Temporary and proposed section 482 regulations.

• Position: Intercompany transfer pricing

On August 6, 1993, Tax Executives Institute filed the following comments with the Internal Revenue Service on its temporary and proposed regulations under section 482 of the Internal Revenue Code relating to transfer pricing. TEI's comments were prepared under the aegis of its International Tax Committee, whose chair is Lisa Norton of Ingersoll-Rand Company. TEI members materially contributing to the preparation of the comments include Charles Greene of Unisys Corporation; Michael J. Henry of Morton International, Inc.; Robert Lamm of the Aluminum Company of America; Donald J. Prush of Ralston Purina Company; David T. Pye of Syntex Corporation; and Raymond G. Rossi of InTEI Corporation. On August 16, 1993, Ms. Norton testified on the Institute's behalf at an IRS hearing on the regulations.

On January 13, 1993, the Internal Revenue Service issued temporary and proposed regulations under section 482 of the Internal Revenue Code, relating to intercompany transfer pricing. The regulations were published in the Federal Register on January 21, 1993 (58 Fed. Reg. 5263, 5310), and in the Internal Revenue Bulletin on March 8, 1993 (1993-10 I.R.B. 5, 60). The regulations replace, in part, proposed regulations issued on January 24, 1992.

Concomitantly with the issuance of the temporary and proposed section 482 regulations, the IRS issued proposed regulations under sections 6662(e) and 6662(h) of the Code, relating to the imposition of the accuracy-related penalty for substantial and gross valuation misstatements attributable to section 482 allocations. TEI filed comments on the proposed penalty regulations on April 21, 1993, and testified at an IRS hearing on May 14, 1993.(1)

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our 4,800 members represent approximately 2,400 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 government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works--one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed and temporary regulations under section 482 of the Code, relating to intercompany pricing.

Overview

TEI commends the Internal Revenue Service for its efforts to move the substantive section 482 regulations closer to international standards. The reaffirmation of the arm's-length standard, the expanded use of a range of arm's-length prices, and the emphasis on transaction-based comparables and results-oriented pricing all signal a greater appreciation for the realities of international competition and corporate America's global marketing organizations than did the 1992 regulations.

The temporary regulations represent a significant improvement over the 1992 regulations. For example, the temporary regulations eschew the rigid priority of methods set forth in the 1992 regulations. In addition, a controversial concept in the 1992 regulations-the comparable profit interval (CPI)--no longer serves as an automatic check on, or "backstop" for, the other pricing methods. These changes make the regulations more manageable and provide taxpayers with greater flexibility in choosing their pricing methodology. The Institute remains concerned, however, about several aspects of the substantive regulations, including their excessive documentation requirements, "second-guessing" of business decisions, limitations on the use of the profit-split and "other" methodologies, and their interaction with the proposed penalty regulations.

The best summary of the IRS's approach to section 482 is set forth in the proposed penalty regulations. The preamble to those regulations states that "[t]he experience of Internal Revenue Service examiners has been that the majority of taxpayers are unable to provide an explanation of how their intercompany pricing was established." 1993-7 I.R.B. at 79. The preamble avers that the lack of "contemporaneous documentation" of how a controlled transaction result was determined increases the time spent and the expense incurred by both the taxpayer and the IRS in determining whether that result is arm's length and also increases controversy between taxpayers and the IRS. According to the preamble, the proposed penalty regulations are designed to "encourage" taxpayers to document their transfer pricing transactions and to provide that documentation to the IRS upon request. 1993-7 I.R.B. at 79. The interaction of the proposed penalty regulations with the substantive section 482 regulations effectively impose a documentation requirement as a cornerstone of section 482.

The requirements of contemporaneous documentation imposed by the temporary regulations are needlessly burdensome and costly to taxpayers. TEI believes that the requirements should be limited to what is reasonably necessary to provide examiners with a "road map" or audit trail of a taxpayer's intercompany transactions, including information on the method used and any comparables relied upon. At a minimum, meaningful guidance must be provided on the scope of the contemporaneous documentation requirement.

The temporary regulations essentially require taxpayers to perform a functional analysis of every cross-border transaction. This requirement is particularly onerous for taxpayers having only routine intangibles. We submit that not every intercompany transaction deserves the scrutiny required by the substantive section 482 regulations. The depth of the required functional analysis and documentation should vary in accordance with the nature of the taxpayer's intercompany transactions. For example, taxpayers with an internal comparable uncontrolled price or transaction should not be required to perform indepth functional analyses of the transaction--the comparable should suffice.

Although the "sound business judgment" rule of the 1992 regulations(2) has ostensibly been abandoned, echoes of the rule still remain in the temporary regulations. Provisions calling for the evaluation of the "alternatives [that are] realistically available" or "alternative commercial arrangements" resonate of the old concept with a new name(3) The temporary regulations are apparently intended to require taxpayers to perform a "make-or-buy" analysis to determine whether the taxpayer could have more profitably manufactured the product itself rather than purchase it from an affiliate. This approach, however, was soundly rejected by the courts in Bausch & Lomb v. Commissioner.(4) Consistent with that result, TEI believes that hypothetical arrangements should not be a factor in determining comparability. The IRS's only concern should be whether the results of a taxpayer's pricing decisions are within the range of arm's-length, comparable results. In other words, the IRS should not second guess business decisions made by the taxpayer.

Although the regulations expand the use of the profit-split methodology, they place undue limitations on the use of that methodology. Under the proposed regulations, taxpayers must make a binding election to use the profit-split method and meet other procedural requirements. The requirement for a binding election creates a one-way street in section 482 enforcement: the IRS may use the methodology to challenge a taxpayer's transfer pricing structure, but the taxpayer (absent an election) may not use the profit-split method to defend its structure. Frankly, we question whether the election requirement is valid; certainly, it is unnecessarily restrictive. Courts have clearly accepted profit splits as a legitimate methodology under section 482,(5) and the method is especially compatible with the statute's commensurate-with-in-come standard. Moreover, the use of the methodology should be expanded beyond situations where there are non-routine intangibles on both sides of the transaction. "Profit-split" is not a dirty word (or even two words); its use should not be unreasonably circumscribed.

Finally, TEI remains troubled by the interaction of the substantive section 482 rules with the transfer pricing penalty imposed under section 6662(e). The most disquieting aspect of the temporary regulations is the specter of a penalty imposition for what could not possibly be viewed as noncompliant behavior. We are particularly concerned that a taxpayer could fail the reasonable cause and good faith test simply because it inadvertently failed to satisfy certain procedural rules (for example, a failure to disclose that precludes a taxpayer from using an "other" method). We continue to believe that section 482 adjustments should give rise to a penalty only where the taxpayer engages in demonstrably culpable behavior.

In sum, the temporary regulations represent a vast improvement over the 1992 regulations, but they should be clarified and revised to take into account the ways in which multinational corporations do business and to avoid imposing undue administrative burdens with little or no revenue effect.

Temp. Reg. [section] 1.482-IT(b)(2)(iii): The Best Method Rule

The temporary regulations affirm that the standard to be applied in transfer pricing cases is that of a taxpayer dealing at arm's-length with an uncontrolled party. Temp. Reg. [section] 1,482-iT(d)(1) provides that a section 482 allocation may be made in any case in which either...