The Section 482 White Paper - a Canadian perspective.

• Author: Boidman, Nathan

The Section 482 White Paper--A Canadian Perspective (*1)

1. OVERVIEW

   For many observers, in Canada and other foreign countries as well as the United States, the enactment in 1986 of the super royalty rule (1) appeared to revolutionize the manner in which cross-border intercompany transfers of manufacturing or marketing intangibles would be required to be priced for U.S. tax purposes. It seemed that the general (and often illusive) arm's-length standard would no longer govern and that U.S. licensors would generally be required to increase charges to foreign subsidiary licensees.

   Tax authorities in high-tax countries such as Canada have been particularly concerned that such increased charges would exceed those mandated by an arm's length standard. There were basically three reasons for such concerns. First, although super royalty was intended by Congress to counter unacceptable shifting of profit by U.S. companies to subsidiaries based in low or no tax havens (such as Puerto Rico), the rule as enacted applies to transfers by U.S. companies to subsidiaries located in high-tax countries such as Canada. Second, the 1986 reduction of U.S. corporate tax rates and restriction of foreign tax credits (by H.R. 3838) created an impetus for U.S. companies to maximize intercompany charges to subsidiaries in high-tax countries. Third is the requirement, expressed in the legislative history to the enactment of super royalty, that where licenses of high-value intangibles are involved, there is required an annual or other periodic assessment of the actual income earned by the group and a commensurate periodic adustment of the payments actually being made (or if not made, to be reported for U.S. tax purposes) by the parties. (2)

   The 1986 enactment left unclear how super royalty would apply and there was anxiously awaited an indepth study, which the Treasury was mandated to prepare by the Conference Report, concerning intercompany arrangements in general and the manner in which super royalty would be applied in particular. (3) The study--"the White Paper"--was released on October 18, 1988. (4)

   The White Paper sets out detailed proposals respecting the substantive aspects of super royalty as well as proposals for administrative compliance policies and practices, and thus should go a long way toward alleviating the initial concerns. The White Paper indicates that super royalty will not depart from the arm's-length standard as applied in other countries such as Canada (5) and that it will not depart in any material fashion from the pre-1986 law in the United States. This view, however, is not necessarily shared by all, and tax authorities in countries such as Canada continue to worry that super royalty will lead, inadvertently or otherwise, to excessive charges by U.S. companies to Canadian and other foreign subsidiaries. (6)

2. A BASIC LIMITATION IN

   TRANSFER PRICING RULES

   There seems to be a contradiction between the nature of the problem posed by intercompany transactions and the way it is being dealt with by tax administrators. Intercompany pricing questions are ones of fact and circumstances and no single set of rules can provide a basis to measure and assess, in a technical or scientific and objective fashion, compliance with the objective of proper pricing between related parties. All legislation, except in the case of Japan, recognizes this basic limitation and provides a briefly worded general rule mandating an arm's-length price, which comprises no more than four or five lines of law. (7)

   On the other hand, the tax administrators charged with enforcing compliance with the arm's-length principle seek to establish detailed rules. (8) Tax administrators devote substantial energy attempting to establish a quasi-legal basis for the manner in which they consider a fair and reasonable price (which is the legal principle) is to be determined in any particular case, and in this sense the White Paper could be seen as nothing more than another variation on this theme. In the absence of true comparables (transactions of a largely identical nature, undertaken with unrelated parties) or arbitrary (apportionment formula) methods of dividing up income between related parties, there is no objective basis upon which taxpayers' transactions can be tested. Taxpayers and tax administrators must subjectively evaluate how taxpayers would have acted with third parties and if they fail to agree, the courts will impose their own (subjective) evaluation. (9)

   Where comparables are not available, resort is then required to so-called secondary methods. In the case of integrated manufacturing and marketing operations, there is the retail sales method, where one company does the manufacturing and the other the marketing. Where both are involved in the manufacturing, there is the cost-plus method. These "secondary" methods are often subjective and where they fail to provide an adequate solution, reliance must be had on "other" or "fourth" methods. (The White Paper rejects the priority of the secondary methods over the latter.) Here there is a clear acknowledgment of the basic problem and, from a legal analysis standpoint, a reversion to the basic principle that, ultimately, the amount should be "reasonable" and it is a question of facts and circumstances which, of course, vary in each case. The U.S. regulations on "fourth" or "other" methods are basically non-existent while Revenue Canada has sought to give a simple example of what might be a so-called "fourth" method. (See paragraph 20 of the Information Circular 87-2.)

