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Proposed section 6038A regulations: new recordkeeping, information reporting, record production, and translation requirements with respect to transactions between a foreign-owned U.S. corporation and its foreign related parties.

Proposed Section 6038A Regulations: New Recordkeeping, Information Reporting, Record Production, and Translation Requirements With Respect to Transactions Between a Foreign-Owned U.S. Corporation and Its Foreign Related Parties

A. Overview

In December 1990, The Internal Revenue Service issued proposed regulations implementing 1989 and 1990 amendments to section 6038A of the Internal Revenue Code and the 1990 addition of section 6038C. Under the proposed regulations, in the case of a U.S. corporation (reporting corporation) (1) which is owned at least 25 percent by a foreign shareholder, that shareholder and any related party, especially a foreign related party, directly or indirectly involved in transactions with the reporting corporation, will be required to maintain (and produce and translate when demanded by the IRS) extensive records relating to such transactions as specified in the regulations.

One proposed requirement for particular concern involves the keeping of, or creating where not otherwise maintained, combined industry segmented profit and loss statements, referred to as "material profit and loss statements." The industry segments are based on product lines, products, or models. Generally, materiality depends on the amount and percentage of gross revenue derived by, or assets used by, or operating profit of, the related party group with respect to sales to third-party customers of U.S.-connected products. In addition, the proposed regulations make sweeping demands for maintaining foreign documentation otherwise created, especially so-called "pricing documents" which are broadly defined to include "all documents relevant to establishing the appropriate price or rate for transactions between the reporting corporation and any foreign related party," and then broadly illustrated by example, encompassing virtually all records potentially related to establishing transfer prices, including records that might have limited or no utility in the particular case.

Amelioration of the extensive burdens from such recordkeeping requirements could result from agreements with the District Director or the Assistant Commissioner (International) which are available to particularize the recordkeeping obligations of related party groups, or from the "final" regulations (given that final regulations are sometimes less burdensome that the proposed regulations). Indeed, in many cases the particular agreement approach should be tested.

Recordkeeing is not the extent of the potential burden. The production and translation of the records maintained could well be at least equally burdensome, depending on the restraint used by the IRS in demanding foreign records. Although high IRS officials have informally suggested that there would be internal restrictions on the demands made for foreign records, the proposed regulations do not address that question. It is important that the restraints be issued before or at the same time as the final regulations. In particular, there is concern that International Examiners might generically request or summons "pricing documents" for the particular transfer prices being reviewed. Such a request or summons would be extraordinarily broad.

Accordingly, there should be an official directive that (i) there will be no generic requests or summonses for "pricing documents"; (ii) generally request will not be overbroad and burdensome and must identify the records with sufficient specificity to permit adequate response to the request; and (iii) there will be high-level review of whether, and the extent to which, foreign documents and translations should be demanded. In this connection, the Senate Finance Committee Report accompanying the foreign recordkeeping proposals generally required that where records of a related party are obtainable in a timely and efficient basis under the information exchange procedures provided under a tax treaty, the IRS generally would make use of such procedures before issuing a summons to the designated agent on behalf of the related party. (In speeches, IRS officials have stated that there will be supplements to the Internal Revenue Manual addressing these issues.)

Finally, thought should be given to the substantive use the IRS will make of the records that are produced and translated, given the current uncertainty about the pricing method or methods which should be used in any given situation to arrive at acceptable transfer prices. The requirement for material profit and loss statements by industry segments clearly suggest that the IRS will emphasize the profit split method, at least as a check. It should be noted that profit split is not a priority method in the existing regulations; profit split is the method of last resort in the Treasury and IRS's October 1988 Transfer Pricing White Paper; profit split has low international acceptability; and identifying the combined profit does not indicate how the profit should be split. In any event, given the mass of records soon to be available to the IRS, the Treasury Department should accelerate the process of issuing proposed revisions to the section 482 regulations in order to narrow the methods that need to be considered in any given situation. Similarly, the acceleration of the Advance Pricing Agreement (formerly Advance Determination Ruling) procedures could effectively keep the records explosion under control for those taxpayers seeking advance guidance.

In addition to monetary penalties, failure to designate the reporting corporation as a limited agent to comply with an IRS summons (not quashed by a District Court) issued to the reporting corporation for production and translation of records of the reporting corporation or a foreign related party, or failure of the reporting corporation or a foreign related party to maintain required records such that a summons is quashed, wouldd empower the IRS to make adjustments to the cost of goods and deductions under review in its "sole discretion," with only limited jucidial review.

This article analyzes the provisions of the proposed regulations comments on their overall feasibility, and discusses problems associated with assuring compliance with the proposed regulations. (2)

B. Background

The proposed regulations set forth proposals on how the IRS and Treasury would implement the 1989 and 1990 amendments to section 6038A and the 1990 addition of section 6038C which imposed recordkeeping, reporting, and record production obligations on a reporting corporation (generally, a U.S. corporation at least 25 percent owned by a single foreign shareholder after application of attribution rules, and foreign corporations engaged in a U.S. trade or business). The reporting corporation is required to maintain, or cause to be maintained, records of its transactions and those of related parties, including foreign related parties, from which the "correct treatment" of its intercompany transactions with any foreign related party can be determined by the IRS. (3)

The principal aim of the legislation was to facilitate the task of the IRS in enforcing U.S. transfer pricing (4) rules under section 482 of the Code and to enable the IRS to reach records of the foreign related parties directly or indirectly involved in transactions with the reporting corporation by imposing recordkeeping requirements on the reporting corporation that include such records of the foreign related parties.

