The US Transfer Pricing Regime

Section 482 of the IRS Tax Code authorizes the IRS to adjust the income, deductions, credits, or allowances of commonly controlled taxpayers to prevent evasion of taxes or to clearly reflect their income. The regulations under section 482 generally provide that prices charged by one affiliate to another, in an intercompany transaction involving the transfer of goods, services, or intangibles, yield results that are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances, ie on an arms' length basis.

Note that the basis of Section 482 is non-geographic; it applies to any relevant transaction whether domestic or international.

Section 482 provides guidance for related parties in their determination of an appropriate arm's-length transfer price to be charged in their related-party transactions. Section 482, says the IRS, and the accompanying Regulations are necessary to prevent related taxpayers in different taxing jurisdictions from easily and artificially shifting items of income and expense between these different tax jurisdictions (with differing rates of tax).

Section 482 will usually be applicable in any situation where a United States entity enters into transactions (e.g. sales, loans, provision of management services) with a related foreign entity. The intent of §482 is to ensure that, from a United States tax perspective, an arm's-length price is charged in all related-party multi-jurisdictional transactions.

The IRS's powers under Section 482 extend to any case in which either by inadvertence or design the taxable income of a controlled taxpayer is other than it would have been had the taxpayer, in the conduct of his affairs, been dealing at arm's length with an uncontrolled taxpayer. Transactions between controlled taxpayers which may involve a section 482 issue include the following:

• One entity makes a loan or advance to another entity and charges no interest or does not charge an arm's-length interest rate;
• One entity performs services for another entity without charge or at a charge which does not reflect an arm's-length payment;
• One entity leases property to another entity at a rental charge that is not an arm's-length rental charge;
• One entity sells poperty to another entity at a sales price that is not an arm's-length price;
• One entity leases intangible property to another entity for no royalty fee or a fee that is not an arms-length fee;
• One entity enters into a cost sharing arrangement with another entity to share costs to develop intangibles but all related costs are not shared.

Section 482 requires that the "best method" be employed to determine arm's length pricing for each intercompany transaction. Among the factors to be taken into account in determining the best method is "the degree of comparability between the controlled transaction (or taxpayer) and any uncontrolled comparable and the quality of the data and assumptions used in the analysis." A number of different methods are offered by the regulations:

• Comparable Uncontrolled Price Method (also called the Comparable Uncontrolled Transaction Method for intangible transfers);
• Comparable Profits Method;
• Profit Split Method;
• Resale Price Method;
• Cost Plus Method.

Services And Intangible Property

The Treasury has supplemented its original Section 482 regulations on services and intangible property on several occasions.

Treasury guidance on services and intangible property was amended and supplemented in 2004.

The amended regulations provided updated guidance under section 482 that replaced existing guidance under section 1.482-2(b) relating to controlled services transactions and existing guidance under section 1.482-4(f)(3) relating to the allocation of income attributable to intangible property.

The updated regulations provided generally that the arm's length amount charged in a controlled services transaction must be determined under one of the transfer pricing methods provided for or referenced in the proposed regulations. The guidance regarding transfer pricing methods provided for in the proposed regulations generally is consistent with the current regulatory guidance regarding the transfer pricing methods applicable to transfers of tangible or intangible property and is consistent with international standards in this area.

In addition, the new regulations provided a new cost-based method that may be used to price low-margin controlled services transactions that meet certain quantitative and qualitative conditions and requirements. This simplified cost-based method generally requires a less robust analysis of services transactions within its scope than would be required under the other pricing methods. The simplified method is intended to preserve aspects of the current rules that provide appropriately reduced administrative and compliance burdens for low-margin services while bringing the current rules more into line with the arm's length standard and eliminating aspects of the current rules that have proved problematic.

The new regulations provide updated guidance consistent with international standards in this area on the threshold issue of whether activities constitute the rendering of services for the benefit of another member of a controlled group.

The new regulations provide guidance to better coordinate and harmonize the rules applicable to services transactions with the rules for other types of transactions under section 482, in particular transfers of intangible property. The Treasury Department and the IRS believe that such guidance is necessary to mitigate the extent to which the form or characterization of a transfer of intangibles as the rendering of services can lead to inappropriate results. The Treasury Department and the IRS believe that the transfer pricing rules should reach similar results in the case of economically similar transactions, regardless of the characterization or structuring of such transactions. Thus, several provisions of the proposed regulations are intended to minimize or to eliminate the differences between the transfer pricing analysis of services transactions related to intangibles and the analysis of transfers of intangible property.

