Now what? Collateral consequences of transfer pricing adjustments.

• Author: Lewis, Patricia Gimbel

1. Overview

   If it is determined under section 482 of the Internal Revenue Code that a U.S. taxpayer underpaid its U.S. income tax by reason of a transfer pricing error, the immediate consequence is that the U.S. company owes additional U.S. income tax. Beyond that, three crucial tax inquiries come into play:

   * Double Taxation: Can the foreign tax previously paid by its foreign affiliate with respect to the amount now reallocated be credited or refunded to avoid double taxation?

   * Adverse Collateral Tax Consequences: Can any adverse collateral U.S. tax consequences of the reallocation be avoided or mitigated?

   * Ability to Repatriate Funds: What are the U.S. and foreign tax consequences of a reimbursement of the U.S. company by its foreign affiliate to compensate for the original transfer pricing error? Although repatriation is not required as a tax matter, funds may be needed from the foreign affiliate to pay the additional U.S. tax or for financial or business reasons.

   Similar issues may be presented if a taxpayer avoids section 482 adjustments by reporting transaction results on a timely filed tax return based on prices different from those actually charged(1)(*) (so-called compensating adjustments), or makes similar corrections pursuant to an advance pricing agreement (APA).

   Two basic dynamics are operative here. First, the IRS must make appropriate correlative allocations to the income of the related party.(2) Second, the IRS will generally permit an "as-if" approach, thereby allowing the parties to end up in the same position they would have been in had the original transaction been conducted at arm's-length.

   The taxpayer's focus, of course, cannot be exclusively on U.S. tax consequences. A continual, and complex, interface is created by the rules and policies of the taxing authority having jurisdiction over the foreign related party(ies). These vary significantly and are often difficult to determine. Of note is the March 1995 draft of the second part of the Organisation for Economic Co-Operation and Development's transfer pricing guidelines,(3) which encourages tax administrations to avoid "secondary adjustments" in most cases, because of complexity, coordination, and other problems.

   In analyzing the collateral consequences of transfer pricing adjustments, the relationship and identities of the U.S. and foreign parties can be critical. Pertinent categories for present purposes are (1) U.S. parent/foreign subsidiary, (2) U.S. subsidiary/foreign parent, and (3) siblings of a foreign parent. This article sets forth separate examples for each category, though there are many common substantive and procedural issues. Also, the examples involve inbound purchases of tangible goods, but essentially the same net result and issues obtain in outbound transactions or cases involving intercompany services, intangibles, or loans (with some additional withholding tax issues possible in the latter cases). A matrix at the end of the article summarizes the key concerns and consequences in the three situations.

2. Case A: U.S. Parent/Foreign Subsidiary

   Example: A U.S. multinational corporation (USPAR) buys products manufactured abroad by its foreign subsidiary (FOSUB), a controlled foreign corporation (CFC) for Subpart F purposes.(4) The IRS determines under section 482 that USPAR overpaid for the products, and reduces USPAR's cost of goods sold, increasing its taxable income accordingly. The IRS position is that:

   * The amount of the overpayment represents a capital contribution by USPAR to FOSUB.(5)

   * FOSUB'S earnings and profits (E&P) are reduced by the amount of the overpayment.(6)

   * The foreign tax paid by FOSUB in excess of the amount payable had the sales price been an arm's-length price is deemed a voluntary overpayment of tax to the foreign government and thus is ineligible for foreign tax credit or deduction to USPAR. FOSUB's E&P, however, will generally reflect its actual foreign tax expense, regardless of creditability.(7)

   The IRS approach potentially gives rise to double taxation of the reallocated amount to the extent of foreign taxes paid by FOSUB. Moreover, the "overpaid" funds are held by FOSUB even though it is considered not to have earned them. The following analysis focuses on how to eliminate the double taxation and, if desired, how to move the funds back to USPAR. Adverse collateral consequences of the allocation are not particularly problematic, since the overpayment is treated as a nontaxable capital contribution.

   1. Elimination of Double Taxation

      1. FOSUB should first attempt to secure a foreign tax refund unilaterally, based on the "corrected" amount of its income.(8) This will generally be difficult, however, unless some sort of simultaneous examination process is available, the amount involved is small, or the foreign tax system is relatively informal.

      2. If FOSUB is unable, after "exhausting all effective and practical remedies,"(9) to obtain a refund, USPAR should seek competent authority assistance to mitigate the resulting double taxation accordance with treaty provisions, if applicable, under Rev. Proc. 91-23.(10) Competent authority proceedings in transfer pricing cases can be quite lengthy, difficult, costly, and unpredictable, although the IRS is seriously attempting to streamline and improve the process, with some success. Taxpayers may be required to file amended returns or protective claims for refund with the foreign tax authority to keep the foreign statute of limitations open, satisfy treaty requirements, and meet similar requirements. Timing and "alerting" concerns can be tricky and delicate.

      3. If refund remedies and competent authority rights are exhausted but unavailing, the actual foreign taxes originally paid by FOSUB should be creditable (subject to applicable limitations under section 904).(11) This result, however, is not automatic.(12)

      4. Taxpayers should consider the effect of currency changes. If foreign tax rules compute refunds based on exchange rates in effect for the transaction year and there have been significant intervening changes, FOSUB may experience a real economic benefit or detriment.

   2. Potential Adverse Collateral Tax Consequences

      1. No direct adverse collateral U.S. tax consequenees will result with respect to FOSUB because the overpayment is treated as a nontaxable capital contribution.

      2. The reduction of FOSUB's gross income could affect certain Subpart F calculations, e.g., the 5-percent and 70-percent gross income thresholds in sections 954(b)(3)(A) and 954(b)(3)(B), respectively, and, perhaps, the section 954(b)(4) exclusion for high-foreign-taxed foreign base company income. Other tax regimes involving gross income tests might also be affected, including personal holding company or foreign personal holding company determinations.(13) Expense allocations based on relative gross income amounts could be altered. See Treas. Reg. [sections] 1.861-8(f)(4).

   3. Repatriation of Funds

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