The Section 482 White Paper - a Canadian perspective.
For many observers, in Canada and other foreign countries as well as the United States, the enactment in 1986 of the super royalty rule (1) appeared to revolutionize the manner in which cross-border intercompany transfers of manufacturing or marketing intangibles would be required to be priced for U.S. tax purposes. It seemed that the general (and often illusive) arm's-length standard would no longer govern and that U.S. licensors would generally be required to increase charges to foreign subsidiary licensees.
Tax authorities in high-tax countries such as Canada have been particularly concerned that such increased charges would exceed those mandated by an arm's length standard. There were basically three reasons for such concerns. First, although super royalty was intended by Congress to counter unacceptable shifting of profit by U.S. companies to subsidiaries based in low or no tax havens (such as Puerto Rico), the rule as enacted applies to transfers by U.S. companies to subsidiaries located in high-tax countries such as Canada. Second, the 1986 reduction of U.S. corporate tax rates and restriction of foreign tax credits (by H.R. 3838) created an impetus for U.S. companies to maximize intercompany charges to subsidiaries in high-tax countries. Third is the requirement, expressed in the legislative history to the enactment of super royalty, that where licenses of high-value intangibles are involved, there is required an annual or other periodic assessment of the actual income earned by the group and a commensurate periodic adustment of the payments actually being made (or if not made, to be reported for U.S. tax purposes) by the parties. (2)
The 1986 enactment left unclear how super royalty would apply and there was anxiously awaited an indepth study, which the Treasury was mandated to prepare by the Conference Report, concerning intercompany arrangements in general and the manner in which super royalty would be applied in particular. (3) The study--"the White Paper"--was released on October 18, 1988. (4)
The White Paper sets out detailed proposals respecting the substantive aspects of super royalty as well as proposals for administrative compliance policies and practices, and thus should go a long way toward alleviating the initial concerns. The White Paper indicates that super royalty will not depart from the arm's-length standard as applied in other countries such as Canada (5) and that it will not depart in any material fashion from the pre-1986 law in the United States. This view, however, is not necessarily shared by all, and tax authorities in countries such as Canada continue to worry that super royalty will lead, inadvertently or otherwise, to excessive charges by U.S. companies to Canadian and other foreign subsidiaries. (6)
B. A BASIC LIMITATION IN
TRANSFER PRICING RULES
There seems to be a contradiction between the nature of the problem posed by intercompany transactions and the way it is being dealt with by tax administrators. Intercompany pricing questions are ones of fact and circumstances and no single set of rules can provide a basis to measure and assess, in a technical or scientific and objective fashion, compliance with the objective of proper pricing between related parties. All legislation, except in the case of Japan, recognizes this basic limitation and provides a briefly worded general rule mandating an arm's-length price, which comprises no more than four or five lines of law. (7)
On the other hand, the tax administrators charged with enforcing compliance with the arm's-length principle seek to establish detailed rules. (8) Tax administrators devote substantial energy attempting to establish a quasi-legal basis for the manner in which they consider a fair and reasonable price (which is the legal principle) is to be determined in any particular case, and in this sense the White Paper could be seen as nothing more than another variation on this theme. In the absence of true comparables (transactions of a largely identical nature, undertaken with unrelated parties) or arbitrary (apportionment formula) methods of dividing up income between related parties, there is no objective basis upon which taxpayers' transactions can be tested. Taxpayers and tax administrators must subjectively evaluate how taxpayers would have acted with third parties and if they fail to agree, the courts will impose their own (subjective) evaluation. (9)
Where comparables are not available, resort is then required to so-called secondary methods. In the case of integrated manufacturing and marketing operations, there is the retail sales method, where one company does the manufacturing and the other the marketing. Where both are involved in the manufacturing, there is the cost-plus method. These "secondary" methods are often subjective and where they fail to provide an adequate solution, reliance must be had on "other" or "fourth" methods. (The White Paper rejects the priority of the secondary methods over the latter.) Here there is a clear acknowledgment of the basic problem and, from a legal analysis standpoint, a reversion to the basic principle that, ultimately, the amount should be "reasonable" and it is a question of facts and circumstances which, of course, vary in each case. The U.S. regulations on "fourth" or "other" methods are basically non-existent while Revenue Canada has sought to give a simple example of what might be a so-called "fourth" method. (See paragraph 20 of the Information Circular 87-2.)
Legislators seem to accept that it is futile to try to systematize the general principle, and that its application is best left to the courts. Unless government is prepared to change the nature of the rules and use mechanical (and necessarily arbitrary) apportionment formulae, finding a reasonable arm's-length price in an intercompany transaction (where valid comparables are not available) is not amenable to a comprehensive objective process. (10)
C. THE IRONY OF SUPER
For Canadian observers, the genesis of the super royalty rule is ironic because of a fundamental difference between the tax systems of the two countries in relation to transfers of property to foreign affiliated corporations. From the Canadian perspective, the scheme of taxation under the U.S. Code concerning transfers of property to foreign corporations or "possessions corporations" had a built-in defect--it allowed for a shift of profits to a foreign jurisdiction in a manner not consistent with a comprehensive taxation system which generally seeks to tax all income, particularly in obvious circumstances.
Under Canadian law, a Canadian company which, through its own research and development, creates a valuable product cannot assign the related rights to a foreign subsidiary without being required to either recognize immediate taxable gain (upon an outright assignment) or take into income, over time, a stream of royalty type payments (upon a license of the rights). Upon an outright assignment, section 69 of the Income Tax Act requires that the rights to the product (i.e., the various intangibles, etc.) be valued and are deemed sold at fair market value. The imprecise nature of valuations and the possibility that Revenue Canada will assign a much higher value than does the taxpayer represents a substantial deterrent to actually proceeding with such an arrangement, even if the taxpayer is prepared, which he usually is not, to finance the up-front costs of the future tax savings. (11)
In the United States, before 1984 there was a substantial gap in the U.S. scheme of taxation relevant to the foregoing situation where the developer of the new product was a U.S. corporation. As was seen in the Searle (12) and Eli Lilly (13) cases, the Internal Revenue Code contained no broad-based rule, comparable to section 69 of the Act, which would deem a disposition at fair market value applicable to all transfers of property to a foreign affiliate. There ensued, therefore, the tax-free transfers to possessions corporations or controlled foreign corporations operating in taxhaven environments. (14)
The transferee corporation in such arrangement was often seen as simply serving as a physical contract manufacturer, assuming little risk or making little investment but yet emerging with the lion's share of the overall group profit from the manufacture and sale of the product. This was particularly vexatious to the IRS where (as in Searle and Lilly) the final product was sold through the U.S. parent company's distribution network. From an economic or business standpoint, it is rather clear that the transferee corporations emerged with a share of overall profit totally disproportionate to their input in the overall integrated operation. (15)
Although the U.S. government began reacting, legislatively, to this defect in 1982--with the special measures for possession corporations (Code section 936(h)--and in 1984--with a rule of general application requiring recognition of royalty-type payments over time where intangibles are transferred under section 351 to a foreign corporation (Code section 367(d))--nothing in the Code (even as amended by the super royalty rule) imposes the burden, arising in such circumstances in Canada under section 69 of the Act, of a complete and total taxable disposition. It is probable that, had Code section 351 not applied to the transfers made in the Lilly and Searle cases (by reason of provisions such as section 69), the threat of such substantial immediate taxation may have been a sufficient deterrent to prevent such transfers in the first place and the ensuing series of legislative rsponses (including super royalty). (16)
In summary of this point (apart from the fact that the problem seems to have been cured more by the enactment in 1984 of section 367(d) than by super royalty), (17) it seems clear that issues confronting the U.S. government in this area would not have arisen, in the first place, had the non-recognition provisions of section 351 not extended, in any fashion whatever, to transfer to either foreign corporations or possessions corporations. It is for this reason that Canadians, having regard to the prohibitive effects of section 69 of the Act, can conclude that the same type of problem has not and would not arise under Canadian law.