In particular, the new regulations provide that the arm's length result for a services transaction that effects the transfer of intangible property must be determined or corroborated by an analysis under the transfer pricing rules for transfers of intangible property. In addition, the new regulations limit the use of the simplified cost-based method in the case of services that involve the use of valuable intangibles. The new regulations also provide guidance regarding the use or imputation of contingent-payment arrangements in the context of services transactions, and provide generally applicable guidance on the application of the residual profit split method to make that method more suitable to the analysis of services transactions where appropriate. The cumulative effect of these provisions is to make available in connection with the transfer pricing of controlled services relating to intangibles the analytical tools that are available in connection with the transfer pricing of transfers of intangible property, including the possibility of analyzing transactions as multi-year arrangements in which the consideration for services rendered in one tax accounting period may be due in later periods.

The new regulations also update guidance under existing §1.482-4(f)(3) relating to the allocation of income attributable to intangible property. The taxpayers and other commentators have criticized the framework of §1.482-4(f)(3). In particular, commentators have questioned the use of ownership for purposes of section 482, as distinct from legal ownership or ownership for tax purposes more generally, as an analytical tool for determining the appropriate allocation of income attributable to an intangible. The Treasury Department and the IRS believe that existing §1.482-4(f)(3), when properly applied, generally reaches appropriate results in allocating income attributable to intangible property.

However, the Treasury Department and the IRS are concerned that the regulation may be misapplied to reach “all or nothing” results based on a determination of ownership in cases where an arm's length analysis in accordance with the section 482 regulations would require that the income attributable to an intangible be divided among the controlled taxpayers that made significant contributions to develop or enhance that intangible, and that hold legal rights with respect to that intangible.

As a result, the Treasury Department and the IRS believe that the analytical framework of §1.482-4(f)(3) should be modified. The rules for determining the ownership of an intangible generally should be distinct from the rules for determining the allocation of income from an intangible. The income attributable to an intangible should be allocated among controlled taxpayers under the arm's length standard, in accordance with each party's contributions to the development or enhancement of that intangible and its ownership interests (if any). This analysis generally will preclude “all or nothing” results. The proposed modifications to §1.482-4(f)(3) are possible because of proposed changes to the treatment of controlled services transactions, in particular the conditions and requirements on the use of the simplified cost-based method and the provisions intended to better coordinate and harmonize the rules applicable to services transactions with the rules for transfers of intangible property (including guidance on services that effect transfers of intangible property and guidance on the residual profit split method and contingent payment arrangements).

Cost-Sharing Arrangements

Under a cost sharing arrangement, related parties agree to share the costs and risks of intangible development in proportion to their reasonable expectations of the extent to which they will relatively benefit from their separate exploitation of the developed intangibles.

The Treasury issued new regulations in 2005 to amend and supplement the existing Sec. 1.482-7 regulations. In accordance with Sec. 1.482-1(b)(1), says the IRS, the task is to provide guidance relative to cost sharing arrangements regarding "the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances.''

For purposes of determining the results that would have been realized under an arm's length cost sharing arrangement, the new regulations adopt as a fundamental concept an investor model for addressing the relationships and contributions of controlled participants in a cost sharing arrangement. Under this model, each controlled participant may be viewed as making an aggregate investment, attributable to both cost contributions (ongoing share of intangible development costs) and external contributions (the preexisting advantages which the parties bring into the arrangement), for purposes of achieving an anticipated return appropriate to the risks of the cost sharing arrangement over the term of the development and exploitation of the intangibles resulting from the arrangement.

In particular, the investor model frames the guidance in the proposed regulations for valuing the external contributions that parties at arm's length would not invest, along with their ongoing cost contributions, in the absence of an appropriate reward. In this regard, valuations are not appropriate if an investor would not undertake to invest in the arrangement because its total anticipated return is less than the total anticipated return that could have been achieved through an alternative investment that is realistically available to it.

