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Stateside developments

David Forst and Larissa Neumann of Fenwick & West provide a roundup of recent transfer pricing developments in the US.

The Treasury and the IRS finalised without any substantive changes the § 367 regulations that, as they relate to transfer pricing, change the rules governing the outbound transfer of intangibles in particular regarding foreign goodwill and going concern value. The final regulations retain the proposed regulation's effective date so that the new rules apply to transfers on or after September 14 2015. In finalising the regulations the Treasury ignored the very clear legislative history, the relevant statutory language, virtually all written commentary and testimony at the hearings.

In the preamble to the final regulations, the Treasury and the IRS discuss and reject virtually every taxpayer comment or suggestion regarding the proposed regulations with one exception that deals with useful life and which is discussed below.

The new regulations specify the categories of property that are eligible for the active trade or business exception. Intangible property, including foreign goodwill and going concern value, is not included and thus cannot qualify for the exception. This is the opposite of the prior rules. Under the 1986 temporary regulations, all property was eligible for the active trade or business exception, subject only to five narrowly tailored exceptions. While § 367(d) intangibles did not qualify (because they are subject to § 367(d)), foreign goodwill and going concern value did qualify under the prior rules if they were used in an active foreign trade or business.

However, the new regulations nonetheless require taxpayers to elect to apply § 367(d)'s periodic royalty rules to a transfer of foreign goodwill or going concern value to a foreign corporation to avoid being taxed on the fair market value of those assets in the year of the transfer. This effectively treats them as § 367(d)/§ 936(h)(3)(B) assets contrary to the statute.

The proposed regulations would have eliminated the long-standing 20-year cap on the useful life of § 367(d) intangible property. The final regulations effectively do the same thing. The final regulations provide that taxpayers may, in the year of transfer, choose (elect) to take into account § 367(d) inclusions only during the 20-year period beginning with the first year in which the US transferor takes into account income pursuant to § 367(d). However, they state that this limitation should not affect the present value of all amounts included by the taxpayer under § 367(d).

Accordingly, the regulations require a taxpayer that elects to limit § 367(d) inclusions to a 20-year period to include, during that period, amounts that reasonably reflect amounts that, in the absence of the 20-year limitation, would be included over the useful life of the transferred property following the end of that 20-year period. Thus, a higher-than-arm's-length amount would need to be included in income in each of the first 20 years.

For purposes of determining whether income inclusions during the 20-year period are commensurate with the income attributable to the transferred property, and whether adjustments should be made for taxable years during that period while the statute of limitations for those taxable years is still open, the IRS may take into account information with respect to taxable years after that period, such as the income attributable to the transferred property during those later years.

The regulations also revise the definition of useful life to provide that it includes the entire period during which exploitation of the transferred intangible property is reasonably anticipated to affect the determination of taxable income in order to appropriately account for the fact that exploitation of intangible property can result in both revenue increases and cost decreases.

The Treasury and the IRS believe that the value of many types of intangible property is derived not only from the use of the intangible property in its present form, but also from its use in further development of the next generation of that intangible and other property.

The Treasury and the IRS believe that if the software has value in developing a future generation of products, the software developer would not ignore the value of the use of the software in future research and development and hand over those rights free of charge, and an uncontrolled purchaser would be willing to compensate the developer to obtain such rights. This obviously ignores the likely substantially reduced value most intangibles will have over time – perhaps a short time – when viewed from the perspective of an on-going arm's-length charge.

Consistent valuation of controlled transactions

The significance of the § 367(d) regulations discussed above could have further reaching consequences, given new IRS coordination regulations under § 482. Section 482 authorises the Treasury and the IRS to adjust the results of controlled transactions to clearly reflect the income of commonly controlled taxpayers in accordance with the arm's-length standard and, in the case of transfers of intangible property (within the meaning of § 936(h)(3)(B)), so as to be commensurate with the income attributable to the intangible.

While the determinations of arm's-length prices for controlled transactions is governed by § 482, the tax treatment of controlled transactions is also governed by other code and regulatory rules applicable to both controlled and uncontrolled transactions. Controlled transactions always remain subject to § 482 in addition to these generally applicable provisions.

The new temporary regulations provide for the coordination of § 482 with those other code and regulatory provisions. The new coordination rules thus apply to controlled transactions including controlled transactions that are subject in whole or in part to §§ 367 and 482. Transfers of property subject to § 367 that occur between controlled taxpayers require a consistent and coordinated application of both sections to the controlled transfer of property. The controlled transactions may include transfers of property subject to § 367(a) or (e), transfers of intangible property subject to § 367(d) or (e), and the provision of services that contribute significantly to maintaining, exploiting or further developing the transferred properties.

The Treasury and the IRS say the consistent analysis and valuation of transactions subject to multiple code and regulatory provisions is required under the best method rule described in Treas. Reg. § 1.482-1(c). A best method analysis under § 482 begins with a consideration of the facts and circumstances related to the functions performed, the resources employed, and the risks assumed in the actual transaction or transactions among the controlled taxpayers, as well as in any uncontrolled transactions used as comparables.

