transfer pricing insider

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1 transfer pricing insider Volume 2, Number 2 august 2008 baker & mckenzie transfer pricing annual update Source: WG&L Journal of International Taxation Baker & McKenzie s Transfer Pricing Annual Update, generally covering summer 2006 through March 2008, summarizes major transfer pricing related developments in the United States, Canada, and Mexico. 1 This Update first covers recent significant U.S. transfer pricing developments, including cost sharing and buy-in related matters, the advance pricing agreement (APA) annual report and guidance, and U.S. state and local tax developments. After the U.S. discussion are OECD, Canadian, and Mexican transfer pricing developments. Baker & McKenzie Transfer Pricing Annual Update CIP on Cost-Sharing Buy-In Adjustments Commensurate with income. Definition of intangible property. CWI Guidance Significant Transfer Pricing Cases Xilinx. Veritas. Adaptec Services Temporary Regulations Additional Guidance Notice Rev. Proc APA Annual Report Application statistics. Processing time. APA program office structure, staffing, training. Type of transactions covered in APAs. Industries covered in APAs. Services covered in APAs. Transfer pricing methods in APAs APA term. Model APA and balance sheet adjustments. Transfer Pricing Penalties Inadequate documentation. Industry Director Directive. CIP. Foreign-to-foreign exclusion. Services audits. IRS Audit Guidelines for Former Section 936 Corporations Arm s-length royalty. Determination of other associated charges. Foreign goodwill and going concern value. Audit guidelines related to Section 936 conversion issues. FIN 48 and Impact on Transfer Pricing Review Rev. Proc Latest Procedure on Competent Authority Relief IRS Audit Guidelines on Factoring of Receivables U.S. State and Local Tax Developments NY requires combined reporting for related corps. Significant economic presence may create state nexus. Other intangible holding co. state cases. REITs. OECD Attribution of Profits to PEs Significant people function. Implementation issues. Canada Transfer Pricing Update Mexico Transfer Pricing Update Exhibit 1. APA Program Staff Exhibit 2. Covered Transaction Number of APAs Exhibit 3. Transfer Pricing Methods Used for Transfers of Tangible and Intangible Property Exhibit 4. Transfer Pricing Methods Used for Services One New York Plaza, 34th Floor New York, New York T F Monmouth House City Road London EC1Y 2AL, United Kingdom T xbsolutions.com

2 CIP on Cost-Sharing Buy-In Adjustments The main U.S. transfer pricing developments during relate to intangible property and, in particular, cost sharing matters. On September 27, 2007, the IRS issued a coordinated issue paper (CIP) on cost sharing buy-in adjustments (LMSB ). The CIP followed several developments regarding the cost sharing Regulations including two Industry Directives. 2 The CIP provides guidance to IRS personnel regarding methods to use to determine arm s-length consideration for the transfer of pre-existing intangible property rights to a cost sharing arrangement (CSA). The CIP concludes that the income or forgone profits method generally is the most reliable method of measuring arm s-length consideration for the transfer of pre-existing intangible property on the formation of the CSA, and that the acquisition price method generally is the best method of measuring the arm s-length consideration for making the pre-existing intangible property acquired in an acquisition available to a CSA. The CIP further states that the comparable uncontrolled transaction and residual profit split methods generally do not provide a reliable measure of an arm s-length buy-in payment. The CIP also addresses the scope of intangible property rights subject to a buyin payment and certain other issues. The CIP focuses on a presumed typical fact pattern involving a CSA between a U.S. parent corporation (U.S.P) and a related controlled foreign corporation (CFC). The CIP assumes that the U.S.P has significant self-developed intangibles and a research and development (R&D) capability consisting of fixed assets, an experienced workforce, and a record of successfully developing products or technologies; and that the CFC performs limited functions, has limited capabilities, owns no intangible property, performs no R&D, and merely provides cash to partially fund the R&D performed by the U.S.P. The CIP makes other factual assumptions, including that the CFC does not bear significant development risk, that a particular platform intangible exists that controls essentially all value arising out of future R&D activity, that this control over the value of future R&D activity lasts essentially forever, and that the prior history of a particular R&D team is the principal determinant of future success. The CIP concludes that certain methods are the best methods for determining buy-in payments based only on certain assumed hypothetical facts. 3 The proper application of the best method rule, however, requires a thorough analysis of all of the facts and circumstances of each case and the reliability of the various pricing methods in the context of those facts and circumstances (Reg (c)). A thorough analysis of the facts is also required by the arm s-length standard of Section 482, to which CSAs are subject. 4 Moreover, in deciding Section 482 cases, the courts prefer to rely on evidence of actual transactions between unrelated parties rather than generic economic theories based on hypothetical facts. 5 commensurate with income On the commensurate with income (CWI) principle, the CIP provides that only the IRS, not the taxpayer, can make CWI adjustments unless such flexibility was provided and paid for in the original buyin license arrangement. This essentially reiterates the IRS position in the general advisory memorandum issued by Chief Counsel s office (AM ), discussed below, addressing the application of the CWI standard under Section 482. The IRS indicates that appropriate risks associated with a CSA should be reflected in the upfront economic arrangement, and the participants should accept the outcome (and associated risks) of their arrangement. definition of intangible property The CIP also expands the definition of intangible property under Reg to suggest that the definition should be read to include business opportunities, goodwill, going concern value, workforce in place, and business synergies. The IRS argues in the CIP that such intangibles and other items not listed in Section 936(h)(3) or the Section 482 definition of intangibles should nevertheless be treated as assets for which a buy-in payment is required. The IRS clearly suggests that the provisions of Section 367(d) permitting a tax-free transfer of foreign goodwill and going concern value should be construed very narrowly and that, effectively, no material value should attach to foreign goodwill. The IRS also argues that the accounting value of goodwill is not an accurate measure for purposes of Section 482 and buy-in royalties. cwi guidance On March 23, 2007, the Office of Associate Chief Counsel (International) (ACCI) released IRS Generic Legal Advice AM ( GLAM ). The GLAM, which was addressed to the Office of Appeals and the LMSB, provided ACCI s analysis of five issues, four of which deal primarily with use of the CWI standard in related-party transactions involving transfers of intangible property. Below is a brief overview of the five issues. The first issue was whether a taxpayer, in the first instance, may apply Section 482 during an examination, during consideration by appeals, or in a docketed case if the IRS has not proposed an allocation under Section 482. Not surprisingly, the GLAM concluded that a taxpayer may not invoke Section 482 as grounds for making a hindsight adjustment. The IRS view is that the CWI standard must be applied consistently with the arm s-length standard. A taxpayer has the ability and the right to achieve a CWI result through the structure, risk allocation, and fixed or contingent form of payment that it adopts upfront for its controlled transaction, so long as that comports with economic substance. Although Reg (a)(3) authorizes a taxpayer to use Section 482 to report results on a timely return based on prices different from those actually charged, it may do so only if necessary to reflect an arm s-length result. The second issue was whether a taxpayer may apply the CWI provision to challenge a Section 482 adjustment that was made by the IRS examination team ( Exam ) where Exam did not itself apply the CWI provision. The GLAM acknowledges that Reg (g)(4) does provide for a limited taxpayer right to a setoff against a Section 482 allocation on account of another nonarm s-length transaction. The Regulation provides substantive and procedural rules under which the IRS will allow a taxpayer s claim for a setoff against its original Section 482 allocation on account of a Section 482 allocation that the taxpayer raised regarding another non-arm s-length transaction going in the opposite direction. The GLAM concluded that a taxpayer may not apply the CWI provision to challenge a Section 482 2

3 adjustment that Exam made, emphasizing that nothing in Reg (g)(4) or any other provision of the Section 482 Regulations suggests that the taxpayer may alter the terms or prices of the primary transaction itself (i.e., the subject of the IRS original Section 482 allocation) based on hindsight in contravention of the arm s-length standard. The third issue was whether income in the phrase commensurate with the income attributable to the intangible in Section 482 refers to income received prior to the transfer or license of an intangible (past profits), income anticipated to be received after the transfer or license of an intangible (projected profits), income actually received after the transfer or license of an intangible (actual profits), or some other measure of income. The GLAM concluded that income in commensurate with the income attributable to the intangible in Section 482 should generally be construed as operating profits attributable to the intangible that the taxpayer would reasonably and conscientiously have projected at the time that it entered into the controlled transaction. However, the IRS is at an inherent disadvantage since it examines a transaction only after the fact. Thus, the Service, in its discretion, provisionally may treat actual profits as evidence of projected profits and make periodic adjustments as if those results were projected at the time of the controlled intangible transfer. Taxpayers may rebut the presumption by, for example, showing that such results were beyond the taxpayer s control and could not reasonably have been anticipated at the time of the transaction. The fourth issue addressed the situation where a qualified cost sharing arrangement specifies buy-in payments in the form of a royalty or other contingent consideration, and the actual amount paid by a participant in a particular year differs from the amount estimated to be due in that year. The question was whether the CWI provision permits (or requires) a CSA participant to make trueups to account for the difference. The GLAM concluded that the taxpayer s form of buy-in payment will be respected if it is consistent with economic substance. The fifth and final issue was whether Appeals may take into account provisions in an income tax treaty or convention or the OECD transfer pricing guidelines in determining the appropriate settlement of a Section 482 allocation proposed by Exam. The GLAM concluded that treaty provisions do not dictate the specifics or application of domestic law to the extent the domestic law reaches results consistent with the treaty obligations. Treasury and the IRS consider Section 482 and the Regulations to be wholly consistent with treaty obligations and the OECD transfer pricing guidelines. Outside the Competent Authority process under a treaty, tax administrators are bound to enforce compliance with Section 482 and the Regulations without reference to the OECD transfer pricing guidelines. The issues described above and the conclusions in the GLAM are hardly new or surprising. Taxpayers and the IRS have long been at odds over whether the ability to apply the CWI standard lies within the IRS s power only. However, Section 482 on its face is unambiguous and the GLAM s conclusion that CWI adjustments are solely the province of the IRS is contrary to the plain meaning of the statute. The first sentence of Section 482 provides the Secretary of the Treasury with the discretion to distribute, apportion, or allocate items under Section 482. The second sentence, however, which provides a rule for measuring the income from a transfer or license of intangible property, is not similarly limited by a reference to the Secretary. The CWI standard is a general rule that does not contain a restriction that it applies only to taxpayers or to the IRS. The absence of the reference to the Secretary in the second sentence is evidence that the rule is one of general application. Assuming arguendo, that the CWI provision may be applied by the IRS only, if Exam has proposed an adjustment at its discretion using the authority under the first sentence of Section 482, Exam has no discretion under the second sentence of Section 482 with respect to the application of the CWI provision. The second sentence provides that in the case of any transfer (or license) of intangible property (within the meaning of Section 935(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible (emphasis added). Accordingly, at minimum, if a Section 482 adjustment is made by Exam, Exam has no discretion with respect to the application of the CWI provision and it must undertake a CWI analysis. significant transfer pricing cases The level of activity with regard to the cost sharing Regulations was matched by the IRS activity at the court level. This year s most significant transfer pricing cases all related to cost sharing issues. The three most significant cases were Xilinx Inc., 125 TC 37 Xilinx Inc., (appeal pending to 9th Circuit); Veritas Software Corp. & Subs., Symantec Corp. (Dkt. No ); and Adaptec Inc. (Dkt. No ). To date, only Adaptec has settled. xilinx On January 16, 2004, Fenwick & West petitioned the U.S. Tax Court in Xilinx. Trial was held in November Xilinx argued that the Commissioner erred in determining that the cost of stock options should be included in a cost sharing agreement. Xilinx had entered into a cost sharing agreement related to the transfer of acquired technology with its Irish subsidiary. The agreement excluded the compensatory stock options and included all appropriate research expenses and costs. The percentage of costs was related to each party s respective anticipated benefits from the technology. On August 30, 2005, the Tax Court held that Section 482 did not require Xilinx to include in the cost sharing agreement with its Irish subsidiary any costs from the stock options that it awarded to its R&D employees. The Tax Court stated that the express language of the arm s-length standard, in Reg (a)(1), establishes that the standard applies to Reg , and requires cost sharing participants to share the cost of intangible development as unrelated parties acting at arm s length would. On August 30, 2006 the IRS filed an appeal to the Ninth Circuit, arguing that the regulatory history supported its assertion that the commensurate-with-income language in Reg replaced the arm s-length standard in the Section 482 Regulations and, therefore, required Xilinx, in its cost sharing agreement with its Irish subsidiary, to share some of the costs of the stock options that it had awarded to its R&D employees. While the Section 482 3

