject to scrutiny be similar in size and scope to the transactions examined previously. (51) This would be particularly appropriate in the case of a longstanding cost-sharing agreement that had been examined in multiple audit cycles. (52) The proposed regulations do not seem to fully appreciate the long delay between conducting research activity and reaping its reward. The research and development work may not pay off for ten or more years. The longer the development period (or the lag between developing an intangible and exploiting it), the more difficult it will be to establish that the benefits are attributable to a particular research and development project cost. The complexity of establishing what benefit comes from particular intangibles grows exponentially where multiple intangibles are developed from a single project or multiple phases in the development and refinement of a single intangible. (53) Cost-sharing payments, of course, do not extract a profit element from the payor. Therefore, the principal issue for tax authorities around the world is whether the degree of benefit conferred on the payor-participant justifies the allowance of a deduction. (54) While cost sharing is usually employed in the context of related parties, there are a number of third-party arrangements, such as research partnerships, for which IRS regulatory guidance has been provided. See, e.g., Treas. Reg. [sub-section] 1.41-2(a)(4)(ii) and (iii). (55) Example (2) of Prop. Reg. [section] 1.482-2(g)(4)(ii)(E). (56) The legislative history supports this view: In revising Mon 482, the conferees do not intend to preclude the use of certain bona fide research and development cost-sharing arrangements as an appropriate method of allocating income atttibutable to intangibles among related parties, if and to the extent such agreements are consistent with the purposes of this provision that the income allocated among the parties reasonably reflect the actual economic activity undertaken by each. Conference Report at II-638 (emphasis added). The Treasury Department and Internal Revenue Service's "Report on the Application and Administration of Section 482," which was released April 9, 1992, reiterates this theme in Chapter 4 on Administrative Developments. (57) Prop. Reg. [section] 1.482-2(g)(4)(ii)(A). (58) Prop. Reg. [section] 1.482-2(g)(2)(C)(2). The proposed regulations permit a taxpayer to substitute alternative reference period to measure the operating income where it can establish a lag period between the costs incurred and benefits produced. (59) If a member of a group of controlled taxpayers acquires an intangible from another member other than an a participant in a qualified cost-sharing arrangement, the district director may make allocations under the rules for arm's length transfers of intangible property prescribed in Prop. Reg. [section] 1.482-2(d). See Prop. Reg. [section] 1.482-2(g)(1)(i). (60) Government subsidies and location savings should be allocable directly to the operating income of the participant that benefits directly from them. (61) Example 2 of Prop. Reg. [section] 1.482-2(g)(4)(ii)(E) acknowledges that the economic functions performed by the parties win limit the application of the cost/income ratio. Yet, the example employs the cost/income ratio to find the agreement is not "substantially disproportionate," limiting the adjustment to a reallocation of costs. (62) The example implies that a cost-sharing agreement is disqualified where the cost/income ratio is grossly disproportionate and no effort is undertaken to amend the agreement. If the general rule for disqualification of a cost-sharing agreement is a conjunctive test, TEI recommends that Prop. Reg. [section] 1.482-2(g)(2)(ii)(C)(1) be clarified to expressly state this. TEI believes such a clarification would provide a proper shield from the inadvertent disqualification of cost-sharing arrangements. (63) See, eg., Treas. Reg. [section] 1.924(d)-(1)(e)(1)(i). (64) Indeed, in uncontrolled cost-sharing agreements, the continuing participants often seek to sue the departing party for breach of the agreement. (65) See Prop. Reg. [section] 1.482-2(g)(4)(iv)(D), Examples (4) and (5). (66) 1988-2 C.B. at 499, n. 232. (67) Example (2) in Prop. Reg. [section] 1.482-2(g)(4)(iv)(D) illustrates the application of the buy-in rules. The example covers a cost-sharing agreement to develop a commercially feasible process of capturing energy from nuclear fusion. In year 10, a new participant joins the group and pays the other participants their pro-rata share of the fair market value of the intangible. The example concludes that "the principles of paragraph (d) of this section may be used to determine whether the new member's payment was commensurate with the income attributable to any intangible that is eventually developed." The example suggests that the sole consideration a new participant may pay to the existing participants is a cash entry fee (be it current, deferred, or contingent). In similar uncontrolled transactions, however, a new participant's commitment to shoulder part of any significant future costs for the development of a high-risk intangible may be accepted as sufficient consideration. The application of a commensurate with-income complete to any stage of an incomplete intangible is unreasonable. (68) Any required modification to the cost-sharing allocation should be prospective from such point in time. (69) Preamble, 1992-8 I.R.B. at 29. (70) There may be slightly inconsistent treatment among U.S. controlled groups, but TEI believes that this in likely to be immaterial because International Accounting Standards are dose to U.S. GAAP standards. Furthermore, the key to evaluating a cost-sharing agreement in consistency within the group. (71) The use of tax accounting principles would be especially burdensome in the likely situation where the parties are subject to different tax regimes. If the IRS mandates that U.S. tax accounting principles apply, an unreasonable requirement would be imposed on the non-U.S. participants to a cost-sharing arrangement. Furthermore, the cost-sharing agreement may be invalidated in foreign jurisdictions that impose their own cost accounting rules. (72) We are still evaluating the effect of the recently proposed regulations on the computation of earning and profits of foreign subsidiaries. For a U.S. subsidiary of a foreign parent, our comments appear valid. (73) If the IRS requires that currency gain or lose to be computed as part of the cost-sharing payment, TEI recommends that taxpayers be permitted to adjust the cost/income ratio for the reasons described in the text. Hence, any currency gain or loss would be considered as an additional cost of developing intangibles or as reimbursement for the same kind of cost. Such an increase in cost or reimbursement, however, should be excluded from the cost/income ratio to avoid any unexpected shifts in that ratio by reason of factors beyond the control of the participants. (74) The White Paper states (1988-2 C.B. at 471, n. 99): "Location savings were specifically authorized for certain Puerto Rican affiliates by Rev. Proc. 63-10, 1963-1 C.B. 490, 494. Location savings do not otherwise accrue to an affiliate, but under the arm's-length standard are distributed as the market place would divide them. (75) In addition, the revenue impact of the section 482 proposed regulations would greatly exceed the anticipated revenue gain from the 1986 changes with respect to cost-sharing elections by possessions corporations, which we understand to have been $20 million. (76) Under section 1059A, the purchaser of property imported into the United States may not increase the basis or inventory cost of such property to an amount greater than that taken into account when computing the customs value of the property. The customs value of imported property becomes final 90 days after liquidation, which occurs on the date of payment of the duties.
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