The investor model, says the IRS, is grounded in the legislative history of the Tax Reform Act of 1986 which provided in pertinent part as follows:

In revising section 482, the conferees do not intend to preclude the use of certain bona fide cost-sharing arrangements as an appropriate method of allocating income attributable to intangibles among related parties, if and to the extent such agreements are consistent with the purposes of this provision that the income allocated among the parties reasonably reflect the actual economic activity undertaken by each. Under such a bona fide cost-sharing arrangement, the cost-sharer would be expected to bear its portion of all research and development costs, on successful as well as unsuccessful products within an appropriate product area, and the cost of research and development at all relevant developmental stages would be included. In order for cost-sharing arrangements to produce results consistent with the changes made by the Act to royalty arrangements, it is envisioned that the allocation of R&D cost-sharing arrangements generally should be proportionate to profit as determined before deduction for research and development. In addition, to the extent, if any, that one party is actually contributing funds toward research and development at a significantly earlier point in time than the other, or is otherwise effectively putting its funds at risk to a greater extent than the other, it would be expected that an appropriate return would be provided to such party to reflect its investment.

There are special implications that are derived from determining the arm's length compensation for external contributions in line with the investor model. In evaluating that arm's length compensation, it is appropriate, consistent with the investor model, to determine (1) what an investor would pay at the outset of a cost sharing arrangement for an opportunity to invest in that arrangement, and (2) what a participant with external contributions would require as compensation at the outset of a cost sharing arrangement to allow an investor to join in the investment. The appropriate ``price'' of undertaking a risky investment is typically determined at the time the investment is undertaken, based on the ex ante expectations of the investors.

Given the uncertainty about whether and to what extent intangibles will be successfully developed under a cost sharing arrangement, ex post interpretations of ex ante expectations are inherently unreliable and susceptible to abuse. Accordingly, an important implication of determining the arm's length result under the investor model, reflected in the methods, is that compensation for external contributions is analyzed and valued ex ante. The ex ante perspective is fundamental to achieving arm's length results.

The new regulations begin by specifying the transactions relevant to a cost sharing arrangement. Importantly, the proposed regulations acknowledge that in a typical cost sharing arrangement, at least one controlled participant provides resources or capabilities developed, maintained, or acquired externally to the arrangement that are reasonably anticipated to contribute to the development of intangibles under the arrangement, namely what are referred to as external contributions.

Thus, the new regulations integrate into the definition of a cost sharing arrangement both ``cost sharing transactions'' regarding the ongoing sharing of intangible development costs as well as ``preliminary or contemporaneous transactions'' by which the controlled participants compensate each other for their external contributions to the arrangement (that is, what the existing regulations refer to as the ``buy-in''). The new regulations provide that Sec. 1.482-7 only governs arrangements that are within (or which the controlled taxpayers reasonably concluded to be within) the definition of a cost sharing arrangement. Arrangements outside that definition must be analyzed under the other sections of the section 482 regulations to determine whether they achieve arm's length results.

The new regulations provide supplemental guidance on the valuation of the arm's length amount to be charged in a preliminary or contemporaneous transaction. The proposed regulations clarify that the valuation of the rights associated with the external contribution that is compensated in a preliminary or contemporaneous transaction cannot be artificially limited by purported conditions or restrictions.

Rather, the arm's length compensation, and the applicable method used to determine that compensation, must reflect the type of transaction and contractual terms of a ``reference transaction'' by which the benefit of exclusive and perpetual rights in the relevant resources or capabilities are provided. This compensation will be determined by a method that will yield a value for the obligation of any given controlled participant that is consistent with that participant's share of the combined value of the external contribution to all controlled participants.

The new regulations include provisions to facilitate administration of, and compliance with, the cost sharing rules. These include contractual provisions required for cost sharing arrangements, documentation that must be maintained (and produced upon request by the IRS), accounting requirements, and reporting requirements.

Compliance

Penalties for incorrect application of transfer-pricing regulations are severe, and the IRS has considerably stepped up its audit activity on transfer pricing, so that companies of all sizes need to take precautions, either by commissioning transfer-pricing reviews from external professionals, or by negotiating Advanced Pricing Agreements with the IRS (see below).

Transfer pricing reviews provide the documentation necessary to withstand IRS audits. In any event, most companies in the US with related-party transactions are required to compile “reasonable and full” documentation of arm’s-length pricing prior to filing annual returns. Failure to produce this documentation within 30 days of notice of audit places the company at risk for additional tax, interest and penalties on the adjustments identified.

If the valuation of any transfer price is 200% greater or 50% or less of an arm's-length transfer price or if the net §482 adjustment for the particular taxable year exceeds the lesser of $5 million (at the time of writing) or 10% of the taxpayer’s gross receipts, then the penalty for exceeding the particular threshold is 20%. If the valuation of any transfer price is 400% greater or 25% or less of an arm's-length transfer price or if the net §482 adjustment for the particular taxable year exceeds the lesser of $20 million (at the time of writing) or 20% of the taxpayer’s gross receipts, then the penalty for exceeding the particular threshold is 40%.