A related party broadly includes the (or any) 25-percent foreign shareholder of the reporting corporation; any entity, foreign or domestic, which is related within the meaning of section 267(b) or section 707(b)(1) to the reporting corporation or the (or any) 25-percent foreing shareholder; or any other person who is related to the reporting corporation within the meaning of section 482. A corporation filing a consolidated income tax return with the reporting corporation, however, is not considered to be a related party for purposes of these regulations. Certain attribution rules apply in determining whether a corporation is 25 percent foreing owned or is a related party under section 6038A, including special look-through rules for partnerships.

To overcome the defense of a U.S. reporting corporation that it cannot produce records of a foreign related entity which it does not control, the legislation requires each foreign related party to designate the reporting corporation as its limited agent to furnish records and testimony (5) in response to demands and summonses issued by the IRS.

C. Effective Dates

None of the provisions of the section 6038A amendments and section 6038C are self-executing, but become effective in accordance with regulations. Proposed regulations are not effective for this purpose. Accordingly, there are no rules in effect at the present time. Nevertheless, when the proposed regulations become final, the present intent is apparently to apply them retroactively, covering all "open" tax years.

The proposed regulations state that the record maintenance requirement "is generally effective as of December 10, 1990. Records in existence on or after March 20, 1990, however, must be maintained without regard to when the taxable year (to which the records relate) began." While the quoted language is not clear, it would seem to mean:

* Records that are required to be maintained by the regulationsd and that actually existed any time on or after March 20, 1990, must be maintained for the periodd specified in the regulations. (The record retention period is discussed below.)

* Records that are required to be maintained by the regulations relating to events taking place on or after December 10, 1990, must be maintained, or created and maintained, for the period specified in the regulations. (This category overlaps the first category except for records not otherwise maintained.) (6)

With respect to the record production requirement (by demand or summons), the translation requirement, penalties, etc., if the effective date provisions are adopted as proposed, the practical effect would be that once the final regulations are issued, these provisions are applicable for all open tax years.

The proposed regulations would somewhat expand the information to be reported on Form 5472. The expanded form is to be used for taxable years beginning after July 10, 1989.

D. Form 5472

1. In General

Under section 6038A as in effect prior to the 1989 and 1990 amendments, a reporting corporation was generally required to file separate information returns on Form 5472 with respect to each related corporation (expanded to each related party in the proposed regulations) with which it had a reportable transaction of the kind listed in current Treas. Reg. [section] 1.6038A-1(c)(2). Included in the transactions subject to reporting are: sales and purchases of stock in trade and other tangible property, commissions, interest (and the principal of loans and advances, except for normal open account transactions otherwise reported), royalties, and consideration for technical, managerial, and other services. (7) Under the proposed regulations, the reporting corporation will be required to continue to file Form 5472, but for taxable years beginning after July 10, 1989, the information required would be somewhat expanded. (8)

Form 5472 was revised in November 1990 to reflect both the recent legislative changes concerning sections 6038A and 6038C and the 1986 addition of section 1059A, which limits the transfer price that an importer may claim for U.S. income tax purposes to that which would be consistent with the value claimed for customs purposes. The revised from also requires information on the 25-percent foreign shareholder and any other foreign or domestic party related to the reporting corporation. In addition to the nine categories of transactions required to be disclosed on old Form 5472, the new form adds a tenth catch-all category to require disclosure of any other amounts paid or received that are not specifically identified or listed in the other nine categories.

Under revised Form 5742, a reporting corporation that imports goods from a foreign related party must disclose whether its inventory costs for such goods are different from the costs taken into account in computing the customs value of the goods (adjusted pursuant to section 1059A) and, if so, the reason for the difference. Furthermore, the revised form requires the reporting corporation to state whether the documents supporting its conclusion on the congruity of its treatment for tax and customs purposes are in existence and available in the United States at the time the Form 5472 is filed. Accordingly, each reporting corporation should establish procedures that compare its inventory cost and the customs value reported and account for any differences. For example, international freight and insurance charges are not subject to customs duties but are included in inventory costs. Although many reporting corporations may have previously assumed that they have not violated the requirements of section 1059A, they now have to make an affirmative declaration to that effect and state whether the applicable documentation exists.

The proposed regulations provide for furnishing of the information now included in the revised Form 5472 and would, in addition, require information regarding (i) the total assets of the reporting corporation; (ii) where its business is conducted; and (iii) the aggregate value in U.S. dollars of gross payments made with respect to (or received in connection

with) all foreign related party transactions as reported in a new Forum 5472 to be issued in connection with the final regulations, along with the election and authorization set forth in Appendices A and B to this article.

As presently required, Form 5472 is to be filed with the reporting corporation's income tax return by the due date, including extensions, for filing the income tax return. A copy of Form 5472 is also to be sent to the IRS Service Center in Philadelphia, Pennsylvania. It is assumed that the present Form 5472 will be amplified in a timely fashion to reflect the new requirements.

2. Foreign Banks

Under the proposed regulations, effective as of December 10, 1990, a reporting corporation (including a foreign corporation) whose sole trade or business in the United States is a banking, financing, or similar business as defined in regulation section 1.864-4(c)(5)(i) must file Form 5472. Under currently applicable rules, such enterprises have not been required to file Forms 5472.

