Recent Developments In Transfer Pricing Create Uncertainty For Multinational Corporations

Sunday, April 1, 2007 - 01:00

Introduction

Transfer pricing continues to be one of the hot topics in the tax world, especially for multinational corporations ("MNCs"). On July 31, 2006, the Internal Revenue Service ("IRS") issued final and temporary regulations ("new Services Regs") regarding intercompany pricing for services and the allocation of income from intangible property between controlled parties. On September 11, 2006, the IRS settled a long-running transfer pricing dispute, the largest tax dispute in its history, by accepting payment of approximately $3.4 billion in taxes and penalties as well as the abandonment of refund claims of an additional $1.8 billion from GlaxoSmith-Kline ("GSK"). Is it a coincidence that these events closely followed one another given that the issues involved are similar? Not likely since tax positions taken by corporations with respect to transfer pricing are coming under more and more scrutiny not only by the IRS but also the audit firms in order to comply with FIN 48, the recent financial accounting guidance relating to uncertain tax positions. The difficulty from a compliance perspective is that unlike other areas of tax, transfer pricing analyses rarely provide black or white results. As described below, the message for a MNC and its counsel is that not only has the cost of compliance associated with transfer pricing increased but the uncertainty (or variance) surrounding transfer pricing outcomes has increased as well.

The Heat Is On

Transfer pricing is the area of tax law that deals with the allocation of income resulting from transactions between commonly controlled parties. In the United States transfer pricing is governed by Section 482 of the Internal Revenue Code ("Code") and the regulations thereunder. The allocation of income between controlled parties needs to be consistent with the arm's length standard; that is, the income should be the same as that which would result from similar transactions between unrelated parties. In 1968, the IRS issued procedural rules for evaluating the arm's length nature of intercompany transactions. These regulations were, most recently, amended in 1994 and were applicable to tax years beginning after October 6, 1994 ("1994 TP Regs"). In the next year, the IRS issued regulations (Treas. Reg. 1.6662-6) that allow taxpayers to avoid penalties from a transfer pricing adjustment if the taxpayer maintains contemporaneous documentation (i.e., documentation that exists at the time the tax return is filed) demonstrating how the taxpayers determine its transfer prices under the regulations.

Prior to the penalty provisions, the IRS had great difficulty obtaining data from some MNCs let alone evaluating the arm's length nature of a MNC's intercompany transactions. The penalty provisions, or more accurately the avoidance of penalty, were intended to be a carrot, rather than a stick, to assist the IRS in enforcing Code Section 482. Whether the IRS asked for the contemporaneous documentation depended on the discretion of the International Examiner ("IE"). As a practical matter, some IEs would rarely ask for a MNC taxpayer's transfer pricing documentation and when they did, the IRS, at least until recently, did not strictly enforce the timing aspects of the contemporaneous documentation rules as the goal was to have documentation available at the time of the audit. In many instances, a taxpayer could prepare documentation upon receipt of the Information Document Request requesting the transfer pricing contemporaneous documentation which would occur long after the tax return was filed. Further, the imposition of a penalty depended on the judgment of the IE if an adjustment was made. Depending on the relationship between the MNC and the IE, a penalty may not have been imposed even though one could have been applied.

The transfer pricing tax world began to change several years ago when then Commissioner of the Large and Midsize Business Division of the IRS Larry Langdon issued a directive to the IEs that they request a taxpayer's transfer pricing documentation at the start of all audits. In addition, procedures were established such that in the event of a substantial transfer pricing adjustment, an IE had to affirmatively petition his supervisors not to impose a penalty. Further in light of FIN 48, the preparation of transfer pricing documentation is now critical in order to get sign-off from auditors as well as avoid penalties from the IRS.

Uncertainty Remains

Additional uncertainty remains because the rules with respect to certain services and whether such services are really intangible property are in the midst of a change. As noted in the introduction, the IRS settled with GSK as well as introduced the new Services Regs related to intercompany services transactions (which were not specifically addressed in the 1994 TP Regs). The common theme is the IRS' new approach to dealing with intercompany services, in particular sales and marketing and research and development. One of the premises of the new Services Regs is that if one entity is providing a service that is likely to result in the creation of a valuable intangible or intellectual property ("IP"), then the intercompany payment to the party providing that service should reflect the value created. For example, if Company A "contracts" with Company B, a related party, to performs research and development activities and this activity results in the development of valuable intellectual property, then Company A should earn an amount greater than a routine return because of its ability to create such value.