D. ANALYSIS OF SUPER
ROYALTY FROM THE
As previously suggested, it is perhaps ironic that syper royalty--enacted as a response to perceived abuses of the U.S. tax system by U.S. based multinationals--is viewed by some, including Revenue Canada, as an instrument by which U.S.-based multionationals may exacerbate a perceived preexisting predilection to overcharge Canadian subsidiaries in order to reduce excess foreign (Canadian) tax credits. The Canadian government has long been concerned about this problem and as early as 1963 enacted legislation specifically aimed at U.S.-based multionationals. (18) Revenue Canada now fears that the enactment of super royalty can provide a rationale for U.S. companies to increase charges to Canadian affiliates in order to reduce excess of foreign taxes. (19) It would, indeed, be ironic if U.S. companies were to utilize the super royalty rule, enacted to reduce profit shifting of income out of the United States, to improperly shift income into the United States and out of Canada. It is not difficult, however, to visualize the fears which Revenue Canada may have that the enactment of super royalty can provide a handy mechanism (and rationale) to further plunder the Canadian fisc through increased charges to Canadian affiliates. (20)
2. Consistency with the Arm's-Length
Principle in Canada
a. Overview. In principle, super royalty, as interpreted by the White Paper, is nothing more than a codification of pre-1986 jurisprudential principles augmented by a more systematic approach to pricing methods where the objective standard of the "comparable uncontrolled price" is not available. To this extent, super royalty raises an issue of form, not substance, in the international context and does not give rise to conflict with the tax law governing intercompany transactions in Canada or other countries.
The White Paper states that super royalty is not to depart from the arm's-length standard (as understood internationally and presumably therefore in Canada).
The chapter concludes that the arm's-length standard is the accepted international norm for making transfer pricing adjustments. The study reaffirsm that Congress intended the commensurate with income standard to be consistent with the arm's-length standard, and that it will be so interpreted and applied by the Internal Revenue Service and the Treasury Department. (at page 3.) (21)
There is, however, a disquieting aspect of the White Paper's view of super royalty in relation to competent authority cases at pages 61 and 62:
The Service and Treasury recognize that implementation of the commensurates with income standard in all its particulars, including periodic adjustments, treatment of lump-sum payments and access to information to perform the necessary analysis, may lead to differences with the competent authorities of our treaty partner and perhaps more general issues of treaty policy and interpretation. Recognizing this, the United States competent authority and the Treasury Department should be receptive to the concerns of foreign governments, and endeavor to seek bilateral solutions insofar as those concerns can be accommodated in a manner consistent with the Congressional intent in enacting the commensurate with income standard.
Is this to be interpreted as suggesting any restriction on competent authority procedure to resolve transfer pricing disputes?
In general, the reviews of the White Paper have been mixed and clearly not all observers share the views expressed herein. Canadian and Japanese government officials have been quite critical whereas other observers have been more generous. (22)
b. Comparables Retained as Priority Standard. Comparable uncontrolled prices remain, under super royalty, the primary standard, in preference to any other method of determining an arm's-length price. The White Paper distinguishes between comparables which are "exact" and those which are "in-exact." In the former case, there is no basis for periodic adjustment, whereas in the latter case the requirement for periodic adjustment seems to entail a rebuttable presumption that related parties would provide for modification of their arrangements, over time, as facts and circumstances change.
This is not inconsistent with the general notion of an arm's-length standard, or the Canadian rules, (23) and this approach does not detract from the problem discussed earlier that the majority of cases are not in fact governed by comparables nor the problem noted in the U.S. cases, discussed in Chapter 4 of the White Paper, that the courts are inconsistent in their views of comparability in varying fact patterns. (24)
The White Paper's position on comparables may be summarized as follows:
1. where a transaction with a related party can be tested against "exact" comparables, those would govern to the exclusion of any other pricing method and there would be no periodic adjustments. This is discussed more fully below.
2. An "exact" comparable can only involve a transaction in the same intangible, licensed by one of the parties to an unrelated party.
3. The standards for determining whether comparables are "exact" turn on "external" factors (that is with respect to the business and economic environment in which the comparable licenses take place) as well as "internal" standards (that is the terms of the contractual arrangements between the parties).
4. Not inconsistent with the problem noted elsewhere, that courts often cannot agree on whether things are comparable or not, the White Paper states:
No amount of general discussion of these standards (i.e., the "internal" and "external" standards) is likely to turn them into objective tests. As in all matters concerning transfer pricing, facts and circumstances must determine the outcome of specific cases. (At page 88.)
5. Inexact comparables are transactions involving similar although not identical intagibles. (25) In some circumstances "other" or "fourth" methods may be relevant where only inexact (not exact) comparables are available.
The foregoing may be compared to Revenue Canada's approach as set out in the Information Circular at paragraph 14:
Application of the comparable, uncontrolled price method tends to be restricted by the difficulty in establishing that the product involved, the market, the credit terms, reliability of supply and other pertinent circumstances are indeed comparable. The Department believes that if the comparable uncontrolled price method is to be used, variations in the respective circumstances should be minor or capable of quantification on some reasonable basis.
The use of fourth methods to support inexact comparables is consistent with paragraph 19 of the Information Circular:
Other methods may be employed in support of one of the three aforementioned methods or in circumstances where none of these methods is appropriate. (Emphasis added.)
Revenue Canada clearly shares the White Paper's view that the use of inexact comparables is acceptable only if differences can be reflected by a reasonable number of adjustments (see paragraph 14 of the Information Circular).
c. Other Methods Where Comparables Not Available. In the absence of comparables, the arm's-length standard can only be applied on the basis of either relatively subjective evaluations (secondary or other (fourth) methods) (26) or arbitrary formula approaches, neither of which meet the objectivity desired by the arm's-length standard. The White Paper opts for fourth methods, consistent with the international norm and the approach in Canada, and attempts to formulate an analytical framework on which such determinations can be elevated to a quasi-objective process.
The White Paper's principal proposal is the "arm's-length return method," which is intended to simulate the market place and result in a price to reflect how the parties may have dealt had they been unrelated. The arm's-length return approach seeks "to identify the assets and other factors of production that will be used by the related parties in the relevant line of business and would try to assign market returns to them." (Page 95 of the White Paper)
The methodology (made up of the "basic arm's length return method" and the "profit-split addition" would be as follows (at pages 96, et seq. of the White Paper):
1. Prepare a functional analysis--i.e., break down each line of business into its component activities or functions.
2. Identify which of the functions utilize only factors of production that can be measured and assigned market returns.
3. Distinguish between those functions that make significant use of pre-existing intangible assets (usually of or by transferors) and those that do not (usually by transferee).
4. Start off assigning values to the transferee's factors of production because that is usually easier than assigning to the transferee values for the intangible.
5. Assign income to each of the functions' measurable factors, that is "the functions that employ measurable factors will probably be carried on by a wide range of unrelated parties for which information will probably be available regardign market returns earned by them."
6. After indentifying returns for the transferee's functions, the residual income is then allocated to the transferee, which obviously will receive the lion's share in potentially high profit situations.
7. If, however, both parties have valuable intangibles, the residual income must be allocated by a profit split.
8. Do not allocate income for functions related to selling goods to a related party.
9. To assign returns to the parties, the White Paper suggests two methods:
(a) Identify unrelated parties' rates of return on assets utilized in a particular function, taking into account only the nonliquid assets relative to the function for the line of business being examined (this assumes such information is available); and
(b) meausre arm's-lenth information against a yardstick other than rates of return on assets--e.g., the ratio of income to operating costs seen in DuPont, useful in measuring returns on service activity or in situations where assets are difficult to measure consistently or where there is reason to believe that the relationship and costs are more stable or easier to measure than the relationship between income and assets. (27)
10. Where both parties hav intangibles, a distinction should be made between "routine" intangibles and those which are unique or have major importance to the enterprise and few unrelated parties possess. When more than one affiliate has these types of intangibles (excluding the case of the pure contract manufacturer affiliate, such as in Lilly or Searle), and identified in the White Paper as situations involving mature and complex onshore (e.g., European) affiliates, a profit split is required to reflect the return to each party with the valuable intangibles.
11. A "profit split" essentially is a judgment call.
Even without the resemblance to the key elements of the pricing rationale considered or adopted in prior cases in the United States (or considered in Canada in Indalex, (28) a case involving an offshore subsidiary interposed to transship the purchase of raw materials), it is clear that the method constitutes an approach to "other" or "fourth" pricing methods, necessary where comparables do not govern. An introductory comment in the White Paper foreshadows the required use of fourth methods, as well as the U.S. government's desire to systematize same to the extent possible:
In practice, taxpayers and agents rely upon comparable uncontrolled prices or transactions, when they exist. When they do not exist, agents or taxpayers use whatever method they believe best reflects the economic realities of the transaction at issue. (At page 23.)
The fourth methods recommended by the White Paper (the basic arm's-length return method and the profit-split addition) seem to have been used by U.S. courts in Lilly, Searle, and DuPont. (29) DuPont also used the test of the ratio of gross income to total operating costs as a test of the appropriateness of the income split between the U.S. manufacturer and its Swiss distribution subsidiary. The return on capital analysis in DuPont was considered by the Federal Court in Indalex. DuPont rejected as inappropriate gross margin analysis (and therefore the retail method).
