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Section 482: proposed new regulatory approaches.

The Internal Revenue Service (IRS) released its proposed revisions to the U.S. transfer-pricing regulations on January 24, 1992. 1 This action follows the 1986 amendment to section 482 of the Internal Revenue Code, which added the requirement that the payment for transfers (or licenses) of intangibles be commensurate with the income attributable to such property, 2 as well as the Treasury Department's issuance in 1988 of a "White Paper" dealing with the new statutory provision and related topics. 3 The next steps will be for the IRS to receive comments on the proposed regulations, to hold public hearings, and then to promulgate final regulations. The deadline for comments and requests for public hearings is May 29, 1992.

The proposed regulations replace with a new regime the provisions of the current regulations that deal with transfers of intangibles, including licenses and sales of intangibles. These new intangibles rules also would apply to sales of goods in which intangibles are a material factor and where services are provided involving intangibles that are a material factor. The regulations for transfers of other tangible property would continue in effect, but they have been substantially modified to reflect some of the concepts applied to intangibles. Although the IRS's proposals are subject to modification and generally would not go into effect until 1993, they can and should be taken into account now in resolving certain existing transfer-pricing disputes and for planning purposes.

Set forth below are the key features and implications of the proposed regulations. A more detailed description of the new regulatory rules follows.


* The proposed regulations significantly alter the manner in which transfer prices for both intangible and tangible property will be reviewed by the IRS, by reference to a range of operating profit. The centerpiece of the proposed regulations is a bottom-line operating profit analysis that will apply except in those rare instances where near-perfect comparables are avalaible. This analysis effectively attributes to taxpayers engaged in related-party transactions an amount of operating income somewhere within a range -- referred to as the "comparable profit interval" (CPI) -- that the taxpayers would have earned had their performance been equivalent to comparable businesses operating at arm's length. The CPI concept represents important progress, providing a measure of flexibility to taxpayers, since, until recently, the IRS thought in terms of only a single correct transfer price. It is also intended to narrow disputes by discouraging both the IRS and the taxpayer from taking extreme positions.

* The proposed regulations are extremely technical and complex, and introduce new areas for dispute. The computation of the CPI involves a host of new concepts and terms (e.g., the "tested party," "applicable business classification," "profit-level indicators," constructive operating income," and "convergence"). In order to construct a CPI, one needs detailed financial information regarding similar businesses. At the time needed, such data often may be either inaccessible (e.g., the comparables are privately owned) or nonexistent (e.g., the comparables are divisions or segments of integrated companies). Moreover, the selection of businesses whose data are to be used and the actual use of the available data require a series of subjective judgments, each of which presents a potential source for disagreement.

* The proposed regulations are not structured to facilitate the prospective setting of acceptable transfer prices. The proposed regulations generally require a comparison of a related party's operating profit ratios with those of comparables for the tax year at issue, as well as the first preceding year and the first succeeding year. Thus, by definition, most of such information will not be available in advance. An Advance Pricing Agreement (APA) may be helpful in this respect. 4

* The proposed regulations adopt various positions the IRS has taken in audits and, without success, before the courts. The proposed regulations contain provisions addressing the significance of the presence or absence of related-party contracts, the ability to consider together related transfers of tangible property and intangibles, the comparison of data from different years, and the need to consider the effects of sales volumes and other factors in assessing whether arm's-length transactions may be used to establish a comparable uncontrolled price. All such issues have been the subject of dispute in recent court decisions. The proposed regulations are designed in some instances to reverse outcomes not to the liking of the IRS. 5

* Foreign adherence to the U.S. concepts may be necessary to avoid double taxation. Certain of the transfer-pricing methodologies and principles embodied in the proposed regulations are somewhat novel and, accordingly, may not be fully understood by, or acceptable to, the tax authorities of other countries. Obviously, if two different sets of rules are applied in a cross-border transfer-pricing dispute, any Competent Authority proceedings designed to avoid double taxation may be severely inhibited unless the results of the different approaches happen to coincide. In this connection, the Treasury Department has undertaken a program to obtain international acceptance of the new U.S. concepts.

