Globalization of world markets turned transfer pricing into one of the dominant sources of international tax disputes between taxpayers and taxing authorities. International differences in regulations and revenue motivation further proliferated tax controversies.
Corporations realized that growing transfer pricing disputes require prevention techniques and defense strategies that commonly include Pre-Filing Agreement Program (PFA) and Advance Pricing Agreements (APAs), Competent Authority/Mutual Agreement Procedures (MAP), arbitration, various dispute resolution mechanisms, and international treaties.
Lack of arm’s-length conduct in intercompany pricing has caused lost revenue in the billions in the past years. Yet, IRS litigation was in the main unsuccessful but triggered significant changes in its examination policies.
Similar to the IRS, the Organization for Economic Cooperation and Development (OECD) and G20’s Inclusive Framework Base Erosion and Profit Shifting (BEPS) transfer pricing project relies on the functions performed, assets employed, and risk incurred, and requires adherence to an arm’s-length pricing and avoidance of profit shifting. However, intercompany transactions in intangibles constitute a major source of controversies in transfer pricing due to differences in definitions and valuation methodologies.
Aware of the inherent difficulties, the OECD issued guidance on hard-to-value intangibles (HTVI) in connection with BEPS Action 8, which is now incorporated into the OECD Transfer Pricing Guidelines. The HTVI approach authorizes tax administrations to use ex-post (or historic) evidence on the financial outcomes of an HTVI transaction as presumptive evidence on the appropriateness of the ex-ante (or expected) pricing arrangements. The new guidance is aimed at instituting a common pricing methodology among tax administrations in assessment of intercompany pricing for intangible property (IP).
The U.S. Tax Cuts and Jobs Act (TCJA), enacted in 2017, replaced tax code Section 936(h)(3)(B) with a new definition of IP under Section 367(d)(4) that includes goodwill, going concern value, and workforce in place. The new definition expanded the scope of IP and brought it in line with the definition used by the OECD and industry at large. Certain intangible assets that do not fall under the revised definition are transferrable in international intercompany transactions free of charge. The income in international intercompany transactions in IP needs to be commensurate with the income attributable to the intangible (Section 482), and the valuation of the intangible property could be on an aggregate basis or on the basis of realistic alternatives.
In early January 2018, the Large Business and International (LB&I) Division of the IRS issued several new directives for transfer pricing examination procedures and policies that could substantially reduce transfer pricing audit cost and controversies and might enhance corporations’ and the government’s efficiency. Transfer pricing issue costs are quite high for taxpayers and make up a substantial share of LB&I Division’s resources.
- First, the LB&I partially dropped the mandatory transfer pricing information documentation request (IDR) that was in force since 2003, except for examinations arising under approved LB&I campaigns, or for examinations with initial indications of transfer pricing compliance risk.
- Second, the LB&I examiners are barred from changing a taxpayer’s selected best method, except if they believe that a different method would result in a more reliable measure of an arm’s-length outcome. The best method change must be approved by the Director of Field Operations and the national Transfer Pricing Review Panel. This directive recognizes that transfer pricing disputes involving divergent views on the best method for determining an arm’s-length result are the most time-consuming and expensive.
- A third LB&I directive encourages examiners to thoroughly evaluate whether the imposition of penalties is appropriate in every transfer pricing matter, which signals that there is no need to rush to penalties, except in egregious case.
- The fourth directive recognizes reasonably anticipated benefits (RAB) as acceptable benchmark for the purpose of determining the buy-in cost in cost sharing arrangements (CSAs). That is, a taxpayer’s selection of a methodology for determining the buy-in cost allocation should be respected as long as it’s reasonable, although alternative allocators could be conceived. This directive, similar to the best method, could significantly align taxpayers and the IRS.
This article discusses eight court cases that have significant implications on international transfer pricing management, and that contributed to the evolution of more reasonable transfer pricing regulations. The transfer pricing disputes include cases with the following significant issues:
- Selecting the best method—comparable uncontrolled price (CUP)/comparable uncontrolled transaction (CUT) or comparable profits method (CPM) (in the case of Medtronic);
- Whether stock-based cost (SBC), which includes stock option compensation of employees, should be included in CSAs (Altera);
- Whether prior closing agreements between the IRS and a taxpayer are applicable indefinitely or each audit cycle stands on its own (Coca Cola);
- Whether the IRS can cancel an APA (Eaton);
- Definition and valuation of intellectual property (IP) (Amazon);
- CSA—buy-in valuation issues (Facebook);
- Royalties for intellectual property (Perrigo);
- Profit shifting via royalties and cost sharing (Coca Cola and others); and
- Taxpayer’s right to access IRS Appeals (Facebook).