Additionally, in cases where no transfer price was charged or where no transfer pricing report was prepared, then the 40% penalty will generally always apply.

Although an APA is the most secure way to avoid imposition of transfer pricing penalties, the process of agreeing an APA is complex and in itself expensive, so that most smaller businesses cannot realistically employ APAs. The IRS has developed APA procedures tuned to the needs of small businesses, but costs can still be prohibitive in many cases. Thus, a transfer pricing review may in many cases be the more cost-effective option.

Even the preparation of transfer pricing reports can be very time consuming, and there is no guarantee that the IRS will not prevail in a particular case.

The American Jobs Creation Act of 2004

The American Jobs Creation Act of 2004 (the Act) included a new tax deduction, contained in Section 199 of the Tax Code, based on a percentage of the taxpayer’s qualified production activities (QPAI), intended to replace the international export tax incentive schemes banned by the WTO. The new deduction raises some transfer pricing issues. The deduction probably applies to both US and foreign-owned businesses operating in the USA.

The deduction amounts to 3% of QPAI in 2005 and 2006, 6% in 2007-2009, and 9% in 2010 and thereafter. For transfer pricing purposes, the allocation of gross receipts between qualifying domestic production gross receipts (DPGR) and non-qualifying gross receipts is critical.

Treasury Notice 2005-14 gave preliminary (but already highly complex) guidance on the new deduction.

Under § 199(c)(1), QPAI is the excess of DPGR over the sum of: (a) the cost of goods sold (CGS) allocable to such receipts; (b) other deductions, expenses, or losses directly allocable to such receipts; and (c) a ratable portion of deductions, expenses, and losses not directly allocable to such receipts or another class of income.

Section 199(c)(3) provides special rules for determining costs in computing QPAI. Under these special rules, any item or service brought into the United States is treated as acquired by purchase, and its cost is treated as not less than its value immediately after it enters the United States. A similar rule applies in determining the adjusted basis of leased or rented property when the lease or rental gives rise to DPGR. If the property has been exported by the taxpayer for further manufacture, the increase in cost or adjusted basis must not exceed the difference between the value of the property when exported and its value when brought back into the United States after further manufacture.

Section 199(d)(4)(A) provides that all members of an expanded affiliated group (EAG) are treated as a single corporation for purposes of § 199. Section 199(d)(4)(B) provides that an EAG is an affiliated group as defined in § 1504(a), determined by substituting “50 percent” for “80 percent” each place it appears, and without regard to § 1504(b)(2) and (4).

Section 199(d)(4)(C) provides that, except as provided in regulations, the § 199 deduction is allocated among the members of the EAG in proportion to each member’s respective amount (if any) of QPAI.

There are multiple difficulties of definition in these and other sections which have got to be considered in the light of transfer pricing regulation, particularly perhaps where contract manufacturing is involved.

The intention of the Act was to some extent to encourage firms to relocate overseas production activity to the continental USA, and it aimed to do this by improving the domestic tax regime in relation to overseas ones. Inevitably this impacts on transfer pricing methodology and outomes, with consequences for overall corporate tax planning.

On the other hand, the availability of the deduction for property that is manufactured only “in significant part within the United States”, which includes a safe harbour where at least 20% of total cost is incurred in domestic conversion, was likely to offer international tax-planning opportunities for many companies. Meeting the 20% rule would depend on values established under transfer pricing policies.

Internal Revenue Service Commissioner Doug Shulman has warned that the agency is ratcheting up its efforts to police the US international tax system and will focus its compliance efforts in three main areas, including transfer pricing, withholding taxes and hybrid entities.

In December, 2008, Internal Revenue Service Commissioner Doug Shulman warned that the agency was ratcheting up its efforts to police the US international tax system and would focus its compliance efforts in three main areas, including transfer pricing, withholding taxes and hybrid entities. "We must recognize that US multinational corporations shopping for the best tax deals across the globe will come under increased public scrutiny back home," Shulman said in his speech before the 21st Annual George Washington University International Tax Conference.

"Let me be clear. Some of these tax strategies can be legal. And many corporations and their legal and tax advisors are genuinely trying to comply with the myriad of international tax laws they face and to avoid double taxation. Legitimate practices to minimize tax exposure are also essential for US corporations to operate and remain competitive in the global marketplace where foreign-based corporations have such tools at their disposal."