* An APA may become the best way for a taxpayer to ensure that its transfer-pricing practices will not be challenged by the IRS. The uncertainties and other problems resulting from the new regulations make it all the more advantageous for a taxpayer to consider an APA. At the present time, such an agreement is the only way to effectively resolve, in advance, the myriad transfer-pricing issues that will invariably arise under the proposed regulations. An APA would be especially useful, for example, in making such difficult determinations (required by the proposed regulations) as identifying the tested party, choosing the applicable business classification, determining the relevant comparables and profit-level indicators, making appropriate adjustments, and establishing convergence. In addition, the Competent Authority procedure, which is an integral part of the APA process, offers the opportunity to confront and resolve differences with our treaty partners before they materialize, rather than after the fact. 6 This process requires the agreement of each treaty partner, and to date a significant number of U.S. treaty partners have agreed to the process on a general or experimental basis.

* Comments can be presented to the IRS and constructive changes suggested. Interested taxpayers and organizations may provide the IRS with their written comments on the proposed rules. There will also be a public hearing that should serve as a useful forum to provide input to the IRS. Although it might be tempting to dwell on the defects and shortcomings of the new rules, taxpayers should recognize that many of the IRS's proposals will undoubtedly survive. Thus, taxpayers may eventually find themselves in the position of having to persuade foreign tax authorities to accept, not reject, the new U.S. regulatory provisions. The ultimate goal should be for the IRS (and foreign tax authorities) to adopt rules that will serve as a basis for uniform international standards and procedures.

* Treasury's imminent report to Congress on transfer pricing may produce legislation. In addition to the regulatory process, it is important to note that the Treasury Department has prepared a report to Congress on transfer pricing which was due April 2, 1992. This report could result in legislative changes, including procedural refinements and, possibly, major substantive changes (although Treasury is on record as opposing substantive changes).

* Taxpayer reporting and recordkeeping obligations continue. The proposed regulations do not address reporting and recordkeeping in the section 482 context, although the preamble to the propose regulations suggests that new requirements may be issued in the future. 7 For foreign-owned taxpayers, section 6038A and the regulations there-under also remain in effect. 8 The application of the recordkeeping obligations under section 6038A, however, should be heavily influenced by the new section 482 regulations, since the section 6038A regulations contain an overriding relevancy limitation. In addition, the section 6038A regulations include a procedure for obtaining District Director agreements on recordkeeping and record production both in connection with an APA and otherwise. 9 Again, such agreements should be heavily influenced by the proposed regulations.

* Measures should be taken now to reduce exposure to substantial section 482 adjustments and penalties. A 1990 amendment to the Code established severe penalties for net transfer-pricing adjustments which exceed $10 million, unless the taxpayer can establish that it acted in good faith and with reasonable cause. 10 Although the new regulations do not address the penalty provisions, they do accord better treatment to those taxpayers whose transfer prices produce profits that are within or are only slightly outside the CPI. The clear message to taxpayers, therefore, is that they should be prepared to establish that they have made a reasonable effort to comply with the statutory and regulatory requirements regarding transfer pricing. As previously stated, this can be achieved with certainty by securing an APA. Taxpayers who do not wish to proceed with an APA may be required to demonstrate that their transfer prices were set with due consideration to the revised statute and to the proposed regulations as an official (though preliminary) expression of what the statute means. At a minimum, every affected taxpayer should consider a review and a revision, as necessary, of its current transfer-pricing policies and practices, and be in a position to show the good faith and reasonableness of such policies and practices.


A. Transfers of Intangibles

The proposed regulations prescribe, in order of priority, three methods for ascertaining an arm's-length consideration for transfers of intagibles: (1) the matching transaction method (MATCH), 11 (2) the comparable adjustable transaction method (CAT), 12 and (3) the comparable profit method (COMP-PROFIT). 13 Neither the IRS nor the taxpayer is required to establish the inapplicability of a higher priority method before applying a lower priority method. 14 In the absence of an agreement, however, either party has the option of establishing the applicability of a higher priority method.

It is important to note that these methods will govern any transfer of an intangible in a controlled transaction, including transfers of intangibles occurring through a sale of goods or the rendition of services -- as long as the income attributable to the intangible is "material" in relation to the income attributable to the tangible property or services to which it relates. 15 In applying these methods, the realm of comparables has been expanded by eliminating the rigid geographical and temporal restrictions of prior law. On the other hand, neither the CAT method nor the COMP-PROFIT method will be regarded as applicable unless they produce results that are within the CPI. 16

1. MATCH Method. The MATCH method entails matching controlled and uncontrolled transactions to one another to determine an arm's-length consideration for the controlled transaction. Transactions are considered a match (or comparable) if the same intangible is transferred in both the controlled and uncontrolled situations and the contractual terms and surrounding economic conditions are either the same or substantially similar. The requirements for alplication of the MATCH method are quite strict. The intangible involved must be essentially identical in the two sets of transactions. Furthermore, although adjustments can (and must) be made for differences in economic conditions and contractual terms (including geographic and use restrictions), adjustments are permissible only if they are few in number and, taken together, have only a "minor effect" on the consideration charged. Since the MATCH method relies on the most complete and accurate data and requires the fewest adjustments, it has the highest priority.

