A Request for Guidance and Relief from the Timely Reporting Requirement of Section 1.482-1(a)(3) of the Internal Revenue Regulations

• Publication year: 2018
• Author: By William H. Quealy, Jr.

A Request for Guidance and Relief from the Timely Reporting Requirement of Section 1.482-1(a)(3) of the Internal Revenue Regulations1

By William H. Quealy, Jr.²

I. EXECUTIVE SUMMARY

Unless otherwise authorized by statute or regulation, taxpayers generally are bound to account for the income realized from transactions with commonly controlled entities based on the form and terms of the transactions as executed.³ Section 482 of the Internal Revenue Code of 1986⁴ grants the Secretary the discretion to reallocate the income, expense or credits from transactions among commonly controlled entities where necessary to prevent the evasion or avoidance of tax or to more clearly reflect income.⁵ The Secretary and the courts are in agreement that Section 482 does not authorize taxpayers to depart from the terms of their controlled party transactions when reporting taxable income nor does it grant taxpayers a right to compel the Secretary to do so.⁶

The Secretary promulgated Section 1.482-1(a)(3) which allows taxpayers to disregard the terms of their controlled party transactions if necessary to report an arm's length result. Under the terms of the delegation of Section 482 authority, taxpayers may report an increase to the income from controlled party transactions at any time, but they may only report a decrease to the income from controlled party transactions on a timely original return. This is referred to herein as the "timely reporting requirement" and is imposed solely by regulation. The timely reporting requirement may be waived at the Commissioner's discretion.

Although Section 1.482-1(a)(3) is an interpretative regulation which delegates the Secretary's authority under Section 482 to reallocate income from controlled party transactions, the Secretary has extended the timely reporting requirement to bar any post-filing decrease to income from controlled party transactions, even those which are not based upon allocations made pursuant to or required by Section 482. The timely reporting requirement has been raised as an absolute bar to prevent taxpayers from reporting decreases to income resulting from the correction of scrivener's errors, computational errors or accounting errors.

A premise of the paper is that application of the timely reporting requirement imposed by Section 1.482-1(a)(3) to bar adjustments which are necessary to correctly account for income from controlled transactions as executed strays far beyond the scope of Section 482. The underlying statute merely grants the Secretary discretion to depart from the terms of controlled party transactions where necessary to prevent evasion or more clearly reflect income. Unless the Secretary has made a determination under Section 482 that the income expenses or other items of the controlled transaction must be reallocated to prevent evasion or more clearly reflect income, there is no basis to limit a taxpayer's ability to report changes to income or claim any overpayments of tax which result from the changes to income from controlled party transactions which is accounted for and reported based upon the terms as executed.

A rule which prohibits taxpayers from filing otherwise timely claims for overpayments of tax resulting from the correction of an accounting, computational or scrivener's error while at the same time imposing penalties on taxpayers who fail to self-correct errors that might result in underpayments of tax does not promote a clear reflection of income or prevent evasion. Extending the timely reporting rule promulgated under Section 482 as a bar against any downward adjustment to income from controlled party transactions, including those adjustments which do not rely on the delegation of authority at Section 1.482-1(a) (3), may result in a distortion of income to the prejudice of taxpayers and most certainly creates unfair or inequitable tax administration.

The article examines some circumstances where a rigid application of the "timely reporting rule" to all taxpayer initiated downward adjustments does not result in a clear reflection of income, but rather frustrates the overarching goals of promoting fairness and efficiency in the administration of the tax laws. The article also seeks to identify the relevant administrative concerns and potential unintended consequences should the timely reporting requirement be more narrowly applied or be waived through the administrative relief procedures. Ultimately, the article recommends that formal relief procedures be published to allow taxpayers to seek automatic and/or discretionary relief from the timely reporting requirement with respect to certain categories of post-filing adjustments.

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II. CURRENT LAW

A. Section 482

Congress recognized early on that commonly controlled parties might manipulate the terms of their transactions to avoid or evade taxation by shifting the incidence of taxation to one or the other of the parties. The Secretary was first given authority to reallocate income or expenses from controlled party transactions where necessary in his discretion to more clearly reflect income in 1918.⁷ This grant can be traced to Section 482 which in relevant part reads:

In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses . . .

Regulations promulgated under Section 482 confirm that the Secretary's authority will only be exercised to the extent necessary to achieve the same taxable result from controlled party transactions as would be obtained if the same or similar transaction had been conducted between unrelated parties acting at arm's length⁸ The regulations implementing Section 482 run several hundred pages and describe in great detail the various methods by which the income or expenses reported from various types of controlled party transactions can be evaluated and adjusted if necessary to achieve an arm's length result. Courts have uniformly adopted the arm's length result as the benchmark against which the Commissioner's exercise of discretionary authority to reallocate income or expense must be tested for abuse.⁹

It is difficult for commonly controlled parties to determine in advance whether the terms on which they execute their transactions will mirror the results likely to be obtained from the same or similar transactions between unrelated parties. The determination of an arm's length result often requires a historical review of relevant market data. Unless otherwise provided by law, parties to controlled party transactions were bound to report the income from controlled party transactions based on the form and terms as executed.¹⁰ Taxpayers were bound even if the terms of their controlled party transactions did not generate an arm's length result; i.e., an allocation of income or expense which was consistent with that realized by unrelated, uncontrolled parties engaged in the same or similar transactions.

B. Section 1.482-1(a)(3)

The Secretary recognized that controlled parties may not be able to negotiate arm's length terms for their controlled transactions in advance of executing the transactions or even within the affected parties' annual accounting periods. Taxpayers provided comments noting that the ability to unilaterally depart from the terms of controlled party transactions and reallocate income where necessary to achieve an arm's length result was necessary to mitigate the risk of the accuracy related penalties.¹¹

Even without running the risk of substantial penalties, requiring taxpayers to adhere to the terms of their transactions as executed created potential inefficiencies in tax administration. The primary responsibility to correctly determine and report income from controlled party transactions would be shifted from the taxpayer to the Secretary who had exclusive authority under Section 482 to depart from the terms of the transactions where necessary to achieve an arm's length result. This clashed with the principle of tax administration which depends upon a voluntary, self-assessment by the taxpayer of its correct liability.

Only by delegating authority to taxpayers to make the initial allocation of income where necessary to report an arm's length result on their original returns could the primary obligation to voluntarily determine and correctly report income from controlled transactions be shifted back to taxpayers. To this end, the Secretary promulgated Section 1.482-1(a)(3) which provides:

Taxpayer's use of section 482. If necessary to reflect an arm's length result, a controlled taxpayer may report on a timely filed U.S. income tax return (including extensions) the results of its controlled transactions based upon prices different from those actually charged. Except as provided in this paragraph, section 482 grants no other right to a controlled taxpayer to apply the provisions of section 482 at will or to compel the district director to apply such provisions. Therefore, no untimely or amended returns will be permitted to decrease taxable income based on allocations or other adjustments with respect to controlled transactions. See § 1.6662-6T(a)(2) or successor regulations.

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While the regulation advises taxpayers that they "may" depart from the terms of their controlled transactions where necessary to achieve an arm's length result when reporting income, the reference to the accuracy related penalties at Section 6662(e) effectively compels taxpayers to determine and correctly report income based upon an arm's length...