4 Regulations at issue in Xilinx did not speak to whether stock options should be cost shared, the IRS in 2003 issued new Section 482 final Regulations that explicitly require companies to share employee stock option costs with affiliates. 6 However, Xilinx calls into question whether the stock options portion of the new Regulations, applicable to tax years beginning August 26, 2003, will be able to withstand a court challenge. On January 9, 2007, the Department of Justice filed its appellate brief stating that the Tax Court invalidated the central core of the Treas. Reg when it found that parties in a cost sharing agreement only have to share costs that unrelated parties would share; thus, Xilinx s Irish subsidiary did not have to share the costs of stock options with its U.S. parent company. The IRS contended that the arm s-length result mandated by. Reg (b)(1) is obtained in the case of a cost-sharing arrangement when the controlled participants in the arrangement adhere to the arm s-length sharing ratio of. Reg (a)(2), which can be given effect only if the participants share all of the costs incurred in their development of intangibles as required by Reg (b)(1). On March 22, 2007, Xilinx filed a reply brief arguing that the Tax Court ruling should be affirmed. Xilinx contends that the IRS s arguments on appeal misconstrue the Tax Court opinion and conflict with the legislative history and plain meaning of the Section 482 Regulations. Xilinx contends that the IRS s brief mischaracterized the Tax Court s opinion when it claimed that the court had mandated the use of comparable transaction evidence in determining arm s-length conduct. Xilinx argues that, to the contrary, the Tax Court refused to preclude evidence regarding what constitutes arm s-length conduct when it denied cross-motions for summary judgment on the stock options issue. Xilinx also argued that the IRS s position is flawed because it creates a new and abstract standard that grants the IRS an irrebuttable presumption of correctness based solely on economic assumptions and produces a result contrary to what occurs in actual transactions. Finally, Xilinx contended that the IRS, in arguing that the Tax Court s interpretation of Reg (b)(1) was incorrect, shifted its focus from one provision of the Regulation at trial to another in the appeals court, essentially presenting a new issue on appeal. According to Xilinx, when the two provisions are read together, they undermine the IRS s position, actually permitting comparability analysis, and not requiring the exclusion of evidence. On April 30, 2007, the IRS filed a reply brief arguing that Reg (b)(1) does not require the consideration of uncontrolled parties or transactions in every instance. The IRS further claimed that such a mandate would be the only reason for not applying Reg (d)(1) s requirement that the commensurate-with-income standard of Reg (a)(2) is satisfied when cost sharing participants share all the costs related to the intangibles development activity. On March 30, 2007, the Software Finance and Tax Executives Council and the AeA (formerly the American Electronics Association) filed an amicus brief in support of Xilinx s brief in the case. The amici argued that the IRS s position improperly replaces the Section 482 arm s-length standard with an abstract rule that does not permit taxpayers to introduce facts establishing that uncontrolled parties would not share any amount for employee stock options. The groups further objected to the IRS s interpretation on broader grounds, stating that the IRS position permits reallocations to or from U.S. taxpayers even when they have complied with the arm s-length standard based on evidence of uncontrolled transactions. veritas On June 26, 2006, Baker & McKenzie petitioned the U.S. Tax Court in Veritas. Veritas, a subsidiary of Symantec, argued that the IRS erred when it allocated under Section 482 (1) $2.4 billion to Veritas as a lump sum buy-in payment from a foreign subsidiary ( Veritas Ireland ); (2) $9.8 million to Veritas from another Irish affiliate ( Veritas Ltd. ) to include stock-based compensation in the R&D cost sharing pool; (3) $65.8 million to Veritas from Veritas Ltd. for other unspecified costs in their cost sharing agreement; and (4) $25.4 million to Veritas from the company s foreign subsidiaries, in aggregate, for technical support services performed in The petition also contested $303.1 million in Section 6662 penalties (accuracy-related penalty on underpayments) penalties because the company relied in good faith on advisor Ernst & Young to determine the appropriate arm slength rates and royalty payments. On April 10, 2007, the IRS conceded $6 million of the original $9.8 million in stock-based compensation that it proposed to include in the pool of costs shared by Veritas and Veritas Ltd. The parties agreed that the disposition of the remaining $3.8 million in stock options at issue would be determined by the final decision in Xilinx, described above, which is on appeal to the Ninth Circuit. In the agreement, the IRS also conceded its entire proposed income adjustment of $25.4 million relating to several foreign subsidiaries performance of technical support services in The IRS further agreed to drop all of the $303.1 million in Section 6662 penalties that it assessed to Veritas for 2000 and The remaining issues are scheduled for trial on July 30, 2008, in San Francisco. As for the $2.4 billion, the petition asserts that Veritas and Veritas Ireland, among other related parties, entered into a cost sharing agreement on November 3, 1999, for computer software R&D conducted by any party to the agreement. Under the agreement, the parties measured the reasonably anticipated benefits by the relative gross revenue attributable to each party s territory during the R&D fiscal year. Veritas also granted Veritas Ireland a technology license to manufacture, market, distribute, license, and sell the intangibles in Europe, the Middle East, Africa, and Japan. In exchange for the licenses, Veritas Ireland paid 25% royalties for the sale of the products and for product support from November 1, 1999, through October 31, 2000, at which time the royalties were no longer an obligation. Veritas Ireland also paid decreasing royalty rates on a scale starting at 34.7 % that was reduced to zero by November 1, Under the licensing agreement, the parties adjusted the royalties as necessary to ensure that Veritas Ireland made an arm s-length payment that was commensurate with the income attributable to the intangibles. According to the petition, Veritas Ireland paid $123.9 million in royalties to Veritas. The petition contends that the IRS s proposed adjustment concerning Veritas licensing to Veritas Ireland exceeds Veritas consolidated worldwide profits for by approximately $545 million 4

5 adaptec On March 14, 2001, Fenwick & West petitioned the U.S. Tax Court in Adaptec. Adaptec argued that the IRS erred in increasing royalties paid by a foreign subsidiary (AMS) to Adaptec, increasing acquisition buy-in royalties that AMS paid to Adaptec, and adjusting the cost sharing payments from AMS to Adaptec. Adaptec and AMS entered into a cost sharing arrangement, trademark license, and technology license. For the technology buyin, the IRS contended that the cost sharing agreement was not a qualified cost sharing agreement. Adaptec argued, however, that the cost sharing agreement was valid and resulted in an overpayment of tax. As to the royalty payments, the IRS based its theory on a memorandum and a report prepared by a consultant that evaluated the buy-in in the cost sharing agreement. The memorandum applied a profit split model and the report used a market capitalization approach to value the technology intangibles. Adaptec argued that the market capitalization analysis was not a proper method under Section 482. The IRS also contended that there was no evidence to support a useful life of the technology that extended beyond the term of the royalties that were paid. For the acquisition buy-in issue, Adaptec acquired several companies and held rights to use previously developed intangibles. The IRS claimed in each instance that the proposed adjustment was based on the argument that Adaptec sold to AMS a percentage of the intangibles owned by the acquired company equal to AMS s cost sharing percentage. Again, the IRS s consultant applied a profit split method, but it did not seem that the IRS argued the market capitalization analysis on the acquisition buy-in. Adaptec also argued that it was eligible for setoffs under Section 482 relating to its inclusion of the cost of stock options in the cost sharing agreement. Several stipulations of settled issues were filed including the technology buy-in royalty adjustment, cost sharing adjustment, and other adjustments. On September 28, 2006, Adaptec and the IRS agreed that the company would accept $21 million in transfer pricing adjustments to settle its tax liability for the buy-in payments related to technology acquisition by AMS. Adaptec also agreed to a $7 million increase in income for , even though the years were not part of the Tax Court petition. The settlement, however, did not address the $28.7 million from the original deficiency notice for the technology buy-in and $105.3 million when taking into account the IRS s alternative adjustment in its amended answer. Under the terms of the settlement, however, the IRS agreed that no other increases would apply to the company s taxable income for any other tax year for the acquisition buy-in. On November 20, 2007, the final stipulated decision was entered. The discussion of the above cases wraps up what has been a busy year in cost sharing. As of April 2008, the cost sharing Proposed Regulations have not yet been finalized but are anticipated within the near future. 7 services temporary regulations additonal guidance On August 1, 2006, Treasury and the IRS issued Temporary Regulations (TD 9278) on the treatment of services under Section 482 ( services Regulations ). 8 To provide additional guidance in response to taxpayer comments to the services Regulations, the IRS issued Notice , IRB 269, and Rev. Proc , IRB 295, which are summarized below. notice The additional guidance in Notice relates principally to the effective date of the services Regulations, application of the business judgment rule under the services cost method (SCM), necessary documentation, and penalty relief. Effective date. Under Temp. Reg T(b) of the new services Regulations, the SCM replaces the historical cost safe harbor for non-integral services. Notice partially pushes back one year the effective date of Temp. Reg T(b). The services Regulations as they relate to the identification and evaluation of controlled services eligible to be priced at cost (i.e., the SCM) thus now apply to tax years beginning after December 31, Notice , however, did not change the effective date of the portion of Temp. Reg T(b)(2) relating to the application of the business judgment rule under the SCM, described further below. The business judgment rule remains effective for tax years beginning after December 31, The net effect of the modifications is that taxpayers for a limited time may continue to apply the historical Regulations in Reg (b) for purposes of identifying controlled services that are eligible to be priced on a cost basis without a markup (i.e., services that are non-integral within the meaning of existing Reg (b) (7)). Taxpayers must, in conjunction, also satisfy the SCM business judgment test in Temp. Reg T(b)(2). Alternatively, taxpayers may apply the SCM as in Temp. Reg T(b), without taking into account any of the temporary modifications described above. All of the provisions of the SCM will be fully effective in all respects for tax years beginning after December 31, Application of business judgment rule. To apply the SCM under the services Regulations, a taxpayer must conclude, in its business judgment, that covered services do not contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure in one or more trades or businesses of the service provider, recipient, or both. Notice contains additional provisions that supplement the application of the business judgment rule: Taxpayers are to apply the business judgment rule by reference to one or more trades or businesses of the controlled group, as defined in Reg (i)(6), instead of the renderer, recipient, or both, as stated in Temp. Reg T(b) (2). This modification allows the possible use of the SCM where a dedicated services subsidiary of a controlled group provides primarily low margin or covered services and few other activities. The business judgment rule should take into account whether a particular activity contributes to the operating profit of one or more controlled parties, as that term is defined in Reg (d)(3). Thus, services that contribute to the profitability of a company below the operating profit line are potentially eligible for the SCM. Notice reiterates that the services Regulations incorporate a high threshold to exclude services otherwise eligible 5