2. CAT Method. The CAT method also involves recourse to comparable arm's-length transactions, but its application is considerably broader than that of the MATCH method. The CAT method may be used where the intangibles in the controlled and uncontrolled transactions are not exactly the same. The intangibles and their stages of development must still be sufficiently similar, however, so that the differences can be accounted for through adjustment and with reasonable accuracy in fixing the terms of an appropriate consideration for the controlled transaction. Adjustments for differences in economic conditions and contractual terms must also be made, but are permissible even if they are not few in number or minor in effect. The only requirement is that the adjustment for each material difference must be based on reliable and accurate data and be reasonably susceptible of quantification. Although the proposed regulations provide a series of examples to illustrate the circumstances in which the CAT method may or may not be applied, 17 they contain very limited guidance on how to make appropriate adjustments or, for that matter, how to locate and select transactions that will be deemed suitable CAT comparables. As discudded below, the result of the CAT method must be validated by the CPI.

3. COMP-PROFIT Method. The COMP-PROFIT method must be used whenever both the MATCH and CAT methods are inapplicable. The COMP-PROFIT method utilizes the CPI to determine a transfer price, rather than simply for verification. Since the COMP-PROFIT method focuses primarily on profits, its application requires the least transactional comparability between the controlled and uncontrolled transactions. The COMP-PROFIT method involves attribution of the operating profit levels actually realized by those independent businesses that are most similar to the controlled parties, based on the best available information. It is the method of last resort. It appears, therefore, that the COMP-PROFIT method is intended to be usable in virtually any situation. (The proposed regulations do not state whether there are any circumstances in which the COMP-PROFIT method would be inapplicable or how an arm's-length consideration is to be determined if there is a total absence or unavailability of data reflecting the financial performance of relevant comparables.) Again, the proposed regulations do not provide sufficient guidance for finding or choosing COMP-PROFIT method comparables and, consequently, these matters still remain a fertile field for disputes between the IRS and taxpayers.

4. Effect of Comparable Profit Intervals. As stated, both the CAT method and the COMP-PROFIT method require construction of a Comparable Profit Interval (CPI). 18 For the CAT method to be valid, its results must fall within the CPI. A CPI also is used to determine the extent to which the IRS can make an adjustment of the transfer prices reported by the U.S. taxpayer where the COMP-PROFIT method is used. If the reported results are such that the operating profit of the tested party is within the CPI, the IRS cannot make an adjustment. 19 If the operating income of the tested party falls outside the CPI, however, the IRS adjustment is to take into account how far outside the interval the tested party's operating income falls (unless either no consideration was paid for the transferred intangibles or the consideration paid was substantially disproportionate to the value of the intangibles, in which case the adjustment will be base on the "most appropriate point" in the CPI). 20 Accordingly, taxpayers falling well outside the CPI will find their adjustments based on the "most appropriate point" in the interval, whereas the adjustments for taxpayers close to the interval may be smaller than necessary to reach that "most appropriate point." An example in the proposed regulations 21A and statements made by Treasury officials suggest that this procedure will result in a dollar-for-dollar adjustment; that is to say, for each dollar outside of the CPI, there will be an adjustment of the same number of dollars within the CPI, but not beyond the "most appropriate point." The dollar-for-dollar concept, however, has not been expressed as a specific rule because the Treasury recognizes that there might be disagreement on the boundaries of the CPI. This adjustment rule is designed to encourage taxpayers to comply with the proposed regulations. When considered in combination with the reasonable-cause exception to the transfer-pricing penalties, taxpayers have a strong incentive to take the proposed regulations into account in formulating their transfer-pricing programs.

