Responding to the changes in the transfer pricing landscape
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Responding to the changes in the transfer pricing landscape

The Internal Revenue Service appears to be strengthening its stand on aggregating transactions and applying economic substance rationales to override related-party contracts. David Forst and Larissa Neumann of Fenwick & West discuss US developments including the IRS and Treasury Department-issued 482 Temporary Regulations.

There have been a number of recent important developments on the US transfer pricing front. The Internal Revenue Service (IRS) issued new § 482 regulations in what seems to be an effort to strengthen its positions on aggregating transactions and applying economic substance rationales to override related-party contracts.

In a recent Notice, the IRS stated that regulations will be issued applying the transfer pricing methods in the cost-sharing rules to transfers of intangibles to controlled partnerships.

In the Guidant LLC v. Commissioner, 146 T.C. No. 5 (2016) motion for partial summary judgment, the Tax Court ruled in favor of the IRS on a question of aggregation in a transfer pricing adjustment.

New 482 Temporary Regulations

The Treasury Department and the IRS issued new Temporary Regulations under § 482 that are effective to taxable years ending on or after September 14 2015. The stated purpose is to coordinate § 482 with other Code provisions. However, the changes to the 482 regulations appear to be more aggressive than simple coordination rules and clarifying changes.

The preamble states that controlled transactions always remain subject to Section 482 even if other Code provisions apply. In the preamble, the IRS states that it has encountered taxpayer positions involving incomplete assessments of the relevant functions, resources, and risks, and an inappropriately narrow analysis of the scope of the transfer pricing rules. It certainly will benefit the taxpayer to have prepared thorough and well-drafted documentation.

The new provision in 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, without regard to the form or character of the transaction. The regulation states it is necessary to consider the entire arrangement as determined by the contractual terms, whether written or imputed in accordance with the economic substance, in light of the actual conduct of the parties. The IRS will likely attempt to use this regulation to more aggressively assert that controlled parties' contractual arrangements should be ignored in favor of some broader economic substance argument.

Temp. Treas. Reg. § 1.482-1T(f)(2)(i)(B) states that transactions may be considered together, and taken as a whole, if they are so interrelated that an aggregate analysis provides the most reliable measure of an arm's length result. Prior rules provided for aggregation only in the case of controlled transactions involving related products or services. The preamble calls this a clarification, but the Obama administration proposed a change in the statute to permit this type of aggregation, but that proposal was never enacted.

The Temp. Treas. Reg. § 1.482-1T(f)(2)(i)(C) provision provides that overall value (including any synergies) must be taken into account. The preamble and regulations repeatedly refer to "synergies". It is not clear what these "synergies" are. "Synergies" are not an intangible listed in § 936(h)(3)(B), and parties operating at arm's length do not license "synergies".

The Temporary Regulation contains 11 examples. Examples 1 through 4 are materially the same as prior regulations. The remaining examples are new.

Example 5 deals with aggregation. Parent owns 10 individual patents that together can be used to manufacture and sell a successful product. Parent anticipates that it can earn $25 from the patents as a bundle. Parent licenses all 10 patents to a foreign subsidiary to be exploited as a bundle. Comparable data indicates that each license is worth $1, implying a total value of $10. The example states that it would not be appropriate to use the $1 dollar comparables because it does not reasonably reflect the enhancement to value resulting from the interrelatedness of the 10 patents exploited as a bundle.

In Example 6, parent and its foreign subsidiary have a cost sharing agreement, but the parent continues to perform support for the foreign subsidiary. The example states that the IRS may impute agreements or even another platform contribution transaction (PCT) for the support services. This example implies that the IRS's assertion of economic substance overrides the actual contractual terms. Examples 8 and 9 also involve cost sharing agreements where the IRS can ignore the contracts.

In Example 10, parent provides R&D services building on the product platform. The example states the parent is providing an embedded value to the foreign subsidiary and the foreign subsidiary must compensate the US parent for this value. The example states that parent takes the position that the know-how does not have substantial value independent of the services of any individual on the R&D Team. This is the position the taxpayer took in Veritas and won.

Transfers of IP to Controlled Partnerships

In Notice 2015-54 Treasury and the Service state that they intend to issue regulations similar to the Treas. Reg. § 1.482-7 cost-sharing regulations to controlled transactions involving partnerships. Specifically, the Notice states that regulations will be issued applying the methods specified in Treas. Reg. § 1.482-7(g), as adjusted to take into account the differences between partnerships and cost sharing arrangements. Additionally, the Notice states that the regulations will provide periodic adjustment rules that are based on the principles of Treas. Reg. § 1.482-7(i)(6) so that in the event of a trigger based on a significant divergence of actual returns from projected returns, the IRS may make periodic adjustments under a method based on Treas. Reg. § 1.482-7(i)(6)(v), as well as any necessary corresponding adjustments to section 704(b) or section 704(c) allocations.

The Notice states in its Reasons For Exercising Regulatory Authority that an example it is concerned about is where a domestic partner receives a fixed preferred interest in exchange for the contribution of an intangible that is assigned a value that is inappropriately low, while a related foreign partner is specially allocated a greater share of the income from the intangible.