E. General Rule on Records That Must Be

Maintained and Safe Harbor

Prop. Reg. [section] 1.6038A-3(a)(1) sets forth the basic rules concerning the maintenance of records, as follows:

(a) General maintenance requirements. -- (1) Section 6001 and section 6038A. A reporting corporation must keep the permanent books of account or records as required by section 6001 that are sufficient to establish the correctness of the federal income tax return of the corporation, including information, documents, or records ("records") to the extent they may be relevant to determine the correct treatment of transactions with related parties. See section 6001 and the regulations thereunder. This requirement applies to records of the reporting corporation itself, as well as to records of any foreign related party that may be relevant to determine the correct treatment of transactions between the reporting corporation and foreign related parties. While records required to establish the correct tax treatment of transactions between the reporting corporation and foreign related parties are within the scope of section 6001, section 6038A and this section provide detailed guidance regarding the required maintenance of records with respect to such transactions and specifies penalties for noncompliance.

Thus, the proposed regulations start with the proposition that reporting corporations are subject to the general recordkeeping requirements of section 6001 of the Code. Those requirements, moreover, ecompass records relevant to determining the treatment of transactions with related parties. Under the authority of section 6038A, the general rule applies to the relevant records of the foreign related parties as well as to the records of the reporting corporation. The record maintenance requirements of the proposed regulations do not apply to the records of a foreign government or a controlled commercial entity (controlled by a foreign government, as provided in section 892(2)(B) of the Code). Nevertheless, if a controlled commercial entity otherwise qualifies as a reporting corporation, it must file Form 5472.

With respect to the records that must be maintained in connection with reporting corporation transactions with related parties, there are at least two regimes for maintenance, and apparently a third:

* There is the "safe harbor" regime under which the record maintenance requirements of section 6038A will be deemed to be met if six categories of records are maintained (together with all internal records storage and retrieval systems). The safe harbor regime is discussed in part F of this article.

* There is also a particular agreement regime under which a particular agreement with the District Director or the Assistant Commissioner (International) can establish recordkeeping requirements that substitute for those provided in the regulations. This is discussed in part H of this article.

* There also appears to be a section 6001 regime under which the reporting corporation maintains the records generally required by the regulations under section 6001, with section 6038A and the regulations thereunder not altering the requirements of which records must be maintained other than as a result of extending the recordkeeping requirements to the foreign related parties. The proposed regulations, however, are not clear and it may be that it is intended that the "safe harbor" is not a true safe harbor, but rather intended as mandatory. (9)

It is clear under the language of sections 6038A and 6038C that the IRS has the authority to establish mandatory requirements, and is not required to have a section 6001 regime. In spite of this authority, the proposed regulations -- particularly through the use of the term "safe harbor" -- suggest that the IRS does not intend to exercise that authority, and that taxpayers can meet their obligations by complying (along with their foreign related parties) with the general requirements of the section 6001 regulations. The final regulations should clarify the point.

If there is a section 6001 regime, reporting corporations can forgo the protection of the safe harbor and, in such circumstances, would not be required to create records not otherwise produced in order to be able to furnish material profit and loss statements. This is because the regulations under section 6001 do not generally require the creation of specific records, and do not require the creation of material profit and loss statements. Also, some of the other safe harbor requirements may go beyond what is required under section 6001. Particularly some of the types of records listed under the pricing documents category would not normally be the type of financial records that one would think have to be maintained for tax purposes. But the scope of what is required under the section 6001 regulations is far from clear. As a practical matter, any reporting corporation that fails to produce a record in one of the six categories on the ground that it has not chosen the safe harbor regime can expect to have an adverse reaction from the IRS and, therefore, its obligations under section 6001 are likely to be severely tested. A safer strategy between the safe harbor and the unstructured approach for a reporting corporation that chooses to rely on section 6001 would be to maintain all types of documents listed in the safe harbor categories (including pricing documents) except for the material profit and loss statements. Many reporting corporations, however, might decide that they would be better off proceeding under the safe harbor in order to avoid the basic issue of section 6001's scope. The approach of the taxpayer is likely to depend on its particular philosophy of cooperation with the IRS.

As previously stated, the IRS can clarify the issue in the final regulations but may choose not to do so. The suggestion has been made, both in the proposed regulations and informally, that the safe harbor categories can be viewed as merely informing foreign related parties about U.S. recordkeeping requirements (section 6001) and practices. If the IRS expressly states that the six categories of records must be kept regardless of whether they are required by section 6001, then it loses its ability to argue that section 6038A is nondiscriminatory with respect to foreign-owned U.S. corporations. Moreover, if discrimination is established, it may constitute a treaty violation, and since section 6038a does not clearly override treaties, it could be that treaty protection would apply.

On the other hand, the IRS may be reluctant to clarify that reporting corporations can forgo the protection of the safe harbor since it clearly hopes that reporting corporations will be able to produce records in the six safe harbor categories. Even though the IRS might decide not to clarify the issue in connection with the proposed regulations, should litigation develop it would be very difficult for the IRS to proceed without taking a position on whether the six safe harbor categories are mandatory.

The practical solution for taxpayers may be a particular agreement with respect to records required to be maintained, assuming that the IRS is willing to enter into such agreements on reasonable terms.