B. Sales of Tangible Property

The proposed regulations retain the same methods of pricing for tangible property as those set forth in the original regulations: the comparable uncontrolled price (CUP), resale price, and cost-plus methods. 21 The CUP method continues to have first priority. In applying CUP, the proposed regulations include a list of additional factors that must be evaluated for price effects: sales volume, inventory turnover rates, and advertising and warranty practices. 22

Where the CUP method is inapplicable, the decision whether to use the resale price or cost-plus approaches depends upon which method relies on the most complete and accurate data and requires the fewest and most readily quantifiable adjustments. (This fule contrast with the priority of the resale price method over the cost-plus method under the current regulations.) 23 The proposed regulations note that recourse to the resale price method is ordinarily more appropriate where a manufacturer sells products to an affiliated distributor that resells the articles without further processing or the use of significant intangibles. If the affiliated buyer further processes the products or uses significant intangibles, however, the cost-plus method will normally be more appropriate. 24 As in the case of the existing regulations, recourse to a so-called "fourth" method is authorized, but only if the CUP, resale price, and cost-plus methods have not been applied. 25 (As in the case of the provisions dealing with intangibles, the inapplicability of a higher priority method can be assumed until its applicability is established.) The new regulations specifically confirm that "fourth" methods may include analyses based on profit-level indicators, such as operating margins, rates of return on assets, and Berry ratios. 26

The proposed regulations' most significant change to the rules relating to the sale of tangible property is the requirement that a transfer price determined under the resale price, cost-plus, or any "fourth" method must produce a level of operating income for the controlled party that is within the CPI. 27 As in the case of CAT, if the results produced by the resale price method or the cost-plus method do not fall within the CPI, the method is deemed inapplicable. Apparently, other methods must then be tested until one produces results within the CPI. In assessing the reliability and applicability of "fourth' methods for pricing tangible property, the method that produces a result that is at or closest to the "most appropriate point" withing the CPI will be regarded as the best approach.

The new regulations will permit the IRS to apply each of the pricing methods to product lines or other groupings where there are a large number of transactions and it is impractical to ascertain an arm's-lenght price for each transaction. The IRS is further allowed to employ "reasonable statistical sampling techniques" for this purpose. 28

The scope of the tangible property pricing methods are significantly reduced because of the rule that requres application of the intangible pricing methods to transfers of property (or the rendition of services) if the income attributable to associated intangibles is material. The tangible property pricing methods would continue to apply, however, where the relevant intangibles are developed by the transferee of the tangible property, since no controlled transfer of an intangible deemed to be is involved. In such circumstances, the proposed regulations generally would apply the cost-plus method, reversing the priority of the resale price method under the existing regulations.

C. The Comparable Profit Interval

The construction of a CPI -- a range of profitability -- is the most meaningful innovation included in the new regulations. Conceptually, it constitutes a potential "safe harbor" zone for transfers of intangibles in transactions that do not lend themselves to the MATCH or CUP methods. The problem, of course, is that in the absence of an APA, a taxpayer can have no assurance that the range it believes is justified is one that the IRS will accept. Nonetheless, the mere recognition by the IRS that there is an acceptable range of profits offers an element of flexibility lacking in the current regulations and affords taxpayers significant opportunity to minimize exposure to section 482 adjustments and penalties.

There are six steps involved in constructing the CPI. (29) Several of these steps entail essentially mechanical or arithmetic procedures. At least three of the steps, however, will require considerable skill and knowledge, since they involve locating, assembling, interpreting, adjusting, and applying commercial and financial data and information.

1. Step One: Select the controlled party whose profits are to be tested. (30) The tested party can be any one of the affiliated businesses that is a party to the controlled transaction, including an entity that is not under examination by the IRS. This may thus include a foreign party not subject to U.S. taxation. Since the tested party should be the one whose operating income can be verified using the most reliable data and with the fewest adjustments, the tested party normally will be the transferee in the case of a transfer of an intangible. (31) Where there is a transfer of tangible property, if the resale price method is being applied, the tested party ordinarily will be the related buyer (reseller) of the products; where the cost-plus method is used, the tested party ordinarily will be the seller in the controlled transaction.

2. Step Two: Find the comparables whose profitability will be used to establish the CPI. (32) Comparable businesses whose functions and circumstances are most similar to the relevant operations of the tested party must be identified. To identify relevant comparables, it will ordinarily be necessary to define and isolate (or segment) the particular controlled operations to be tested and then correlate them to those of businesses dealing with one another at arm's length. The delineation of the tested operations by function, product, market, or the like should be as broad as possible to encompass all potential comparables, yet sufficiently narrow to include only relevant data and information. Needless to say, the selection (and appropriate segmentation) of proper comparables is critical, since, if there is any serious error at this point, the succeeding steps in the analysis are rendered academic.