The consistency of the arm's-length return method and the Canadian approach to fourth methods should be evaluated in light of the stated purpose of the super royalty rule:
The general goal of the commensurate with income standard is, therefore, to ensure that each party earns the income or return from the intangible that an unrelated party would earn in an arm's-length transfer of the intangible. (At page 47.)
To make such determination and arrive at an appropriate transfer price, there is to be an assessment of the functions performed, the economic costs incurred, and the risks assumed by the parties. The objective is to assign income commensurate with the relative economic contribution of each party and the relative risks taken by each party. There seems to be no inconsistency between such a rule or philosophy and the arm's-length standard as understood in Canada or other countries which rely on the 1979 OECD Report. (30) This method is stated to apply regardless of the form of the transfer--outright sale, license, sale of tangible property which incorporates valuable intangibles or the transfer of intangibles through the provision of services.
Paragraphs 11 and 12 of Revenue Canada's Information Circular 87-2 deal with the approach to be taken where intercompany arrangements cannot be based on transactions that would arise in the usual course of events between third parties. The idea, not inconsistent with the White Paper, is to establish a subjective but analytical approach to intercompany arrangements where comparables do not govern. In such circumstances, paragraph 11 advocates ". . . a thorough functional analysis of the activities and contributions of each group member, and should clarify and quantify the various factors which were considered in establishing the transfer prices, e.g., technical assistance, access to technology, reward for economic risk, financing assistance, etc."
Paragraph 12 goes on:
The quantum of income taxed in Canada should be consistent with the real profit contribution of the Candian taxpayers involved, based on the economic functions performed and the risks assumed by them. This result is achieved when non-arm's-length transactions with non-residents are consistently made at reasonable arm's-length prices. The determination of reasonable arm's-length prices, while necessarily somewhat subjective, is nevertheless a question of fact, and therefore the situation of each taxpayer must be examined on its own particular circumstances and merits.
Both of the foregoing paragraphs, appearing in the introductory portion of the Information Circular, are intended to govern any type of transfer in respect of any type of things. Furthermore, paragraph 15, which deals with the transfer of goods, establishes the fundamental nature of the analysis, regardless of the type of transaction, (31) required where comparables are not available:
Where appropriate comparables are not available and the taxpayer must use one of the other methods discussed in the following paragraphs, it is recommended that a thorough functional analysis of the activities of the group members be carried out (as mentioned in 11 above). A functional analysis will indentify and evaluate, with respect to a given product or product line, the role and contribution of each member including the economic risk assumed and the degree of responsibility for engineering and production, continuing research, management and administration, marketing and customer services. A functional analysis will facilitate informed decisions as to what constitutes an "appropriate" mark-up or a "reasonable" profit contribution, and it will help to identify severe distortions in the margins of related parties.
Although paragraph 45 of the Information Circular provides that a royalty rate for a license where comparables are not available is to be determined by drawing "comparisons with royalty rates in the same industry or a similar industry involving relatively similar products, similar market conditions, and similar licensing arrangements," paragraph 47 effectively incorporates the approach advocated in paragraph 15, where it states:
In the same way that a taxpayer is expected to explain the basis for the intercompany pricing policy when questioned by the Department, the taxpayer should also be prepared to demonstrate the reasonableness of intercompany royalties, having regard to all of the pertinent facts and circumstances.
Thus, the principles advocated by Revenue Canada do not conflict with the White Paper proposals and, to that extent, the super royalty legislation, is consistent with the Canadian approach. (32)
The White Paper's analysis of the arm's-length return method is focused on the issues which have faced the IRS (the possessions corporation manufacturing arms in Lilly and Searle, and the offshore marketing arms in DuPont and Hospital Corporation of America). It is not surprising that the White Paper does not relate the approach to the above noted type of issue seen in the Canadian case law involving offshore companies interposed to import goods (e.g., Dominion Bridge, Spur Oil, Irving Oil, and Indalex); this is simply because this type of case has not preoccupied the IRS and certainly has not come before the American courts. As already noted, Revenue Canada relied upon elements of the IRS's approach in litigating the Indalex case. Similar arguments were raised in Irving Oil (33) but were rejected because the Federal Court held that the issue was governed by comparable uncontrolled prices, which render inapplicable fourth methods, such as the arm's-length return method discussed in the White Paper.
In summary, the arm's-length return method does not seem to be inconsistent with the arm's-length principle as understood and applied in Canada and other countries which base their inter-company pricing rules on the OECD guidelines.
d. The Periodic Adjustment Rule. Undoubtedly the most vexatious and controversial aspect of the super royalty rule is the requirement that the proper measure of intercompany charges related to the transfer of unique or high-value intangibles requires an annual or other periodic assessment of the actual income earned by the group as a whole in order to arrive at a proper apportionment of income. This entails a periodic adjustment of the payments actually being made (or if not made, to be reported for U.S. tax purposes) by the transferee to the transferor. The White Paper's explanation of this requirement, however, may dissolve this issue and provide the basis for reconciliation with the law in Canada and other countries. (34)
Periodic adjustment will not be required where the license may be tested by exact comparables, although there is some inconsistency between the text of the White Paper and its Example 1. (35) In other cases (particularly involving inexact comparables), the requirement for periodic adjustment seems to have the character of a rebuttable presumption, and it reflects the view of the IRS that, where unique intangibles are involved, providing for periodic change of the division of income is the manner in which related parties would have contracted.
Taxpayers will have the burden of showing the contrary to the IRS or a court--that is, that the unrelated parties, in the circumstances under review, would not have provided for such a periodic adjustment. Although the suggested burden is high, (36) the effect, in principle is no different from the process in Canada, where Revenue Canada can assume facts (including an assumption as to whether or not unrelated parties would have provided for a review or renegotiation of the terms of a contract), with the taxpayer then having the burden of proving the contrary. (37)
The White Paper clearly establishes a less onerous rule than did the original legislation. In particular, nowhere in the legislative history was it indicated that the rule would take the form of a rebuttable presumption.
There is a general view that the periodic adjustment requirement overrides the decision in French, (38) which, according to the White Paper, "endorsed the view that a long-term, fixed-rate royalty agreement could not be adjusted under section 482 based on subsequent events that were not known to the parties at the original contract date." (At page 63.) Although the White Paper states that super royalty is in part a legislative rejection of French, it would seem the actual nature of the proposal can be reconciled with that decision.
The White Paper asserts, at pages 63 and 64, that there is much evidence of arm's-length pricing agreements that do provide for adjustments of royalty rates and payments under the agreement based on subsequent events, particularly if the profitability of the intangible is significantly higher, although unanticipated. This is strictly a question of fact: is there any reason to believe that proof thereof would not allow a court to distinguish the facts of the French case and the surrounding evidence of comparable licensing arrangements? Although the White Paper states at page 64 that it is ". . . perfectly consistent with the arm's-length standard to treat related-party license agreements generally as renegotiable arrangements and to require periodic adjustments to the transfer price to reflect substantial changes in the income stream attributable to the intangible," (39) the paper goes on to confirm that where exact comparables exist or evidence is made to the contrary, periodic adjustment would not be required. At page 64, it is stated:
If a particular taxpayer demonstrates that it has comparable long-term, non-renegotiable contractual arrangements with third parties, the arm's-length standard will preclude periodic adjustments of the related-person intangible transfer price. In that event, a comparable would exist by definition, which would determine the consideration for the related-person transfer, both initially and over time. Comparables are always the best measure of arm's-length prices.
The latter point is considered to be inapplicable in the case of high-profit intangibles unless there is an "exact comparable." Mere "inexact" comparables will not automatically prevent periodic adjustment. The White Paper stipulates, at page 65, that periodic adjustments will not be made where a taxpayer can demonstrate each of the following three factors, in respect of inexact comparables:
1. Events had occurred subsequent to the license agreement to cause the unanticipated profitability;
2. The license contained no provision pursuant to which unrelated parties would have adjusted the license; and
3. Unrelated parties would not have included a provision to permit an adjustment for the change to cause the unanticipated profitability.
In other words, it would be open to taxpayers to rebut the presumption by bringing adequate proof of the foregoing factors. In this respect, the White Paper states "it would be appropriate to impose a high standard of proof, such as a clear and convincing evidence standard, on taxpayers in order to demonstrate that the subsequent profitability could not have been anticipated" and, furthermore, "in no event should this test be available to taxpayers if inexact comparable licenses with no provision for periodic adjustments cannot be found in the marketplace." (At page 65.) (40)
That the White Paper suggests that the penalty sections of the Code should be beefed-up to the extent that taxpayers do not voluntarily effect periodic adjustments and the potnetial issues on audit that may arise from the periodic adjustment requirement (including the necessity to achieve correlative adjustments in other countries such as Canada) does not, per se, mean this requirement is inherently inconsistent with the arm's-length standard. Perhaps one effect of super royalty in general, and the periodic adjustment requirement in particular, will be pressure on tax authorities to provide advance approval for intangible transfer arrangements. This could be a type of advance ruling through the competent authority procedure, although Revenue Canada has been reluctant in the past to entertain such rulings, primarily on the basis that an advance ruling would limit its flexibility in the event of any subsequent competent authority procedure respecting the subject matter of the ruling.