Finally, it should be emphasized that regardless of the recordkeeping requirements, any record relevant to determining transfer prices that is actually in the hands of the reporting corporation or a foreign related party at the time a proper summons is issued is subject to production.

F. The Six Safe Harbor Categories

The proposed regulations list, as a "safe harbor," six categories of records that, if kept, would be treated as meeting the record maintenance requirements under section 6038A. In addition, the proposed regulations require that all internal records storage and retrieval systems used for each taxable year be retained.

The proposed regulations provide that, with respect to four of the six "safe harbor" categories of records, (10) there is no requirement to create that are ordinarily not created by the reporting corporation or its related parties. Where records in these categories exist, however, they must be maintained. The two exceptions with respect to which records must be created if not ordinarily maintained are (i) basic accounting records and (ii) records to produce "material profit and loss statements."

It is noted that the proposed regulations state that records not applicable to the business of the reporting corporation and any foreign related party need not be maintained. Also, the requirements are limited to the types of documents that are directly or indirectly related to transactions between the reporting corporation and any related party and relevant to obtaining proper transfer prices. While these statements evince an intent to ameliorate the requirements, they will have little practical effect unless they are reflected in recordkeeping agreements (discussed below) that reflect particular pricing methods.

The six "safe harbor" categories will be discussed in turn, starting with the two categories with respect to which records must be created if not already maintained:

1. Original Entry Books and Transactions Records

Original entry books and transaction records include U.S. and foreign records such as general ledgers, sales journals, purchase order books, cash receipts books, cash disbursement books, canceled checks and bank statements, work papers, sales contracts, and purchase invoices that are relevant to transactions between the reporting corporation and any foreign related party. These are the types of records normally kept by reporting corporations and foreign related parties so that there would appear to be little problem in the first instance. Even this basic category, however, presents formidable problems, including the following:

First, such records must be kept as long as they may be relevant to determine the correct U.S. tax treatment of transactions with the reporting corporation, and in no case less than the applicable statute of limitations for the taxable year in which the transaction took place. Since foreign record retention periods tend to be shorter than U.S. record retention periods, this could present a serious problem.

Second, as a condition to keeping these records outside of the United States, they must be produced within 60 days of a demand by the IRS, unless an extension is provided for good cause.

2. Material Profit and Loss Statements

a. In general. This category that may require creation of records is of principal concern. The proposed regulations require underlying records from which the reporting corporation can prepare "material profit and loss statements" of the reporting corporation and all related attributable to "U.S.-connected products or services" - that is, products (or services) imported to, or exported from, the United States by transfers between the reporting corporation and any foreign related party. Those statements must apparently reflect the revenue and expenses of all members of the related group directly or indirectly involved in a transfer involving the United States entity, including records of the cost of raw materials or components produced by one related party and sold to a second related party for use in manufacturing finished goods that are sold to the reporting corporation. A reporting corporation, of course, may have a number of related parties involved, for example, in manufacturing at various stages and selling to it the goods that it imports; it is understood that the costs of all related parties must be reflected in a single combined profit and loss statement for each industry segment and that transactions between related parties are eliminated in the combination process. This follows the approach used for DISC and FSC purposes.

The records to produce the material profit and loss statements should be kept under U.S. generally accepted accounting principles if they are normally maintained in such manner. If foreign accounting principles differing from U.S. generally accepted accounting principles are used, an explanation must be furnished on the material differences between the two types of accounting principles.

The proposed regulations do not actually require that material profit and loss statements be created prior to a demand or summons of the IRS if they are not otherwise maintained. Rather, the regulations require that the underlying records that would be needed to produce materials profit and loss statements be kept. Since material profit and loss statements must be delivered to the IRS within 120 days after demand, however, the proposed regulations would appear to require a system under which the material profit and loss statements could be produced within that period. While the proposed regulations provide for extensions, it could be that extensions are only available for unanticipated problems, and that the foreign related party is required to establish a system for a 120-day turnaround time.

The material profit and loss statement is designed to furnish a segmented profit and loss statement that relates to certain product lines, products, or models, generally depending upon the statements otherwise maintained, the amount of sales, or assets used, or operating profit attributed to, the particular product line, product, or model. A profit and loss statement will be material if it meets (i) the existing records test, (ii) the significant industry segment test, or (iii) the high-profit test. These three tests are discussed seriatim.

b. Existing records test. If a profit and loss statement was prepared by any member of the related party group in the course of its business operations, that statement is material and is required to be available where the statement reflects to any extent the profit and loss of the related group attributable to U.S.-connected products or services. Included in this category might be statements produced for internal accounting or management pruposes, or for disclosure to shareholders or financial institutions or government agencies.

c. Significant industry segment test. The significant industry segment test provides that a profit and loss statement of the related party group will be material where the following three conditions are present:

i. Single industry segment. The statement would reflect the profit and loss of the related party group attributable to a "single industry segment," that is, a segment of the combined operations of the related group in providing groups of products (properly classified as a product line), products, or models

(or components therefor) to third parties not members of the related group, determined under "level of specificity" rules that essentially require that the test be applied to the narrowest potential industry segment that meets the three tests.

ii. Gross revenue. The gross revenue from the U.S.-connected products (or services) attributable to the industry segment sold to third parties is $25 million or more in the taxable year. If components are involved that are included in other products before sales to third parties, the total gross revenue attributable to the components is to be determined by a fraction, based on production costs of the related party group attributable to the component products over the production costs of the related party group attributable to the finished products in which the components are incorporated. That fraction is applied to the gross revenue from sales of the finished products to third parties to determine whether the $25 million amount has been met.

