The top US tax controversies in 2018
Adam Halpern and Larissa Neumann of Fenwick and West examine some of the most important US tax disputes so far this year.
Coca-Cola I: Transfer Pricing
In Coca-Cola Co v Commissioner, TC Dkt 31,183-15, the Tax Court denied the IRS's Motion for Partial Summary Judgment on September 7, 2017. The IRS made transfer-pricing adjustments under § 482 that produced aggregate deficiencies in excess of $3.3 billion for Coca-Cola's 2007-2009 taxable years. In the Summary Judgment Motion the IRS unsuccessfully asked the Court to hold as a matter of law that a 1996 closing agreement had no conceivable relevance to any issue before the court.
In the closing agreement, Coca-Cola and the IRS agreed to a methodology (the "10-50-50 method") for calculating profits of Coca-Cola's foreign affiliates. Under this method the foreign affiliates would retain 10% of gross revenues as a routine return and the residual operating income (after certain adjustments) would be split 50%-50%. The closing agreement covered Coca-Cola's tax years up to and including 1995.
The closing agreement also provided penalty protection both during the term of the agreement and for tax years after 1995. The closing agreement provided that, if Coca-Cola continued to calculate royalties in accordance with the 10-50-50 method, or another method to which the parties subsequently agreed, Coca-Cola would be deemed to have met the "reasonable cause and good faith" exception to the penalties in §§ 6662(e)(3)(D) and 6664(c).
Coca-Cola continued to use the 10-50-50 method to compute product royalties through 2009. For 1996-2006, the IRS accepted Coca-Cola's application of the 10-50-50 method and (with one exception) made no § 482 adjustments to the product royalties. However, during the 2007-2009 examination the IRS determined that the transfer prices using the 10-50-50 method were not arm's-length.
The Tax Court held that the execution of the closing agreement was a historical fact and provides the obvious starting point for any narrative of the events leading up to the 2007-2009 audit. The Tax Court stated that the 10-50-50 method prescribed by the closing agreement is the method that Coca-Cola used when computing its taxable income for the years at issue and this alone gives the closing agreement relevance.
The closing agreement also had relevance in addressing an issue involving the creditability of a Mexican tax on the profits of a Mexican branch, as further discussed in "Coca-Cola II" below. The branch's income was based on the methodology set forth in the closing agreement.
The issue and the IRS's position bears a striking conceptual similarity to three prior cases in which the court seemingly followed a prior transfer pricing agreement between the taxpayer and the IRS that the IRS decided it no longer liked. In Eaton v Commissioner, TC Memo 2017-147 (2017), the Tax Court criticized the IRS for cancelling APAs retroactively, stating that the IRS's desire to change the underlying agreed-upon transfer pricing method was an abuse of discretion. In Medtronic Inc v Commissioner, TC Memo 2016-112 (2016, on appeal), and Eli Lilly v Commissioner, 856 F3rd 855 (7th Cir 1988), there also were prior transfer pricing agreements between the taxpayer and the IRS that the IRS subsequently decided it no longer liked and instead asserted large tax deficiencies. The Eaton and Medtronic cases are discussed below.
In all three cases the IRS lost when it deviated from its prior agreement with the taxpayer. In all three cases the Courts' transfer-pricing conclusions were basically those to which the parties had previously agreed, with slight modifications.
Coca Cola II: Foreign Tax Credits
The Tax Court in Coca-Cola Co v Commissioner, 149 TC No 21 (Dec. 14, 2017), granted Coca-Cola partial summary judgment allowing foreign tax credits for Mexican taxes paid by a branch ("Mexico Licensee") on income that was subject to an IRS adjustment under § 482.
In 2015 the IRS issued a notice of deficiency for the taxable years 2007-2009, asserting that the royalties the Mexico Licensee paid to the US were too low and not calculated at arm's length. If the royalties the Mexico Licensee paid to the US are successfully increased by the IRS under § 482 the adjustment would reduce the Mexico Licensee's income, the corresponding Mexico income taxes and the corresponding foreign tax credits. The IRS asserted that the Mexico Licensee overpaid its Mexican income tax and therefore the taxes were not "compulsory" and thus not "taxes" within the meaning of § 901. The Tax Court held that the Mexican taxes were "compulsory" levies and that the IRS erred as a matter of law in disallowing the foreign tax credits.
The IRS and Coca-Cola had entered into a closing agreement that covered taxable years 1987-1995. The closing agreement did not apply after 1995, except that it provided if Coca-Cola continued to use the agreement's methodology thereafter it would be deemed to have satisfied the "reasonable cause and good faith" exception to the § 6662 penalty. Coca-Cola continued to use the agreement's methodology through 2009. For years through 2006 the IRS accepted the methodology and, with one exception, made no § 482 adjustments to the product royalties.
In continuing to use the closing agreement's methodology the Mexico Licensee and Coca-Cola relied on advice from a Mexican tax attorney. The Mexican tax attorney advised the Mexico Licensee to continue paying royalties under the same method since there had been no changes in operations or the transactional relationship sufficient to justify a higher royalty rate. The Mexican tax attorney advised that the SAT (Mexico's federal taxing authority) would not permit the Mexico Licensee to reduce its Mexican income tax by paying higher royalties.
Two requirements must be satisfied in order for a foreign tax payment to be considered "compulsory and creditable" under § 901. First, the payment must be made based on a reasonable interpretation and application of foreign law (including applicable tax treaties). Second, the taxpayer must exhaust all effective and practical remedies, including the invocation of competent authority procedures available under applicable tax treaties, to reduce the taxpayer's liability for foreign tax. The regulations do not specify what constitutes a "reasonable interpretation and application" of foreign law but they do provide a safe harbor by allowing taxpayers to rely on good-faith advice from a competent tax professional. The IRS did not dispute that the Mexico tax attorney Coca-Cola used was competent tax professional.
