Proposed section 482 regulations.

• Position: Includes related article

On July 28, 1992, Tax Executives Institute filed the following comments with the Internal Revenue Service on the proposed section 482 regulations relating to transfer pricing and cost sharing. The proposed regulations are intended to implement the commensurate-with-income standard of section 482 which was enacted in the Tax Reform Act of 1986. The Institute's comments were prepared under the aegis of it8 International Tax Committee, whose chair is Raymond G. Rossi of Intel Corporation. Preparation of TEI's comments was coordinated by Lisa Norton of Ingersoll-Rand Corporation, vice-chair of the Committee, who headed a special task force of TEI members to prepare the comments. On August 31, 1992, Ms. Norton represented TEI at an IRS public hearing on the proposed regulations. (Ms. Norton's testimony which summarizes TEI's principal points begins on page 414.

On January 24, 1992, the Internal Revenue Service issued proposed regulations under section 482 of the Internal Revenue Code, providing rules for intercompany transfer pricing and cost sharing. The proposed regulations (INTL-372-88 and INTL-401-88) were published in the Federal Register on January 30, 1992 (57 Fed. Reg. 3571), and in the February 24, 1992, issue of the Internal Revenue Bulletin (1992-8 I.R.B. 23).(1*)

1. Background

   Tax Executives Institute (TEI) is the principal association of corporate tax executives in North America. Our approximately 4,700 members are employed by more than 2,000 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and the government alike.

   As a professional association, TEI is firmly committed to maintaining a tax system that works - one that is consistent with sound tax policy, one that taxpayers can comply with, and one in which the Internal Revenue Service can effectively perform it;s examination function. Many of TEI's members work for multinational enterprises for which the transfer pricing and cost sharing rules issued under section 482 have a substantial impact. They know first-hand the counterproductive effect of lengthy controversies with the IRS and foreign revenue authorities over transfer pricing issues. They also know first-hand of the need for certainty in an area fraught with disagreement. Thus, TEI brings an informed perspective to bear on the proposed transfer pricing and cost sharing regulations under section 482.

2. Overview

   The Tax Reform Act of 1986 amended section 482 to require that consideration for intangible property transferred to related parties be commensurate with the income attributable to the intangible. The Conference Report on the 1986 Act recommended that the IRS conduct a comprehensive study of intercompany pricing rules and consider whether the regulations under section 482 should be modified.(2) The Treasury Department and IRS issued the study of intercompany transfer pricing (hereinafter "the White Paper") on October 18, 1988.(3) Many of the concepts enunciated in the White Paper have been incorporated into the proposed regulations. If adopted, the proposed regulations will fundamentally change how multinational companies determine their intercompany pricing for transfers of both tangible and intangible property. Moreover, the proposed regulations deviate substantially from the internationally accepted definition of the arm's-length standard (notwithstanding the assertion to the contrary contained in the recent report to Congress by the Treasury Department and IRS concerning the administration of section 482).(4)

3. Summary of Comments

   The Tax Reform Act of 1986 added one 36-word sentence to section 482. The legislative history of the change manifested congressional concern about transfers of "high-profit intangibles" to related foreign entities in low-tax jurisdictions.(5) The IRS, however, has seized upon a specifically targeted statutory amendment to revisit every facet of the section 482 regulations and to overturn every taxpayer-favorable court decision that it perceives as encroaching on the IRS's power to allocate income or deductions under section 482. TEI submits that this attempt to vitiate existing precedent not only exceeds Congress's expressed concerns but it will inevitably and unnecessarily lead to controversy in many situations that could prudently be resolved under the existing regulations.

   The proposed regulations proceed on the theory that they should be used to establish transfer prices between related entities. Hence, the IRS "anticipates that taxpayers win use these regulations to establish transfer prices for controlled transactions using the best available data, and that [taxpayers] will provide the data as early as is practicable in the course of an examination by the [IRS]."(6) Such a view, which infects the core of the proposed regulations, misapprehends the purpose of section 482. The statute authorizes the IRS to redetermine income between related parties only if such a redetermination is "necessary" to prevent the evasion of taxes or to clearly reflect income. In other words, section 482 mandates such adjustments only where the taxpayer's method produces an unreasonable result. TEI believes the regulations under section 482 should not be used to mandate intercompany pricing methodologies, but rather to provide guidance on whether a taxpayer's actual pricing results will be found to be reasonable.

   Notwithstanding TEI's specific concerns regarding the practical implementation of the proposed regulations, the Institute applauds the proposed regulations insofar as they acknowledge that the arm's-length standard will produce a range of acceptable prices and results. Although taxpayers and the government must ultimately settle on a single price in evaluating a particular set of transactions, the comparable profit interval (CPI) concept efficaciously shifts the focus to the range that surrounds any particular price. It thus increases the area within which agreement between taxpayers and the government may be reached - preferably at the earliest stages of examination.

   The CPI regime should not, however, supplant other internationally accepted measures of arm's-length pricing, such as the comparable uncontrolled price (CUP), resale-price, and cost-plus methods. If the other pricing methods sanctioned by the existing Treasury regulations are constricted in application (or de-emphasized to the point of irrelevance), the CPI concept will not serve its intended purpose - reducing controversy and disagreement - but rather will create uncertainty and provoke protracted litigation to define the boundaries of the application of CPI and the myriad new terms introduced.

   The elevation of CPI, in effect, as the principal method of determining arm's-length consideration - whether for intangible property or tangible property with significant embedded intangibles - raises the potential for unresolved disputes with U.S. treaty partners and concomitant double taxation. We believe that foreign governments will find the restrictions on the use of the internationally accepted methods - CUP, resale-price, cost-plus, etc. - so onerous and the results under CPI so overreaching that they may retaliate by increasing the number of transfer pricing issues raised against the local affiliates of U.S.-based multinationals. Furthermore, the mandatory imposition of CPI as a pricing method (or validation procedure) in all but the few cases that meet the constricted matching transaction method (MTM) and CUP standards will significantly increase the number of competent authority cases sought by U.S. taxpayers. This is unfortunate, for the competent authority process should not be viewed as the forum for resolving a vast number of pricing disputes. We further believe that a large increase in the magnitude of income adjustments and number of transfer pricing cases will lead to a profusion of unagreed competent authority cases. In anticipation of these results, TEI recommends that treaty negotiation procedures be revised to seek a provision for the mandatory use of arbitration where the competent authorities are unable to agree.

   The best way to assuage concerns of taxpayers and foreign governments alike and to reduce the number of competent authority cases is to promulgate safe-harbor rules under the regulations. Thus, TEI recommends that CPI be applied as a safe harbor rather than as a mandatory pricing method (or validation process). In addition, TEI proposes other safe harbors or rebuttable presumptions that may be employed to reduce the number of pricing disputes. If CPI is to become the predominant method for setting transfer prices (rather than the safe harbor TEI recommends), it is essential that taxpayers be afforded the opportunity to establish why - under their facts and circumstances - the prices are arm's length and properly diverge from a mechanical CPI-based income adjustment.

   Prop. Reg. [section] 1.482-2(g) sets forth rules for qualified cost-sharing arrangements. Cost-sharing arrangements are agreements containing objective formulae to share the risks and rewards of collaborative research and development activity. The proposed regulations respond positively to many of the criticisms directed at the White Paper's treatment of cost sharing. In general, the rules provide a foundation upon which a workable regulatory framework may be constructed. There are some areas, however, that require clarification and comment. In particular, the proposed regulations create a new test against which the operating results of the cost-sharing participants must be measured to determine whether the arrangement is reasonable. Where a cost-sharing agreement fails to allocate costs...