The White Paper's recommendations respecting periodic adjustments in respect of lump-sum payments (at pages 68 and 69) may prove trouble-some in coordinating adjustments with other countries. Rather than make an adjustment in the year of sale (when it becomes evident that the price received was too low and the presumption that there should be a change cannot be rebutted), the White Paper suggests, in order to avoid certain administrative issues, a convoluted formula-approach designed to loosely spread the super royalty adjustment over the number of years associated with the period during which the transferee benefits from the transferred intangible. Under Canadian law, there is generally no basis to readjust the transaction except in the year of sale. (41)
Where there are no comparables and the arm's-length return method is used, periodic adjustments are an inherent part of the process of identifying factors of production used by the parties in allocating income in respect thereof: the income allocation adjusts as the factors change. The very essence of this method is an allocation based upon assessment of the contribution made. Does this not evolve on an ongoing basis? This method would not appear to depart from the existing views and those of the United States or under the 1979 OECD guidelines respecting the nature and use of "other" or "fourth" methods. In essence, periodic adjustments are simply an inherent part of such methods and should not be seen as constituting a new pricing rule in the United States or elsewhere. The point is summarized in the White Paper at page 102)
Thus, as an affiliate's plant, equipment and other measurable factors change from the projections in the initial analysis, the income allocated to them should change. Similarly, the profit-split percentage is intended to reflect the relative values of significant intangible assets owned by the parties. When the value of intangibles belonging to one of the parties has changed, the percentage should be changed. (42)
e. Summary. The White Paper distinguishes between normal profit intangibles and high-profit potential intangibles. The former are considered to relate to widely used products where comparables would often be available to assess intercompany licensing fees. The latter entail unique and unusual products that may be expected to generate profits far beyond the returns normally found in the industry, where third-party licenses generally would not arise and, accordingly, where the special vigor of the super royalty rules are required. (43)
Inasmuch as such intangibles normally are not licensed to unrelated parties, comparables are not available, and it is inadequate to have reference to royalty rates, which often arise in respect of normal profit intangibles. Therefore, third-party royalty rates cannot be utilized on some adjusted basis. Rather, in the language of the White Paper, "enactment of the commensurate with income standard was thus a directive to promulgate rules that would give primary weight to the income attributable to a transferred intangible in determining the proper division of that income among related parties." (At page 52.)
Do Revenue Canada's views, as expressed in the Information Circular, clash with this thought? Is paragraph 45 of Revenue Canada's Information Circular in conflict? The difficult situations targeted by the White Paper (with respect to high-profit potential intangibles) do not involve "relatively similar products," "similar market conditions," and "similar licensing arrangements" addressed by paragraph 45. Moreover, paragraphs 11, 12, 13, 15, and 47 of the Information Circular clearly foresee that, where situations are not comparable, proper pricing will involve some sort of allocation based on assessment of the "relative contributions of the parties to the license" (paragraph 47 of the Information Circular). This is clearly the aim of super royalty.
As previously discussed, the controversial periodic adjustment aspect of the super royalty may not be in conflict with Canadian law. That feature, as interpreted by the White Paper, will have no application whatever where there are so-called exact comparables and, in the case of inexact comparables, the rule seems to be nothing more than a rebuttable presumption; in the Canadian context, such could take the form of assumption of facts by Revenue Canada in raising assessments. In cases where there are no comparables at all, the periodic adjustment rule is simply another of the unique factors to be taken into account in applying a facts and circumstances evaluation based on functional analysis of the relative economic contributions by the parties and the relative economic risks assumed by the parties.
As well as consistency in underlying principles, the methodology of their application, advocated in the White Paper (namely, the basic arm's-length return method or the profit-split method), can be viewed as a reasoned approach to an "other" or "fourth" method, required where comparables do not govern and, as such, not in conflict with Canadian law. (44)
The White Paper proposals, although much more sophisticated than anything seen to date in Canada, can be viewed as one means of achieving the objective stated in paragraphs 11, 12, and 15 of the Information Circular. Where comparables do not govern, as discussed in paragraph 14 (leaving aside the secondary resale and cost-plus method), the Circular in paragraph 19 acknowledges the requirement for "other methods":
Other methods may be employed in support of one of the three aforementioned methods or in the circumstances where none of these methods is appropriate. This is consistent with the recommendations of the OECD. The method utilized should reflect an attempt to present the particular transaction in terms of what would have transpired in an arm's-length relationship.
The two basic fourth methods advocated by the White Paper seem to be designed to answer the question, "what would have transpired in an arm's-length relationship." This objective also underlies Revenue Canada's approach to transfer pricing. Both countries agree that where there are valid comparables, they should govern to the exclusion of any other method. Both countries agree that in the absence of comparables, the pricing should seek to arrive at results for both parties that likely would have arisen had they been dealing as third parties. The White Paper, relying upon a combination of the U.S. case law and economic theory, goes into much detail about how this process is to be accomplished. The Information Circular (leaving aside the rather narrow points made in paragraph 20) provides no elaboration. The approach of the Federal Court in Indalex, however, does suggest that to the extent the methodology proposed by the White Paper is viewed as a reasonable approach to simulating transactions between unrelated parties, it should be given careful consideration by Revenue Canada.
3. Effects on Revenue Canada's
Approach to Auditing Canada-U.S. Issues
A preliminary observation by U.S. practitioners who have had an opportunity to study the White Paper is that the recommendations concerning procedural matters -- maintenance of transfer pricing information on a current basis in taxpayers' books and records, beefed-up reporting of transfer pricing methods on Forms 5471 and 5472 and the specter of more substantial penalties for failure to disclose information or a substantial understatement of income--are the real problems raised by super royalty, and the White Paper. The concerns underlying these proposals are not restricted to the IRS. Canada's tax reform has resulted in statutory amendments designed to increase Revenue Canada's ability to audit international transfer pricing issues. (45)
It would seem clear from Revenue Canada's standpoint that the White Paper initiative in this area is highly favorable as it should dovetail with its own efforts in assessing intercompany pricing arrangements involving Canadian and U.S. companies. In particular, the information arising under these rules would presumably be available to Revenue Canada through the treaty exchange-of-information provisions and may alleviate the difficulties that Revenue Canada now experiences in determining the basis upon which charges are made to Canadian subsidiaries of U.S. companies. This is especially so where such information would include, as suggested in the White Paper, data the taxpayer has gathered concerning comparable transactions and analysis it has prepared concerning rates of return, profits splits, or other information or analysis the taxpayer has used in arriving at its transfer prices.
4. Effects on Canadian
Subsidiaries of U.S. Parent
As noted earlier, an unfortunate aspect of super royalty is that it has clearly been enacted in light of the abuses involving off-shore subsidiaries of U.S. multinationals, a problem not germane to Canada-U.S. transfers. Notwithstanding the relatively narrow focus of the problem, the scope of the super royalty rule is not limited to the abuse areas. Stated differently, super royalty would never have been enacted in relation to transactions between U.S. companies and affiliates in high-tax jurisdictions such as Canada, but typical of the shotgun approach to anti-avoidance tax legislation, the rule applies indiscriminately. Neither the statutory enactment nor the White Paper limits its application.
In concept, the new rules may be particularly troublesome where intangibles are transferred to Canadian subsidiaries that essentially perform a service function and do not carry on their own viable and independent manufacturing and marketing operation and do not develop and eventually own its separate high-value intangibles. In such case, the method mandates an allocation of residual income to the U.S. company (utilizing the arm's-length return method) without a profit split. Such effects do make sense but will be countenanced only if Revenue Canada accepts the allocation as reflecting the true economic relations between the U.S. parent and the Canadian subsidiary. In such a case, consistent treatment by the two countries will not be difficult to achieve.