6 for the SCM pursuant to the application of the business judgment rule. As long as the taxpayer reasonably concludes in its business judgment that the covered services do not contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure in one or more trades or businesses of the controlled group, that business judgment will be respected. The test therefore does not depend on the reasonable exercise of the IRS s judgment in examining the taxpayer. Election of SCM and documentation requirements. Notice confirms that taxpayers have the option of electing the SCM under the services Regulations. A statement in the taxpayer s books and records showing the taxpayer s intent to apply the SCM is all that is required as a necessary condition for application of the SCM (see Temp. Reg T(b)(3)(i)). The Notice further confirms that there is no requirement for a taxpayer to attach such statement to its tax return. Notice also clarifies that the books and records documentation under Temp. Reg T(b)(3)(i) for services analyzed under the SCM need not be generated contemporaneously with filing of the income tax return. In addition, for tax years beginning after December 31, 2006, and on or before December 31, 2007, the written contract required for a contingent payment arrangement (under Temp. Reg T(i)(2)) need not be entered into prior to, or contemporaneous with the start of the applicable arrangement. Instead, the written contract need only be prepared prior to, or contemporaneous with, the filing of the income tax return. Penalty protection. During the one-year transition period, Notice provides that reasonable efforts to comply with the services Regulations, as modified by the Notice, will avoid the imposition of penalties for the controlled services transactions (excluding services transactions evaluated under the historical cost-safe harbor and the new business judgment rule). Consequently, penalties, including but not limited to those within the meaning of Section 6662(e) and (h) (increase in penalty for gross valuation misstatements), will not apply for tax years beginning after December 31, 2006, and on or before December 31, 2007, provided that the taxpayer makes reasonable efforts to comply with the general documentation provisions of Section 6001 and Reg (d)(2)(iii). This relief is intended to provide taxpayers a reasonable transition period to analyze the services Regulations, execute any required contractual agreements, and prepare any transfer pricing documentation for transactions subject to the Regulations. rev. proc In Ann , IRB 321, the IRS issued an initial list of 48 specified covered services, which were permitted to be charged at cost under the SCM. In response to taxpayer comments that the list of services was too narrow, the IRS issued Rev. Proc , expanding the list of the enumerated services permitted to be charged out at cost to 101 categories. The expanded list also generally provides references to other activities similar to the specifically covered services, an attempt by the IRS to show that the specific covered services should be structured and interpreted in a practical, common-sense manner. The IRS declined, however, to treat activities of entire departments as per se exempt from markup. Thus, although the list is much broader, taxpayers will still have to devote significant resources in identifying which controlled services are not core business activities. apa annual report On March 27, 2008, the APA program released its ninth annual report, 9 describing the experience, structure, and activities of the program during calendar year The annual reports are intended to provide insight into the APA program s case processing, productivity, staffing, types of transactions covered, and transfer pricing methodologies applied. Application statistics. In 2007, the APA program received 92 new APA applications 10 and executed 81 APAs. 11 In comparison, the APA program received 167 new APAs and executed 82 APAs in The APA program renewed 29 APAs 13 and executed 8 revised or amended APAs during In addition, the percentage of executed bilateral APAs to total APAs increased to 67% in 2007 from 47.5% in Inbound cases accounted for the majority of the APA program s caseload in 2007, with 52 APAs executed involving foreign multinationals with U.S. subsidiaries. However, U.S. multinationals with foreign subsidiaries substantially increased their participation in 2007 in the APA program with 28 executed APAs. Processing time. Slight improvement has been made in the median processing time for both unilateral and bilateral APAs in 2007, with the median time to complete a unilateral APA decreasing from 18.7 months in 2006 to 16.7 months in 2007, and from 43.7 months in 2006 to 42.3 months in 2007 for a bilateral APA. At the end of 2007, the APA program had an inventory of 217 active cases consisting of 112 bilateral cases that have been forward to the Competent Authority office for discussion with the treaty partner. The remaining 105 active cases are 26 unilateral APAs and 79 bilateral APAs for which the APA program has not yet completed recommended a negotiating position. Pending requests for APA consisted of 209 bilateral APAs and 40 unilateral APAs. Of the unilateral APAs currently in inventory, 26 have been pending for two years or less, and of that number, 16 have been pending for one year or less. Of the pending bilateral APA requests, 35 have been pending for longer than 36 months and 156 for 36 months or less, and of that number, 117 have been pending for 24 months or less. APA program office structure, staffing, training. The APA program office is organized into four branches. Branches 1 and 3 are staffed with APA team leaders and Branch 2 with economists, and each is located in Washington, D.C. Branch 4, the APA West Coast Branch, headquartered in Laguna Nigel, California with an additional office in San Francisco, California, is staffed with both APA team leads and economists. At the end of 2007, the APA staff was organized as in Exhibit 1. 6

7 Type of transactions covered in APAs. A variety of types of transactions were covered in the 81 executed APAs (the total exceeds 81 because some APAs cover multiple issues). See Exhibit 2. Industries covered in APAs. APA requests came from taxpayers in 19 different industries. As in prior years, the wholesale trade and durable goods industry, filed the largest number of APA requests at requests. Other prolific industries were computer and electronic product manufacturing, and miscellaneous manufacturing, each with requests. The electronic equipment, appliance and component manufacturing industry filed 7-9 requests in Other industries that filed 4-6 requests each were chemical manufacturing, transportation equipment manufacturing, and professional, scientific and technical services. The remaining 12 industries accounted for one to three requests each. Services covered in APAs. In 2007, marketing and distribution services were each covered in 20 APAs. Seventeen APAs involved technical support services and 12 involved sales support. Other types of services covered by APAs included administrative, management, contract R&D, product support, R&D, logistical support, assembly, communication services, purchasing, legal, destination services (hotel and reservations), manufacturing services, billing services, warranty services, license administration services, consulting, and testing and installation services. Transfer pricing methods in APAs In 2007, the comparable profits method (CPM), with varying profit-level indicators (PLIs), 15 was used more than 72 times in APAs involving transfers of tangible and intangible property. Exhibits 3 and 4 outline the TPMs used in all APAs involving transfers of tangible or intangible property. APA term. Approximately 63% of all APAs completed in 2007 covered a five-year term. APAs with six-to-ten or more-year terms comprised 30% percent of executed APAs, while those covering three- or four-year terms consisted of 7%. Model APA and balance sheet adjustments. The Annual Report included a model APA based on the updated procedures in Rev. Proc In addition, the Annual Report provides formulas on making balance sheet adjustments. 16 Transfer Pricing Penalties The Code provides for two transfer pricing penalties under Section 6662(e): (1) the transactional penalty and (2) the net adjustment penalty. Once an examiner and manager determine that the transactional or net adjustment penalty should apply, they must submit that recommendation to the Transfer Pricing Penalty Oversight Committee ( Committee ) for approval. The IRS established the Committee to ensure nationwide uniform application of the documentation requirement and reasonableness standard. The Committee consists of personnel from the International, Examination, Appeals, and Chief Counsel Divisions of the IRS and is required to review all cases in which transfer pricing penalties are asserted. 17 Pending Committee approval, transfer pricing penalties may be imposed. Inadequate documentation. On June 18, 2007, it was reported that the Committee was seeing more cases. According to Jeffrey Johnson, International Technical Advisor (LMSB Prefiling and Technical Guidance), in nearly all penalty cases, taxpayers have transfer pricing documentation in place but it does not meet the regulatory requirements for penalty protection. Johnson noted that the primary reasons why documentation fails are (1) taxpayers do not select and apply the best method in a reasonable manner, (2) the conclusions reached are not supported by background documents, and (3) the tested party data used is incomplete or inaccurate. Johnson attributes the current rise in penalty assessments to international examiners increased awareness of transfer pricing issues. 18 Industry Director Directive. In connection with the IRS s Large and Mid- Size Business Division (LMSB) Industry Issue Focus (IIF) initiative, the IRS released LMSB Industry Director Directive #1 on Transfer of Intangibles Offshore/Section 482 Cost Sharing Buy-in Payment (LMSB ) on April 5, The Directive reaffirms existing LMSB guidance that examiners are to request and evaluate transfer pricing documentation at the outset of the examination planning process. The Directive further instructs examiners that, as a Tier I issue of high strategic importance to LMSB, the cost sharing buy-in issue should be raised and fully developed on audit. The Directive provides examiners with a host of IRS personnel to assist with audit evaluation and issue development, specifically, International Technical Advisors Jon Tamaki and Matthew Hartman, and High Tech Industry Counsel Michelle Korbas. Within the Office of Chief Counsel, the ACCI Branch 6 has jurisdiction over technical issues under Section 482. LMSB has also designated International Field Counsels to coordinate technical issues with ACCI attorneys. 19 CIP. For penalty purposes, however, the CIP issued in September 2007 acknowledges that taxpayers may be able to demonstrate, under the facts and circumstances, that application of a transfer pricing method specified by the Regulations, memorialized in contemporaneous documentation, allows a reasonable conclusion that the taxpayer s method was the best method, and permit the taxpayer to avoid transfer pricing penalties. 20 In other cases, the CIP counsels that it may not be possible for taxpayers to demonstrate that a specified method could be reasonably applied. 21 Foreign-to-foreign exclusion. An IRS Chief Counsel Memorandum (CCM) issued April 4, 2007, addressed the foreignto-foreign exclusion from the net adjustment penalty. 22 The CCM focuses on the solely between foreign corporations language of Section 6662(e)(3)(B)(iii). The taxpayer, a domestic parent of a consolidated group of companies with foreign manufacturing affiliates, argued that a portion of the transfer pricing adjustment assessed on the group was attributable entirely to transactions between the group s foreign affiliates, and thus excluded from the penalty threshold. Exam s position was that although the foreign to foreign transactions were 7