For example, states the preamble, if consideration of the facts and circumstances reveals synergies among interrelated transactions, an aggregate evaluation under § 482 may provide a more reliable measure of an arm's-length result than a separate valuation of the transactions. In contrast, an inconsistent or uncoordinated application of § 482 to interrelated controlled transactions that are subject to tax under different code and regulatory provisions may lead to inappropriate conclusions.

The best method rule requires the determination of the arm's-length result on controlled transactions under the method, and particular application of that method, that provides the most reliable measure of an arm's-length result. The preamble also refers to the "realistic alternative transactions" rule and states that "on a risk-adjusted basis" this may provide the basis for application of unspecified methods to determining the most reliable measure of an arm's-length result.

Additional features of new § 482 tegulations

New Temp. Treas. Reg. § 1.482-1T(f)(2)(i)(A) provides that arm's-length compensation must be consistent with, and must account for all of, the value provided between parties in a controlled transaction, without regard to the form or character of the transaction. For this purpose, it is necessary to consider the entire arrangement between the parties, as determined by the contractual terms, whether written or imputed in accordance with the economic substance of the arrangement, in light of the actual conduct of the parties.

The preamble says this requirement is consistent with the principles underlying the arm's-length standard, which require that arm's-length compensation in controlled transactions equal the compensation that would have occurred if a similar transaction had occurred between similarly situated uncontrolled taxpayers; however, this appears to take a more BEPS-friendly approach than the IRS advocates in international settings.

Temp. Treas. Reg. § 1.482-1T(f)(2)(i)(B) "clarifies" Treas. Reg. § 1.482-1(f)(2)(i)(A), which provided that the combined effect of two or more separate transactions (whether before, during, or after the year under review) may be considered if the transactions, taken as a whole, are so interrelated that an aggregate analysis of these transactions provides the most reliable measure of an arm's-length result determined under the best method rule of Treas. Reg. § 1.482-1(c).

Specifically, a new clause was added to provide that this aggregation principle also applies for purposes of an analysis under multiple provisions of the code or regulations. A new sentence also elaborates on the aggregation principle by noting that consideration of the combined effect of two or more transactions may be appropriate to determine whether the overall compensation is consistent with the value provided, including any synergies among items and services provided.

The temporary regulation does not retain the statement in Treas. Reg. § 1.482-1(f)(2)(i)(A) that transactions generally will be aggregated only when they involve "related products or services".

Temp. Treas. Reg. § 1.482-1T(f)(2)(i)(C) provides that, for one or more controlled transactions governed by one or more provision of the code and regulations, a coordinated best method analysis and evaluation of the transactions may be necessary to ensure that the overall value provided (including any synergies) is properly taken into account. A coordinated best method analysis of the transactions includes a consistent consideration of the facts and circumstances of the functions performed, resources employed, and risks assumed, and a consistent measure of the arm's-length results, for purposes of all relevant code and regulatory provisions.

Analog devices: Section 482

Analog Devices, Inc. (ADI) repatriated cash dividends from one of its foreign subsidiaries, a controlled foreign corporation, (CFC) and claimed an 85% § 965 dividends received deduction for 2005. ADI reported no related party indebtedness during its testing period pursuant to § 965(b)(3).

The IRS determined that the annual 2% royalty received by ADI from CFC should be increased to 6% for 2001 – 2005. ADI agreed with the proposed adjustment. In 2009, ADI and the IRS executed a closing agreement pursuant to Rev. Proc. 99-32, 1999-2 C.B. 296, to effect the secondary adjustments required after a primary § 482 allocation. The closing agreement established accounts receivable pursuant to the revenue procedure and deemed them created as of the last day of the taxable year to which they relate. The IRS subsequently determined that the accounts receivable constituted an increase in related party indebtedness under § 965(b)(3) during ADI's testing period, which the IRS determined decreased ADI's § 965 DRD.

The Tax Court held that the parties did not reach an agreement in the closing agreement regarding the treatment of the accounts receivable under § 965. The court further held a § 965(b)(3) does not provide that the accounts receivable constituted related party indebtedness arising during ADI's testing period. Thus, the accounts receivable did not increase CFC's related party indebtedness during the testing period.

Previously, the Tax Court had determined in BMC Software Inc. v. Commissioner, 141 T.C. 224 (2013), (BMC I) that in such a situation taxpayer's DRD was reduced. The Fifth Circuit reversed at 780 F.3d 669 (5th Cir. 2015) (BMC II). The Tax Court stated that BMC II is not binding in the instant case in which an appeal would lie to the First Circuit. However, the Tax Court stated that given the reversal and the parties' arguments, the instant case required the court to revisit its analysis in BMC I.

The court concluded that the important goals of stare decisis to ensure that "evenhanded, predictable, and consistent development of legal principles" and to "foster reliance on judicial decisions" are not served by the court's continued adherence to its previous opinion. The court stated there has been no predictable or consistent development of the legal principles affecting the current case.

On balance, the Tax Court concluded that the importance of reaching the right result in ADI outweighed the importance of following the court's precedent. The decision in favour of ADI was "reviewed by the court" with the judges voting 13-4 to reverse BMC I.