3. Step Three: Compute the "constructive operating income" of the tested party based on the financial performance of the comparables. (33) The "constructive operating income" of the tested party is computed by applying the profit-level indicators (PLIs) derived from the comparables to the tested party. The ability to perform this exercise depends on the extent to which reliable data are available for the comparables and the extent to which the PLIs provide a reliable basis for comparing the profits of the uncontrolled parties to those of the tested party. Once again, the new regulations leave the taxpayer to its own devices. The revised rules, however, do specify which PLIs the IRS may regard as probative. They are:

* Rate of Return on Assets (ROA)

* Ratio of Operating Income to Sales (Operating Margin)

* Ratio of Gross Income to Operating Expenses (Berry Ratio)

* Other Margins (such as the ratio of operating income to labor costs or the ratio of operating income to all expenses other than those included in cost of goods sold)

* Comparable Profits Splits (residual and overall) (34)

The proposed regulations state that the IRS will also consider any other indicator that reflects a perceptible relationship between "various factors" and income if the taxpayer can demonstrate that the indicator can be, and is in fact, reliably applied.

The actual computation of the tested party's constructive operating income involves imputing to the tested party a dollar amount of income equal to that which it would have realized had it experienced the same PLI results as the potential comparables. This can be done by using several different PLIs derived from a single potential comparable or by using one or more PLIs derived from multiple potential comparables. Before these calculations are made, however, it is necessary to adjust the financial data for the tested party --

* to reflect any section 482 allocations other than those made for transfer-pricing purposes but that affect the tested party's income, and

* to reconcile material differences between the accounting treatment employed by the potential comparables and the tested party.

In this latter regard, it is particularly important to restate assets and income where, for example, the tested party's financial assets or inventory are inordinately high (or low) in relation to the potential comparables.

To illustrate the application of Step Three, assume that a potential comparable's ROA for the tested period was 28.4 percent, its Operating Margin was 12.5 percent, and its Berry Ratio was 138.5 percent. After adjustment of the tested party's financial statement to conform it to that of the potential comparable, the amount of the tested party's income is recalculated by imputing to it the same ROA, Operating Margin, and Berry Ratio as that of the potential comparable. To the extent other potential comparables can be found, the process is repeated, forming a data base as comprehensive as the available and reliable information will permit.

4. Step Four: Determine the Comparable Profit Interval (CPI). (35) The CPI is determined by selecting those amounts of constructive operating income derived from the potential comparables for the tested party that converge to form a range that "is reasonably restricted in size." The economic theory underlying this procedure is that where there is a convergence of the constructive operating incomes (i.e., the comparables' PLIs produce similar amounts of imputed profits for the tested party), such results indicate that the potential comparables and the tested party are similar. Proceeding from this premise, the converging constructive operating incomes can be used to set the boundaries of the CPI. Where there is divergence, the disparate PLI data will be excluded unless further adjustments can be made to reduce the differences to acceptable levels.

The proposed regulations include a number of examples that demonstrate how the CPI is formed and how the data are to be construed and applied. One of the most informative examples involves a situation where the tested party is an exclusive U.S. distributor of its foreign parent's products. (36) Eight potential comparables are identified, and their ROAs, Operating Margins, and Berry Ratios are used as PLIs. Since their individual PLIs vary considerably from company to company, they produce a rather broad range of constructive operating incomes, some of which are well above or well below the tested party's actual reported income. The constructive operating incomes derived from four of the potential comparables, however, are clustered together. According to the proposed regulations, this "convergence" provides persuasive evidence that these four independent distributors are not only similar to one another, but that the tested party, had it been operating at arm's length, should have registered operating income within the range of operating incomes derived from these particular comparables. Accordingly, the CPI for the controlled U.S. distributor was fixed by the constructive operating incomes of these four closest comparables. The data for the other potential comparables were disregarded.

5. Step Five: Determine the "most appropriate point" within the CPI to set the tested party's arm's-length income. (37) In cases where the CPI is not being employed merely to validate the results under a priority method, the "most appropriate point" in the range may have to be determined. This would be required where the COMP-PROFIT method is used and the reported results of the tested party are not within or close to the CPI. It would also be needed to test a "fourth" method under the rules relating to tangibles. The proposed regulations provide the if statistical techniques were used to construct the CPI, the most appropriate point should be determined using statistical measures of central tendency. If statistical techniques are not used, various qualitative factors are to be considered, with special weight being accorded to those particular comparables and PLIs that appear to be most relevant.

6. Step Six: Determine the transfer price for each controlled transaction. (38) This final step, applicable only when Step Five becomes operative, simply involves the conversion of the "most appropriate point" within the CPI to a transfer price for the controlled transactions.