In any other cases, for example, where the Canadian licensee is in fact carrying on its own separate viable business, it is difficult to imagine that Revenue Canada will not accept the theory of allocation, advanced in the White Paper, that is based on profit splits entailing some valuation of the separate intangibles owned by each company. The profit-split concept should provide common ground on which the requirements of the U.S. and Canadian rules may be reconciled, particularly if the IRS adopts a generous approach in assessing the value of the functions performed by the Canadian affiliate and its own intangibles with respect to sales promotion, marketing, packaging, distribution, transportation, etc. Ultimately, however, this entails nothing more or less than a facts and circumstances inquiry to distinguish between (i) the amount of income attributable to the right to use the intangible and (ii) the amount attributable to the efforts made by the licensee to exploit, through its manufacturing and marketing process, the technology and other intangibles granted under the relevant license, as well as the separate intangibles developed by the licensee.
The overall effect of tax reform in both countries serves as an incentive for U.S. companies to increase charges to their Canadian subsidiaries, in order to reduce the potential for excess foreign tax credits. It is suggested, in view of the foregoing observations, that super royalty, should not, per se, result in increased charges to Canadian subsidiaries where such charges have been formulated in accordance with the economic principles underlying the proposed fourth methods of the White Paper. The controversy surrounding super royalty, however, may have established an expectation on the part of taxpayers and Revenue Canada that there will be pressure to increase licensing fees or cost-sharing contributions, and undoubtedly all such arrangements will be subject to closer scrutiny from Revenue Canada than in the past. (46) On the other hand, it is likely that the IRS will be more focused on transactions
either involving the type of tax-haven arrangements that prompted Congress to enact super royalty or the transfer of intangibles to U.S. companies by foreign groups and there will presumably be less attention to licenses by U.S. companies to subsidiaries in high-tax jurisdictions such as Canada.
It is also theoretically possible, although unlikely in practice, that U.S. parent companies will be motivated to increase charges to Canadian subsidiaries in order to avoid licenses being recharacterized as a transaction subject to section 367(d) of the Code, which results in the deemed income being treated as U.S. source income and thus not eligible for foreign tax credit relief. The White Paper, at page 53, describes the situation, as follows:
Moreover, a license payment that is less than some specific percentage of the appropriate arm's-length amount could be considered so devoid of economic substance that the arm's-length charge should be subject to section 367(d). Thus, those related-party transfers which deviate substantially from the proper commensurate with income payment would be subject to section 367(d), even if cast in the form of a sale or license.
Is it clear that any such resourcing would only apply to the deemed income and not to the actual payment made under the license? Does Article XXIV of the Convention override the domestic (section 367(d)) sourcing rule? Wouldn't such situation, in any event, be worked out through Article IX competent authority procedure? This illustrates the more oblique issues that may arise out of super royalty, although in this particular case the basis was established by the 1984 enactment of section 367(d). The White Paper provides precious little guidance in this area.
Paragraph 212(1)(d) of the Act and Article XII of the Convention levy a 10-percent withholding tax on royalty payments under a license or payments of a contingent nature in respect of an outright assignment but not on lump-sum payments in respect of an outright assignment. Where excessive charges are made to a Canadian company and not otherwise subject to withholding (e.g., in respect of lump-sum payments for an outright assignment), withholding tax on a deemed dividend pursuant to the combined provisions of section 15 and Part XIII of the Act could arise although here again, in the context of a U.S. parent and a Canadian subsidiary, the withholding rate should be reduced to 10 percent; where such charges are made by an offshore affiliate of a U.S.-based multinational, treaty rates would not apply and the withholding would be at 25 percent. In relation to excessive charges and the provisions of section 15 in this context, reference should be had to Indalex pursuant to which the excess payment to an offshore affiliate of a U.S. parent would not qualify as deemed dividend to the U.S. shareholder, with the result that the withholding rate would be 25 percent and not 10 percent.
5. Effects on Canadian Parent
Companies with U.S.
The White Paper also confirms, at page 48, that the super royalty rule applies to "inbound" transfers--that is, to licenses and other transfers of intangibles to U.S. companies--as well as "outbound" transfers. Contrary to initial impressions, the super royalty rule no longer appears to be the basis for a Canadian multinational to charge inordinate amounts to U.S.-related licensees of intangibles. (47) This is merely the flip side of the foregoing discussion and, to the extent that the super royalty rule does not depart from the arm's-length standard, it would appear that super royalty will only affect Canadian licensors in two ways. First, it may provide a conceptual framework upon which licensing charges properly can be increased from preexisting levels (assuming, in effect, inadequate charges in the past). In respect of future licenses, it will provide a rationale for extracting the maximum amount of royalties based on the relative contribution theory underlying the arms-length return method (where, of course, comparables do not govern). Second, the recordkeeping requirements concerning the basis upon which licensing arrangements are established will undoubtedly add a substantial degree of complexity in dealing with such intercompany transactions.
6. Cost-Sharing Arrangements
Cost-sharing arrangements do not seem to pose any particular problem in the Canada-U.S. context and nothing in the White Paper suggests that this well change. (48) The White Paper notes that "Congress intended to permit bona fide cost-sharing arrangements, but expected the economic results of such arrangements to be consistent with the commensurate with income standards." (At page 4.)
The detailed discussion in Chapters 12 and 13 indicate that, provided the arrangement generally makes "economic sense"--that is, the parties contribute amounts in proportion to reasonably projected share of benefits fromt he exploitation of the product of the shared R & D program, there are only three meaningful issues:
1. Is the participation of a particular unit of the multinational in the program tailored to distort results for tax purposes by having low-tax affiliates "cherry pick" (i.e., participate only in successful R & D programs)?
2. Do affiliates in high-tax jurisdictions participate in programs not particularly relevant to their manufacturing and sale activities?
3. Are so-called buy-in payments designed to adequately compensate a member of the cost-sharing group for a contribution of either specific resources to the cost-sharing group exceeding the cost shares otherwise arising or of intangibles resulting from prior and separate R & D of one of the members?
The latter two issues can arise in the context of Canadian participation in U.S. (parent) sponsored cost-sharing arrangements.
Paragraphs 34-39 of the Information Circular dea with cost-sharing arrangements. The basic notion is expressed in paragraph 35. In considering deductibility of contributions by a Candian affiliate to a cost-sharing arrangement, "the Department will look to the nature and quantum of the benefits received" and "the Canadian taxpayer obviously must be in a position to benefit from the R & D, if not immediately at least potentially, by having a genuine and substantial interest in the results." This mirrors the second issue noted above. (49) The Circular indicates, in paragraph 37, that whatever the method utilized, it "should be appropriate to the particular circumstances in each case" and notes that "it is not possible to specify any basis of allocating the expenses being preferable."
Revenue Canada's Information Circular does not deal with the "buy-in" issue simply because its views on cost-sharing arrangements are expressed in the context of projects undertaken by foreign companies to which the Canadian member of the multinational makes contributions. The first issue (relating to the Lilly and Searle situations where intangibles were transferred to a tax-haven affiliate) is not, therefore, a concern for Revenue Canada and hence there is no discussion thereof in the Information Circular. With respect to the second issue, reflecting a concern shared by both Revenue Canada and the IRS, the White Paper delves into the following aspects of the question of determining the relationships between contributions made and benefits:
1. Is the range of products covered by the agreement too broad or too narrow, relative to the expected participation in manufacturing and marketing by the participating parties?
2. Are the participants in the cost-sharing group assigned exclusive geographic rights?
3. Do the participants engage directly in the exploitation of the intangible?
4. What is the appropriate method of measuring anticipated benefits?
5. Are periodic adjustments to the cost-sharing arrangements required?
6. What are the appropriate direct and indirect costs to be shared?
7. Should there be a profit element?
8. Should cost-sharing arrangements extend to "marketing intangibles"?
9. Should there be particular formalities respecting such arrangements?
The objectives of the White Paper in this area seem to be totally consistent with those of Revenue Canada. For example, it is obvious that if a Canadian company enters into a cost-sharing agreement and the rights to exploit the Canadian marketplace represents two percent of the world market, it would not be reasonable for the Canadian company to contribute more than two percent toward the cost of the project. This is another instance of a facts and circumstances evaluation and is expressed in the White Paper, as follows:
Underlying all of the problems discussed in the legislative history of the 1986 Act in relation to cost-sharing arrangements is the fundamental principle that the costs borne by each of the participants should be proportionate to the reasonably anticipated benefits to be received over time by each participant from exploiting intangibles developed under the cost-sharing arrangement. This cost share/benefit principle has several facets, including the appropriate product area to be covered (discussed in section B above), definition of costs to be covered (discussed in section D below), and the measurement of anticipated benefits and several other issues discussed below. (At pages 116 and 117.)
Inherent in such process is periodic adjustment. The White Paper advocates that "the cost shares should be adjusted periodically on a prospective basis to reflect changes in the estimates of relative benefits including a change in the measurement standard if that becomes appropriate." (At page 120.)