SELECT COURT CASES
Altera Corp. v. Commissioner
In May 1997, Altera Corp., now a subsidiary of Intel Corp., and Altera International entered into a cost-sharing agreement (CSA) that was effective from that date through 2007. In allocating the costs, Altera Corp. excluded stock-based cost (SBC). The IRS subsequently made transfer pricing adjustments in each of the tax years 2004-2007 by including SBC in the CSA. Altera challenged the IRS in the U.S. Tax Court on whether stock-option compensation should be included in their CSAs with a Cayman Islands subsidiary, claiming that the IRS ignored comparable unrelated agreements that didn’t include stock option costs.
The Tax Court unanimously held that Treasury Regulation 1.482-7A(d)(2) was invalid and that SBC costs are not among the costs shared in a CSA. In early 2016, the IRS filed an appeal before the U.S. Court of Appeals for the Ninth Circuit. The Ninth Circuit upheld the Treasury regulation and reversed the Tax Court’s decision. In a final decision issued in June 2019 the court stated that related entities must share the cost of employee stock compensation in order for their cost-sharing arrangements to be classified as qualified cost-sharing arrangements and thus avoid an IRS adjustment. The court held that the government reasonably interpreted the transfer pricing regulations as an authorization to require internal allocation of SBC in the CSA, provided that the costs and income allocated were proportionate to the economic activity of the related parties.
Apparently, Altera was unhappy with appeal’s decision. In November 2019, the U.S. Court of Appeals for the Ninth Circuit denied Altera’s petition for rehearing of its case. Altera was recently granted an extension until April 15 to file an appeal with the U.S. Supreme Court.
Eaton Corp. v. Commissioner
Eaton Corp., a global manufacturer of electrical and industrial products headquartered in the U.S., entered into APAs for 2001–2005 and 2006–2010 that covered manufacturing breaker and electrical control products in Puerto Rico and the Dominican Republic. In early 2010, Eaton discovered that it made computational errors in its APA calculations and tax reporting. By October 2010, the company had corrected these errors and amended both its APA reports and federal income tax returns. The IRS maintained that Eaton violated the terms of the APAs and therefore canceled them, adjusted the company’s 2005-2006 income, and imposed a penalty.
After a trial in 2015, the Tax Court held that the IRS abused its discretion by canceling the APAs despite that fact that Eaton’s errors were immaterial and inadvertent and insufficient grounds for the IRS to cancel the APAs. After a trial in 2017 relating to the IRS deficiency assessment of Eaton’s 2005 and 2006 taxable income by roughly $370 million, the court ruled that there was no adjustment under Section 482. The Tax Court subsequently dismissed the penalty imposed on Eaton in light of the canceled APAs.
Medtronic v. Commissioner
Medtronic is a U.S. company engaged in R&D, design, manufacturing, and sales of cardiac and neurologic medical devices through related entities around the world. Its largest manufacturing facility is Medtronic Puerto Rico to which it licensed the intangible property required to manufacture medical devices, and received royalties of 29% on intercompany sales of devices and 15% on sales of leads.
The key dispute with the IRS was whether Medtronic Puerto Rico made arm’s-length payments to Medtronic US for IP necessary to manufacture and sell medical devices. The IRS did not accept Medtronic’s position that product quality plays a very significant role in the medical devices area, and the manufacturer plays a key role in ensuring quality. The government argued that quality is simply a baseline competency that other simple manufacturers could have performed.
The IRS deemed Medtronic Puerto Rico as a contract manufacturer of components that enjoyed a huge shift of profit, because it incurred about 10% of the joint value-added costs of the medical devices value chains and about 60% of the operating profits. The IRS issued a notice of deficiency of $548 million for 2005 and $810 million for 2006, or a total of $1,358 million, by raising the royalty rates. The IRS selected MPROC as the tested party and used 14 comparables to calculate the deficiencies by applying the comparable profits method (CPM). The government raised the royalties to 49.4% on devices and 58.9% on leads, which shifted to Medtronic US 91.9% and 94.4% of operating income for 2005 and 2006, respectively.
