THE 2017 STATUTORY CHANGE TO § 482
The 2017 Tax Reform Act added a new third sentence to § 482 that allows aggregation and the consideration of realistic alternatives if it produces the most reliable means of valuation. The exact sentence is: "For purposes of this section, the Secretary shall require the valuation of transfers of intangible property (including intangible property transferred with other property or services) on an aggregate basis or the valuation of such a transfer on the basis of the realistic alternatives to such a transfer, if the Secretary determines that such basis is the most reliable means of valuation of such transfers."
An aggregation rule is also set forth in the temporary § 482 regulations. Temp. Treas. Reg. § 1.482-1T(f)(2)(i)(B) states that the combined effect of two or more interrelated transactions can be aggregated if aggregation provides the most reliable measure of an arm's length results under the best method rule.
The new third sentence in § 482 and the temporary regulation allow aggregation if it provides the most reliable measure of an arm's length result. If there is a reliable comparable transaction and at arm's length in the marketplace parties do not aggregate, then aggregation is not the most reliable means of valuation. The statute and regulations do not give the IRS unfettered discretion to apply aggregation concepts. The IRS is bound by the arm's length standard and the best method's most reliable means of valuation.
The Tax Court recently addressed IRS aggregation arguments in Medtronic v. Commissioner, T.C. Memo. 2016-112 (2016), on appeal, Guidant v. Commissioner, 146 T.C. No. 5 (2016), Amazom.com, Inc. v. Commissioner, 148 T.C. No. 8 (2017), on appeal, and Veritas Software Corp. v. Commissioner, 133 T.C. No. 297 (2009). These cases all involved § 482 aggregation regulations as they existed before the new statutory language and the temporary regulations.
Under the IRS's view, aggregation was required in all of these cases. The Tax Court held that transactions may be aggregated if an aggregated approach produced the "most reliable means of determining the arm's length consideration for the controlled transactions." If the transactions were accounted for and priced separately in the marketplace then aggregation is not the most reliable means of valuation.
Whether the IRS abused its discretion by aggregating transactions involving intangibles, tangible goods, and provision of services is a question of fact. In Medtronic, Guidant, Veritas and Amazon, aggregating the transactions did not result in a reasonable determination of true taxable income.
The Tax Court has repeatedly rejected the IRS's attempt to aggregate transactions based on the fact that aggregation does not produce a reliable result. If there is a reliable CUT transaction then aggregation is not appropriate if aggregation is not done in the marketplace.
The new third sentence in § 482 and the temporary § 482 regulations retain the "most reliable means" standard and the arm's length standard should be read consistently with the Tax Court's aggregation holdings in Veritas, Amazon and Medtronic.
Recent statements by an IRS official seem to agree, at least insofar as new regulations will not be necessary. Brian Jenn, of the U.S. Treasury Department, was quoted as stating that the statutory change can be read as simply authorizing the temporary regulations that the IRS already has in place. This presumably does not mean there will not be future disputes, however. The IRS would seem not to agree with these cases, and has appealed two of them.
NEW IRS DIRECTION FOR TRANSFER PRICING?
An IRS official stated that the IRS is reevaluating its approach to transfer pricing enforcement and litigation after recent losses in court. Kirsten Wielobob, Deputy Commissioner for Services and Enforcement, said the Service is looking at how it assesses and selects cases for examination and how it analyzes issues. She said the IRS cannot continue to do things as it currently does them. The IRS is facing resource constraints. In addition, the IRS has received clear messages from the courts on the IRS's approach to transfer pricing.
In our view, the IRS really does need to reevaluate its approach to transfer pricing. The IRS has taken some extreme positions such as reneging on prior transfer pricing agreements, taking positions contrary to those the U.S. took in BEPS negotiations, etc. Litigating Amazon to effectively re-litigate Veritas would seem to have been a waste of government resources. Appealing Amazon, Medtronic and Altera, 145 T.C. No. 3 (2015), also would seem not to be a good investment of government resources.