However, Shulman added that "we have also seen some corporations constructing transactions to avoid tax entirely on certain income, or trying to go beyond the avoidance of double taxation and engage in 'double-dip' transactions whereby they get a deduction or credit for the same amount in two countries."

According to Shulman, US-based corporations more than tripled their foreign profits between 1994 and 2004, rising from USD89bn to USD298bn, with 58% of that profit earned in low tax or no tax jurisdictions. Meanwhile, multinational enterprises increased from 3,000 in 1990 to more than 63,000 in 2007 and the value of foreign tax credits being claimed increased by more than 25% in just two years from 2005 to 2007. "And this gives pause to some US taxpayers and policymakers who want to be sure that that these corporations are paying their fair share at home," he said.

"It’s clear that no one – not the IRS or any tax administration system in the world – can afford to fall behind this fast pace. Nor can we afford a go-it-alone strategy. To this end, I am committed to engaging with my counterparts across the globe and pushing forward what I see as the collective and shared enterprise of fair and effective tax administration," he revealed.

Shulman said that the agency is starting to make progress in its international efforts in the corporate arena by focusing on three specific areas in a bid to "reign in those corporations who are pushing the envelope."

"First is Transfer Pricing. This is one of the most difficult areas for both tax authorities and taxpayers," he said, adding that the agency's specific focus will be on cost sharing, contract manufacturing, and global dealing.

Shulman explained: "Cost sharing involves those taxpayers aggressively pursuing transfer pricing schemes to shift income out of the US to low or no tax jurisdictions. One of the most common is to transfer a valuable intangible for less than arms-length compensation. The IRS has been vigorously attacking many of these transactions where we see corporate taxpayers crossing the line. In addition to pursuing cases in the audit and exam cycle, we are also working on temporary regulations related to cost sharing.

"Contract manufacturing is about taxpayers trying to avoid subpart F income in foreign locations that do not have sufficient manufacturing activity. The IRS and Treasury are also working on regulations in this area that will make it more difficult for taxpayers to use this abusive tax planning.

"Global dealing is somewhat analogous to the transfer of intangibles such as research and development related to a new drug, but it is applicable to financial institutions. Specifically, financial institutions will attempt to book transactions such as loans and swaps in low-or-no tax jurisdictions and then argue that a disproportionate amount of the profit should be allocated to the low-or-no tax jurisdiction."

The second area of concern for the IRS is hybrid structures, including hybrid entities or hybrid instruments. "Regardless of the form, their underlying purpose is to either exclude income from taxation or obtain double deductions/credits in various jurisdictions."

"One of the most problematic of these structures are Foreign Tax Credit generators. In my opinion, FTC generator transactions are examples of situations where certain taxpayers may be trending toward the 'bad actor' end of the spectrum," Shulman commented.

The third area of heightened compliance will be with regards withholding taxes, and Shulman disclosed that this has already been added to the 'Tier I' list of issues by the agency.

"The tier issue process will provide the needed organizational priority and coordination to ensure taxpayer compliance with the US withholding tax provisions. Our compliance efforts will span efforts to ensure individual, business and corporate taxpayers understand and fulfil their withholding tax filing obligations to addressing transactions that attempt to circumvent withholding taxes or claiming improper tax treaty withholding rates," Shulman told the audience.

In September, the Senate Permanent Subcommittee on Investigations held a hearing looking into how the IRS has been investigating certain investment banks who have been trying to help their clients – mostly hedge funds – avoid dividend withholding tax. During the hearing, there was also discussion about securities lending transactions and Notice 97-66.

"IRS is reviewing the notice," Shulman said. "However, in the interim, we’re examining very carefully those transactions whose primary purpose is to avoid dividend withholding tax and will propose adjustments as needed."

Shulman also said that the IRS will continue its campaign against unreported offshore accounts and will use the Qualified Intermediary programme as its main weapon. Under the proposed changes to this programme, financial institutions that are QIs must provide early notification of material failure of internal controls. They must also improve evaluation of risk of circumvention of US taxation by US persons. And they must include audit oversight by a US auditor.

"Admittedly, the QI program is a maturing, and complex program and there are flaws that must be addressed. I became convinced early in my tenure that we need to shore up the QI program and continuously enhance, improve and strengthen it. And we are" he remarked.

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