After a trial in 2016, the Tax Court rejected the IRS’s tax deficiency notice and made several adjustments to Medtronic’s Pacesetter product royalty and arrived at a revised royalty rate on intercompany sales of 44% for devices and 22% for leads that were very close to the memorandum of understanding result that Medtronic negotiated in a prior audit cycle. The Tax Court observed that the IRS’s analysis allocated an unreasonably small share of profits to MPROC by dismissing the importance of quality.
On appeal to the U.S. Court of Appeals for the Eighth Circuit, the IRS argued that the Tax Court failed to apply the best method by using an adjusted CUT for determining the arm’s-length royalty rate that the Puerto Rican subsidiary owed its U.S. parent for licenses in 2005 and 2006. The appeals court vacated the Tax Court decision and ordered it to justify more extensively that its determination of Medtronic’s transfer pricing was arm’s-length. It seems that perhaps the court was not convinced that a modified CUT was the best method, and perhaps a profit based transfer pricing approach could be more suitable to establish an arm’s-length royalty.
Amazon v. Commissioner
Amazon.com Inc. entered into a CSA in 2005 with its Luxembourg affiliate granting it the right to use certain intangibles in Europe in exchange for an upfront buy-in payment and subsequent annual payments for ongoing intangible development costs. To determine the buy-in amount, Amazon valued each group of transferred assets separately using the comparable uncontrolled transaction (CUT) method between $284 million and $413 million, whereas the IRS applied a discount cash flow (DCF) approach and a new and expanded definition of IP valued it at $3.5 billion.
Amazon argued that the IRS improperly valued the pre-existing intangibles by using an incorrect definition of intangibles. The government valuation encompassed intangible assets that were not within the definition of IP under Treas. Reg. 1.482-7A. The IP under the CSA could not include residual-business assets such as Amazon’s culture of innovation, the value Amazon workforce in place, going concern value, goodwill, and growth options. .
Amazon filed a petition in the Tax Court challenging the IRS’s valuation. The Tax Court ruled in 2017 that the IP valuation method that Amazon used was reasonable, whereas the IRS’s adjustment was arbitrary, capricious, and unreasonable, and constituted an abuse of discretion. The Tax Court rejected the IRS’s valuation methodology because it improperly included in the buy-in payment the value of subsequently developed intangibles, rather than the preexisting intangible property under the cost sharing regulations in effect during 2005-2006; and the IRS erred when it used the DCF method to value the buy-in payment. The court deemed the CUT method as the best method to price the buy-in.
The IRS appealed before the Ninth Circuit, which affirmed the Tax Court’s decision and held that the definition of “intangible” for the CSA buy-in did not include residual-business assets. The transfer pricing regulations’ definition of “intangibles” required that they be independently transferable assets and have value on a stand-alone basis. On appeal the IRS argued that the TCJA expanded the definition of intangibles and broadened it, thus resulting in the proposed adjustment. The court of appeals noted that the IRS derivation of the buy-in cost of pre-existing intangibles under the CSA included residual business assets that were not defined as intangibles under the applicable regulations. Treas. Reg. 1.482-7A specifies the requirements of qualified cost sharing arrangement and the methods for determining taxable income resulting from such transaction. The appeals court ruled in favor of Amazon.
Coca-Cola v. Commissioner
This case involves a prior transfer pricing closing agreement with the IRS, which the Coca-Coca Co. followed for 11 years, which is probably applicable in the current audit. Coca-Cola conducted its core international business through controlled foreign licensees, which produced and sold beverage concentrates to independent bottlers under manufacturing and quality guidelines set by the U.S. company, the legal owner of the company’s most valuable IP.
Coca-Cola asserted that the CUT method using the master-franchising transactions was the best method for determining the arm’s-length royalty, yielding a royalty rate of 12.3% on concentrate sales. The IRS claimed that during the three-year period of 2007-2009 Coca-Cola undercharged seven foreign affiliates for trademarks and formulas used in the production and sale of concentrates abroad. The asymmetrical spit of the joint operating income indicates a vast shift of profit to low tax jurisdictions, where foreign licensees earned over $11 billion in operating profits, while Coca-Cola reported approximately $800 million.
The IRS issued tax deficiencies of $3.3 billion for the years 2007-2009 based on its income allocations of $9.4 billion to Coca-Cola from subsidiaries in Ireland, Swaziland, Mexico, Brazil, Chile, Costa Rica, and Egypt. On Dec. 14, 2015, Coca-Cola Co. filed a petition in the U.S. Tax Court challenging the proposed adjustment. The issue is still being litigated.
