Edward Tanenbaum

Industry focus approach to compliance

The Large and Midsize Business Division (LMSB) of the IRS, which is responsible for examining businesses with assets of $10 million or more, has implemented an industry issue focus approach to compliance to improve consistency in the resolution of issues across industries. Compliance issues are identified by field agents through examinations, reviews of schedule M-3s and other sources. The issues are then prioritised and tiered. This strategy represents a shift towards centralisation of the resolution of issues that the IRS considers to be most prevalent and subject to the greatest compliance risk.

Tier I issues are high priority issues with significant impact on one or more industries. Of the 15 Tier I issues identified by the IRS and posted on its website in March 2007, two are transfer pricing issues: section 936 exit strategies and transfer of intangibles offshore/cost sharing.

Section 936 exit strategies

Section 936 provided a tax credit against US income taxes on income earned by a US corporation with a trade or business in Puerto Rico (possession corporation). Income earned by a possession corporation was determined under special rules in section 936(h) (5) (cost sharing and profit split) and limited the credit to manufacturing profits from Puerto Rican operations. After a 10-year phase-out period, taxpayers are no longer able to claim this credit for tax years beginning after December 31 2005, and many US corporations that operated in Puerto Rico and enjoyed the benefits of section 936 have been reorganising their international structures.

Earlier this year, an LMSB industry director issued an industry director directive entitled "Tier 1 Issue-Industry Director Directive on Section 936 Exit Strategies #1." This directive provides direction to field agents for efficient examinations of this issue in an audit. The premise of this directive is that controlled foreign corporations (CFCs) that US taxpayers organised to replace their section 936 corporations retain an inordinate amount of group profits. As a Tier 1 issue, LMSB-wide coordination and executive oversight is required for section 936 exit strategies, specifically, (1) the determination of an arm's length royalty payable to the US licensor by a CFC; (2) the determination of the proper transfer prices for other associated inter-company charges for services, marketing and distribution activities and other manufacturing activities conducted by the US parent; and (3) taxation under section 367(d) for any intangibles transferred to a new CFC to be determined on an arm's length basis. While assuming that the US parent usually owns all significant intangible property related to the former possession corporation, the directive recognises that to the extent the CFC has taken on some or all of the entrepreneurial risks and responsibilities, the royalty should reflect the contributions of both the US parent and the CFC. An issue management team (IMT) has been established to review and approve all issues under examination that are related to section 936 exit strategies.

Transfer of intangibles offshore/482 cost sharing

In a typical cost sharing arrangement (CSA), one party, usually the US taxpayer, contributes intangibles developed prior to entering into the CSA for further development under the CSA. The other party, usually the foreign participant, must pay arm's length consideration (buy-in payment) for the deemed transfer abroad of an interest in such intangible.

On April 5 2007, an LMSB industry director issued a memorandum for industry directors "Tier 1 – Transfer of Intangibles Offshore/§482 Cost Sharing Buy-in Payment." The LMSB position is that cost sharing arrangements "are often used by taxpayers inappropriately to transfer intangible assets and associated profits offshore to related foreign affiliates for inadequate consideration," resulting in material underreporting of taxable income by US corporations.

It states that an IMT has been formed to identify, develop, resolve and improve IRS-wide coordination of section 482 cost sharing buy-in issues. In other words, for the IRS, cost sharing buy-in issues are under the central control of the IMT. Subject to a documented risk and materiality analysis, international examiners (or other agents) are instructed to raise and fully develop the section 482 cost sharing buy-in issue.

Centralised coordination

The IRS believes that transfer pricing is often used for tax avoidance purposes and is intent on aggressively reviewing the transfer pricing aspects of certain "high risk" transactions, and that the best way to deal with such transactions is by centralised coordination. It remains to be seen whether this initiative will lead to increased controversy or coordinated issue resolution.

Edward Tanenbaum (edward.tanenbaum@alston.com) New York; Bob Cole (bob.cole@alston.com), Wash., D.C.; Akemi Kawano (akemi.kawano@alston.com).