8 relevant to the consideration of the transfer price that the parent corporation s domestic partnership paid for finished products, the transfer price adjustment was to the domestic partnership transaction; thus the foreign to foreign exclusion did not apply. On these facts, the Chief Counsel s Office advised the field that the transaction was not solely between foreign corporations within the meaning of the statute. Services audits. During the American Bar Association tax conference on November 2, 2007, John Breen, Branch 6 Chief, Office of Chief Counsel (International), reported that the IRS is directing examiners to focus on highvalue services, particularly in the area of intangibles, and to request transfer pricing documentation upfront, at the outset of the services audit. 23 IRS Audit Guidelines for Former Section 936 Corporations On February 2, 2007, the IRS Industry Director for the retail, food, pharmaceuticals, and healthcare industries issued a directive on Section 936 exit strategies ( 936 Directive ). 24 Section 936 allowed taxpayers to take a tax credit on income earned form its trade or business operations in Puerto Rico. Typically, the corporation in Puerto Rico ( Possession Corporation ) was a wholly owned subsidiary of another U.S. corporation ( U.S. Parent ). Possession Corporation usually performed the manufacturing activities while U.S. Parent performed marketing functions. The products produced by Possession Corporation were usually sold to the U.S. or foreign affiliates. Prior to its phase-out, Section 936 gave Possession Corporation a credit for income that was attributable to its manufacturing activities. As a result of a ten-year phase-out, however, the tax credits allowed under Section 936 ended for tax years beginning after December 31, As a result, corporations began restructuring their operations to preserve their historically lower tax rates. The 936 Directive gave the example of a common restructuring plan, post Section 936: a CFC is formed in a lowtax jurisdiction; the manufacturing activities of Possession Corporation are organized as a branch of the CFC; the tangible assets of Possession Corporation are transferred to the CFC in a Section 351/361 transfer; and U.S. Parent licenses use of intangible property to the CFC. The 936 Directive gave examples of issues that could arise in the context of Possession Corporations that may have restructured in response to the phase-out of Section 936: (1) determination of arm s-length royalty to U.S. Parent; (2) determination of transfer prices for other associated charges for services, marketing and distribution activities, and other manufacturing activities conducted by U.S. Parent; and (3) taxation under Section 367(d) for any intangibles transferred to the new CFC. Arm s-length royalty. The IRS s concern relates to whether the royalty rate paid by the CFC to U.S. Parent properly reflects the economic realities surrounding the transfer of the intangible property. As expected, the IRS suspects that U.S. Parent is not being properly compensated and, consequently, that income is being disproportionately shifted to the CFC in the low-tax jurisdiction. The IRS reasons that as a newly formed corporation, the CFC could not have participated in the development of the intangible property. However, the IRS does concede that not all income attributable to the intangible property should be recognized by U.S. Parent. Factors such as the assumption of various risks and responsibilities come into play when dividing profits between U.S. Parent and the CFC. Determination of other associated charges. Here, the IRS s concern relates to whether controlled transactions exist in addition to the transfer of the intangible property. This concern arises from the IRS s belief that the new CFC has only the manufacturing assets transferred from the Possession Corporation and intangible property licensed from U.S. Parent as assets. Other functions such as R&D, marketing, distribution, and outsourced manufacturing may give rise to controlled transactions above and beyond the intangible property. The IRS also suggests that these items, when combined as a whole with other worldwide affiliates, may have synergistic effects that enhance the value of other activities. These effects, the IRS contends, should be considered in any valuation. Foreign goodwill and going concern value. Finally, the IRS believes that the foreign goodwill and going concern exception to Section 367(d) should be narrowly construed. First, the IRS view is that a taxpayer s characterization of items as foreign goodwill and going concern should be questioned. Second, the IRS states that it will scrutinize whether goodwill and going concern value is actually foreign so as to be exempted from Section 367(d). Audit guidelines related to Section 936 conversion issues. The 936 Directive included, as an attachment, guidelines intended to be used by IRS examiners to develop and analyze Section 936 issues. These guidelines were provided in a three-step process. (1) The first step mostly involves fact gathering by the examiner, who will issue mandatory transfer pricing information documentation requests (IDRs) to gather any contemporaneous transfer pricing studies. This includes transfer pricing studies for the years under audit, the year or years in which the Section 936 conversion occurred, and all intervening years. The examiner will gather information related to Section 351/367(d) transfers of intangible property, licensing/royalties, and claims of outbound transfers of foreign goodwill and going concern, and look for any cost sharing agreements. The examiner will also perform a functional analysis of the assets transferred, risks assumed by the entities, and conversion steps of the corporation from Section 936 to its current organizational structure. The examiner s functional analysis may include visiting the CFC s operations in Puerto Rico. Based on the information gathered, the examiner will analyze the best method adopted by the taxpayer under Section 482 to determine whether, in the IRS s opinion, another method would be more reliable. (2) This step outlines the key facts that the examiner will pay close attention to while gathering information, including 8

9 the date that Possession Corporation converted from its Section 936 operations to its new corporate structure. The examiner will also identify all assets transferred under Section 351/361, both tangible and intangible and specifically question assets that are transferred tax-free as foreign goodwill and going concern value. This includes intangible property improperly categorized as, or valuable workforce in place included as, foreign goodwill and going concern value. The examiner will determine the existence of valuable workforce in place, which the IRS believes is intangible property for purposes of Section 936(h)(3)(b). (3) The last step is for the examiner to investigate the licensing of intangible property from U.S. Parent to CFC or any cost sharing agreements between them (transfers of intangible property were covered under step 1 above). This step entails the usual analysis under Section 482 to determine whether an arm slength price was used in the license or cost sharing agreement. FIN 48 and Impact on Transfer Pricing Review The new financial reporting tax position disclosure rules introduced by Financial Accounting Standards Board (FASB) Interpretation No. 48 ( Accounting for Uncertainty in Income Taxes ) (FIN 48), interpreting Statement of Financial Accounting Standards No. 109 ( Accounting for Income Taxes ) (FAS 109), require public companies listed in the United States to provide increased transparency of both their tax structures and specific tax vulnerabilities. Although the FASB is charged with providing consistency in accounting to assist and protect shareholders in making informed investment decisions, the IRS is an indirect beneficiary of the FIN 48 requirements. With its adoption of FIN 48, the FASB joins Congress by adding to public companies ever growing obligations to increase tax structure transparency and share data (e.g., the Patriot Act, Sarbanes-Oxley) with the government and the public. With FIN 48, the FASB requires public companies to share information of particular interest to the IRS, and, with respect to transfer pricing issues, of particular interest to any relevant foreign tax authority. For public companies listed in the United States, FIN 48 requires companies to evaluate each tax position under a two-step process: (1) determine whether the position is more likely than not to be sustained by a tax authority or court (worldwide) based on its technical merits and, if yes, (2) the company must recognize the largest portion of that benefit that is more than 50% likely to be realized. Tax positions found in such analysis to be ineligible for recognition benefit must be recorded as a company liability to comply with its U.S. financial reporting obligations. These disclosures will provide the IRS, as well as foreign tax authorities, with a road map to public company tax structures and tax vulnerabilities. Over the past several years, transfer pricing regimes, including documentation obligations, have expanded exponentially around the globe, requiring multinational companies to engage in global reviews of intercompany transactions. Although the review of global transactions and tax positions has increased, there is great uncertainty as to the merits of many foreign tax positions and the likelihood of success on audit by a local tax authority or court. This issue is particularly relevant with respect to transfer pricing positions due to the recent introduction of transfer pricing laws in numerous countries where there is little or no guidance or experience with the required analysis, review, or interpretation of the new laws. With respect to transfer pricing and FIN 48 for U.S. relevant transactions, generally, the protection seemingly provided by following U.S. or even foreign transfer pricing documentation requirements appears to no longer be enough. Transfer pricing documentation will typically provide a company with protection only from penalties, not from adjustments. Thus, to satisfy the auditors scrutiny of FIN 48 analyses, companies are subject to increased scrutiny. The additional level of uncertainty that the FIN 48 review of transfer pricing matters has introduced may result in an increased interest in the APA program among public companies. Cost sharing developments (and, in general, developments relating to the transfer of intangibles) are affecting discussions with auditors and public companies FIN 48 tax reserves. Further, the introduction of the new U.S. services Regulations, 26 effective for tax years beginning after December 31, 2006, is also influencing public companies FIN 48 tax reserves. Expenses qualifying as stewardship are more narrowly defined in the new services Regulations, requiring transfer pricing analysis of transactions that were previously disregarded. Although it is too early to tell the eventual effect of FIN 48 on transfer pricing positions for U.S. publicly listed companies, the introduction of FIN 48 requirements and analysis has further solidified the importance of conducting global transfer pricing analyses and documentation review, as well as the importance of conducting further analysis as to the sustainability and merits of such positions. Rev. Proc Latest Procedure on Competent Authority Relief Rev. Proc , IRB 1035, addressed the procedures for taxpayers requesting assistance from U.S. Competent Authority under tax treaties. Tax treaties generally permit taxpayers to request assistance from Competent Authority if they consider the actions of the treaty countries to result in taxation inconsistent with the treaty. Rev. Proc does not make any major changes to the procedure, but provides several clarifications. The following is a short list that summarizes the changes and clarifications: Clarification of the standards for acceptance of requests for Competent Authority assistance to include non-u.s. persons as permitted under applicable tax treaties. Clarification of signature requirements for requests for determinations regarding limitation on treaty benefits. Addition of requirements for filing copies of submissions on electronic media. Additional detail regarding information to be submitted with requests for Competent Authority assistance. Clarification of current practices regarding coordination with IRS Appeals. 9

10 Clarification of the coordination of the accelerated Competent Authority procedure with requests for APAs. Clarification of current practices regarding the processing of requests for the simultaneous Appeal procedure. 27 Reduction in the frequency with which taxpayers, who file protective claims, must apprise the U.S. Competent Authority of their intent to eventually file a request for Competent Authority assistance to annually. Clarification of the role of U.S. Competent Authority in considering requests regarding conforming a taxpayer s accounts and allowing repatriation of certain amounts following an allocation of income between related U.S. and foreign corporations under Section 482. Denial of Competent Authority assistance where the underlying transaction is a listed transaction under Regs (b) (2) and (b)(2). Implementation of user fees for request for determinations regarding limitation of treaty benefits. Several of the clarifications in Rev. Proc coordinate the Competent Authority procedures with other administrative procedures, e.g., IRS Appeals and APAs. Taxpayers who disagree with a proposed U.S. adjustment may (1) pursue their right of administrative review with IRS Appeals, (2) make a request for a simultaneous Appeals procedure, or (3) request Competent Authority assistance immediately for bilateral consideration. If the taxpayer who is pursuing its rights with IRS Appeals believes that it has a Competent Authority issue, the taxpayer may contact the U.S. Competent Authority and apply for the simultaneous Appeals procedure, where the taxpayer requests Competent Authority assistance and IRS Appeals consideration for the same issue. The U.S. Competent Authority will consult with IRS Appeals to determine whether the simultaneous Appeals procedure is appropriate. If the simultaneous Appeals procedure allowed, the taxpayer is notified. During the simultaneous Appeals procedure, the U.S. Competent Authority continues to have jurisdiction over the issue. Requests for unilateral withdrawal of a proposed U.S. adjustment must be directed to IRS Appeals rather than to the U.S. Competent Authority. Nevertheless, if a taxpayer enters into settlement discussions with IRS Appeals, the U.S. Competent Authority may rely on, but is not necessarily bound by, such previous consideration by IRS Appeals, even if the taxpayer does not go through the simultaneous Appeals procedure. A taxpayer that enters into the Appeals arbitration program generally may not request Competent Authority assistance until the arbitration process is completed. However, if the taxpayer demonstrates that a request for Competent Authority assistance is necessary to keep open a statute of limitations in the treaty country, Competent Authority assistance may be requested while arbitration is pending, and the U.S. Competent Authority will suspend action on the case until arbitration is completed. Further, Rev. Proc explains that a taxpayer implicitly invokes the accelerated Competent Authority procedure when the taxpayer requests that its bilateral APA be applied retroactively to previously filed years. The accelerated Competent Authority procedure is the process by which a taxpayer may request that the Competent Authorities resolve an issue that arises in several years. Finally, Rev. Proc clarifies that, following an allocation of income between related U.S. and foreign corporations, the U.S. Competent Authority must provide relief consistent with the principles of Rev. Proc , CB 296, which generally provides a means to conform a taxpayer s accounts and allow repatriation of certain amounts. 28 IRS Audit Guidelines on Factoring of Receivables On June 29, 2006, the IRS issued its first Audit Technique Guide (ATG) (LMSB ), specifically covering transfer pricing principles, with a focus on the intercompany factoring of receivables. 29 Although the stated objective of the guide is to assist examiners in audits involving domestic entities that sell receivables to foreign related parties or perform intercompany factoring, more generally, this guide indicates the direction of the IRS s efforts in training examiners how to treat transfer pricing issues. Also, with this snapshot on factoring, the ATG provides insight into how the IRS will treat future transfer pricing issues that affect all transfer pricing practitioners. The ATG includes an example of factoring. A U.S. subsidiary ( Taxpayer ) of a foreign parent earns sales income and books accounts receivable ( AR ). Taxpayer then factors the AR to a brother-sister foreign affiliate ( Factor ). Companies typically engage in factoring services when they need AR collected or securitized to generate cash flow. A factor performs these services in return for certain fees, usually a discount off the AR, administrative fees, commissions, and interest. 30 The issue in the ATG is the potential evasion of taxes on income earned in the United States from deducting factoring expenses related to the same income, especially when the related-party Factor might not perform any of the typical services of a factor, including the collection of the AR. The ATG emphasizes that Taxpayer may be paying foreign factoring fees, even though typical factoring services might not be performed by Factor. Specifically, Taxpayer may continue to perform the collections activity, but now as an agent of Factor. In addition, the ATG notes that Taxpayer and Factor may be engaged in a financing arrangement involving the securitization of the AR. The ATG acknowledges that some factoring arrangements may involve a domestic instead of an offshore factor, or two domestic entities, which could have state tax implications. 31 The ATG outlines the following minimally required steps to be taken during an examination: (1) issue an IDR to determine if any accounts receivables were sold; (2) review the tax return balance sheet to determine if the AR reflected therein are reasonable for the size and type of business; (3) perform a comparative analysis of the balance sheet for the current and at least 5 prior tax years, noting any significant reduction in accounts receivables (emphasis added); (4) review the tax preparation work papers for large debits to income; and (5) review and analyze Form 5472 (Information Return of a Foreign Owned Corporation) and the audited financials of both the domestic and related foreign entities for footnotes 10