   Legislators seem to accept that it is futile to try to systematize the general principle, and that its application is best left to the courts. Unless government is prepared to change the nature of the rules and use mechanical (and necessarily arbitrary) apportionment formulae, finding a reasonable arm's-length price in an intercompany transaction (where valid comparables are not available) is not amenable to a comprehensive objective process. (10)

3. THE IRONY OF SUPER

   ROYALTY--FROM THE

   CANADIAN PERSPECTIVE

   For Canadian observers, the genesis of the super royalty rule is ironic because of a fundamental difference between the tax systems of the two countries in relation to transfers of property to foreign affiliated corporations. From the Canadian perspective, the scheme of taxation under the U.S. Code concerning transfers of property to foreign corporations or "possessions corporations" had a built-in defect--it allowed for a shift of profits to a foreign jurisdiction in a manner not consistent with a comprehensive taxation system which generally seeks to tax all income, particularly in obvious circumstances.

   Under Canadian law, a Canadian company which, through its own research and development, creates a valuable product cannot assign the related rights to a foreign subsidiary without being required to either recognize immediate taxable gain (upon an outright assignment) or take into income, over time, a stream of royalty type payments (upon a license of the rights). Upon an outright assignment, section 69 of the Income Tax Act requires that the rights to the product (i.e., the various intangibles, etc.) be valued and are deemed sold at fair market value. The imprecise nature of valuations and the possibility that Revenue Canada will assign a much higher value than does the taxpayer represents a substantial deterrent to actually proceeding with such an arrangement, even if the taxpayer is prepared, which he usually is not, to finance the up-front costs of the future tax savings. (11)

   In the United States, before 1984 there was a substantial gap in the U.S. scheme of taxation relevant to the foregoing situation where the developer of the new product was a U.S. corporation. As was seen in the Searle (12) and Eli Lilly (13) cases, the Internal Revenue Code contained no broad-based rule, comparable to section 69 of the Act, which would deem a disposition at fair market value applicable to all transfers of property to a foreign affiliate. There ensued, therefore, the tax-free transfers to possessions corporations or controlled foreign corporations operating in taxhaven environments. (14)

   The transferee corporation in such arrangement was often seen as simply serving as a physical contract manufacturer, assuming little risk or making little investment but yet emerging with the lion's share of the overall group profit from the manufacture and sale of the product. This was particularly vexatious to the IRS where (as in Searle and Lilly) the final product was sold through the U.S. parent company's distribution network. From an economic or business standpoint, it is rather clear that the transferee corporations emerged with a share of overall profit totally disproportionate to their input in the overall integrated operation. (15)

   Although the U.S. government began reacting, legislatively, to this defect in 1982--with the special measures for possession corporations (Code section 936(h)--and in 1984--with a rule of general application requiring recognition of royalty-type payments over time where intangibles are transferred under section 351 to a foreign corporation (Code section 367(d))--nothing in the Code (even as amended by the super royalty rule) imposes the burden, arising in such circumstances in Canada under section 69 of the Act, of a complete and total taxable disposition. It is probable that, had Code section 351 not applied to the transfers made in the Lilly and Searle cases (by reason of provisions such as section 69), the threat of such substantial immediate taxation may have been a sufficient deterrent to prevent such transfers in the first place and the ensuing series of legislative rsponses (including super royalty). (16)

   In summary of this point (apart from the fact that the problem seems to have been cured more by the enactment in 1984 of section 367(d) than by super royalty), (17) it seems clear that issues...