In line with the comments made by Ms. Wielobob, the IRS subsequently issued four new transfer pricing directives. The directives state that transfer pricing issues make up a substantial portion of the Large Business and International Division ("LB&I") inventory and that significant resources are devoted to transfer pricing issues.
Under the first directive, approval is required for IRS examiners to change the taxpayer's transfer pricing method. The approval must be granted by the Treaties and Transfer Pricing Operations ("TTPO") Transfer Pricing Review Panel before the transfer pricing method used in the taxpayer's contemporaneous transfer pricing documentation or an Advance Pricing Agreement ("APA") submission can be changed.
New cost-sharing stock-based compensation audits were suspended by the second directive. The directive instructs examiners to stop opening issues on stock-based compensation included in cost-sharing arrangement ("CSA") intangible development costs until the Ninth Circuit issues an opinion in Altera Corp. v. Commissioner.
Under the third directive, examiners are to stop developing adjustments based on changing a taxpayer's multiple reasonably anticipated benefits ("RAB") shares to a single RAB share when subsequent platform contribution transactions are added to an existing CSA until an agencywide position is finalized.
The fourth directive states that the evaluation of possible penalties should be undertaken only after the examination team has completed enough of its analysis to know the order of magnitude of the potential adjustment and has a deep factual background. The directive encourages examiners to complete a diligent penalty analysis.
BEPS OPEN ISSUES
New Discussion Draft on PE Profit Attribution
The OECD published a new discussion draft in July 2017, providing high-level guidance for the attribution of profits to PEs in the circumstances addressed by the BEPS Report on Action 7. In particular, the new discussion draft covers PEs arising from Article 5(5) of the OECD Model Treaty, including examples of a commissionaire structure for the sale of goods, an online advertising sales structure, and a procurement structure. It also includes additional guidance related to PEs created as a result of changes to Article 5(4) of the OECD Model Treaty, and provides an example on the attribution of profits to PEs arising from the anti-fragmentation rule.
The new discussion draft states that under Article 7 of the OECD Model Treaty, the only profits attributable to a PE are those that would have been derived if the PE were a separate and independent enterprise performing the activities in question. This principle is to apply regardless of whether a tax administration has adopted the "authorized OECD approach." The examples included in the report demonstrate the application of this principle, and provide that the ownership of assets and the assumption of risks related to functions performed by a PE are to be assigned to the PE. The application of this principle in a manner that treats the ownership of assets and assumption of risks as having been transferred to the PE would be contrary to the parties' actual transaction and legal agreements, and could raise important questions regarding whether a tax administrator has the authority to restructure a taxpayer's transaction in this manner.
OECD Hard-to-Value Intangibles Discussion Draft
The OECD released a discussion draft on May 23, 2017 addressing hard-to-value intangibles ("HTVI"), titled "Implementation Guidance on Hard-to-Value Intangibles." The HTVI approach is intended to allow tax administrators to use after-the-fact profit information as presumptive evidence about the appropriateness of the parties' transfer prices which of necessity had to be determined prior to the transaction. The new rules are quite controversial, and would seem to deviate from the arm's length standard. The major concern is how tax administrators will apply them in practice.
The new discussion draft is helpful to the extent it makes clear that tax administrators are not to base transfer prices and valuations solely on ex post income. However, the application of these rules in practice will determine the reasonableness of the new rules in the context of the OECD Transfer Pricing Guidelines' overriding theme that related parties are supposed to deal at arm's length.
The OECD issued a revised discussion draft in June 2017 under BEPS Action 10 titled "Revised Guidance on Profit Splits." The revised discussion draft is intended to clarify rules applicable to the transactional profit-split method by identifying indicators for its use as the most appropriate transfer pricing method, and providing additional guidance on determining the profits to be split and how to split those profits.
The Tax Executives Institute provided comments on the revised OECD discussion draft, including its general comment that the final guidance on profit splits should clearly state that the transfer pricing best method requirement has not been changed. It should be clear that the profit-split guidance is not intended to promote the method to make it more prevalent, but rather to assist in the method's application. The most appropriate method to assess the arm's length nature of transactions should always be used and there should be no requirement to use the profit-split method as an additional or corroborative method.