The rules for intercompany transactions in the United States, Canada and those several other countries which base their systems on the 1979 OECD Report essentially consist, irrespective of the format or language in which they are couched, of two elements:
1. All countries give primacy to objective comparables (when available) as the means of establishing intercompany transactions (a true arm's-length standard). This excludes the majority of cases.
2. In the majority of cases where valid comparables are not available, there are no specific rules per se; the matter is left to a facts-and-circumstance evaluation (except where political subdivisions impose arbitrary formular approaches as seen under certain state law in the U.S. and interprovincially in Canada). Super royalty simply seeks to impose a rigorous functional analysis basis method for allocating income without establishing specific mathematical formula.
Viewed in the foregoing fashion, super royalty does not breach international standards or conflict with Canadian law. Where there are valid comparables, the rules remain unchanged; where there are no valid comparables, super royalty adds, at best, a new dimension (and a rebuttable presumption) that may depart from international standards in form but not in substance.
The White Paper's analysis also serves as a reminder that the arm's-length principle can be fully achieved only where objectively determinable comparables are available. In other cases, intercompany transactions cannot really be evaluated by reference to an arm's length standard and governments have to choose between two very different approaches:
1. The matter can be left to the courts, which will determine an appropriate price on the basis of facts and circumstances (although super royalty may elevate the process to a quasi-science, not totally an art). In this approach, the courts seek to simulate how parties might have acted in an open market environment. This process, however, cannot be expected to provide consistent results.
2. Instead governments can abandon entirely and attempt to have the matter resolved by conditions in the market and rather adopt, on a comprehensive basis, formular-based apportionment methods that may be arbitrary in design, but would at least provide certainty for all parties, taxpayers and tax authorities alike. Unfortunately, the very useful analysis in the White Paper tends to show that substantial numbers of different formular approaches would be required if totally skewed and inappropriate results are to be avoided. Both Canada and the United States reject the latter approach. (50)
The White Paper should serve to eliminate or reduce concern that super royalty will give rise to substantial issues leading to double taxation. Conversely, it is fair to state that Congress created a mountain out of a molehill, inasmuch as the changes advocated in the White Paper could have been achieved by simply modifying the regulations under section 482 without any statutory enactment.
Sections 936(h), 367(d), and 482, prior to the 1986 enactment, provided a basis to deal with the mischief with which Congress was concerned without raising fears in international tax circles of impending chaos. A careful reading of the White Paper shows that super royalty, as interpreted therein, should not supplant the arm's-length standard and the White Paper's analysis will indeed help to crystallize the problems with the arm's-length standard (where comparabless do not exist) in a fashion which should serve taxpayers and tax authorities in all countries. The "new" rules should only be of concern in situations where taxpayers seek to manipulate transfer pricing for high-profit intangibles.
The criticism levied against the White Paper to date seems to be premised upon a distorted view of its proposals. The forest is being lost for the trees. Although it seems relatively clear that the arm's-length return method would at most provide a more focused framework to deal with transactions that cannot be objectively measured by comparables, critics to this point take issue with the particulars of both the theory and the examples by which the nature of such an inherently flexible and subjective principle is explained and illustrated in the White Paper. These discrete elements are elevated to the status of fixed rules of law and then criticized for their shortcomings rather than being seen in the context of a fourth method approach, which by its very nature requires a high degree of judgment based on the particular facts and circumstances surrounding each case. In more than one place and in more than one way, the White Paper qualifies the discussion of the arm's-length return method as a means to an end and not an end itself and it would seem that nowwhere does the White Paper seeks to cast in concrete any of the particular elements comprising the suggested rules or applications thereof.
In summary, the White Paper is an excellent and extremely useful analysis and description of the law governing intercompany transactions in the context of the super royalty legislation and the ways in which such law can be improved. Moreover, to the extent that the White Paper accurately reflects the intention of Congress, it should serve to allay the fears of taxpayers and foreign governments that super royalty did in fact radically change the arm's-length rules. It is suggested that it did no such thing and if anybody should be criticized it is not the IRS and the Treasury but the Staffs of the House and the Joint Committee for escalating what otherwise was a perfectly sensible reaction to the abuses perceived in cases such as Lilly and Searle into something other than a requirement to beef-up or adjust the regulations--the necessity of which itself may be somewhat questionable given the support that courts have given the IRS in such cases to date.
(*1) Editor's Note: This article is adapted from a paper presented to a World Trade Institute conference, "The White Paper on Section 482," which was held in Boston, Massachusetts, on February 6-7, 1989.
(1) Section 482 of the Internal Revenue Code of 1986, as amended by section 1231(d) of the Tax Reform Act, Pub. L. No. 99-514 (H.R. 3838), added the following requirement:
In the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)) the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.
A consequential and similar amendment was made to section 367(d)(2)(A) of the Code.
For a full discussion, see Cole, "Working with the Section 482 White Paper," 41 The Tax Executive 137 (Winter 1989).
(2) H.R. Rep. No. 841, 99th Cong., 2d Sess. II-637 to II-638 (1986) (Conference Report); H.R. Rep. No. 426, 99th Cong., 1st Sess. 420-27 (1985) (House Report). See also Joint Comm. on Taxation, General Explanation of the Tax Reform Act of 1986, 100th Cong., 1st Sess. 1014ff (May 4, 1987).
(3) "The Conferees are also aware that many important and difficult issues under section 482 are left unresolved by this legislation. The Conferees believe that a comprehensive study of intercompany pricing rules by the Internal Revenue Service should be conducted and that careful consideration should be given to whether the existing regulations could be modfied in any respect." Conference Report, at II-638.
(4) Formally, the White Paper is styled, as follows: "A Study of Intercompany Pricing, Prepared by the Treasury Department's Officer of International Tax Counsel and Office of Tax Analysis, and Internal Revenue Service's Office of Assistant Commissioner (International) and Office of Associate Chief Counsel (International), Discussion Draft Released Oct. 18, 1988."
(5) Canadian law on intercompany transactions is governed by the requirement that the price charged be reasonable in the circumstances. The Canadian approach is based on 1979 recommendations of the Organization for Economic Cooperation and Development (1979 OECD Report) and is summarized in Revenue Canada's Information Circular 87-2, "International Transfer Pricing and Other International Transactions," Feb. 27, 1987.
(6) See. e.g., John A. Calderwood (Director, International Audit Division, Revenue Canada, Taxation), "Pricing for Intangibles, Goods and Services under Super Royalty," Georgetown University Law Center Seminar, "International Conference on Section 482 White Paper: Pricing for Intangibles, Goods and Services under Super royalty," (Washington, D.C. October 27 and 28, 1988); Go Kawada (Director, Office of International Operations, National Tax Administration of Japan), "Comments on Section 482 White Paper," Georgetown University Law Center Seminar, supra; and John A. Calderwood, "International Transfer Pricing: Impact of the IRS Section 482 White Paper--A Perspective from Revenue Canada, Taxation," Report of Proceedings of the Fortieth Tax Conference (Canadian Tax Foundation 1988) ( not yet published).
(7) For example, in canada, subsections 69(2) and (3) of the Act mandate a transfer price that is "reasonable in the circumstances," while section 482 of the Code mandates reallocations "in order to prevent evasion of taxes or clearly to reflect the income" of any of the parties to the transaction. Furthermore, as noted above, super royalty is a sinple one sentence addition to the pre-existing one sentence rule. The same pattern can be seen in most other countries, which base their systems on the OECD's recommendations. Only in Japan has the legislator attempted to go beyond the statement of the simple principle. See Article 66(6) of Japan's Special taxation Measure Law, effective for tax years beginning after April of 1986, which sets out the basic arm's-length principle as well as details, mainly tracking the 1979 OECD Report, as to its application.
(8) This is seen in countries such as Canada (Information Circular 87-2), the United States (the section 482 regulations), Germany (1983 Administrative Guidelines), etc. See Boidman, "Canada-U.S. Intercompany (and Other) Taxation Issues," Report of Proceedings of the Thirty-Fifth Tax Conference (Canadian Tax Foundation 1983).
(9) That the issues are not amenable to objective evaluation is substantially borne out by statistics developed by the Internal Revenue Service. This data shows that the factor to be given primacy in seeking to establish a reasonable price, i.e., "comparables," is more often than not unavailable. All agree that, where available, transactions with third parties which are comparable (and, ideally, entered into by the taxpayer under review itself) comprise the best standard against which an intercompany transaction by such taxpayer is to be evaluated. Moreover, it is clear that there can be much subjectivity in determining whether transactions are comparable, thus undermining the apparently simple objectivity of the comparable price approach.
