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US transfer pricing developments

There have been a number of important US developments in transfer pricing in the past 12 months. Kenneth Clark, Ronald Schrotenboer and David Forst of Fenwick & West provide a brief review and highlight a number of these developments.

Administration of Section 482

The IRS continues to focus heavily on transfer pricing and has made administrative changes to do so. In 2010 it established a Transfer Pricing Office that operates within its Large Business and International Division. In the last year it has increased the staffing of that office and has continued to indicate that it is looking for cases to develop its national position. The office has reported that it is seeking to reengineer the "case development process" for transfer pricing audits by establishing new, detailed, step-by-step guidelines.

The IRS previously used a tiered approach to designate what types of issues – including transfer pricing issues – should receive the greatest scrutiny. In 2012 it ended this system. It established what it has called international practice networks (IPNs) to coordinate knowledge and expertise on particular issues. As a practical matter, this change brings greater, not lesser IRS focus on transfer pricing matters.

Continued focus on transfer pricing is evident at all levels of tax controversy. As an example, in December 2012, Amazon filed a petition in the US Tax Court (Dkt 31197-12) challenging the IRS assertion of $2 billion of additional income for the transfer of existing intangibles as part of a cost sharing arrangement. The years covered are the years before the effective date of the temporary revised cost sharing regulations issued in 2009. Because the years at issue are before the regulation (which is the same as Veritas Software Corp v Commissioner, 133 TC 297 (2009)), it is uncertain this is a case where the Transfer Pricing Office chose to develop its national position on cost sharing transactions.

Soft intangibles

Treasury and the IRS plan to issue guidance under section 367(d) to address issues regarding goodwill, going concern, value and workforce in place (soft intangibles). The IRS has stated that questions have been raised about soft intangibles in the context of Notice 2012-39 (involving the transfer of intangibles under section367(d)). According to the IRS these intangibles have to be dealt with under section 367(a) or section367(d).

The rules as they stand exempt the transfer of foreign goodwill and going concern value from. Treasury regulation section 1.367(d)-1T(b). Foreign goodwill and going concern value are defined as the residual value of a business operation conducted outside of the US after all other tangible and intangible assets have been identified and valued (Treasury regulation section 1.367(a)-1T(d)(5)(iii)).

Further, workforce in place has traditionally been viewed as a component of going concern value, and the IRS, in the past, has adopted this approach. In "Amortization of Assembled Workforce," (April 23 1991) the Service stated that any value associated with having a trained staff of employees in place represents the going concern value of an acquired business. The Service, in a different paper of the same name (February 19 1996), stated that its historic position was that an assembled workforce intangible is, as a matter of law, non-amortisable going concern value.

However, in the context of transfers to foreign corporations, the IRS is now pushing for a narrow definition of goodwill and going concern value, including an exclusion of workforce-in-place from going concern value.

This issue arises whenever a US taxpayer incorporates a foreign branch (for example, through a reverse check the box election). The law requires the taxpayer to value the individual items of intangible property listed in section 936(h)(3)(B) and subject the transfer of these intangibles to a contingent payment and the commensurate with income standard under section 482. The IRS's view tends towards a different method of valuation, where the entire enterprise is valued, and subject to the commensurate with income standard, unless specific items can be shown not to constitute intellectual property.

President Obama's FY 2014 budget seeks to clarify existing law that goodwill, going concern value, and workforce in place are part of section 367(d). Of course, they are not, and his budget proposal, if enacted, would result in a change to existing law. (See Veritas v Commissioner, 133 TC No 14, fn 31 (2009)(assembled workforce is not an intangible asset.)

This issue is offered as an alternate IRS argument in a number of docketed cases. (See Medtronics, Inc v Commissioner, TC Dkt No. 6944-11; Guidant LLC v Commissioner, TC Dkt Nos. 5989-11 and 5990-11; Boston Scientific Corporation v Commissioner, TC Dkt. No. 26876-11, and Eaton Corporation v Commissioner, TC DKt No. 5576-12.)

Challenges to arm's-length standard

The arm's-length standard continues to come under pressure as tax regimes worldwide challenge allocations of profits under existing transfer pricing rules. Challenges by the IRS to the arm's-length standard are more muted compared with other taxing authorities, but significant nonetheless.

For example, Sam Maruca, Transfer Pricing Director, IRS LB&I Division, recently stated that taxpayers "constantly" argue for results that could be too good to be true and are not supported in the real world by business at arm's-length. He said the IRS is most concerned about transactions that involve making available "core enterprise technology", that is, the competitive advantage that allows a company to earn returns. He stated there are typically no comparables for those types of assets.

Maruca's statement is reflected in ECC 201111013, which involved the transfer of technology that was not fully developed, and raised the issue of how the transferor should be compensated. The IRS's conclusion, echoing concerns such as those expressed by Maruca, suggest a lack of faith in the Service's own regulations and the regulations' reliance on comparables and the arm's-length standard, which is the law.

The ECC states that none of the traditional specified methods tend to work well in the instant situation, and one needs to resort to unspecified methods. Further, according to the IRS, "one needs a new approach to valuation, relying less on comparables and more on fundamental financial principles". Of course, comparables are the foundation of the arm's-length standard.