D. Other Noteworthy Provisions

Other provisions in the proposed regulations that should be noted include the following:

1. Despite the 1986 amendment to section 482, the proposed regulations state unequivocally that the arm's-length standard will continue to apply in all instances. The language of the general regulatory provisions has been amended, however, to provide that the test to be applied in all intercompany dealings is whether uncontrolled taxpayers "exercising sound business judgment" would have agreed to the same terms given the actual circumstances under which the controlled taxpayers dealt. (39)

2. Under the proposed regulations, the IRS will be authorized to consider the combined effect of all transactions between members of an affiliated group to determine their respective "true taxable income" and to make allocations of income on the basis of the realities, rather than the legalistic formalities, of the controlled transactions. (40) Thus, the new regulations specifically permit the IRS to treat a party that sells its entire output to an affiliate as a contract manufacturer even if there is no contract requiring the latter to purchase all the seller's output.

3. The proposed regulations attempt to clarify ownership of an intangible for section 482 purposes.

a. In the absence of a qualified cost-sharing arrangement (whether actual or as constructed by the IRS), there is a single tax owner depending on who qualifies as the "developer." Other participants in the process are referred to as "assister."

b. In determining who is the developer of the intangible, greatest weight will be given to who bore the costs and risk of developing the intangible and who made available (without adequate compensation) property and services contributing to its development. Other relevant factors include the location of the development activities, the capability of each controlled taxpayer to carry on the project independently, the extent to which each controlled taxpayer controls the project, and the actual conduct of the controlled taxpayers. Any assister must be compensated for its services or for a deemed loan, and the developer alone is entitled to the income from the intangible.

c. In an apparent attempt to augment U.S. tax revenues, the proposed regulations illustrate the developer-assister rule with an example in which a U.S. subsidiary that distributes its foreign parent's products is treated as the developer of the "enhanced U.S. rights to the trade name" that is legally owned by its foreign parent. This determination is predicated on the fact that the U.S. subsidiary has paid the promotional and advertising expenditures that have popularized the trade name in the United States. (41)

4. The IRS will be expressly empowered to make periodic adjustments (normally on an annual basis) to long-term arrangements involving intangibles, with limited exceptions. (42)

5. While the proposed regulations include overall profit splits and residual profit splits as PLIs, as a practical matter their use will be quite limited because these methods cannot be applied except where comparable (arm's-length) splits between uncontrolled parties can be found.

6. Because the IRS is normally obligated to consider a controlled party's performance in the year before and the year after the one under examination, it may very well become possible for a taxpayer to avoid a section 482 allocation in a single aberrant year (e.g., a year in which its actual results are outside the range of normal profitability for that one period).

E. Effective Date and Related Matters

The new regulatory rules will be effective for taxable years beginning after December 31, 1992. (43) Nevertheless, the 1986 commensurate-with-income amendment to the statute is generally effective for taxable years beginning after December 31, 1986. The statutory amendment does not apply, however, to existing intangibles transferred (or licensed) to foreign persons before November 17, 1985, or to others before August 17, 1986. Although it appears that the grandfather provisions are not applicable to Puerto Rico and other U.S. possessions, a contrary argument can be made.

According to the preamble to the proposed regulations, until 1993 the statutory amendment is to be applied using any "reasonable method" not inconsistent with the statute. The IRS further states that it will consider a method that applies the proposed regulations or their general principles to be a "reasonable method." Thus, the proposed regulations are clearly relevant to any taxable year and transfer covered by the 1986 amendment. For earlier transactions, the proposed regulations set forth methods that may well, make business and economic sense in particular circumstances, and, therefore, can properly be considered both by the taxpayer and the IRS as "fourth" methods under the existing regulations.

Since the new regulations were issued in proposed form and comments have been solicited, it is quite possible that some of its provisions may undergo revision. The IRS has specifically requested comments with respect to (i) the possibility of creating "safe harbor" profit ranges constructed by reference to pre-established benchmark standards such as published rates of return on assets (ROA), (ii) the recognition of PLIs other than those identified in the proposed rules, and (iii) the treatment of lump-sum payments.

Finally, it should be observed that the IRS seems to recognize the problems involving availability and access to appropriately refined comparable data needed for purposes of selecting the most appropriate pricing method and developing CPIs. In this connection, the IRS believes it currently has the authority to summons third-party comparable information; it is sensitive, however, to the dual concerns that the business upon which the summons is served is entitled to confidentiality for its trade secrets and that the taxpayer under audit is entitled to review and "cross-examine" the data sources. Possible legislative approaches are being explored.