(10) This basic factor was acknowledged by a senior representative of the U.K. Inland Revenue, Ian Hunter, at a recent conference, as follows:
I think another reason that the U.K. has never sought to introduce subordinate legislation to support the legislation relating to transfer pricing is the very one which has caused difficulty in the United States for the 482 regulations. The number of facts and circumstances to which transfer pricing legisltaion applies are so varied that is difficult to go beyond the initial reference to an arm's-length price to produce regulations which fit in all cases to which they apply. (Ian Hunter, "Foreign Rules for Goods and Intangibles--United Kingdom," presented at Georgetown University Law Center Seminar, supra note 6, at 3).
(11) Even the possibility that the tax arising under section 69 would be deferred by claiming a reserve on the transfer of intangibles, to the extent governed by section 14 of the Act under the decision in Timagami Financial Services Limited v. The Queen, 81 D.T.C. 5064 (F.C.T.D.) and 82 D.T.C. 6268 (F.C.A.), was considered sufficiently offensive to Revenue Canada that Canada's 1987 tax reform, Bill C-139, eliminated reserves on or in respect of proceeds for section 14.
(12) G. D. Searle and Co. v. Commissioner, 88 T.C. 252, 376, (1987).
(13) Eli Lilly & Co v. commissioner, 24 T.C. 996 (1985), rev'd in part, aff'd in part and remanded, Nos. 86-9211 and 86-3116 (7th Cir. Aug. 31, 1988).
(14) See I.R.C. [subsec.] 351, 367, and Rev. Proc. 63-10 and Rev. Proc. 68-23. Section 85 of the Act (the Canadian couterpart of Code [sec.] 351) had an absolute bar against non-recognition transfer to corporations formed outside Canada (Section 85.1 allows such transfers of shares of foreign subdiaries and other affiliates in some circumstances.)
(15) The views of Charles Triplett, an IRS official who was a prime author of the White Paper, as reported in "U.S. Defends Super Royalty as No Violation of Arm's Length," International Tax Report 3 (Sept. 1988), are of interest:
In Triplett's view, the IRS was asleep when it granted favorable rulings for the tax-free transfers of the intangible property associated with "crown jewel" products of subsidiaries in Puerto Rico, Ireland and Singapore.
(16) The White Paper makes perfectly clear the reason for the amendment, at pages 46 and 47:
The primary difficulty addressed by the legislation was the selective transfer of high-profit intangibles to tax havens. Because these intangibles are so often unique and are typically not licensed to unrelated parties, it is difficult, if not impossible, to find comparables from which an arm's length transfer price can be derived.
(17) Had the transfer in Lilly and Searle taken place after the enactments of section 936(h) of the Code in 1982 and 367(d) in 1984, the U.S. transferors would have been required to recognize, as income for U.S. tax purposes, an annual amount as a deemed royalty (but there would not have been a deemed realization in the year of transfer). In this context and in light of the latitude provided the courts by pre-existing section 482 and the regulations made thereunder to allocate income in accordance with the true contributions of the partners, as reflected, as least in part, in E. I. DuPont de Nermours & Co. v. United States, 608 F.2d 445 (Ct. Cl. 1979) and Hospital Corporation of American v. commissioner, 81 T.C. 520 (1983), as well as Lilly and Searle, the add-on of the super royalty rule seems superfluous.
(18) Section 212(1)(a) of the Income Tax Act was added, requiring a 25-percent tax on management and administration fees paid by a Canadian subsidiary to a foreign related company in specified circumstances. ironically, the 1983 Canada-U.S. Income Tax Convention exempts U.S. companies from this tax.
(19) Excess foreign (Canadian) tax credits may arise because of (1) tax rate differentials, (2) the Code "separate basket" rules, or (3) the interest allocation rules. With respect to (1), after tax reform in the two countries, the average overall Canadian rates (including withholding taxes on dividends) may be in the area of 43 percent for manufacturing profit and 48 percent for other profits. The standard U.S. federal corporate rate of tax is now 34 percent, leading to a potential excess foreign tax credit position of 9 percent in the former case and 14 percent in the latter case.
(20) Revenue Canada is also concerned that U.S.-based multi-nationals might have incentive to increase charges to Canadian subsidiaries merely "... in an attempt to ensure that they have complied with your legislation to the detriment of the other taxing jurisdictions." Calderwood, Georgetown University Law Center Seminar, supra note 6, at 13.
(21) Although skeptics may dismiss this type of language in the White Paper as mere rhetoric, at least one U.S. observer believes that this language will create a legally self-fulfilling prophecy. See Fuller, "The IRS Section 482 White Paper," Tax Notes, Nov. 7, 1988, at 655, 660:
The White Paper states that Congress intended no departure from the arm's-lenght standard in that the Tax Reform Act amendment is simply a clarification of the prior law. Since the courts have categorically rejected contract manufacturing and the use of industry statistics, presumably they will continue to do so, since the standard under the White Paper is arm's-lenght, i.e., the same standard under which the courts operated in deciding in prior cases.
(22) For example, Robert T. Cole, a former International Tax Counsel (ITC) to the U.S. Treasury, at a conference held in October (Georgetown University Law Center Seminar, supra note 6), stated:
As a matter of principle, I do not think that any of the rules enunciated in the White Paper depart from arm's-length standard and, therefore, rather than reject the rules before the ink is dry because they might conceivably work to a country's disadvantage in the short run, I urge that they be given fair consideration and a fair trial. Robert Patrick, another former ITC, in a paper to the Canada Tax Foundation, supra note 6, noted the fears of critics that "the study foreshadows an arbitrary attempt to impose a new economic concept and unrealistic compliance requirements ... based on the assumption that there is a precision to establishing the 'right' price." He was, however, of the view that "the study will be accepted as contribution to rationalizing the fourth method under U.S. tax regulations ... and will require more systematic justification fo pricing methods."
(23) John Calderwood, Canadian Tax Foundation, supra note 6, expresses agreement (at page 19) with the White Paper's delineation between exact and inexact comparables, and the ambit thereof.
(24) For a discussion of Revenue Canada's views as to the standards for comparability see paragraph 14 of the Information Circular, supra note 5.
(25) Although not dealt with specifically in the White Paper, one assumes that an "inexact" comparable can also include a license involving the same intangibles under consideration but in circumstances which do not meet the standards for an "exact" comparable.
(26) As noted elsewhere, the White Paper questions the priority of the secondary resale or cost-plus methods and, in any event, these are basically inapplicabel to transfers involving intangibles.
(27) The White Paper states at page 98: "The use of both types of unrelated party information is consistent with the fundamental goal of the basic arm's-lenght return method, which is to use information about unrelated parties to determine the returns that would have been earned had the related parties' activities been undertaken at arm's-length."
(28) indalex Limited v. The Queen, 86 D.T.C. 6039 (F.C.T.D.) and 88 D.T.C. 6053 (F.C.A.) See Boidman, "The Canadian Approach to Offshore International Transactions: Indalex v. The Queen -- A Transhipment Case," 39 The Tax Executive 45 (Fall 1986); and Boidman, "The Canadian Approach to Offshore International Transactions: An Update," 40 The Tax Executive, 383 (Spring 1988).
(29) See White Paper at page 94: "One of the main arguments for the development of an arm's-lenght return method, in fact, is that taxpayers, the Service and especially the courts have found it necessary to use ad hoc and incompletely developed versions of such a method in the past and will undoubtedly continue to do so in the future. Therefore, the goal of this discussion is to aly a foundation for this approach so that it may be used to achieve more consistent and satisfactory results."
(30) Revenue Canada, however, has expressed strong reservations. See John Calderwood, Canadian Tax Foundation, supra note 6, at page 20.
(31) Paragraph (13), which begins the section of the Circular dealing with the transfer of goods, stipulates that the principles discussed therein "...apply to the acquisition or disposition of intangible property as, for example, the outright transfer or ownership of a patent."
(32) With respect to paragraph 45 of the Circular, there was an interesting exchange between John Calderwood of Revenue Canada and Charles Triplett of the IRS at a June 27-28, 1988, Seminar sponsored by the International Tax Institute, "The Competent Authorities from Six Nations Discuss Transfer Price Issues Amidst Changing Tax Rates and Fluctuating Currency Values." According to a summary in the International Tax Report, "U.S. defends super royalty as no violation of arm's-length," page 3, September 1988, Mr. Triplett was quoted as disagreeing with paragraph 45 of the Information Circular in that it does not recognize the impractically of seeking to effectively use inexact comparables for unique high-value intangibles where there are no comparables at all. According to the report, Mr. Caldewood rebutted that the IRS had made no mention of this "crown jewel" problem when it reviewed earlier drafts of the Department's Circular.
