40% transfer pricing penalty upheld.

• Author: Shapland, Rick
• Position: Taxation

For the first time, the Tax Court upheld a 40% penalty against a taxpayer for substantially understating its taxable income due to a transfer pricing misstatement (DHL Corp., TC Memo 1998-461). Many practitioners believe this decision paves the way for the Service to routinely question controversial transfer pricing practices, including transfers of intangible assets outside the U.S.

Facts

DHL had developed and registered its trademark in the U.S., but its international affiliate (DHLI) had registered and defended the trademark in foreign countries. The foreign registrations had not claimed, however, that DHL was the trademark owner. The cost of developing the trademark had not been shared, and, based on written agreement and operating procedures, the parties had acknowledged that DHL owned and controlled the trademark. DHLI had not paid any consideration (payments or royalties) to DHL for using the trademark.

DHL and DHLI had recorded certain intercompany charges for services performed for each other, primarily for any imbalance between the values of shipments originating outside the U.S. that were destined for U.S. addressees and shipments originating in the U.S. destined for foreign addressees.

DHL claimed that the trademark was worth only $20 million and had apparently stonewalled the IRS after the Service issued a deficiency notice. (Ultimately, this did not help DHL's case in court.) In the absence of additional information from DHL, the IRS claimed that the tradename was worth between $500 million and $600 million (reduced to $300 million at trial).

Ownership and Value of the DHL Trademark

The court concluded that DHL, rather than the foreign affiliate, was the owner of the trademark. The court noted that, among other evidence, there existed written communications between general counsels for DHL and DHLI, in which the former stated that the trademark could not be sold to a foreign purchaser without the consent of DHL and its board of directors.

The court held that DHL's position on the $20 million value of the trademark had been based on a "friendly" appraisal by an outside firm. Using other valuation evidence, the court concluded that the total intangible assets of the parties were worth approximately $300 million, which it divided equally between the trademark and the parties' operating systems, quality control guidelines and operating procedures. By applying a marketability discount, the court determined that the trademark's $150...