Facebook Inc. v. IRS
The IRS claimed that Facebook undervalued certain intangible property that it transferred to its Ireland-based subsidiary by approximately $7 billion. Facebook filed a complaint in the federal district court contesting the IRS decision to bar it from appealing its case before the IRS Appeals Office.
Facebook claimed that the IRS acted arbitrarily, capriciously, and in violation of law, in refusing to refer its tax case to IRS Appeals and asked the court to order the IRS to refer its tax case to IRS Appeals. The IRS moved to dismiss Facebook’s complaint under Federal Rule of Civil Procedure 12(b)(1), arguing that Facebook lacked standing and that the IRS’s decision not to refer Facebook’s tax case to IRS Appeals was not reviewable under the APA. The U.S. Chamber of Commerce filed an amicus brief arguing against dismissal. The court held a hearing on April 19, 2018.
Facebook alleged that Revenue Procedure 2016-22 (which provides that IRS Office of Chief Counsel has the authority to deny taxpayers access to IRS Appeals if referral is “not in the interest of sound tax administration”) was arbitrary, capricious, an abuse of discretion, not in accordance with the law, exceeded statutory jurisdiction, authority, or limitation, or was short of a statutory right.
The court ruled in favor of the IRS, because as a matter of law, Facebook did not have a legally enforceable right to compel the IRS to refer its case to IRS Appeals, and the court dismissed Facebook’s complaint.
Preventing taxpayers from appealing to the IRS Appeals is extremely uncommon. This extraordinary case could have been motivated by the government’s confidence in the strength of its proposed adjustment. We note that IRS Appeals seeks to prevent cases from going to court, and they are usually in favor of settling disputes, which commonly results in considerably lower adjustments.
In July 2013, Elan, an Irish pharma company, was acquired by the U.S.-based Perrigo group for $8.6 billion. Ireland’s corporation tax rate was one of the main attractions for Perrigo, and the deal was said to give Perrigo substantial tax savings due to a corporate inversion.
Perrigo was issued a $1.9 billion transfer pricing adjustment by the Irish tax authorities related to its sale of a 50% interest in Tysabri to Biogen, a U.S. pharmaceutical company, eight months before Perrigo acquired Elan. Perrigo disputed the assessment and argues that Elan had conducted business in Ireland for many years entitling the company to a 10 % tax rate (increased to 12.5 % in 2005). The High Court hearings in the Irish $1.9 billion case will commence in April 2020.
On April 26, 2019, Perrigo received a revised Notice of Proposed Adjustment (the “NOPA”) from the IRS auditing Athena Neurosciences, Inc. (Athena), for the tax years ending Dec. 31, 2011, through Dec. 31, 2013. The revised NOPA is based on the theory that when Elan took over the funding of Athena’s in-process R&D in 1996, it should have paid a substantially higher royalty rate for the right to exploit Athena’s IP. The IRS Examination team developed a theoretical 24.7% license royalty rate based on the financial data contained in the original purchase price allocation done in 1996. The proposed income adjustments were then generated by applying that royalty rate to Tysabri® sales revenue. Perrigo strongly disagrees with the IRS position and believes that the original transfer pricing methodology was appropriate and intends to fight the issue in all available administrative and judicial remedies, including potentially those available under the U.S.-Ireland Income Tax Treaty to alleviate double taxation.
The transfer pricing litigation results were generally unfavorable for the government. These results motivated regulatory changes that are designed to provide greater clarity in the intercompany pricing practices, reduce controversy between taxpayers and the IRS, become more consistent with the OECD BEPS, and conform with the TCJA. Accepting taxpayers’ selection of the best method for arm’s-length determination, and reasonably anticipated benefits criteria for determining the buy-in cost in CSAs could significantly reduce conflict, providing, however, that companies conduct their transfer pricing in adherence to the regulations and consistent with comparables. While the U.S. government seems to have become more lenient, the OECD has taken a stricter approach, which could present American multinationals with conflicting practices around the world. Finally, denying a taxpayer’s right to appeal to the IRS Appeals is extremely uncommon and quite alarming. The IRS Appeals seeks to prevent cases from going to court and they are usually in favor of settling disputes, although at considerably lower adjustments.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Harvey Poniachek, Ph.D. is a professor at Rutgers Business School. This article is based on a presentation and discussion at the Stamford Tax Association & Tax Executives Institute in Stamford, Conn. on Jan. 30, 2020.