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US: Thinking through secondary transfer pricing adjustments

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 Some tax authorities are looking to audits as a means of replenishing depleted coffers

Mark Martin and Thomas Bettge of KPMG in the US explore the nature and tax consequences of secondary adjustments arising from transfer pricing adjustments initiated by tax authorities or taxpayers.

Transfer pricing adjustments, always an important topic for many taxpayers, may be even more critical in light of the COVID-19 pandemic. Some tax authorities are looking to audits as a means of replenishing depleted coffers, and many taxpayers may need to rely on post-year-end taxpayer-initiated adjustments to correct their transfer pricing (TP) as more reliable comparable data becomes available. Yet these primary adjustments do not take place in a vacuum. Depending on the jurisdiction, they may entail secondary adjustments that carry their own tax consequences.

Transfer pricing adjustments shift income as required by the arm’s-length principle, but they introduce a disparity between the taxpayer’s tax position and its accounts. Secondary adjustments (or conforming adjustments, as they are called in the US Treasury Regulations) are intended to eliminate that disparity. In some jurisdictions, this misalignment is not regarded as problematic. The OECD Guidelines recognise that many countries simply do not make secondary adjustments. Among those jurisdictions that do recognise secondary adjustments, there can be considerable variation in the rules and their application. In addition, countries’ competent authorities can sometimes depart from strict application of their domestic secondary adjustment rules when negotiating mutual agreement procedure (MAP) cases under double tax treaties.

In the US, secondary adjustments come in two varieties. First, there is a domestic procedure under Rev. Proc. 99-32 that creates an elective cash repatriation mechanism whereby a taxpayer can opt to move funds in order to align its accounts with its tax position. Second, where no such election is made, one or more transactions is deemed to occur. These deemed transactions, which may be called ‘inferential secondary adjustments’, alter the taxpayer’s tax position in order to conform it to the accounts. For instance, where a TP adjustment allocates income from a parent company to its subsidiary, a deemed distribution from the subsidiary to the parent would be inferred to explain how the parent came into possession of the relevant funds.

Conversely, where the primary adjustment increases the income of the parent, the inferential secondary adjustment would take the form of a deemed capital contribution. Where an adjustment is made between brother-sister corporations, both a deemed distribution up to the common parent and a deemed capital contribution from the parent to the entity whose income was decreased may be needed.

Inferential secondary adjustments give rise to various tax consequences, depending on what transactions are deemed to occur. Deemed distributions can trigger dividend income or withholding tax obligations. To the extent deemed distributions exceed both the subsidiary’s earnings and profits and the parent’s basis in the subsidiary’s stock, they may also trigger capital gains. Deemed capital contributions are comparatively innocuous, but do increase the parent’s basis in the subsidiary’s stock. Importantly, they may also trigger reporting obligations, with penalties potentially applicable to any failure to report. 

For TP adjustments affecting the US, repatriation under Rev. Proc. 99-32 presents a way to avoid the tax consequences arising from inferential secondary adjustments, but it has drawbacks of its own. For one thing, accounts payable and receivable set up under Rev. Proc. 99-32 bear interest from the last day of the year for which the primary TP adjustment was made. For tax authority-initiated adjustments, the amount of interest can be significant, though it may be possible to implement repatriation without any interest obligation in a MAP case.

In addition, the Internal Revenue Service (IRS) has indicated that Rev. Proc. 99-32 accounts should be considered indebtedness for purposes of US Internal Revenue Code (IRC) § 956, which is a controlled foreign corporation (CFC) rule requiring US shareholders of CFCs to recognise income based on the amount of US property (including indebtedness) held by the CFC. While IRS setbacks in litigation over IRC § 956 and 2019 regulations restricting its application make this a non-issue for many taxpayers, the IRS position on this matter serves as a reminder that repatriation may entail tax consequences of its own.

How secondary adjustments are best implemented in a given case will depend on the circumstances at hand. Repatriation has historically been favoured over inferential secondary adjustments, but the introduction of the US participation exemption system as part of the Tax Cuts and Jobs Act now means that inferential secondary adjustments may be more favourable for certain transfer pricing adjustments affecting the US. Of course, regard should also be given to the secondary adjustment rules (if any) in the counterparty country. Regardless of what the best option is, this is an area that requires careful consideration: for prudent taxpayers, secondary adjustments should not be a mere afterthought.


Mark Martin

T: +1 713 319 3976


Thomas Bettge

T: +1 713 319 2173


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