The IRS's principal argument was that Coca-Cola could not rely on the advice in good faith because the Mexican attorney based his advice on incomplete facts. Under the IRS's view, the IRS's subsequently proposed transfer pricing adjustment in the case was a fact that was not considered by the Mexican attorney. However, the earliest date on which the IRS informed Coca-Cola that it might challenge the pricing was January 26, 2011, well after Coca-Cola filed its tax returns for 2007-2009.
The IRS contended that the timing of the notice of proposed adjustment was irrelevant and that Coca-Cola was retroactively "on notice" as of 2007-2009. The Tax Court stated that "[t]his argument is hard to take seriously". The regulations clearly indicate that the judgment as to whether an interpretation of foreign law "is likely to be erroneous" is to be made at the time the foreign tax is paid. A taxpayer cannot have had actual or constructive notice of a fact during 2007-2009 when the communication that put it on notice did not occur until 2011.
Grecian Magnesite: Sale of a Partnership Interest
In Grecian Magnesite Mining v Commissioner, 149 TC No 3 (2017), the Tax Court refused to defer to IRS Revenue Ruling 91-32, holding that it would instead follow the Code and regulations to determine whether the taxpayer's gain on the sale of its partnership interest was income "effectively connected" with a US trade or business (ECI). This holding was not unexpected. Many practitioners have long viewed the revenue ruling as suspect and of questionable validity.
The taxpayer, Grecian Magnesite Mining (GMM), was a foreign corporation and part owner of a US limited liability company treated as a partnership for tax purposes. The case arose from a transaction in which the partnership redeemed GMM's interest in the partnership. Under the partnership tax rules, GMM's gain on the redemption was treated as gain from the sale or exchange of GMM's partnership interest.
The court stated that Congress intended § 741, if applicable, to provide capital gain or loss treatment on the sale or exchange of a partnership interest by a partner. The court further held that under § 865, GMM's gain on sale was foreign source income, and under Treas Reg § 1.864-6 it was not a type of foreign source income that is treated as ECI.
FIRPTA contains an exception to this rule: Section 897(g) and its regulations provide that the amount of any money, and the fair market value of any property, received by a foreign person in exchange for a partnership, trust, or estate interest shall, to the extent attributable to United States real property interest, be considered an amount received from the sale or exchange of such property in the United States. Part of GMM's gain was attributable to US real property interests and thus was ECI and taxable to GMM to that extent. The FIRPTA provisions were not in issue in the case; the issue involved the gain amount in excess of the FIRPTA gain.
The 2017 Tax Cuts and Jobs Act (TCJA) added a new statute to overturn Grecian Magnesite. TCJA added new § 864(c)(8) to the Code, providing that if a non-resident alien individual or foreign corporation owns, directly or indirectly, an interest in a partnership that is engaged in any trade or business within the United States, gain or loss on the sale or exchange of all (or any portion of) such interest is treated as ECI. New § 1446(f)(1) provides that if any portion of the gain on any disposition of an interest in a partnership would be treated under new § 864(c)(8) as ECI, the transferee must withhold a tax equal to 10% of the amount realized on the disposition.
Eaton: Cancellation of APAs
The Tax Court ruled in favor of Eaton Corp, agreeing with the company that the IRS abused its discretion by cancelling two advance pricing agreements (APAs) that Eaton and the IRS had entered into to establish a transfer pricing method for certain transactions between Eaton and its subsidiaries (Eaton Corp v Commissioner, TC Memo 2017-147). In a 2013 summary judgment decision Tax Court Judge Diane Kroupa (who was later indicted for criminal tax evasion and plead guilty to the charge) had initially ruled for the IRS, rejecting Eaton's argument that the APAs were enforceable contracts (Eaton Corp v Commissioner, 140 TC No 18 (2013)).
Altera: Cost-Sharing of Stock-Based Compensation
In Altera Corp v Commissioner, Nos 16-70496 and 16-70497 (Jul. 24, 2018), the Ninth Circuit Court of Appeals, in a 2-1 decision, reversed the decision of a unanimous Tax Court, upholding Treas Reg § 1.482-7A(d)(3), the Treasury Department's 2003 regulation that requires stockbased compensation costs to be shared in a qualified cost-sharing arrangement. The Tax Court had struck down the regulation as invalid. Judge Reinhardt passed away before the appellate court's opinion was issued but ended up casting the deciding vote on the 3-judge panel.
There will be more activity in this case. On August 2, 2018 a court order announced that Judge Graber would replace the deceased Judge Reinhardt on the three-judge panel that heard/decided the case. On August 7, 2018 the Ninth Circuit further announced that: "The Opinions filed July 24, 2018 are hereby withdrawn to allow time for the reconstituted panel to confer on this appeal."
Medtronic and Amazon Appeals
The IRS has filed appeals in two other important transfer pricing cases, Medtronic v Commissioner, TC Memo 2016-112, and Amazon.com Inc v Commissioner, 148 TC No 8 (2017). Both were significant taxpayer victories. In both, the Tax Court ruled in favor of the taxpayers on the basis that the taxpayer's "comparable uncontrolled transaction" methodology provided the most reliable method of an arm's length result. The Medtronic appeal is before the Eighth Circuit Court of Appeals; the Amazon appeal is before the Ninth Circuit court.
Adam Halpern and Larissa Neumann
Fenwick & West