11 reflecting the sales and/or securitization of AR. 32 Tax evasion through factors acting as tax shelters is a substantial focus of the ATG, including identification of practitioners and service providers that may have been involved in the marketing of an AR transaction. The examiner is to ask how the sale of AR was conducted, prior to the repeal of mark-to-market accounting under Section 475, and whether special factoring companies were created around or after July 1998, such as off-balancesheet special-purpose entities (SPEs). The examiner is also asked to identify the promoter/advisor or accounting firm involved in structuring taxpayer factoring arrangements, and whether the valuation services for the AR were provided by the same marketer of the sale of AR. As part of the examination, the ATG suggests that the examiner request transfer pricing studies, perform a factoring arrangement functional analysis, and request three to five years of bad debt data to determine the percentage of receivables written off as bad debt. These steps generally outline the structure of a standard transfer pricing audit, including (1) a review of previously prepared transfer pricing materials, (2) a functional analysis, and (3) a financial analysis of data relevant to the transaction. At this stage, an IRS economist typically would be involved in the review of these materials. On the surface, the ATG presents a facts-andcircumstances approach to the treatment of a receivables factoring audit. However, the ATG makes several strong statements that take a different approach, especially on the contractual terms of intercompany factoring arrangements. First, the ATG establishes de facto upper bounds for outbound recourse and nonrecourse factoring fees (0.35% and 0.70%, respectively). These bounds are taken from one example in the Regulations, with an additional burden on the taxpayer to argue that the terms that they are applying meet the facts and circumstances of their own industry. 33 Second, the ATG imputes contractual terms and imposes economic structures, rather than evaluating the factual circumstances that actually surround a transaction. 34 Here, the ATG states that an intercompany factoring arrangement may be abusive if the factoring fees are much higher than the typical factoring fees charged for unrelated parties (emphasis added), without providing guidance on what much higher means, and in what context. 35 The current Regulations give taxpayers substantial freedom to adopt contractual terms in accordance with the economic substance of the dealings. Statements in the services Temporary Regulations, and now this ATG, implicitly impose an economic structure on contractual terms of relatedparty transactions. 36 In conclusion, this ATG is the first public guide from the IRS to outline its treatment of transfer pricing audits, specifically in the context of potential tax evasion through SPEs or non-domestic related entities that engage in factoring. The ATG s treatment of the audit appears at first glance to be a factsand-circumstances approach, with detailed and specific financial and industry data requested, and steps outlined to conduct a basic economic analysis of a taxpayer s intercompany AR profile. Although the ATG is important to intercompany factoring, its broader points need to be considered. First, the ATG is a further indication that the IRS is taking an increased interest in training examiners on how to conduct and execute transfer pricing audits. Additional guides will likely be forthcoming on other Section 482 issues. Second, within the ATG, the IRS makes some indications that a facts-andcircumstances approach will be applied toward transfer pricing audits. The language in the ATG seems to be an encouraging sign that the IRS is willing to look at intercompany transactions in the context of a taxpayer s economic environment. Unfortunately, other portions of the ATG suggest otherwise, in particular relying on implied bounds to assess a taxpayer s position. If the IRS relies more on rules of thumb than accurate and thorough functional and economic analyses, the facts-and-circumstances portions of the ATG may be meaningless. Lastly, the ATG takes a stance that it is reasonable to impute contractual terms from perceived economic conclusions rather than evaluate the economics of the transaction. Implicitly, this takes transfer pricing further away from the income-based statements of Section 482 toward an insistence on market-based approaches. This is a natural direction that appears, on the surface, sensible as market comparables are commonly used in benchmarking routine activities. However, under real-world economic conditions, this may be stifling to business as the most innovative, entrepreneurial, and intangible property-developing taxpayers, by their very nature, lead the market and are not routine. Proper treatment of these taxpayers requires detailed economic understanding of their facts and circumstances rather than crude applications of rules of thumb. U.S. State and Local Tax Developments States continue to challenge tax minimization structures using specialpurpose companies. In the past, many taxpayers used tax reduction strategies involving SPEs to reduce state tax burdens, particularly in separate reporting states. States responded to the reduced tax revenue in several ways, including greater scrutiny of related-party transactions, broader assertions of nexus, increasing assertions that particular structures or transactions were tax-motivated shams, statutory disallowances of deductions for payments to related parties, greater disclosure requirements on filing, and statutory changes to require combined reporting (particularly with special-purpose companies) rather than continued separate reporting. For some years now, states have been applying greater scrutiny to related-party transactions and requiring strict adherence to the laws already in place. More recently, states that required separate reporting have begun to question whether separate reporting is a clear reflection of income of the business activities within the state. Some separate-reporting states are initiating a move from a separatereporting regime to a combined-reporting system to better reflect income. 37 NY requires combined reporting for related corps. The New York legislature recently enacted a law requiring related corporations to file a combined report if there are substantial intercorporate transactions, effective for tax years beginning on or after January 1, The New York State Department of Taxation and Finance ( Department ) issued guidance for this new law on June 25, 2007, to determine whether a combined report is required if there are substantial 11

12 intercorporate transactions. 39 The guidance provides steps to determine which entities should be included in the report, provides examples, and explains key terms such as what constitutes substantial intercorporate transactions. The Department has taken a broad view on substantial intercorporate transactions, stating all activities and transactions of the taxpayer and its related corporation must be considered, including, but not limited to: Manufacturing, acquiring goods or property, or performing services, for related corporations. Selling goods acquired from related corporations. Financing sales of related corporations. Performing related customer services using common facilities and employees. Incurring expenses that benefit, directly or indirectly, one or more related corporations. Transferring assets, including assets such as accounts receivable, patents, and trademarks, from one or more related corporations. Also, intercorporate receipts and expenditures, along with asset transfers, are intercorporate transactions, and the Department will consider whether these transactions have economic substance. Loans and interest on those loans will also be considered in the substantial intercorporate transaction test unless the loan is treated as subsidiary capital, in which case the interest paid and received will not be included, but the loan amount will remain an asset to be included in the substantial intercorporate transaction test. To meet the substantial intercorporate transaction test during a tax year, 50% or more of the corporation s receipts or expenditures must be from one or more related corporations. If the receipts or expenditures fall between 45%-55%, the Department provides a multi-year test that must be applied to determine if the substantial intercorporate transaction test is met. If there is an asset transfer to a related corporation that is 10% or more of the transferor s or the transferee s total assets, the substantial intercorporate transaction test is met if they are engaged in a unitary business. Also, the Department notes that even if the substantial intercorporate transaction test is not met, the corporation may still be required to file a combined report with one or more related corporations if a combined report is necessary to reflect the taxpayer s Article 9-A (franchise tax on business corporations) liability because of intercompany transactions, other agreements, or arrangements. Significant economic presence may create state nexus. It appears that the U.S. Supreme Court currently has little interest in resolving corporate income or franchise tax nexus issues as evidenced by the denial of certiorari in both Lanco Inc. v. Director 40 and Tax Commissioner of West Virginia v. MBNA America Bank, N.A. 41 Although Lanco involved a tax-motivated structure using an intangible holding company, MBNA was a straightforward business tax case apparently not involving tax minimization strategy. Many thought that the Supreme Court would rule on MBNA to resolve whether the physical presence requirement to establish nexus extended to income tax nexus or was limited to sales tax nexus. In MBNA, the sole issue on appeal was whether imposing the West Virginia franchise and corporate income taxes on an entity without physical presence in the state violated the Commerce Clause of the Constitution. The West Virginia Supreme Court had held that the physical presence standard in Quill 42 applied only for sales and use tax and not for franchise or corporate income taxes. The court held that to determine nexus and, therefore, imposition of the franchise or corporate income taxes, a significant economic presence test should be applied. To have a significant economic presence, purposeful direction towards a state is analyzed as it is for Due Process purposes, and the Commerce Clause analysis requires the additional examination of the frequency, quantity and systematic nature of a taxpayer s economic contacts with the state. MBNA, although it had no physical presence in West Virginia, engaged in telephone and mail solicitation of customers in the state and had considerable gross receipts attributable to West Virginia customers. Therefore, the West Virginia court held that MBNA had significant economic presence that created nexus and taxability in West Virginia. Since the U.S. Supreme Court s denial of certiorari, this significant economic presence test has emboldened states to contemplate or implement modifications of their statutes. For example, the New Hampshire legislature adopted an economic nexus standard for its business profits tax. Effective July 1, 2007, the new definition of business activity now includes a substantial economic presence as evidenced by purposeful direction of a business toward the state. 43 The bright-line physical presence test favored by industry increasingly is being replaced by a more fluid and uncertain standard of an economic presence in the state. States increasingly will look to audit companies and assert nexus based on their purposeful activities of sales and marketing in the state and a company s business dealings, frequency, and quality of economic presence. Relief from broad assertions of nexus appears unlikely to come from the courts, and business may have to look to Congress to establish guidelines and limits. It may well be that the Supreme Court s refusal to grant certiorari in MBNA was a deliberate decision to punt the ongoing controversies to Congress for resolution; whether or not that was the motive, the result seems to be to leave resolution to Congress. Other intangible holding co. state cases. States have also continued to attack intangible holding company structures through add-back statutes and by denying deductions. The Alabama Court of Appeals in Surtees, et al. v. VFJ Ventures, 44 found that Alabama s add-back statute was constitutional. In VFJ Ventures, the taxpayer, which manufactures jeans, was a subsidiary of a parent holding company. The subsidiary paid the parent company for certain trademark rights used by other subsidiaries and third parties, and deducted these payments as ordinary and necessary business expenses. The Alabama Department of Revenue determined that these expenses were to be added back under Alabama s add-back statute. 45 VFJ Ventures claimed that the add-back statute was an unconstitutional violation of the Due Process and Commerce Clauses as the statute taxed the income of the intangible management 12