iii. Percentage tests. The third condition to be met requires that (a) the gross revenue from an industry segment is 10 percent or more of the combined gross revenue of all of the group's industry segments, (b) identifiable assets are 10 percent or more of the combined identifiable assets of all industry segments, or (c) the operating profit or operating loss of the industry segment is 10 percent or more of the combined operating profit of all industry segments that resulted in a profit or a loss.

d. High-profit test. A third test is designed to permit the IRS to focus on very profitable products. A material profit and loss statement is to be produced with respect to an activity that yields a particularly high profit. This test applies where the revenues from U.S.-connected products (or services) attributable to the particular industry segment total $75 million or more, and the return-on-assets for the industry segment involved exceeds 10 percent and is at least 200 percent or more of the rate of return-on-assets earned by any significant industry segment that incorporates the business operations of the narrower industry segment being tested for high profits.

e. Summary. Under the material profit and loss statement requirements of the regulations, profit and loss statements are to be a vailable for the greatest number of separate industry segments that meet the significant industry segment test. This means that products imported to or exported from the United States are to be grouped into product lines (products aggregated into a single classification) (11) and tested to determine whether they qualify, standing alone, as significant industry segments, and, if so, each product line is to further tested to determine whether it can be divided into one or more significant industry segments at the level of separate products. (12) The separate products are then to be further tested at the level of separate models. Finally, if a narrower industry segment would meet the high-profit test, the narrower statement must be readied even if the narrower segment, standing alone, would not meet the sigment industry segment test.

As illustrated by the example below, the material profit and loss statements required may well be overlapping. Thus, there may be a material profit and loss statemet of a product line, a product, and a model, all of which contain the same data, as long as at each level the requirements are met.

Although reporting corporations might be inclined to meet the material profit and loss statement in the most expeditious manner possible (without giving a great deal of thought to the myriad judgments that are relevant in preparing such statements), these statements should be prepared and presented with the utmost care. They will, after all, b used by the IRS as a basis for proposing tax adjustments.

One of the greatest difficulties in complying with the material profit and loss requirement may be determining the industry segments for which they are required. Accordingly, in addition to the general possibility for record retention agreements with the District Director or the Assistant Commissioner (International), the proposed regulations specifically provide for agreements identifying the statements required and describing the items to be included therein.

Material profit and loss statements are a major element of the recordkeeping requirement for a reporting corporation that imports products into the United State or exports products from the United States by way of transfers between it and any of its foreign related parties. In contrast, where the reporting corporation does not engage in such transactions, material profit and loss statements would not be required. For example, if the reporting corporation is the licensee of technology of foreign related parties, such statements would not be required.

f. Examples. The proposed regulations illustrate the industry segment process by examples involving the automobile industry and the electronics industry.

Example (1). A related party group is engaged in the manufacture and worldwide sales of automobiles and aftermarket parts. The group's operations within the categories of "automobiles" and "aftermarket parts" are each sufficient to constitute significant industry segments for the group under the rules of paragraph (c)(5) of this section. No narrower classification of aftermarket parts results in any significant industry segments. Automobiles produced by the group are generally classified for marketing purposes by trade names; aggregating groups of automobiles by these trade names results in three significant industry segments, those for trade names A, B, and C. Finally, two car models sold under the trade name A ("A1" and "A2") and one car model sold under the trade name B ("B3"), produce sufficient revenue to constitute significant industry segments. Such classifications into trade names and car models are generally used in the related party group's industry; moreover, different types of classifications would produce fewer significant industry segments. Accordingly, a reasonable level of specificity for this related party group's industry segments would be eight categories of products consisting of "automobiles", "aftermarket parts", "A", "B", "C", "A1", "A2", and "B3".

Example (2). A related party group is engaged in manufacturing electronic goods that are distributed at retail in the United States by the reporting corporation. The group sells three types of products in the United States: televisions, radios, and video cassette recorders (VCRs). Each of these three broad product areas constitutes a significant industry segment for the group as a whole. VCRs can be further segregated by price into high-end low-end models, and the provision of each constitutes a significant industry segment for the group. Revenues from only one VCR model, model number VCRX-10, are sufficiently large to make the provision of that model a significant industry segment. With respect to televisions, the group normally accounts for these products by size. Using this classification, portable televisions, medium-sized televisions, and consoles each constitute significant industry segments. Narrower classifications by television model numbers result in no additional significant industry segments. Finally, sales of a single radio product line, those sold under the trade name R, result in a significant industry segment, but no other radio models or product groups are large enough to constitute a significant industry segment. In each case, these classifications conform to normal business pratices in the industry and result in the greatest possible number of significant industry segments for this related party group. Accordingly, a reasonable level of specificity for this related party group's industry segments would include the ten categories consisting of "VCRs", "high-end VCRs", "low-end VCRs", "model number VCRX-10", "televisions", "portable televisions", "medium-sized televisions", "console televisions", "radio", and "radio trade name R".