The proposed section 482 regulations deal with one of the most important and perplexing international tax issues now being addressed by taxpayers and governments alike. The IRS's acceptance of an income-range concept, its adoption of a "sound business judgment" standard, and its focus upon operating income are all positive developments. But there are still a great many problems that must be solved.

The regulations must be acceptable in principle (if not application) to foreign governments so that the threat of double taxation is not materially increased. If the final regulations are to advance the interpretation and administration of the statute, they must be workable. At a minimum, this will require modification of the CPI concept to lessen disputes, and additional regulatory guidance in the form of safe harbors with at least a presumptive effect. Further, the Treasury can and should do more to derive comparable data from the information it has available or it can otherwise obtain, which should then be made available to taxpayers as well as to International Examiners and other IRS personnel. Finally, transfer-pricing administration must also be made more consistent and predictable. This will require greater National Office participation.

The IRS also needs to consider seriously the fundamental question of which taxpayers ought to be subjected to intensive transfer-pricing scrutiny. For all practical purposes, the multinational businesses that operate in high tax-rate countries are tax stakeholders and are essentially neutral on how the respective taxing authorities share the revenues. It should be possible to provide rules so that taxpayers can meet their transfer-pricing obligations without large administrative burdens. More work needs to be done in the United States and foreign countries to achieve this goal.

(1) Intercompany Transfer Pricing and Cost Sharing Regulations under Section 482, 57 Fed. Reg. 3571 (1992). As the name indicates, the proposed regulations also include new regulatory provisions relating to cost-sharing arrangements. This subject is not discussed in this article.

(2) Tax Reform Act of 1986, Pub. L. No. 99-514, 100 Stat. 2086, 2561-63 (1986).

(3) A Study of Intercompany Pricing, I.R.S. Notice 88-123, 1988-2 C.B. 458 (commonly referred to as the "White Paper"). For a discussion of the White Paper, see Cole, Working with the Section 482 White Paper, 41 Tax Exec. 137 (Winter 1989).

(4) Guidelines on securing Advance Pricing Agreements were issued by the IRS in Rev. Proc. 91-22, 1991-11 I.R.B. 11.

(5) See, e.g., U.S. Steel Corp. v. Commissioner, 617 F.2d 942 (2c Cir. 1980), rev'g 36 T.C.M. 586 (1977); Sundstrand v. Commissioner, 96 T.C. 226 (1991); Bausch & Lomb, Inc. v. Commissioner, 92 T.C. 525 (1989), aff'd, 933 F.2d 1084 (2d Cir. 1991).

(6) On the same date the IRS issued Rev. Proc. 91-22, it also issued Rev. Proc. 91-23, 1991-11 I.R.B. 18, which updates the procedures for requesting Competent Authority resolution of disputes under U.S. tax treaties.

(7) 57 Fed. Reg. 3571, 3577 (1992). The Preamble states that "questions regarding documentation and penalties will be addressed in regulations under sections 6001, 6038, 6038A, 6038C, and 6662(e) rather than under section 482."

(8) Treas. Reg. [subsection] 1.6038A, adopted by T.D. 8353 (June 14, 1991).

(9) Treas Reg. [subsection] 1.6038A-3(e). See also Rev. Proc. 91-38, 1991-30 I.R.B. 16. Agreements may establish the records that must be maintained, how the records must be maintained, the retention period, by whom the records are to be maintained, which industry segment profit and loss statements are material, and a variety of other matters. In most instances, the agreements' requirements will be less demanding as compared to the safe harbor of the regulations.

(10) I.R.C. [subsections] 6662(e) and (h). Where the net transfer pricing adjustment exceeds $ 10 million, the penalty is equal to 20 percent of the adjustment, and where the amount exceeds $ 20 million, the penalty becomes 40 percent.

(11) Prop. Reg. [subsection] 1.482-2(d)(3).

(12) Prop. Reg. [subsection] 1.482-2(d)(4).

(13) Prop. Reg. [subsection] 1.482-2(d)(5).

(14) Prop. Reg. [subsection] 1.482-2(d)(2)(iii).

(15) Prop. Reg. [subsection] 1.482-2(d)(1)(iii)

(16) Prop. Reg. [subsection] 1.482-2(f)(1).

(17) Prop. Reg. [subsection] 1.482-2(d)(4)(vi).