13 companies and the intangibles companies did not have sufficient nexus with the state to impose such a tax. The trial court found that denial of the deduction would distort VFJ Ventures income and therefore ruled that taxpayer qualified for the exception to the add-back statute where add-back was not reasonable. The Alabama Court of Appeals held that the add-back statute was constitutional as it did not implicitly impose a tax on the intangibles management companies. To reverse the trial court s denial of add-back, the appellate court essentially had to recharacterize what appeared to be a factual funding as a legal conclusion. The trend in states is to tax intangible holding companies through affirmative statutes like the substantial economic presence test described above, or to deny the royalty deduction through add-back statutes or attacks on the structure as a sham. Either way, the benefits of intangible holding company structures are becoming more difficult to achieve and in some instances the attempts result in penalties. REITs. Intercompany transactions involving real estate investment trusts (REITs) have also come under scrutiny and attack by the states. In Fleet Funding, the Massachusetts Appellate Tax Board recently ruled that intercorporate transactions between REITs, passive investment companies, and two related parent banking companies lacked economic substance and were shams and therefore should be disregarded for tax purposes. 46 The transactions were part of a tax savings plan where the REITs received interest income from the real estate loans transferred to them by the parent banks. The REITs then paid out the interest income through dividends to the passive investment companies, which then paid dividends to the parent banks. Prior to establishing this structure, the two banks were subject to Massachusetts tax on the interest received from the real estate loans, while after the strategy they were only subject to tax on 5% of the interest income and claimed the 95% dividends received deduction. The REITs also claimed a deduction for dividends paid and therefore were not taxed as well. The Board found that the transactions were instituted for the sole purpose of avoiding Massachusetts tax. As the transactions lacked economic substance and business purpose, they were a sham and the Board denied the dividends paid deductions to the REITs. Although these taxpayers were denied a dividends paid deduction in Massachusetts, a Kentucky court has ruled in favor of taxpayers claiming a dividends paid deduction. In Commonwealth v. Autozone Development, 47 the Kentucky Court of Appeal affirmed a decision that Autozone was entitled to a tax deduction for dividends paid to shareholders. Autozone, a Nevada corporation, began doing business in Kentucky in 1995 and owned and leased land and buildings for its business operations. In its Kentucky returns from , it claimed a deduction for dividend payments to its shareholders resulting in only 5% of Autozone s income being taxed in Kentucky. The Kentucky Court of Appeal had to decide whether a Kentucky statute permitted a REIT to take a deduction from gross income for these dividends paid for purposes of calculating net income. As the federal statute allows a dividend paid deduction to REITs for this purpose, and the Kentucky statute clearly defines net income as gross income minus all deductions allowed by Chapter 1 of the Internal Revenue Code, the court ruled in Autozone s favor. Therefore, under the Kentucky statute, REITs are allowed to take a deduction from gross income for dividends paid to its shareholders. Whether the statutes in Kentucky or in other states with similar statutes will remain unchanged is yet to be seen. Structures involving REITS have been successfully challenged in several recent cases, and at least some legislatures can be expected to pass laws statutorily denying the benefit of REITS as a tax minimization structure in the related-party context. OECD Attribution of Profits to PEs The Organization for Economic Cooperation and Development (OECD) continued its work on several transfer pricing projects, including issues relating to business restructurings, comparability analyses, and application of profits-based methods, but its main focus in recent months has remained the attribution of profits to permanent establishments (PEs). There were two significant developments in this regard. First, the OECD released, on December 21, 2006, what it effectively presented as the final version of Parts I, II, and III of the Report on the Attribution of Profits to a Permanent Establishment ( Report ). Second, on April 10, 2007, the OECD issued for comment a draft revised Commentary on Article 7 (Business Profits) of the OECD model tax treaty ( Draft Commentary ), incorporating aspects of the Report that it believes do not conflict with the existing interpretation of Article 7. Consistent with its 2004 precursor, the Report adopts as the Authorized OECD Approach for attributing profits to a PE a functionally separate-entity approach. Under that approach, the profits to be attributed to a PE are the profits that it would have earned at arm s-length had it been a legally distinct and separate enterprise performing the same or similar functions under the same or similar conditions and dealing wholly independently with the enterprise of which it is a part. The Draft Commentary contains relatively modest amendments and additions that the OECD has indicated are intended to incorporate by reference most principles of the Authorized OECD Approach. Application of the Authorized OECD Approach involves a two-step process. First, a factual and functional analysis is required to identify the economically significant activities and responsibilities undertaken by the PE. This is said to involve an analysis generally akin to that applied under Article 9 of the OECD model treaty, as interpreted by the 1995 OECD transfer pricing guidelines ( Guidelines ). As applied in the PE context, this analysis requires the PE s activities and responsibilities to be considered in the context of those of the enterprise as a whole. As a hypothetical separate enterprise, the PE is deemed to engage in dealings with the head office on arm s-length terms. The profits attributable to the PE are the compensation that would be required for these dealings, determined by applying the transfer pricing methods and other relevant principles of the Guidelines by analogy. Taken into account for this purpose are the functions performed by the PE and the assets that it is deemed to use and the risks that it is deemed to assume in performing those functions. The Report and the Draft Commentary 13

14 provide that the parties accounting records and documentation regarding the dealings between the PE and the rest of the enterprise are relevant as a useful starting point for the analysis, but not determinative. Although such internal documentation lacks legal effect and generally is viewed with more skepticism than is intercompany documentation, it is strongly encouraged and the Report indicates that it generally will be respected if consistent with economic substance, arm s-length behavior, and principles of the Authorized OECD Approach. In calculating the arm s-length profit attributable to the PE, the Report and the Draft Commentary do not limit the amount of attribution to the enterprise s actual profits. Therefore, profits may be attributed to a PE even when the enterprise suffers an overall loss. Both the Report and the Draft Commentary contain a separate discussion of profit attribution with respect to a dependent agent PE, noting that the dependent agent and the principal on whose behalf it acts are separate taxpayers, each of which may be taxable. The Report expressly rejects the argument urged by some commentators that there should be no additional profit attributable to a dependent agent PE if the agent has been paid an arm s-length compensation for its activities. The Report concludes that a single taxpayer approach of this sort would improperly disregard assets and risks that relate to the PE s activities simply because those assets and risks legally belong to the nonresident principal. Thus, the same profit attribution approach applies for dependent agent PEs as for other PEs. The Report and Draft Commentary, like the prior version of the Report, provide an example of profit attribution to a dependent agent PE, but important elements of the analysis are either assumed or omitted. Significant people function. The key entrepreneurial risk-taking function ( KERT function ) terminology for attributing assets and risks to PEs that had been the focus of considerable criticism in the earlier version of the Report has been replaced throughout Part I of the Report with references to significant people functions relevant to the economic ownership of assets and significant people functions relevant to the assumption and/ or management (subsequent to the transfer) of risks. The Report explains that KERT is retained as the appropriate standard to allocate assets and risks to PEs of financial sector enterprises covered under Part II (banks), Part III (financial products of global trading enterprises), and the forthcoming final version of Part IV (insurance companies), because in those sectors, there generally is an intimate relationship between the risks assumed and assets owned-i.e., the same significant people functions typically are relevant to both the assumption of risks and the economic ownership of those assets. On the other hand, the adoption of the significant people function standard for non-financial sectors reflects the OECD s view that there may be different sets of functions that are relevant to the assumption or management of risk and the economic ownership of assets. Moreover, like the prior version of the Report provided in connection with KERT, this Report notes that the significant people function standard is a company-specific determination and that there may not be consistency in such functions even among enterprises in the same industry. According to the Report, the significant people functions relevant to the assumption of risks are those that involve active decisionmaking. Some detail is provided as to how to apply this standard to allocate excess inventory risk and credit risk between the PE and the remainder of the enterprise. In addition, the Report provides some guidance on the allocation of economic ownership of internally developed and acquired intangible property (including both product and marketing intangibles) according to the significant people function standard. These provisions arguably are in contrast to the rules in the current Commentary, which essentially require an apportionment of intangible income and development costs across all parts of the enterprise, and have not been reflected in the Draft Commentary on existing Article 7. Implementation issues. The Report and the Draft Commentary leave ample opportunities for unrelieved double taxation and an increase in Competent Authority requests to resolve controversies. First, the revised approach reflected in these documents still requires many difficult subjective determinations and offers relatively little assistance in making them. For example, neither the Report nor the Draft Commentary provides sufficient guidance on which functions are economically significant, which people functions are significant, which decisions are relevant, and which dealings of the PE should be recognized. Second, the Report and the Draft Commentary sanction inconsistent approaches to the attribution of capital to the PE to support the functions that it performs and the risks and assets attributed to the PE. Deference is given to the approach chosen by the source (host) state if (1) any variances in attribution occur because of conflicts in domestic law and (2) the parties agree that the source state used an authorized approach that results in an arm s-length attribution amount. This tie-breaker rule, however, would not apply where either the source state s domestic law does not provide a capital attribution rule or the member states disagree as to whether the source state s approach produces an arm s-length result. The discussion regarding symmetry, a focus of the prior version of the Report, is conspicuously absent in the current version. The Draft Commentary also raises several difficult implementation issues. It is unclear whether courts would apply the revised Commentary retrospectively as well as prospectively. The OECD s ambulatory approach would encourage retrospective application, to years and even to treaties that predate the revision. It can be argued, however, that treaties are contractual relationships embodying only the parties intent at the time of execution, so that such a retroactive application would be inappropriate. U.S. Treasury and IRS officials have indicated that, although they support the authorized OECD approach, they do not believe they are able to implement any of its provisions without amending existing treaties. This is because Article 7(3) of most U.S. treaties requires a reasonable allocation of certain expenses, which U.S. officials have said they view as inconsistent with the Authorized OECD Approach. The OECD proposed a two-step implementation plan for the Report-(1) immediate and possibly retrospective 14

15 implementation of a relatively ambiguous set of provisions in the Report that are consistent with the current commentary to Article 7, and (2) a delayed implementation, following the second package of revisions to be released in the near future, of changes that, in the OECD s view, can be implemented only after amending existing treaties. This will create significant logical inconsistencies, unintended results, and administrative burdens in the profit attribution regime during the period before the treaties are all renegotiated. In particular, the Draft Commentary incorporates the concept of the PE being engaged in deemed dealings with its head office, and the position that additional profits can be attributable to dependent agent PEs, but retains the current Commentary treatment of intangible property income, presumably to await treaty renegotiation. The absence of a complete and simultaneous implementation of the new approach creates significant risks of over-attribution of profits to PEs and would result in actual implementation of an approach on which the member states did not agree, likely for an extended period as treaties are renegotiated. The final version of the revised Commentary on existing Article 7 is to be released this spring, for inclusion in the 2008 model treaty and Commentary. An amended version of Article 7 and its Commentary also are slated to be released this year for comment, to reflect aspects of the Report, and presumably any subsequent work on its provisions and on Part IV (Insurance), seen as inconsistent with the existing interpretation of Article 7. Canada Transfer Pricing Update The Canada Revenue Agency (CRA) has issued two transfer-pricing memoranda, TPM-09 and TPM-10, and one information circular, Income Tax Information Circular IC 06-1 (the Circular ), that are of particular interest. Also, on September 21, 2007, the Honorable Jim Flaherty, Minister of Finance, signed the fifth protocol ( Protocol ) to the 1980 U.S.-Canada income tax treaty ( Treaty ). 48 The Protocol has not yet been ratified and the U.S. Treasury Technical Explanation has not yet been released. Under Canadian transfer pricing rules, a 10% penalty can apply to transfer pricing adjustment if the taxpayer failed to make reasonable efforts to determine and use arm s-length transfer prices. If the taxpayer does not make or obtain contemporaneous documentation as described in paragraphs 247(4)(a) or (b) of the Income Tax Act ( Act ), the taxpayer will be deemed not to have made reasonable efforts. In addition to these deeming rules, the taxpayer needs to ensure that it makes reasonable efforts, which may be a higher threshold than the contemporaneous documentation pursuant to subsections 247(4)(a) or (b). TPM-09 sheds some light on the CRA s views as to what constitutes reasonable efforts. TPM-09 acknowledges that transfer pricing is not an exact science and requires reasonable judgment by both the tax administration and the taxpayer. The CRA indicates that reasonable efforts means: the degree of effort that independent and competent person engaged in the same line of business or endeavor would exercise under similar circumstances. What is reasonable is based on what a reasonable business person in the taxpayer s circumstances would do, having regarding to the complexity and importance of the transfer pricing issues that arise in the taxpayer s case. The CRA recognizes that the test is not necessarily accuracy, so the criteria for imposition of the penalty focus on the taxpayer s efforts in determining and using arm s-length prices and not solely on the ultimate accuracy of the transfer prices. TPM-09 provides some guidance to taxpayers on how much effort they need to expend. In particular, it states that one of the factors taken into account to determine whether a taxpayer reasonably selected and applied a specified method is whether the taxpayer made a reasonable search for data. For example, it might be reasonable for a taxpayer to devote relatively less effort to find detailed comparable information supporting relatively small controlled transactions than for large transactions. For this purpose, small, controlled transactions may be measured relative to the size of the business. However, it will also be reasonable for taxpayers to devote proportionately more efforts to find comparables for larger, controlled transactions regardless of their relative importance in the taxpayer s business. TPM-09 contains several examples and a sample of cases reviewed by the Transfer Pricing Review Committee (TPRC) in which penalties were under consideration. Taxpayer should review these carefully but in the end they may not provide much guidance in view of the countless factual situations that taxpayers encounter in practice. TPM-10 describes CRA s policy regarding an APA request to cover prior tax years. To obtain a rollback, several criteria must be satisfied, including that a request for contemporaneous documentation has not been issued by a Tax Services Office; the facts and circumstances are the same; the foreign tax administration and the relevant tax services office have both agreed to accept the APA rollback request; and appropriate waivers have been filed. TPM-10 also indicates that effective immediately for any APA for which a pre-filing meeting has not been held, an APA rollback will no longer be permitted where the taxpayer requested a unilateral APA. The Circular attempts to explain why there are differences between transfer prices for income tax purposes and for customs purposes. The main factors that the Circular identifies include: Specific legislation applicable for customs duties purposes vs. the use of guidelines for income tax purposes. Potential use of different methodologies for income tax and customs purposes. Determination of a specific amount for customs purposes vs. a range of acceptable values for income tax purposes. The tendency for income tax purposes to focus on unbundled transaction vs. the need sometimes for customs to require the bundling of certain amounts to arrive at a transaction value. The conflict between the taxpayer s preference to report low value for customs purposes (to minimize customs duties) and high value for income tax purposes (to maximize cost on imported goods). The treatment of disallowed expenses for customs purposes (usually all in 15