3. Pricing Documents

To the extent otherwise created, "pricing documents" are all documents relevant to establishing an appropriate transfer price or rate for transactions between the reporting corporation and any foreign related party. Included as examples are --

* documents related to transactions involving the same or similar products or services of a reporting corporation or a foregn related party with related and unrelated parties;

* shipping and export documents;

* commission agreements;

* documents relating to production or assembly facilities;

* third-party and intercompany purchase invoices;

* manuals, specifications, and similar documents relating to the performance of functions conducted at a location;

* intercompany correspondence dealing with instructions or assistance provided to the reporting corporation by the related foreign person (or vice versa);

* Intercompany and intracompany correspondence concerning transfer prices or negotiation of such prices;

* documents regarding the value of intangibles used or developed by the reporting corporation or the foreign related party;

* documents regarding the direct and indirect costs of material, labor, cost of goods sold, and other expenses; and

* documents relating to direct and indirect selling, and general and administrative expenses such as advertising, sales promotions, or warranties.

This list seems to cover just about every document that conceivably could have an impact on a transfer price examination. As discussed in connection with original entry books and transaction records, the difficult problems will be storing the records after the time when they would otherwise be discarded and producing and translating the records upon demand or summons by the IRS within the time periods contemplated by the proposed regulations. Of course, the extent to which the production and translation process will be onerous depends upon the number and scope of demands and summonses.

4. Foreign Country and Third-Party Filings

In addition, the proposed regulations require that there be maintained financial and other documents filed with a foreign government entity, independent commission, or financial institution that relate to transactions between the reporting corporation and the foreign related party.

5. Ownership and Capital Structure Records

To the extent otherwise created, included in this category are organizational and other charts or records showing the relationship between the reporting corporation and foreign related parties; the location, ownership, and description of all entities and offices directly or indirectly involved in transactions between the reporting corporation and any foreign related party; a worldwide organizational chart; records showing the management structure of all foreign affiliates; and any documents relating to the transfer of stock of the reporting corporation that results in the change of the status of a foreign person as a foreign related party.

6. Records of Loans, Services, and

Other Non-Sales Transactions

To the extent otherwise created, included in this category are records of loans, including third-party loans, relating to transactions between the reporting corporation and a foreign related party; guarantees of debts of the reporting corporation by a foreign related party (or vice versa); hedging and security arrangements between the reporting corporation and a foreign related party; research and development expense allocations; arrangements for furnishing services; patent and copyright registrations; and lawsuits in foreign countries that relate to intercompany transactions.

This category emphasizes the fact that it is not only the foreign related party that sells to or buys from a U.S. reporting corporation that must maintain records and comply with the other requirements of the proposed regulations. The proposed regulations apply, for example, to foreign related parties that make or guarantee loans to a reporting corporation (frequent in the case of real estate transactions), license intangibles to a reporting corporation, are parties with a reporting corporation in a research and development costsharing arrangement, provide services to the reporting corporation, etc. But such types of transactions do not engender the requirement to keep records from which material profit and loss statements could be produced.

G. Retention Period

Records are to be kept as long as they may be relevant to determine U.S. federal tax liability of the reporting corporation with respect to a transaction with a related party, but in no case less than the statute of limitations on assessment and collection for the taxable year for which the transaction affects the tax liability of the reporting coporation.

While the basic statute of limitations for assessment of federal income taxes in the United States is three years from the time the return in filed, the IRS routinely asks for extensions and the practice of most taxpayers is to grant such extensions. Accordingly, it is not unusual for transfer pricing cases to be open for ten years or more after the year in which the transactions took place, which means that records would have to be kept for at least that period. With respect to records that must be kept after the statute of limiatations for assessment for the year in question has closed, important categories relate to the development of intangibles and the carryover of losses.

H. Recordkeeping Agreements with the District

Director or the Assistant Commissioner


The District Director or Assistant Commissioner (International) may, in his or her discretion, enter into an agreement with the reporting corporation specifying what records the reporting corporation must maintain, how those records are to be maintained, and by whom. Although the agreement will primarily cover the records of foreign related parties, there is no provision in the proposed regulations for the foreign related parties to be a party to such agreement.

The agreement can identify the material profit and loss statements of the related party group for which records are to be maintained and describe the items to be included in the profit and loss statements. The scope of the agreement, however, need not be limited to the material profit and loss statement requirement and can be comprehensive in scope.

Such agreement could potentially avoid the dragnet "safe harbor" list of required records and afford certainty about the records of a foreign related party that will satisfy the requirements of section 6038A. It remains to be ascertained, however, whether the IRS is prepared to administer the recordkeeping agreement procedure reasonably and realistically, or whether District Directors will typically require almost the full list of records to be maintained.

The proposed regulations do not specify which IRS office is to be contacted to enter into an agreement. The IRS has informally indicated that the agreements are to be negotiated with the IRS office having audit jurisdiction of the reporting corporation. Where the reporting corporation is a U.S. corporation, the District Director is to be contacted. In the case of a foreign corporation engaged in a trade or business in the United States, the Assistant Commissioner (International) is the negotiating official.

I. Place of Maintenance, Time to Produce

and Translate

In principle, the records, including records of foreign related parties, are to be maintained in the United States. The reporting corporation may elect, however, to maintain records not ordinarily maintained in the United States outside the United States. In such a case, the reporting corporation must agree to produce (by delivery to the IRS, or to a U.S. custodian providing access to the IRS along with an index) the records within 60 days of a request by the IRS and must agree to provide a translation of any portion within 30 days of a request for translation. The records may be maintained by the reporting corporation, the foreign related party, or a third party. Material profit and loss statements in English are to be provided within 120 days of an IRS request. For good cause shown, extensions of time to produce records and translations may be available on a case-by-case basis, especially where there has been a demand or summons for extensive records.

