International tax: a whole new world for intangibles.

• Author: McComber, Donna
• Position: Tax Developments in 2016, part 2 - Cover story

As the year comes to a close, we have a natural tendency to reflect on the past twelve months. This year has been exciting and challenging. Brexit. Summer Olympics. The U.S. presidential elections. This also has been an exciting and challenging year for international tax professionals deciphering recent guidance. The Internal Revenue Service restructured the Large Business and International (LB&I) Division. The OECD published more guidance on international tax. The Tax Court decided Medtronic. (1)

The OECD, the IRS, and the Treasury Department have recently kept international tax professionals on our toes with respect to intangibles, particularly because the international tax community was absorbing and analyzing both the OECD's Final Reports for Action Items 8 through 10 and the IRS and the Treasury's Section 367(d) guidance, both of which were issued last fall. OECD base erosion and profit shifting (BEPS) presentations have dominated international tax conferences. Country-by-country (CbC) reporting and development, enhancement, maintenance, protection, and exploitation of intangibles (DEMPE) functions have taken over cocktail discussions. There is a lot of uncertainty as to how these new rules will be used (or interpreted) by tax authorities around the world.

In this article, we provide key international tax developments over the past year that affect intangibles and offer suggestions for minimizing related challenges.

LB&I Restructuring

Given the increased importance of international issues, the historic divide between domestic and international divisions of LB&l didn't make sense. As a result, LB&I implemented a new "one LB&I" structure in February 2016, which will take two to four years to implement fully. There were multiple reasons for this restructuring, apart from LB&I's shrinking workforce and budget reductions. Changes in LB&I's audit approach were required, because better issue selection on audit was needed, and the IRS did not routinely deploy resources effectively. Evidence lies in the IRS' lost court cases and the fact that the vast majority of double-tax cases in the Advance Pricing and Mutual Agreement (APMA) program are foreign-initiated. (2) In addition, better issues had to be identified and a more agile approach was needed, with the ability to drop issues and move on if necessary. Also, the old method of selecting an income tax return to audit federal and international issues often meant finding out too late in the audit cycle that a specialist, such as an engineer or economist, was needed. Often there was no specialist available.

The new method for conducting audits is identifying the issue (called campaigns) first, and then selecting the returns likely to demonstrate these issues. Campaigns will be deployed only if the right resources are available, with the "right" team and the "right" training in place to address the specific issue. The IRS' goal in restructuring is to drive compliance and to be transparent about campaigns and how issues will be tested. While taxpayers certainly appreciate advance notice of the audit issues important to the IRS, many taxpayers are worried that LB&I will take a cookie-cutter approach to issues and will not treat each issue based on the facts specific to each taxpayer. (3) Given that IRS intangible audits should be more focused and strategic as a result of the reorganization, to address these campaigns successfully, companies should carefully document and corroborate their intercompany pricing with their specific facts, distinguishing themselves from the basic facts of the campaigns with specific examples when warranted.

Because audits involving intangibles are particularly difficult, LB&I released several International Practice Units (IPUs) related to intangibles in 2016. The IRS focuses on intangible property transactions during audits because they are often high value, and intangibles are viewed as "portable" to other jurisdictions. The IPUs are training guides and directives that include step-by-step instructions on how to examine a given issue. The units show detailed examples and include toolkits with documents needed to perform the audit, such as sample information document requests (IDRs) and links to related-issues IPUs. It is important for companies to review the IPUs that involve issues that affect their transactions, analyze sample IDRs, and watch for new campaign announcements.

Cost-Sharing Arrangement IPUs

In February 2016, the IRS released two new IPUs related to CSAs, both of which entail changes to an existing CSA. (4) The first CSA IPU, titled "Change in Participation in a Cost-Sharing Arrangement (CSA)--Controlled Transfer of Interest and Capability Variation," was released on February 4, 2016. It provides guidance for analyzing a CSA when there is a change in participation that alters the participants' interests under the CSA. A change in participation under a CSA occurs when there is either a controlled transfer of interest or a capability variation among participants. Both changes in participation may require an arm's-length payment.

When a transfer of interest or a capability variation occurs, the controlled participant's reasonably anticipated benefit (RAB) share that results from exploiting the cost-shared intangibles changes. An example in the IPU that provides for a capability variation is the purchase of an additional manufacturing plant by one of the participants, which was not expected at the start of the CSA. The additional plant would typically result in an increase in the RAB share for the participant. The change in RAB share due to the additional plant would constitute a controlled transfer of interest in cost-shared intangibles and would require an arm's-length payment. The participant whose RAB share decreases is considered the transferor, and the participant with an increased RAB share is the transferee.

The primary issue with a change in participation that results in a controlled transfer of interest or capability variation is calculating the arm's-length payment that would be required for the incremental change in the RAB shares between the transferor and the transferee. The IPU points out that it is important to determine which controlled participants are affected and whether there is a federal income tax consequence with respect to the change. If a U.S. participant is a party to a participation change and was the transferor of cost-shared intangibles, it would be expected to report the arm's length payment received for the transfer as taxable income. Conversely, if the U.S. participant was the transferee, then there would be a deduction for the arm's-length payment made to another cost-sharing participant (transferor).

The second CSA IPU, titled "Pricing of Platform Contribution Transaction (PCT) in Cost-Sharing Arrangements (CSA) Acquisition of Subsequent IP," was released on February 8, 2016. This IPU provides guidance for pricing a PCT when a participant in a CSA acquires a company after entering the CSA. A PCT would be required for any...