16 or all out) vs. for income tax purposes (reasonable in the circumstances). The timing of valuation for customs purposes (time of importation) may differ from the timing for income tax purposes (when the transaction is entered into). Use of exchange rates at different times for customs and income tax purposes. Retroactive downward price adjustments for income tax purposes (e.g., due to Competent Authority settlements) would not be recognized for customs purposes. Longer reassessment periods for income tax than for customs purposes may result in adjustment of only income tax values. The Circular identifies and explains several differences between: The transaction value method for customs purposes and the comparable uncontrolled price (CUP) method for income tax purposes. Transaction value of identical or similar goods vs. CUP. Deductive value for customs purposes vs. resale price for income tax purposes. Computed value for customs purposes vs. cost plus for income tax purposes. The use of other methods for customs and income tax purposes. The Protocol contains four new provisions that are particularly important from an intercompany pricing standpoint. First, in response to the decision of the Federal Court of Appeal in The Queen v. Dudney, 2000 DTC 6169, 49 the definition of PE in Article V of the Treaty will be expanded. In particular, where services are performed by an individual in a contracting state on behalf of an enterprise of the other contracting state and the individual is present in the other state for a period or periods aggregating at least 183 days in any 12-month period and, during that period or periods, more than 50% of the gross active business revenues of the enterprise consists of income from the services performed in that other state by that individual, the enterprise will be deemed to have a PE in that other state. For example, a U.S.-resident individual who performs services at several clients premises for more than 183 days in Canada in any 12-month period could be taxable in Canada even though he would not otherwise have an office or fixed place of business in Canada. In addition, if services are provided in the other state for an aggregate of 183 days or more in any 12-month period with respect to the same or a connected project for customers who either are residents of that other state or maintain a PE in that other state and the services are provided in respect of that PE, the enterprise will also have a PE. This provision should be of great concern, for example, to many corporations that enter into service contracts requiring their employees to be at their client s premises for substantial periods. Second, the voluntary arbitration procedure in Article XXVI(6) of the Treaty will be replaced by a mandatory arbitration procedure. Under the new provision, taxpayers will be able to compel the Competent Authorities to refer a dispute to binding arbitration if they cannot resolve the issue themselves. This arbitration procedure will be mandatory for the revenue authorities but entirely elective for the taxpayer. The procedure will apply to cases that are, when the Protocol enters into force, already being considered under the Treaty s mutual agreement procedure, as well as cases that subsequently come under consideration. The arbitration result will not be binding on the taxpayer but will be binding on the revenue authorities. Accordingly, the taxpayer can still elect to proceed through the domestic appeal channels if it is dissatisfied with the results of the arbitration. To be eligible for arbitration, the case must involve the application of one or more Articles of the Treaty that the Competent Authorities have agreed in an exchange of notes will be the subject of arbitration. Further, it cannot be a particular case that the Competent Authorities agree, before the date that arbitration proceedings would otherwise have begun, is not suitable for determination by arbitration. However, the case may be a particular one that the Competent Authorities agree is suitable for determination by arbitration. In connection with the arbitration procedure, Canada and the United States exchanged diplomatic notes on September 21, 2007, that set out rules and procedures that apply to such arbitrations. In general, each contracting state will have 60 days from the date that the proceeding begins to send a written communication to the other contracting state appointing one member of the Arbitration Board. Within a further 60 days, the two members appointed by the contracting states will appoint a third member who will serve as chair of the board. Within 60 days of appointment of the chair, each of the contracting states is to be permitted to submit proposed resolutions and a supporting position paper. The arbitration board is to deliver a determination in writing to the contracting states within six months of the appointment of its chair. The board will adopt as its determination one of the proposed resolutions submitted by the contracting states. This should encourage settlement negotiations between the two states. A determination by the Arbitration Board will constitute a resolution by mutual agreement under Article XXVI. Each concerned person must, within 30 days of receiving the determination of the Arbitration Board from the Competent Authority to which the case was presented, advise that Competent Authority whether that concerned person is subject to determination of the Arbitration Board. If any concerned person fails to advise the relevant Competent Authority within the required time, the determination of the Arbitration Board will be considered not to have been accepted in that case. Third, the new limitation-on-benefits provisions contained in Article XXIXA, which would now apply for purposes of Canadian as well as United States taxation, may affect the rights of a taxpayer to seek Competent Authority relief for double taxation issues. There are several interpretative issues that may need to be clarified before a taxpayer can be assured of entitlement under the Treaty (see, for example, the submission to the Canadian Department of Finance by the Joint Committee on Taxation of the Canadian Bar Association and the Canadian Institute of Chartered Accountants, dated January 8, 2008). Fourth, under current Canadian rules, LLCs that are fiscally transparent for U.S. tax purposes are not regarded as U.S. residents because they are not subject to U.S. taxation. As a result, they do not qualify for treaty benefits, including Competent Authority, in Canada. The changes proposed in Article IV(6) of the Treaty will entitle the investor in 16

17 an LLC who is resident in the United States to the treaty benefits. Mexico Transfer Pricing Update As of January 2008, in the context of both Mexico s preferential tax regimes rules and provisions dealing with related-party transactions for income tax purposes, the Mexican tax authorities are entitled to determine for tax purposes only that relatedparty transactions are a simulation, i.e., an attempt to avoid taxation by creating a legal structure or entering into transactions that have no real purpose other than tax avoidance. In cases of simulation, the tax effects applicable to the simulated act will be those related to the act that the parties actually intended. The Mexican tax authorities in declaring (through the corresponding tax resolution) that a transaction is a simulation must identify the act so simulated and the one that the parties actually intended, the tax benefit obtained through the simulated act, and the grounds on which the existence of the simulated act was determined. A new single-rate tax on business income (impuesto empresarial a tasa unica or IETU) was recently enacted. The IETU is a minimum corporate tax payable when it exceeds the income tax, levied at the rate of 17.5% (16.5% during FY2008, 17% during FY2009, and 17.5% onwards) and operates on a cash flow method whereas the income tax operates on an accrual method. With respect to transfer pricing rules, for purposes of the IETU, taxpayers are also required to take into account the arm s-length principle in their related-party transactions. There is a risk that the application and interpretation of existing transfer pricing rules with respect to certain taxpayers for example, contract manufacturing programs or maquiladoras will be compromised due to the enactment of the IETU. In addition, an official Presidential Decree was enacted to reduce certain tax burdens that were not considered at the time that the IETU was proposed and enacted, providing partial relief for companies in Mexico s export manufacturing sector and other taxpayers hit hard by the enactment of the IETU, in effect as of January 1, With the Decree, there is a relatively modest adjustment in the base to be used for IETU purposes for maquiladoras that choose to use a transfer pricing study to determine the amount of the payments that they must receive from their foreign affiliates for Mexican income tax purposes. Maquiladoras generally determine their income tax base under special rules in Article 216-BIS of the Mexican income tax law, by electing to either cause their taxable income to be equal to a safe harbor threshold in that Article, or receive a processing fee from a foreign affiliate equal to a normal OECD transfer price plus an amount each year equal to 1% of the value of machinery and equipment made available to the maquiladora on free bailment for use in its manufacturing operations. The Presidential Decree provides that for purposes of calculating their IETU liability, maquiladoras that have elected to use the transfer pricing alternative under Article 216-BIS will need to receive an additional payment in excess of the normal OECD transfer price that is equal to 1.5% (instead of 1%) of the value of the foreign-owned machinery and equipment. This change will apply solely for purposes of calculating the maquiladora s IETU liability. Since there has been no change in the provisions of the October 2003 Presidential Decree (described below), it is likely that the application of the IETU at the rate of 17.5% of the income tax base could result in some increase in the tax burden for most or all maquiladoras. Pursuant to the 2003 Presidential Tax Decree, a maquiladora that falls within the definition provided above is eligible for an income tax exemption calculated by computing the 28% tax that would apply from determining the tax profit (income minus allowable deductions, before net operating losses) that would result from the highest of (1) 6.9% of the assets used in the maquila activities (including assets owned by the nonresident party and, as an election, excluding the value of inventory), or (2) 6.5% of the operating costs and expenses of the Mexican maquiladora (excluding certain expenses and the substitute tax for the credit on salaries and including certain expenses by the nonresidents, such as the salary of the expatriates present in Mexico if such expatriates are present in the country for more than 183 days). Subsequently, the Mexican maquiladora should calculate what the 28% tax would be if the tax profit were computed on the highest of a return of only 3% of the same assets and operating costs and expenses. The difference between the aforementioned calculations is the amount of the income tax exemption. This incentive may eliminate Mexican income tax altogether for many capital-intensive maquiladoras. Although not directly related to transfer pricing, thin capitalization rules established to prevent tax planning based on excessive indebtedness (i.e., to reduce the tax base or to reassign profits or losses at the taxpayer s convenience) remain in force during 2008 by limiting the deduction of interest generated from debts derived from capital taken on loans in excess of three times the stockholders equity. This rule applies only when the debts are contracted with related parties. This limitation does not apply to taxpayers that obtain a favorable APA ruling from the tax authorities that accompany the ruling request with a registered public accountant s transfer pricing study as to the methodology showing that the transaction is at arm s-length. The provision does not state whether the authorization request and report should refer only to the interest-earning financing transaction or to all related-party transactions. This could mean double work for taxpayers with a transfer pricing study. The provision also fails to state the period to be covered by the report. The abovementioned thin capitalization rule does not apply to members of the financial systems in furtherance of their corporate purpose, when they meet the capitalization rules under the applicable laws. On the audit side, the tax administration continues conducting transfer pricing audits of multinationals with substantial net operating losses. Also, in December 2007 (by means of a legal reform enacted in October 2007 to the organizational structure of the tax administration), a general restructuring was carried out within each of the tax administration s tax departments, giving their officials more specialized powers. The transfer pricing department was no exception to this restructuring, which essentially sought to enlarge the tax administration s transfer pricing team and provide transfer pricing officials with more efficient audit powers. 17