Recent OECD papers on intangibles, base erosion and profit shifting reflect, perhaps, an even greater discomfort with the arm's-length standard, which, of course, undergirds transfer pricing rules. The OECD report entitled "Revision of the Special Considerations for Intangibles in Chapter VI" of the OECD transfer pricing guidelines states that for a member of a multinational group to be entitled to intangible related returns, it should in substance: perform and control important functions related to the development, enhancement, maintenance and protection of the intangibles and control other related functions performed by independent enterprises or associated enterprises that are compensated on an arm's-length basis; bear and control the risks and costs related to developing and enhancing the intangible; and, bear and control risks and costs associated with maintaining and protecting its entitlement to intangible related returns.

While not explicitly stated, views such as those expressed in the paragraph above could lead practitioners to think that the OECD is edging away from the arm's-length standard and towards formulary apportionment as the basis for transfer pricing. Of course, this would be a change from long-standing tax law with its focus on the arm's-length standard, as memorialised in hundreds, if not thousands, of bilateral income tax treaties. The IRS, while expressing its own discomfort with current law, has not gone as far as the OECD in this area.

2012 APA report

The IRS's APA report for 2012 shows an increase in the number of APAs executed during 2012. This follows a restructuring of the APA office and an increase in its staff members. It also represents the IRS making a dent in a substantial backlog after a slow 2011.

Processing time either increased or decreased depending on how you interpret the statistics. The APA report states that the processing time decreased, and reaches this result by comparing 2011 average processing time to 2012 median processing time. However, in doing apples-to-apples comparisons, the average processing time went up from 40.7 months to 41.7 months and the median processing time went up from 36.5 months to 39.8 months. Further, the processing time for a new APA increased dramatically from 39.5 months median to 50.6 months median.

The number of APAs filed in 2012 is consistent with the five-year average of APAs filed during 2008 to 2012. The APA report states that 75% of the APAs involved foreign parent companies while only 25% involved US parent companies. Fifty-three percent of the bilateral APAs finalised or renewed during 2012 were with Japan. Canada and the UK represented 16% and 10%, respectively. About three-quarters of the APAs used either CPM on TNMM.

Claim for refund barred

In Intersport Fashions West v U.S. ___ Ct Cl. ___ (2012), the Court of Federal Claims ruled in favour of the government's summary judgment motion that the taxpayer could not claim tax refunds based on the restructuring expenses of its foreign parent, (Treasury Regulation 1.482-1(a)(3)) because the expenses were not claimed on a timely filed return. This regulation prohibits taxpayer-initiated section 482 adjustments on untimely or amended returns.

The suit arose in the context of a 2005 IRS examination of the taxpayer's 2001 to 2003 returns. As a result of the audit, the taxpayer was assessed additional income. The taxpayer then filed amended returns for 2001 and 2002 claiming additional deductions for expenses allocated from its foreign parent.

The court stated that subject to a limited right of a controlled taxpayer to report allocate income after the year in issue, a controlled taxpayer may not affirmatively use section 482 or compel the Service to make a section 482 allocation. The fact that the original return may have contained a mistake did not excuse the filing of an untimely return.

Court challenge to blocked income regulations

3M Company v Commissioner, TC Dkt No 5816-13, filed on March 11 2013, involves the IRS's allocation of royalty income from a Brazilian subsidiary to its US parent. The taxpayer asserts that the royalties in issue are not permitted under Brazilian law.

First Security Bank of Utah v Commissioner, 405 US 394 (1972), a US Supreme Court case, held that if the law prevents the taxpayer from earning certain income, the taxpayer did not have the necessary control that section 482 requires, and an allocation under section 482 would be inappropriate. Subsequently, Proctor & Gamble v Commissioner, 961 F.2d 1255 (6th Cir 1992), held that this applies where foreign law is involved, as well. Exxon Corp v Commissioner, 66 TCM 1707 (1993), aff'd, Texaco v Commissioner, 98 F3d 825 (5th Cir 1996), followed these cases with respect to Saudi Arabian crude pricing.

Treasury regulation section 1.482-1(h) attempts to reverse the First Security decision providing that foreign laws limiting intercompany payments will be taken into account only if the laws apply equally to controlled and uncontrolled transactions. The 3M case seeks adjudication of this longstanding issue.

Furthermore, it is not clear how the IRS's assertion of section 482 fits that provision's statutory purposes, which is to prevent the evasion of taxes and to clearly reflect income. 3M could not have evaded taxes if its Brazilian subsidiary wasn't allowed to pay the asserted royalty and its income could not have been clearly reflected.




Kenneth Clark

Partner, tax department chair, tax litigation group

Fenwick & West

Tel: +1 650.335.7215


Kenneth Clark is the head of the firm's tax litigation group. His practice focuses on complex federal tax litigation and tax controversy work. He has tried a number of cases in the US Tax Court and has managed a variety of complex commercial disputes in a number of foreign countries and more than 20 states.




David Forst

Partner, Tax Group

Fenwick & West

Tel: +1 650.335.7254


David Forst, Fenwick's tax practice group leader, focuses on international corporate and partnership taxation. He is an editor of, and regular contributor to, the Journal of Taxation. He represents clients worldwide in a wide variety of transfer pricing planning and controversy matters. Mr. Forst is included in Euromoney's Guide to the World's Leading Tax Advisers and was named one of the top tax advisers in the western US by International Tax Review.




Ron Schrotenboer

Partner, Tax Group

Fenwick & West

Tel: +1 650.335.7207


Ron Schrotenboer represents both US-based companies in domestic and international transactions and foreign-based companies with operations in the US. He is involved with a number of IRS and state income tax audits, appeals, and tax court cases, including 482 transfer pricing cases. He was also named one of the leading tax lawyers in the US in Euromoney's Guide to Leading Tax Advisers, and Guide to the World's Leading Transfer Pricing Advisers.

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