Proposed section 6038A regulations: new recordkeeping, information reporting, record production, and translation requirements with respect to transactions between a foreign-owned U.S. corporation and its foreign related parties.

• Author: Cole, Robert T.

Proposed Section 6038A Regulations: New Recordkeeping, Information Reporting, Record Production, and Translation Requirements With Respect to Transactions Between a Foreign-Owned U.S. Corporation and Its Foreign Related Parties

1. Overview

   In December 1990, The Internal Revenue Service issued proposed regulations implementing 1989 and 1990 amendments to section 6038A of the Internal Revenue Code and the 1990 addition of section 6038C. Under the proposed regulations, in the case of a U.S. corporation (reporting corporation) (1) which is owned at least 25 percent by a foreign shareholder, that shareholder and any related party, especially a foreign related party, directly or indirectly involved in transactions with the reporting corporation, will be required to maintain (and produce and translate when demanded by the IRS) extensive records relating to such transactions as specified in the regulations.

   One proposed requirement for particular concern involves the keeping of, or creating where not otherwise maintained, combined industry segmented profit and loss statements, referred to as "material profit and loss statements." The industry segments are based on product lines, products, or models. Generally, materiality depends on the amount and percentage of gross revenue derived by, or assets used by, or operating profit of, the related party group with respect to sales to third-party customers of U.S.-connected products. In addition, the proposed regulations make sweeping demands for maintaining foreign documentation otherwise created, especially so-called "pricing documents" which are broadly defined to include "all documents relevant to establishing the appropriate price or rate for transactions between the reporting corporation and any foreign related party," and then broadly illustrated by example, encompassing virtually all records potentially related to establishing transfer prices, including records that might have limited or no utility in the particular case.

   Amelioration of the extensive burdens from such recordkeeping requirements could result from agreements with the District Director or the Assistant Commissioner (International) which are available to particularize the recordkeeping obligations of related party groups, or from the "final" regulations (given that final regulations are sometimes less burdensome that the proposed regulations). Indeed, in many cases the particular agreement approach should be tested.

   Recordkeeing is not the extent of the potential burden. The production and translation of the records maintained could well be at least equally burdensome, depending on the restraint used by the IRS in demanding foreign records. Although high IRS officials have informally suggested that there would be internal restrictions on the demands made for foreign records, the proposed regulations do not address that question. It is important that the restraints be issued before or at the same time as the final regulations. In particular, there is concern that International Examiners might generically request or summons "pricing documents" for the particular transfer prices being reviewed. Such a request or summons would be extraordinarily broad.

   Accordingly, there should be an official directive that (i) there will be no generic requests or summonses for "pricing documents"; (ii) generally request will not be overbroad and burdensome and must identify the records with sufficient specificity to permit adequate response to the request; and (iii) there will be high-level review of whether, and the extent to which, foreign documents and translations should be demanded. In this connection, the Senate Finance Committee Report accompanying the foreign recordkeeping proposals generally required that where records of a related party are obtainable in a timely and efficient basis under the information exchange procedures provided under a tax treaty, the IRS generally would make use of such procedures before issuing a summons to the designated agent on behalf of the related party. (In speeches, IRS officials have stated that there will be supplements to the Internal Revenue Manual addressing these issues.)

   Finally, thought should be given to the substantive use the IRS will make of the records that are produced and translated, given the current uncertainty about the pricing method or methods which should be used in any given situation to arrive at acceptable transfer prices. The requirement for material profit and loss statements by industry segments clearly suggest that the IRS will emphasize the profit split method, at least as a check. It should be noted that profit split is not a priority method in the existing regulations; profit split is the method of last resort in the Treasury and IRS's October 1988 Transfer Pricing White Paper; profit split has low international acceptability; and identifying the combined profit does not indicate how the profit should be split. In any event, given the mass of records soon to be available to the IRS, the Treasury Department should accelerate the process of issuing proposed revisions to the section 482 regulations in order to narrow the methods that need to be considered in any given situation. Similarly, the acceleration of the Advance Pricing Agreement (formerly Advance Determination Ruling) procedures could effectively keep the records explosion under control for those taxpayers seeking advance guidance.

   In addition to monetary penalties, failure to designate the reporting corporation as a limited agent to comply with an IRS summons (not quashed by a District Court) issued to the reporting corporation for production and translation of records of the reporting corporation or a foreign related party, or failure of the reporting corporation or a foreign related party to maintain required records such that a summons is quashed, wouldd empower the IRS to make adjustments to the cost of goods and deductions under review in its "sole discretion," with only limited jucidial review.

   This article analyzes the provisions of the proposed regulations comments on their overall feasibility, and discusses problems associated with assuring compliance with the proposed regulations. (2)

2. Background

   The proposed regulations set forth proposals on how the IRS and Treasury would implement the 1989 and 1990 amendments to section 6038A and the 1990 addition of section 6038C which imposed recordkeeping, reporting, and record production obligations on a reporting corporation (generally, a U.S. corporation at least 25 percent owned by a single foreign shareholder after application of attribution rules, and foreign corporations engaged in a U.S. trade or business). The reporting corporation is required to maintain, or cause to be maintained, records of its transactions and those of related parties, including foreign related parties, from which the "correct treatment" of its intercompany transactions with any foreign related party can be determined by the IRS. (3)

   The principal aim of the legislation was to facilitate the task of the IRS in enforcing U.S. transfer pricing (4) rules under section 482 of the Code and to enable the IRS to reach records of the foreign related parties directly or indirectly involved in transactions with the reporting corporation by imposing recordkeeping requirements on the reporting corporation that include such records of the foreign related parties.

   A related party broadly includes the (or any) 25-percent foreign shareholder of the reporting corporation; any entity, foreign or domestic, which is related within the meaning of section 267(b) or section 707(b)(1) to the reporting corporation or the (or any) 25-percent foreing shareholder; or any other person who is related to the reporting corporation within the meaning of section 482. A corporation filing a consolidated income tax return with the reporting corporation, however, is not considered to be a related party for purposes of these regulations. Certain attribution rules apply in determining whether a corporation is 25 percent foreing owned or is a related party under section 6038A, including special look-through rules for partnerships.

   To overcome the defense of a U.S. reporting corporation that it cannot produce records of a foreign related entity which it does not control, the legislation requires each foreign related party to designate the reporting corporation as its limited agent to furnish records and testimony (5) in response to demands and summonses issued by the IRS.

3. Effective Dates

   None of the provisions of the section 6038A amendments and section 6038C are self-executing, but become effective in accordance with regulations. Proposed regulations are not effective for this purpose. Accordingly, there are no rules in effect at the present time. Nevertheless, when the proposed regulations become final, the present intent is apparently to apply them retroactively, covering all "open" tax years.

   The proposed regulations state that the record maintenance requirement "is generally effective as of December 10, 1990. Records in existence on or after March 20, 1990, however, must be maintained without regard to when the taxable year (to which the records relate) began." While the quoted language is not clear, it would seem to mean:

   * Records that are required to be maintained by the regulationsd and that actually existed any time on or after March 20, 1990, must be maintained for the periodd specified in the regulations. (The record retention period is discussed below.)

   * Records that are required to be maintained by the regulations relating to events taking place on or after December 10, 1990, must be maintained, or created and maintained, for the period specified in the regulations. (This category overlaps the first category except for records not otherwise maintained.) (6)

   With respect to the record production requirement (by demand or summons), the translation requirement, penalties...