The election to keep records outside the United States must be made annually in a statement provided in or attached to the Form 5472 for the year, starting with filings after the section 6038A regulations become final. (Appendix A contains the lection form required by the proposed regulations.) In addition, in order to establish non-U.S. maintenance for documents that were in existence on or after March 20, 1990, pertaining to prior taxable years, a "retroactive" election is required and should be included with the first timely filed Form 5472 after the regulations become final.

The District Director or the Assistant Commissioner (International) may invalidate this election, but only if there exists a clear pattern of failure to maintain or timely produce required records.

J. Agency Designation

When the proposed regulations become final, each foreign related party that had a reportable transaction with the reporting corporation will be required to designate the reporting corporation to act as its limited agent. (13) (Appendix B contains the statement required by the proposed regulations.) This device has been created in order to provide the IRS with jurisdiction over the records of foreign related parties. The designation is to be made annually by a statement provided in or attached to Form 5472. For the taxable year for which Form 5472 was filed before the issuance of the final regulations, the designation is to be supplied when requested by the IRS. The designation is to be signed by both the foreign related party and the reporting corporation.

Under the proposed regulations, a foreign related party can supply one designation to the common parent of a group of reporting corporations filing a consolidated return, in lieu of separate designations for each reporting corporation with which it had transactions. But, so far, a separate designation is required from each foreign related party.

Apparently, once the regulations are issued in final form and the agency designation is filed, the agency will apply to any requests or summons issued by the IRS on or after December 10, 1990, with regard to any open tax year of the reporting corporation.

K. Hearing on the Proposed Regulations

A public hearing on the proposed regulations is to be held on February 22, 1991. In connection with the notice-and-comment process and the public hearing, the IRS specifically requested comments on certain points, including: (i) suggestions on "ways to permit related foreign corporations to file a single agency designation"; (ii) whether the varius tests for determining "material profit and loss statements" are appropriate, including case studies thereon; (iii) existing accounting and business practices for maintaining profit and loss statements; (iv) alternatives to the profit and loss statements standards to accompany objections thereto; and (v) whether a profit margin analysis should be substituted for a return-on-assets analysis for the high-profit test.

Taxpayers should endeavor to communicate their problems with the proposed regulations to the irs and Treasury. As long as final regulations have not been issued, the IRS generally considers comments (even if received after the end of the formal comment period). The more specific the analysis, the more likely it is to be taken into account.

L. Additional Comments on the Proposed


The proposed regulations in practical effect discriminate against foreign-controlled U.S. subsidiaries because they impose recordkeeping requirements of a type and to an extent that are not imposed on domestic corporations that are not foreign controlled. No IRS regulation provides what specific records a U.S. corporation (not foreign controlled) must maintain for income tax purposes, except in the case of some statutory provisions narrowly affecting certain specialized activities or entities. Thus, a domestic corporation that is not foreign controlled need not create records where the corporation's available records are sufficient to permit the determination of taxable income. Particularly, an uncontrolled domestic corporation could not be required to furnish a segmented profit and loss statement if it had not already prepared such a statement. (14) It could be argued that any discrimination that exists flows not from the regulations but from the 1989 and 1990 amendments to the Code. A review of the 1989 legislative history, however, suggests an intent that the overall effect of the statute and regulations not discriminate against foreign-owned companies as compared with U.S.-owned corporations.

While the record creation and record maintenance requirements in themselves might impose substantial difficulties, the more important potential for heavy burdens on taxpayers depends upon the practice that the IRS eventually follows in demanding and summonsing the records that have been maintained. To the extent that those demands and summonses are broad and general, they can create enormous burdens indeed. Such burdens would be exacerbated by the translation requirement. While taxpayers have the option of going to District Court to seek to reduce the obligations to produce records, historically District Courts have largely deferred to the views of the IRS on what is required to enforce the tax laws. Accordingly, self-restraint by the IRS is very much called for in this instance.

Finally, if the substantive transfer pricing rules were made more specific and clear guidance given to taxpayers in setting intercompany prices by methods that would satisfy the IRS, taxpayers and International Examiners would know what records are needed to comply with the rules. If such guidance were available in lieu of the general principles now contained in the section 482 regulations, there would be no need for the encyclopedic list of business records subject to production and translation now included in the proposed regulations. Also helpful would be the development of the Advance Pricing Agreement process that can provide guidance on a case-by-case basis. As matters now stand, the taxpayer could be required to produce a mass of records so that the International Examiner may scour for some material to support a pricing method that would result in an adjustment. Such a state of affairs hardly constitutes effective and efficient tax administration.

Stepping back, the real question is whether the burdens that would be required in maintaining, creating, producing, and translating records are necessary for the United States to operate an appropriate transfer pricing system. The proposed regulations present a substantial danger that masses of documents will be maintained, created, produced, and translated without substantially advancing the ability of the taxpayers and the IRS to set, review, and finally determine appropriate transfer prices.

(1) Under authority of section 6038C, the proposed regulations also apply to foreign corporations engaged in a U.S. trade or business, and such corporations are included in the definition of a "reporting corporation." The preamble to the proposed regulations states that additional regulations under section 6038C will be issued at a later time.