A look back will provide an understanding of the IRS' perspective. The 1994 TP Regs state that the result of an arm's length transaction must take into account the functions, assets and risks incurred by the related parties to the transaction. Taxpayers have pursued strategies to segment the functions and assets from the risk between commonly controlled entities to achieve reductions in their effective tax rates. A common practice has been for U.S.-based MNCs to enter into an agreement whereby the costs, plus a mark-up, for the company's R&D department, typically located in the U.S., are shared with a related party in a low tax jurisdiction. The non-U.S. rights to the resulting IP are owned, at least from an economic perspective, by the related entity in the low tax jurisdiction. The defense for such a practice is that there is risk associated with the R&D activity (i.e., there is no guarantee that the activity will result in the development of valuable IP). Pharmaceutical companies spend millions on the development of new drug compounds in hopes of finding the blockbuster drug. If the MNC has structured its development activity in the way described and the R&D activity does not result in a successful outcome, then both the U.S and the low tax jurisdiction will incur the expense without any revenue to offset it. On the other hand, if the R&D does result in a blockbuster drug, a significant amount of income will remain outside of the U.S. While a R&D project may be clear cut, what if the a similar structure is put in place to update existing IP? The risk of failure may be substantially less but the resulting transfer of income offshore is similar. In addition, the difficulty from a tax perspective is that the lines are not always clear as to whether a company would share actually share the risk associated with either new development activity or the development of a next generation product.

The IRS has responded to migration (perceived or actual) of valuable IP offshore with the passage of the new Services Regs. These regulations limit the ability to migrate IP out of the U.S. merely by paying cost, plus a mark-up. In effect, the IRS is asserting that U.S. based MNCs are net exporters of valuable IP and want to limit the ability of these MNCs to decrease their U.S. tax base through transfer pricing. This theme also formed the basis for the IRS' attack on GSK. This case centered on the value of marketing intangibles. GSK had developed a patented drug, Zantac, in the United Kingdom which was hugely successful in the United States and the rest of the world. The IRS argued that it was not the patent that created the excess profitability, since there were several other competing products on the market, but rather the marketing done by GSK's U.S. subsidiary. And as a result, the U.S. subsidiary should earn more than a routine return on its activities.

The focus of IRS scrutiny is not limited to the funding of R&D by a low-tax jurisdiction. Other areas of significant uncertainty include situations in which 1) product developed outside of U.S. is popular in the U.S. (e.g., GSK) and 2) the taxpayer has restructured its business such that income in the U.S. entity has declined substantially.

Conclusion

The past year has seen an increased focus on the preparation of contemporaneous documentation to avoid any penalties from transfer pricing adjustment as well as to book benefit for financial statement purposes. In addition, the IRS has also raised the stakes with respect to the provision of intercompany services in an attempt to limit outbound migration of intellectual property and the consequent income. These events make clear that some areas of transfer pricing can leave taxpayer with substantial uncertainty in a transfer pricing examination.

Nevertheless, MNCs can better prepare for the increased transfer pricing scrutiny by ensuring that the transfer pricing analysis and the contemporaneous documentation has taken into account all the relevant facts and circumstances surrounding the transaction and that the economic analysis demonstrates that the results are consistent with the arm's length standard. An independent party review of the documentation can identify areas of strength and weakness in the analysis. Although the dollars involved in a transfer pricing examination can be significant, experience shows that taxpayers with thorough, complete and independently reviewed transfer pricing documentation have a greater chance of success with the IRS and other taxing authorities.

Barry T. Freeman, Ph.D. is a Managing Director in the New York office of Wealth and Tax Advisory Services, Inc., a member of HSBC Group. He is the national transfer pricing leader and focuses on structuring, developing and implementing transfer pricing solutions for corporations. He can be reached at 212-525-4706.

Please email the author at barry.t.freeman@wtas.com with questions about this article.