The parties entered into a closing agreement against the backdrop of longstanding case law holding that "a court may not include as part of the agreement matters other than the matters specifically agreed upon and mentioned in the closing agreement".

A caption taken verbatim from the IRS's pattern agreement regarding Rev. Proc. 99-32 is not a matter to which the parties specifically agreed. It is not a determined clause that binds the parties, but rather an introductory clause that signals the transition from the recitals to the determined clauses. Therefore, giving the phrase "for all federal income tax purposes" a literal application would be to ignore the court's mandate to interpret a contract in context and would broaden the scope of the closing agreement beyond that which the parties intended.

That the closing agreement provided in a recital that it applied "for all federal income tax purposes" was the focus of the four dissenting judges who felt that this language meant that § 965 was included within the parties' agreement.

The majority, however, held that when the parties signed the closing agreement they did not manifest an intent with respect to § 965(b)(3). The court's opinion states that the dissent would have the court give the phrase "for all federal income tax purposes" a literal interpretation and ignore the intent of the parties. The parties signed a closing agreement that enumerated specific tax consequences, and § 965 was not specifically enumerated. A literal interpretation of the boilerplate "for all federal income tax purposes" would render surplusage the provisions of the closing agreement that listed the transaction's tax implications in considerable detail.

The court also read the holding in Schering Corp. v. Commissioner, 69 T.C. 579 (1978), to be consistent with its holding in ADI. In Schering, read the disputed phrase in a Rev. Proc. 65-17 closing agreement in context rather than applying a literal interpretation that would expand the closing agreement past its intended scope. This is the same approach the court took in ADI.



David Forst

Fenwick & West

Tel: +1 650 335 7254

Fax: +1 650 938 5200

David Forst is the practice group leader of the tax group of Fenwick & West. He is included in Euromoney's Guide to the World's Leading Tax Advisers. He is also included in Law and Business Research's International Who's Who of Corporate Tax Lawyers (for the last six years). David was named one of the top tax advisers in the western US by International Tax Review, is listed in Chambers USA America's Leading Lawyers for Business (2011-2016), and has been named a Northern California Super Lawyer in Tax by San Francisco Magazine.

David's practice focuses on international corporate and partnership taxation. He is a lecturer at Stanford Law School on international taxation. He is an editor of and regular contributor to the Journal of Taxation, where his publications have included articles on international joint ventures, international tax aspects of M&A, the dual consolidated loss regulations, and foreign currency issues. He is a regular contributor to the Journal of Passthrough Entities, where he writes a column on international issues. David is a frequent chair and speaker at tax conferences, including the NYU Tax Institute, the Tax Executives Institute, and the International Fiscal Association.

David graduated with an AB, cum laude, Phi Beta Kappa, from Princeton University's Woodrow Wilson School of Public and International Affairs, and received his JD, with distinction, from Stanford Law School.



Larissa Neumann

Fenwick & West

Tel: +1 650 335 7253

Larissa Neumann focuses her practice on US tax planning and tax controversy with an emphasis on international transactions. She has broad experience advising clients on acquisitions, restructurings and transfer pricing issues. She has successfully represented clients in federal tax controversies at the audit level, in appeals and in court.

Larissa appears in International Tax Review's World's Tax Controversy Leaders and in Euromoney's World's Leading Tax Advisers. Euromoney selected Larissa for inclusion in the Americas Women in Business Law Awards shortlist for Best in Tax Dispute Resolution in 2014 and she was named the 2015 Rising Star: Tax. She was also named to the Silicon Valley Business Journal's 40 Under 40. In 2016, Larissa was named a Rising Star in tax by Law360.

Larissa frequently speaks at conferences for professional tax groups, including TEI, IFA, Pacific Rim Tax Institute, Bloomberg, and the ABA. She is the ABA International Law Tax Liaison.

Larissa has published several articles, including recently:

  • US Tax Overview, Euromoney's LMG Rising Stars 2015

  • US transfer pricing litigation update, International Tax Review (March 2015)

  • Areas of TP Scrutiny in a pre- and post-BEPS World, International Tax Review (February 2015)

  • US International Tax Developments, The Euromoney Corporate Tax Handbook 2015

  • US Transfer Pricing Developments, International Tax Review (2014)

  • US Tax Developments, International Tax Review (December/January 2013)

  • Character and Source of Income from Internet Business Activities, The Contemporary Tax Journal (July 2011)

  • The Application of the Branch Rule to Partnerships, International Tax Journal (July – August 2010)

Fenwick has one of the World's Top Tax Planning and Tax Transactional Practices, according to International Tax Review, and is first tier in tax, according to World Tax. International Tax Review gave Fenwick its San Francisco Tax Firm Award a total of seven times and its US Tax Litigation Firm Award a total of three times. International Tax Review has also named Fenwick Americas M&A Tax Firm of the Year.

Larissa is a leader on Fenwick's Pro Bono Review Committee and regularly provides pro bono services to various non-profit organisations. Fenwick was recognised by The National Law Journal Pro Bono Hot List (2014) and Larissa's non-profit work is pointed to as exemplary in the profile.

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