(2) This article does not discuss the exceptions for transactions with parties not known to be related. A de minimis rule exempts a reporting corporation from the record maintenance and authorization of agent requirements of the proposed regulations where the reporting corporation's payments made to (or received from) foreign related parties with respect to related party transactions have a value of not more than $2 million and the aggregate value of such payments is less than 10 percent of the reporting corporation's U.S. gross income. In such situations, however, the reporting corporation must still file a Form 5472 and comply with the general record maintenance requirements of section 6001. Taxpayer comments on this de minimis rule are specifically requested by the proposed regulations.

(3) With respect to foreign corporations engaged in a U.S. trade or business, the purpose is broader -- "to determine the liability of such corporation for tax."

(4) The term "transfer pricing" is used broadly to include all types of consideration in related party transactions, including, for example, royalties.

(5) The testimony point is important, but since it is not dealt with in the proposed regulations, it is not discussed in this article.

(6) The proposed regulations reflect Treasury's intent to make the record creation requirement in the final regulations apply retroactively to December 10, 1990, the date of publication of the proposed regulations in the Federal Register. This can result in an undue and unreasonable burden on taxpayers. Amended section 6038A provides that the reporting corporation "shall maintain (in the location, in the manner, and to the extent prescribed in regulations) such records as may be appropriate to determine the correct treatment of transactions with related parties as the Secretary shall by regulations prescribed (or shall cause another person to so maintain such records)." Fixing the date as of which the creation of records must commence at December 10, 1990, the date on which the proposed regulations were published, notwithstanding the uncertainty as to the record creation requirements in the final regulations, creates difficulties for taxpayers. Where records which the proposed regulatios provide are to be maintained have not been created by related foreign entities, it is unreasonable to expect those entities to arrange their recordkeeping procedures on the basis of proposed regulations. In particular, as will be developed in the text that follows, the proposed regulations provide that the reporting corporation must be prepared to compile and furnish "material profit and loss statements". A requirement to furnish such segmented profit and loss statements with a starting date of December 10, 1990, is unrealistic and an unnecessary hardship, when it is not yet known whether this requirement will be included in the final regulations. Moreover, it is not clear how one would apply this requirement starting on a date which is not the beginning of a tax year.

(7) Under the current and proposed regulations, where neither party to a transaction of the type listed as a reportable transaction is a U.S. person and the transaction does not give rise to income (or deferred payment) that is U.S. sourced or effectively connected with a U.S. trade or business and does not give rise to any expense, loss, or other deduction that is a allocable or apportionable to such income, then the transaction is not a reportable transaction. This is designed to limit the reporting obligations of a reporting corporation that is a foreign corporation engaged in a U.S. trade or business at the same time it has non-U.S.-connected activities. There are also provisions to prevent overlapping reporting.

(8) As under the existing regulations, if a U.S. consolidated return is filed, the group may file a consolidated Form 5472.

(9) Another interpretation is that the six safe harbor categories are already required by the regulations under section 6001 in the case of U.S. taxpayers engaging in transactions with foreign related parties. If that were true, it would mean that the safe harbor regime and the section 6001 regime are identical in this respect. The interpretation is doubtful, however, because at least one of the categories (relating to material profit and loss statements) requires the creation of records. If the IRS wanted to have a general requirement under section 6001, it should amend those regulations rather than characterize those regulations in a second regulation. Moreover, the term "safe harbor" implies that there is a difference between what would otherwise generally be required and what is necessary to comply with the safe harbor.

(10) These four categories, discussed below, are (i) pricing documents, (ii) foreign country and third-party filings, (iii) ownership and capital structure records, and (iv) records of loans, services, and other nonsales transactions.

(11) The proposed regulations define a "product line" as generally meaning "a group of products that are aggregated into a single classification for accounting, marketing, or other business purposes." Examples of products would include "groups of products that perform similar functions; products that are marketed under the same trade names, brand names, or trademarks; and products that are related economically, i.e., having similar rates of profitability, similar degrees of risk, and similar opportunities for growth."

(12) A "product" is defined generally to mean "an item of property (or combination of component parts) which is the result of a production process, is primarily sold to unrelated parties (or incoporated by the related party group into other products sold to unrelated parties) and performs a specific function."

(13) This does not apply, however, to a foreign government or its controlled commercial entity.

(14) Although Financial Accounting Standards Board (FASB) Statement No. 14 requires segmented industry data in some situations, it does not impose a tax requirement. FASB No. 14 makes cross-border segmentation optional (with the extent of segmentation being subject to management discretion) and does not require the narrow segments as under the proposed regulations.

ROBERT T. COLE is a member of the law firm of Cole Corette & Abrutyn, which has offices in Washington, D.C., and London. Mr. Cole received his B.S. degree in Economics from the Wharton School of Finance at the University of Pennsylvania, and his law degree from the Harvard Law School; he also received a post graduate diploma in law from the London School of Economics. He was with the U.S. Department of the Treasury from 1966 to 1973 and held the position of International Tax Counsel from 1971 to 1973. He is vice-chair of the Tax Committee of the National Foreign Trade Council, a Fellow of the American College of Tax Counsel, and a member of the New York State and the Washington, D.C., Bars. Has lectured and written extensively on international tax issues. His article, "Working with the Section 482 White Paper," appeared in the Winter 1989 issue of The Tax Executive.
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Author:Cole, Robert T.
Publication:Tax Executive
Date:Jan 1, 1991
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