(33) 88 D.T.C. 6138 (F.C.T.D.)
(34) John Calderwood states Revenue Canada's basic concerns about the periodic adjustment rule, as follows (Canadian Tax Foundation, supra note 6, at page 33-34):
The periodic adjustment concept likewise poses questions. Will this be on an annual self assessing basis or by an audit basis? It is difficult to accept that this "hindsight" basis is what persons dealing at arm's lenght would do. Where the use of high profit potential intangibles is involved, we suggest arm's-length parties would determine a price at the particular time the use of the intangibles commenced. Also while any royalty rate might initially be for a short duration, provision would be made for subsequent, not annual, renegotiation. As representative from the private sector have pointed out, renegotiation clauses are frequent for downward rate adjustments but rare for increases. While there are occasional examples of third parties obtaining rights or properties (in this context not always intangible property) at bargain prices, the more frequent situation is third parties paying too much for the property. Revenue Canada Taxation submits that it is only in extreme situations that third parties renegotiate for a reduced consideration, seldom, if ever, an increased consideration.
Specifically, with respect to the super-royalty provision, the IRS, through hindsight, will be making adjustments to royalty rate percentages charged to related Canadian companies based on the profits realized by these Canadian companies not only from the use of the underlying technology but also as a result of the Canadian company's own efforts and initiatives. Furthermore, these adjustments may vary from year to year dependent upon the profits earned in Canada. The super-royalty provisions which generally apply for tax years beginning after December 31, 1986, seek to include in the U.S. company's taxable income amounts as payments from related Canadian and other foreign companies,commensurable with the income attributable to the transferred (licensed) intangible properties. This amount may be greater than an arm's-length royalty, the excess amount being classified as the super-royalty.
(35) See Bischel, "The Treasury White Paper Commensurate With Income Standard and Analysis," at the Georgetown Conference, supra note 6, at page 6 of his paper in dealing with Example 1:
The conclusion of the foregoing example is somewhat at variance of the study which indicates that year-by-year equality is not essential if it is reasonable to conclude that the long-term results would be comparable. Hence, the size and markets and royalty payments may annually vary without destroying exact comparability.
(36) Robert Patrick in his paper delivered to the Canadian Tax Foundation's 1988 annual conference, see Patrick, "A U.S. Practitioner's Perspective," supra note 6 observes that "while the study states that the taxpayer may rebut the use of subsequent experience, the required burden of showing that unrelated parties would not have provided for adjustments in cases of inexact comparables appears too difficult to me." Why is this? Michael Abrutyn, "Administrative Requirements -- A Look Ahead," Georgetown Conference, supra note 6, states (at page 8):
It is also suggested that the taxpayer has the burden of proof by 'clear and convincing' evidence (of civil fraud standard) to demonstrate that subsequent profitability cannot have been anticipated. This could prove to be an almost impossible burden for a taxpayer to satisfy because of the high standard and the lack of ability to locate comparables.
(37) See Johnson v. M.N.R., 3 D.T.C. 1182 (1948) (S.C.C.) Revenue Canada's initial assessment of the White Paper does not seem to focus at all on the rebuttable presumption aspect of the periodic adjustment rule.
(38) R. T. French Co. v. Commissioner, 60 T.C. 836 (1973). In French the court rejected an IRS contention that a related-party license should be treated as having an adjustment clause, presumably on the ground that either on the facts in that case or in general third parties do not renegotiate contracts once entered into.
(39) The IRS sources are being questioned. See Nolan, "Application to Goods and Services: Comparables, Basic Rate of Return Method, Profit-Split," George-town Conference, supra note 6, at page 5.
(40) See note 34 supra.
(41) However, Article IX of the Canada-U.S. Income Tax Convention could authorize such adjustments. See also Aluminum Co. of Canada Ltd. v. The Queen, 74 D.T.C. 6408 (F.C.T.D.).
(42) Revenue Canada is particularly concerned about retroactive adjustments under the periodic adjustment rule. Commenting on Conclusion 4 of Chapter 8 of the White Paper (that periodic adjustments generally be prospective unless a different royalty rate would have been set on the date of transfer based upon expectations of the parties), John Calderwood, Canadian Tax Foundation, supra note 6, states at page 17: "The above statment is not too clear. We hope it suggests that taxpayer is not expected to use hindsight in making periodic adjustments."
(43) Even in the case of high profit potential intangibles, the White Paper concedes that valid comparables would govern (at page 52):
In the rate instance in which there is a true comparable for a high profit intangible, the royalty rate must be set on the basis of the comparable because that remains the best measure of how third parties would allocate intangible income.
(44) Paragraph 56 of the Information Circular states that arm's-length pricing is assessed on a transaction-by-transaction basis:
This approach is necessary because the income Tax Act to each transaction between the various related parties and not to the Canadian taxable income, return on sales, return on equity or any other measurement of general profitability.
The White Paper (at page 59) notes that, although the 1979 OECD Report considers the arm's-length standard inconsidtent with "global" methods for transfer pricing, the White Paper notes that the OECD does recognize that adjustments may be made and that "nowhere, however, does the report suggest that the profit related enterprises are relevant to this determination." (At page 60.) Moreover, the White Paper notes that the 1979 OECD Report "specifically authorizes an inquiry into profits or profitability" and provides for analysis of economic functions to determine "when a profit is likely to arise and roughly what sort of profit it is likely to be." In light of these factors, the essential nature of the super royalty rule and revenue Canada's position, it is doubtful whether Revenue Canada will consider its statement in paragraph 56 of the Circular as constituting a bar to acceptance of prices determined in accordance with the principle of the super royalty rule.
(45) See new sections 231.6 and 233.1 and amended subsection 152(4) of the Income Tax Act. See Boidman, "Canadian Tax Reform Proposals--A Response to the U.S. Tax Reform Act of 1986," Tax Management International Journal 318 (Aug. 1987); Lanthier, "Canada: Tough Time Ahead for Multinationals?," 41 The Tax Executive 123 (Winter 1989).
(46) Consistent with Revenue Canada's concerns is the following statement by John Calderwood to the Canadian Tax Foundation conference, supra note 6, at pages 38-39:
Generally, Revenue Canada Taxation agrees with the approach taken where tax havens and possession corporations are involved. However, it would have preferred to see a clearer position taken where treaty partners are involved and this appears to be the consensus among other treaty partners ...
In conclusion, it would appear that the competent authorities' workloads, and those of corporate groups as well, may well increase as a result of the Section 482 White Paper.
(47) Aggregate Canadian federal and provincial corporate tax rates may be less than the effective overall U.S. federal and state taxes that would apply to U.S. effectively connected income earned by a U.S. subsidiary or branch of a Canadian corporation, particularly where there is factored in applicable secondary U.S. taxes (i.e., either dividend withholding taxes in the case of a U.S. subsidiary, or branch profits tax in the case of a U.S. branch). As a result, Canadian companies often have as much incentive to maximize charges against U.S. profits as do U.S. parent companies against Canadian profits.
(48) Revenue Canada generally agrees with the thrust of the White Paper's approach to cost-sharing arrangements, although John Calderwood, Canadian Tax Foundation, supra note 6, at page 22, expresses concern about the basic assumption of the White Paper (that Congress intended to permit cost-sharing arrangements if they produce results consistent with the super royalty rule).
(49) A subsidiary theme in the Information Circular is whether or not there should be a profit or mark-up charge on the R & D function and the effect thereof on withholding taxes, under Part XIII (see paragraph 38 of the Circular). Revenue Canada reiterates its position, expressed in It-303 Special Release, that a payment will not quality for exemption under paragraph 212(1)(d)(ix) if there is a profit element in the amount allocated to the Canadian participant. There appears to be no statutory basis for this restrictive view. As well, there can be some questions as to the applicability of withholding taxes where the conditions of paragraph 212(1)(d)(ii) do not apply. See Boidman, "Revenue Canada's Transfer Pricing Circular: Selected Commentary," 36 Canadian Tax Journal 405 (March-April 1988).
(50) Chapter 10 of the White Paper examines the use of formular methods and conclude that "the market-based arm's-length standard remains the better theoretical allocation method." One way of assessing the risk of significant arbitrarines with any type of rigid apportionment formula is to consider the discussion in the White Paper respecting the priority of pricing methods, where exact comparable do not goven. Facts and circumstances can lead to at least four different theories respecting the choice of appropriate pricing methods (as between "inexact" comparables and the arm's-length return method). The variety of situation requiring distinctive and varying approaches are a good indication of the risk of arbitrary results where a single or small number of fixed approtionment methods are used.
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|Date:||Mar 22, 1989|
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