The Notice appears to take the position that a taxpayer who contributes intangible property and elects the Gain Deferral Method, and therefore the application of the remedial allocation method, could still be subject to further adjustments in excess of its Built-in Gain amount. The Notice states that when intangible property is contributed to a partnership, the IRS may consider making periodic adjustments under Treas. Reg. § 1.482-4(f)(2) in years subsequent to the contribution, without regard to whether the taxable year of the original transfer remains open for statute of limitations purposes. It states that the IRS may do so regardless of whether § 721(a) applies to the initial contribution of intangible property to the partnership. Therefore, in the IRS's view, even if a taxpayer elects the Gain Deferral Method, it still would be subject to adjustments under § 482 even though § 721(a) applies.

Of course, any new rules that the IRS writes in this regard would need to be consistent with the arm's length standard, which underlies all of § 482. See, e.g., Treas. Reg. § 1.482-1(b); Xilinx v. Commissioner, 598 F. 3d 1191 (9th Cir. 2010).

The Notice reiterates the application of § 482 to controlled transactions involving partnerships under existing law. See Treas. Reg. §§ 1.704-1(b)(1)(iii), -1(b)(5), Example 28 in this regard. The Notice states that examples of the application of § 482 under current law include adjustments to the amounts of contributions to, and distributions from, a partnership; partnership allocations, including allocations under § 704(c), and the relative magnitudes of the partners' partnership interests in light of their respective contributions and the related controlled transactions.

The Notice also states that the IRS can impute terms to a partnership agreement that are consistent with the substance of a transaction, for example, when a partner provides services to the partnership but neither the partnership agreement nor any other agreement reflects the provision of such services. Further, according to the Notice, the IRS can apply an aggregate analysis under Treas. Reg. § 1.482-1(f)(2)(i) to the extent that controlled transactions involving a partnership, including contributions of tangible and intangible property and the provision of services by the controlled partners or their affiliates, are interrelated if the aggregate analysis provides the most reliable means of determining the arm's length results for the controlled transactions.

Finally, the Notice also states that Treasury and the IRS are considering issuing regulations under Treas. Reg. § 1.6662-6(d) to require additional documentation for certain controlled transactions involving partnerships. These regulations may require, for example, documentation of projected returns for property contributed to a partnership (as well as attributable to related controlled transactions) and of projected partnership allocations, including projected remedial allocations covered, for a specified number of years.


Guidant involves a group of US corporations that filed consolidated federal income tax returns (collectively, the "taxpayer"). During the years in issue, the taxpayer consummated transactions with its foreign affiliates including the licensing of intangibles, the purchase and sale of manufactured property, and the provision of services.

The IRS utilised § 482 to adjust the reported prices of the different transactions. The IRS asserted an adjustment to the taxpayer's income without making specific adjustments to any of the subsidiaries' separate taxable incomes. The IRS also did not make specific adjustments for each separate transaction, but rather asserted an aggregated transfer pricing adjustment.

The taxpayer filed a motion for partial summary judgment asserting that the IRS adjustments were arbitrary, capricious, and unreasonable as a matter of law since the IRS did not determine "true taxable income" of each controlled taxpayer as required under Treas. Reg. § 1.482-1(f)(iv) and did not make specific adjustments with respect to each transaction.

The court denied the taxpayer's motion stating that neither § 482 nor the regulations thereunder requires the IRS to determine the true taxable income of each separate controlled taxpayer within a consolidated group contemporaneously with the making of a § 482 adjustment. The court also held that the IRS is permitted to aggregate one or more related transactions instead of making specific adjustments with respect to each type of transaction.

While the court stated that Treas. Reg. § 1.482-1(f)(1)(iv) requires the IRS to determine both consolidated taxable income and separate taxable income when making a § 482 adjustment with respect to income reported on a consolidated return, the court held that as a matter of law the IRS can assert a § 482 adjustment before it determines the separate taxable income. The court stated that the regulation does not preclude the IRS from deferring making the separate taxable income determinations for each member until the time when such a determination is actually required.

The court stated that whether the IRS's decision to delay the separate-company taxable income computations constitutes an abuse of discretion under these circumstances is still in dispute and remains to be determined on the basis of the full record as developed at trial. Thus, the court did not conclusively hold that the IRS's § 482 adjustments were not arbitrary, capricious or unreasonable as a matter of fact. It only held that the IRS's § 482 adjustments were not arbitrary, capricious, or unreasonable as a matter of law.

The taxpayer also argued that the IRS's § 482 adjustments were arbitrary, capricious and unreasonable because the service did not make separate adjustments for each transfer of intangible property, transfer of tangible property and provision of services. The applicable regulations in determining the arm's length consideration aggregation is permitted if it serves as the most reliable means of determining the arm's length consideration for the transactions.



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 (2011-2014), 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

Partner, Tax Group

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)

  • U.S. International Tax Developments, The Euromoney Corporate Tax Handbook 2015

  • U.S. Transfer Pricing Developments, International Tax Review (2014)

  • U.S. 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 nonprofit organisations. Fenwick was recognised by The National Law Journal Pro Bono Hot List (2014) and Larissa's nonprofit work is pointed to as exemplary in the profile.

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