18 KEEP TRANSFER PRICING PENALTIES AT ARM S LENGTH! Important Guidance from WG&L! The United States has targeted transfer pricing as an issue of major importance, for both inbound and outbound investments. Therefore, one of the most crucial business and tax considerations for any multinational corporation is how it prices goods, services, and intangibles. WG&L s U.S. International Transfer Pricing examines the case law and regulations and applies those principles to such topics as: Transfer planning studies Presenting positions in the context of litigation or controversy Obtaining an advance pricing agreement (APA) Responding to a summons or examination It explores transfer pricing at work under the constraints of state taxation, customs laws, and other relevant areas. U.S. International Transfer Pricing includes detailed coverage of: The arm s-length standard Essential premises of transfer pricing law The transfer pricing penalty APAs IRS examination and controversy process Don t get caught in the web of complex regulations, risking huge penalties for noncompliance. Let the expert authors of U.S. International Transfer Pricing help you through the planning processes to make the right decisions. Call or visit ria.thomson.com now to learn more about this critical guidance. About the Authors: Sewell, LLP. Associates, New York, New York. Wynne Sewell LLP. INTP6/ Thomson Tax & Accounting. Checkpoint, RIA, PPC and WG&L are registered trademarks of Thomson Professional & Regulatory Inc. Other names and trademarks are properties of their respective owners. TAX & ACCOUNTING 18

19 exhibit 1. apa program staff exhibit 2. Covered Transaction Number of APAs exhibit 3. Transfer Pricing Methods Used for Transfers of Tangible and Intangible Pr 19

20 Exhibit 4. Transfer Pricing Methods Used for Services footnotes 1 - This year s Update was prepared by the following attorneys and economists of Baker & McKenzie LLP and Baker & McKenzie Consulting LLC: Jocelyn A. Belice (San Diego), Salvador M. Borraccia (Toronto), Luis Carbajo-Martinez (Juarez), Elizabeth Chien (San Francisco), Carol Dunahoo (Washington, D.C.), Armin Eberhard (Palo Alto), Paul Ham (Palo Alto), Diana Hickey (Palo Alto), Amber S. Hoffman (Chicago), Ivan A. Morales (Palo Alto), Jorge Narvaez-Hasfura (Mexico City), Pat Powers (Palo Alto), Salim R. Rahim (Washington, D.C.), Tom Respess III (Washington, D.C.), David Stoll (Palo Alto), Gene Tien (Palo Alto), Beth Williams (Palo Alto), Elizabeth Wojcik (Palo Alto). Margreet G. Nijhof (Amsterdam), Elizabeth Chien (San Francisco), and Allison J. Rosendahl (Palo Alto) served as the editors of the article. The above listed attorneys and economists are members of Baker & McKenzie s Transfer Pricing Subgroup of the North American Tax Practice Group. 2 - On April 5, 2007, the IRS released LMSB Industry Director Directive #1 on Transfer of Intangibles Offshore/Section 482 Cost Sharing Buy-in Payment (LMSB ) that provides general guidance, recommends audit techniques and the use of the Checklist for Cost Sharing Arrangements for the development of cost sharing issues, describes published legal guidance, and identifies technical staff available to assist the field. On March 21, 2008, the IRS released additional guidance in LMSB Industry Director Directive #2 on Tier I Issue of Transfer of Intangibles Offshore, Cost Sharing Buy-in Payment (LMSB ) to ensure proper interpretation and treatment for CSA buy-in issue development and valuation methods. Specifically, Directive #2 states that audit teams are expected to comply with the best method rule (Reg (c)). For the reasons stated in the CIP, this rule generally requires that certain unspecified transfer pricing methods described in the CIP be applied to determine the arm s-length result for a buy-in unless there are factual distinctions that would make significant deviations within the CIP methods or some other transfer pricing method more reliable. 3 - The hypothetical base case assumed by the CIP is unlike most real-life situations where the foreign participant brings intangible property to the table or performs substantial functions. 4 - See Reg (b)(1) ( the standard to be applied in every case is that of a taxpayer dealing at arm s length with an uncontrolled taxpayer ); Reg ( If a controlled taxpayer acquires an interest in intangible property from another controlled taxpayer..., the District Director may make appropriate allocations to reflect an arm s length consideration for the acquisition of the interest in such intangible... ). The IRS also has repeatedly promised its treaty partners that it will apply the arm s-length standard to determine Section 482 allocations with respect to cost sharing arrangements. See Article 9 of the 2006 U.S. model income tax treaty ( U.S. model treaty ) and the Treasury Technical Explanation thereto. Similarly, U.S. treaty partners apply the arm s-length standard to CSAs. See OECD model treaty Article 9 and corresponding commentary. 5 - See Xilinx, 125 TC 37 (appeal pending to 9th Circuit) (discussed in the text below); Bausch & Lomb, 92 TC 525, aff d 67 AFTR 2d , 933 F2d 1084, 91-1 USTC ; Sundstrand Corp., 96 TC 226. See also Reg (f)(2)(ii); Preamble, TD 8552, CB 93, TD 9088, August 25, Prop. Reg (REG ). See Kirschenbaum, Lemein, Levey, Litsky, McClellan, and Rahim, Proposed Cost Sharing Regulations Introduce New Standards, 16 JOIT 14 (December 2005). 8 - Levey, et al., Intercompany Service and Intangible Transactions: Temporary Regulations Respond to Taxpayer Criticisms, 17 JOIT 15 (November 2006). 9 - Ann , IRB 751. The annual report is issued under section 521(b) of P.L , Ticket to Work and Work Incentives Improvement Act of 1999, which requires the Secretary of the Treasury to report annually to the public on APAs and the APA program Unilateral (28) and bilateral (64) Unilateral (26), bilateral (54), and multilateral (1) See Eighth Annual APA Report: Completions Increase Substantially, 18 JOIT 5 (May 2007)) Unilateral (13) and bilateral (16) Unilateral (6) and bilateral (2) PLIs used with the CPM of Reg , and as used in the TPM tables in Exhibits 3 and 4, are (1) operating margin (ratio of 20

21 operating profit to sales); (2) Berry ratio (gross profit to operating expenses); (3) gross margin (gross profit to sales); (4) markup on total costs (percentage markup on total costs); and (5) rate of return on assets or capital employed (operating profit to operating assets) Ann , supra note 9, Attachments A and B Ann , IRB See Moses, Officials Address Factors Considered by IRS In Recommending Transfer Pricing Penalties, BNA Daily Tax Report (May 15, 2007), page G Directive #1, supra note 2. See gov/businesses/article/0,,id=169313,00. html Id. See text under heading CIP on Cost- Sharing Buy-In Adjustments 21 - LMSB , September 27, CCA , BNA Daily Tax Report, July 23, 2007, TaxCore See TEI Comments on T.D. 9278, Rev. Proc on Allocation of Income, Deductions From Intangibles, Stewardship Expenses in Controlled Services Transactions, BNA Daily Tax Report (November 29, 2007), TaxCore LMSB , February 7, See Mendez-Torres, The Internal Revenue Code s Role in Puerto Rico s Economic Development, 15 JOIT 22 (February 2004) See text at note 8, supra See IRS Guidance on Requesting Competent Authority Assistance, 18 JOIT 5 (February 2007) Rev. Proc , sections 7.02, 7.06, 8.04, Factoring of Receivables: Audit Technique Guide, LMSB , June 29, Factors are entities that provide any of the following services: (1) investigation of credit risk of client s customers; (2) assumption of customers credit risk; (3) collection of client s accounts receivable from customers; (4) bookkeeping and reporting services related to accounts receivable; (5) provision of expertise related to disputes, returns, and adjustments; and (6) advancing or financing Although the ATG was prepared for federal examiners, state courts have been actively applying Section 482 principles to cases involving factoring. Rulings from Virginia, in particular, outline the use of economic substance arguments to force the consolidation of two state returns. See Virginia Dept. of Tax n, PD and PD 03-57, August 8, 2003; 12 BNA Transfer Pricing Rep t 356 (September 17, 2003); Matter of Hallmark Marketing Corp., N.Y.S. Div. of Tax App., DTA No , January 26, 2006, ; 14 BNA Transfer Pricing Rep t 958 (March 15, 2006) The ATG briefly addresses PE issues by requesting evidence of whether the foreign entity was conducting an active trade or business in the U.S The ATG refers to the Preamble as the source for this example. Reg P-2(h), Example 5(i)(C), uses 0.35% and 0.70% only as quantitative reference points for the case study, which may or may not be appropriate for the risk profile of any given company and industry For a more detailed discussion, see Baker & McKenzie Transfer Pricing Annual Update, Intercompany Service/Intangibles Regulations, 17 JOIT 16 (December 2006) Typical arrangements, by definition, occur in routine, categorical circumstances. Assessment of non-routine arrangements with typical transactions may not properly treat entrepreneurial risk and return The Virginia rulings argued that a nonrecourse factoring arrangement with no discount was not at arm s length because it did not resemble a typical transaction Under a combined reporting system, the income and apportionment factors of the group of entities linked through ownership or flows of value are taken into account N.Y. Tax Law section 211(4)(a). The law defines related corporation as (1) any corporation that owns or controls, either directly or indirectly, substantially all (80% or more threshold test) of the capital stock of the taxpayer; (2) any corporation that has substantially all (80% or more threshold test) of its capital stock owned or controlled, either directly or indirectly, by the taxpayer; and (3) any corporation the capital stock of which is owned or controlled, directly or indirectly, by interests that own or control, directly or indirectly, substantially all of the taxpayer s capital stock N.Y. TSB-M-07(6)C Lanco, Inc. v. Director, Div. of Tax n, 908 A2d 176, cert. den. U.S.S.Ct., June 18, West Virginia Tax Comm r v. MBNA America Bank, N.A., 640 SE2d 226, cert. den. U.S.S.Ct., June 18, Quill Corp. v. North Dakota, 504 US 298, 119 L Ed 2d N.H STT Ala. Ct. Civ. App., Dkt. No , February 8, rev g Ala. Cir. Ct., Dkt. No. CV , January 24, Ala. Code section (b) Fleet Funding, Inc. v. Commissioner of Revenue, C , February 21, K.Y CA , October 12, Earlier, Autozone had lost a case in Louisiana involving the same structure after the Louisiana Supreme Court held that Louisiana could tax the parent of the REIT on receipt of the dividends. Bridges v. Autozone Properties, Inc., 900 So 2d 784 (La., 2005) See Kingissepp, Long-Awaited Protocol to Canada-U.S Tax Treaty Provides Significant Benefits, 18 JOIT 22 (December 2007) See Van Der Hout, U.S. Consultants Providing Services to Canadians Win Major Court Victory, 11 JOIT 41 (May 2000). 21

22 Corporate Solutions from thomson Reuters Workflow - Software - Services - Consulting - Data Management - Research ONESOURCE Income Tax ONESOURCE Property Tax ONESOURCE Manager ONESOURCE Sales & Use Tax ONESOURCE Trust Tax Domestic & International Commercial Real Estate WorkFlow Manager Business License Management Trust Tax Services Federal & State Compliance Complex Property Tax Calendar Corporate Registered Agent Trust Tax Software 1099 Reporting Property Tax Compliance Data Exchange Sales & Use Tax Compliance Trust 1099 Solutions FAS 109 Telecom Regulatory Compliance Estate & Trust Administration FIN 48 Exemption Certificate Management Estate Planner Fixed Assets Tax Rate Subscription Court Accounting Global Tax Planning Provision Transfer Pricing SPEED. DEPENDABILITY. TEAMWORK. DELIVERED ON THE ONESOURCE TAX PLATFORM. transfer pricing insider is published by: The Tax & Accounting business of Thomson Reuters One New York Plaza, 34th Floor New York, New York Monmouth House City Road London EC1Y 2AL, United Kingdom xbsolutions.com Content source WG&L Journal of International Taxation Volume 19, Number 06, June Thomson Reuters/ONESOURCE. All Rights Reserved. 8/08 tax & accounting