Section 482: proposed new regulatory approaches.

• Author: Cole, Robert T.

The Internal Revenue Service (IRS) released its proposed revisions to the U.S. transfer-pricing regulations on January 24, 1992. 1 This action follows the 1986 amendment to section 482 of the Internal Revenue Code, which added the requirement that the payment for transfers (or licenses) of intangibles be commensurate with the income attributable to such property, 2 as well as the Treasury Department's issuance in 1988 of a "White Paper" dealing with the new statutory provision and related topics. 3 The next steps will be for the IRS to receive comments on the proposed regulations, to hold public hearings, and then to promulgate final regulations. The deadline for comments and requests for public hearings is May 29, 1992.

The proposed regulations replace with a new regime the provisions of the current regulations that deal with transfers of intangibles, including licenses and sales of intangibles. These new intangibles rules also would apply to sales of goods in which intangibles are a material factor and where services are provided involving intangibles that are a material factor. The regulations for transfers of other tangible property would continue in effect, but they have been substantially modified to reflect some of the concepts applied to intangibles. Although the IRS's proposals are subject to modification and generally would not go into effect until 1993, they can and should be taken into account now in resolving certain existing transfer-pricing disputes and for planning purposes.

Set forth below are the key features and implications of the proposed regulations. A more detailed description of the new regulatory rules follows.

1. KEY FEATURES AND IMPLICATIONS

   * The proposed regulations significantly alter the manner in which transfer prices for both intangible and tangible property will be reviewed by the IRS, by reference to a range of operating profit. The centerpiece of the proposed regulations is a bottom-line operating profit analysis that will apply except in those rare instances where near-perfect comparables are avalaible. This analysis effectively attributes to taxpayers engaged in related-party transactions an amount of operating income somewhere within a range -- referred to as the "comparable profit interval" (CPI) -- that the taxpayers would have earned had their performance been equivalent to comparable businesses operating at arm's length. The CPI concept represents important progress, providing a measure of flexibility to taxpayers, since, until recently, the IRS thought in terms of only a single correct transfer price. It is also intended to narrow disputes by discouraging both the IRS and the taxpayer from taking extreme positions.

   * The proposed regulations are extremely technical and complex, and introduce new areas for dispute. The computation of the CPI involves a host of new concepts and terms (e.g., the "tested party," "applicable business classification," "profit-level indicators," constructive operating income," and "convergence"). In order to construct a CPI, one needs detailed financial information regarding similar businesses. At the time needed, such data often may be either inaccessible (e.g., the comparables are privately owned) or nonexistent (e.g., the comparables are divisions or segments of integrated companies). Moreover, the selection of businesses whose data are to be used and the actual use of the available data require a series of subjective judgments, each of which presents a potential source for disagreement.

   * The proposed regulations are not structured to facilitate the prospective setting of acceptable transfer prices. The proposed regulations generally require a comparison of a related party's operating profit ratios with those of comparables for the tax year at issue, as well as the first preceding year and the first succeeding year. Thus, by definition, most of such information will not be available in advance. An Advance Pricing Agreement (APA) may be helpful in this respect. 4

   * The proposed regulations adopt various positions the IRS has taken in audits and, without success, before the courts. The proposed regulations contain provisions addressing the significance of the presence or absence of related-party contracts, the ability to consider together related transfers of tangible property and intangibles, the comparison of data from different years, and the need to consider the effects of sales volumes and other factors in assessing whether arm's-length transactions may be used to establish a comparable uncontrolled price. All such issues have been the subject of dispute in recent court decisions. The proposed regulations are designed in some instances to reverse outcomes not to the liking of the IRS. 5

   * Foreign adherence to the U.S. concepts may be necessary to avoid double taxation. Certain of the transfer-pricing methodologies and principles embodied in the proposed regulations are somewhat novel and, accordingly, may not be fully understood by, or acceptable to, the tax authorities of other countries. Obviously, if two different sets of rules are applied in a cross-border transfer-pricing dispute, any Competent Authority proceedings designed to avoid double taxation may be severely inhibited unless the results of the different approaches happen to coincide. In this connection, the Treasury Department has undertaken a program to obtain international acceptance of the new U.S. concepts.

   * An APA may become the best way for a taxpayer to ensure that its transfer-pricing practices will not be challenged by the IRS. The uncertainties and other problems resulting from the new regulations make it all the more advantageous for a taxpayer to consider an APA. At the present time, such an agreement is the only way to effectively resolve, in advance, the myriad transfer-pricing issues that will invariably arise under the proposed regulations. An APA would be especially useful, for example, in making such difficult determinations (required by the proposed regulations) as identifying the tested party, choosing the applicable business classification, determining the relevant comparables and profit-level indicators, making appropriate adjustments, and establishing convergence. In addition, the Competent Authority procedure, which is an integral part of the APA process, offers the opportunity to confront and resolve differences with our treaty partners before they materialize, rather than after the fact. 6 This process requires the agreement of each treaty partner, and to date a significant number of U.S. treaty partners have agreed to the process on a general or experimental basis.

   * Comments can be presented to the IRS and constructive changes suggested. Interested taxpayers and organizations may provide the IRS with their written comments on the proposed rules. There will also be a public hearing that should serve as a useful forum to provide input to the IRS. Although it might be tempting to dwell on the defects and shortcomings of the new rules, taxpayers should recognize that many of the IRS's proposals will undoubtedly survive. Thus, taxpayers may eventually find themselves in the position of having to persuade foreign tax authorities to accept, not reject, the new U.S. regulatory provisions. The ultimate goal should be for the IRS (and foreign tax authorities) to adopt rules that will serve as a basis for uniform international standards and procedures.

   * Treasury's imminent report to Congress on transfer pricing may produce legislation. In addition to the regulatory process, it is important to note that the Treasury Department has prepared a report to Congress on transfer pricing which was due April 2, 1992. This report could result in legislative changes, including procedural refinements and, possibly, major substantive changes (although Treasury is on record as opposing substantive changes).

   * Taxpayer reporting and recordkeeping obligations continue. The proposed regulations do not address reporting and recordkeeping in the section 482 context, although the preamble to the propose regulations suggests that new requirements may be issued in the future. 7 For foreign-owned taxpayers, section 6038A and the regulations there-under also remain in effect. 8 The application of the recordkeeping obligations under section 6038A, however, should be heavily influenced by the new section 482 regulations, since the section 6038A regulations contain an overriding relevancy limitation. In addition, the section 6038A regulations include a procedure for obtaining District Director agreements on recordkeeping and record production both in connection with an APA and otherwise. 9 Again, such agreements should be heavily influenced by the proposed regulations.

   * Measures should be taken now to reduce exposure to substantial section 482 adjustments and penalties. A 1990 amendment to the Code established severe penalties for net transfer-pricing adjustments which exceed $10 million, unless the taxpayer can establish that it acted in good faith and with reasonable cause. 10 Although the new regulations do not address the penalty provisions, they do accord better treatment to those taxpayers whose transfer prices produce profits that are within or are only slightly outside the CPI. The clear message to taxpayers, therefore, is that they should be prepared to establish that they have made a reasonable effort to comply with the statutory and regulatory requirements regarding transfer pricing. As previously stated, this can be achieved with certainty by securing an APA. Taxpayers who do not wish to proceed with an...