(18) Prop. Reg. [subsection] 1.482-2(f)(1).

(19) Prop. Reg. [subsection] 1.482-2(d)(5)(ii).

(20) Prop. Reg. [subsection] 1.482-2(d)(6)(iii).

(21) Prop. Reg. [subsection] 1.482-2(e)(1)(ii).

(21A) Prop. Reg. [subsection] 1.482-2(d)(6)(iii)(C), Example 1.

(22) Prop. Reg. [subsection] 1.482-2(e)(2)(ii).

(23) Compare Prop. Reg. [subsection] 1.482-2(e)(1)(ii) with Treas. Reg. [subsection] 1.482-2(e)(1)(ii).

(24) Prop. Reg. [subsection] 1.482-2(e)(1)(ii).

(25) Treas. Reg. [subsection] 1.482-2(e)(1)(iii); Prop. Reg. [subsection] 1.482-2(e)(1)(iv).

(26) Prop. Reg. [subsection] 1.482-2(e)(1)(iv).

(27) Prop. Reg. [subsections] 1.482-2(e)(1)(iii), (iv).

(28) Prop. Reg. [subsection] 1.482-2(e)(1)(v).

(29) Prop. Reg. [subsection] 1.482-2(f)(3).

(30) Prop. Reg. [subsection] 1.482-2(f)(4).

(31) This assumes that the transferee will not have its own self-developed intangibles. If it does, it is far from clear who the tested party should be. Is it the party with the least valuable intangibles, or does one test both parties? In the latter case, there would be two CPIs to deal with. The proposed regulations do not provide guidance on how to proceed in such circumstances.

(32) Prop. Reg. [subsection] 1.482-2(f)(5).

(33) Prop. Reg. [subsection] 1.482-2(f)(6).

(34) Definitions of various accounting terms relevant to all the PLIs -- such as "sales," "gross income," "operating expenses," "operating income," and "assets" -- are provided at Prop. Reg. [subsection] 1.482-2(f)(6)(iii)(B). The computational methods for the various PLIs are provided at Prop. Reg. [subsection] 1.482-2(f)(6)(iii)(C).

(35) Prop. Reg. [subsection] 1.482-2(f)(7).

(36) Prop. Reg. [subsection] 1.482-2(f)(11)(ii), Example 3.

(37) Prop. Reg. [subsection 1.482-2(f)(8).

(38) Prop. Reg. [subsection] 1.482-2(f)(9).

(39) Prop. Reg. [subsection] 1.482-1(b)(1).

(40) Prop. Reg. [subsection] 1.482-1(b)(1).

(41) See Prop. Reg. [subsection] 1.482-2(d)(8)(iv), Example 4. A careful examination of this example suggests that its appropriate scope may be relatively narrow. In the example, the U.S. subsidiary incurred $5 million of expenses promoting the trade name for which it was not reimbursed by its foreign parent. It would appear, however, that assuming the U.S. distributor earned normal levels of operating income in each year, it would be incorrect to conclude that the U.S. distributor had not been effectively reimbursed for the expenses of promoting the trade name in the United States. The very fact that the distributor realized a normal amount of income would indicate that it had either been directly reimbursed for its promotional expenditures or that reimbursement had been reflected in the transfer prices it was charged.

(42) Prop. Reg. [subsection] 1.482-2(d)(6).

(43) 57 Fed. Reg. 3601 (1992) (to be codified at 26 C.F.R. pt. 1, [paragraph] 4).

ROBERT T. COLE is a member in the Washington, D.C., office of Cole Corette & Abrutyn. He received his B.S. degree from the Wharton School of Finance and his law degree from the Harvard Law School; he also received a post-graduate diploma in low from the London School of Economics. Mr. Cole 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 a member of the New York State and the District of Columbia Bars. Mr. Cole has lectured and written on international tax issues for a number of periodicals, including The Tax Executive.

GILBERT W. RUBLOFF is Counsel to Cole Corette & Abrutyn. He received his law degree from the University of Wisconsin School of Law and is a member of the Bars of the State of Illinois and the District of Columbia. From 1962 to 1988, Mr. Rubloff served with the Tax Division of the U.S. Department of Justice, where he handled the litigation of many of the government's largest tax cases, including the landmark international transfer-pricing case, E.I. DuPont de Nemours v. United States. While at Justice, Mr. Rubloff was a consultant to the United Nations Secretariat on intercompany pricing.
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Author:Rubloff, Gilbert W.
Publication:Tax Executive
Date:Mar 1, 1992
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