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By Michael F. Patton, Esq.
"Insanity: doing the same thing over and over again and expecting different results."Albert Einstein
In July 2011, Samuel Maruca, the IRS Transfer Pricing Director, gave a fairly wide-ranging interview covering a number of topics, including the selection, examination, and litigation of transfer pricing cases. A summary of the interview is set forth at 20 BNA Tax Mgmt. Transfer Pricing Rpt.250 (7/14/11), and the full text of the interview appears at page 260 of the same issue. One of the justifications for having a Transfer Pricing Director that was put forward by IRS officials was to focus the IRS transfer pricing enforcement and litigation efforts. In remarks made at a conference in June 2011, Mr. Maruca indicated that these efforts include an effort to produce "winners" for the IRS in transfer pricing litigation.
Transfer pricing cases currently pending before the Tax Court include a case involving a reorganization of the foreign Western Union operations of First Data Corporation in which it has been reported that the taxpayer valued the compensable intangibles that were transferred at $14.3 million, while the IRS has valued the compensable intangibles at $2.7 billion. 18 BNA Tax Mgmt. Transfer Pricing Rpt. 45 (5/28/09). The First Data case reportedly involves the interplay between transfers of non-compensable foreign goodwill and going concern value and compensable intangible property. In addition, a multi-billion dollar set of transfer pricing cases involving two affiliates of Boston Scientific Corp. is pending in the Tax Court. 19 BNA Tax Mgmt. Transfer Pricing Rpt.1348 (4/21/11). Both the First Data and Boston Scientific cases involve transfers that are subject to §§482 and 367(d). Sections 482 and 367(d) share a common statutory definition of "intangible property," which is found in §936(h)(3)(B). In addition, the "commensurate with income" provision applies to transfers of intangible property that are governed by §§482 and 367(d).
In his interview, Mr. Maruca said:
As far as litigation is concerned, the goal is to pursue only those matters in which we can make a strong case for meaningful adjustments or legal principles we'd like to establish….As I have already said, we need to take a thoughtful approach to both case identification and case development. This includes in the cost sharing area. If that means that we will be perceived as taking a "new" approach, at least in some cases, so be it.
Shortly before Mr. Maruca was appointed, the IRS published informal CCA 201111013 that relates to the development of a pending case involving the transfer of intangibles in a context other than a cost-sharing arrangement. The informal advice (which appears to be an e-mail from the National Office) traces the internal development of the IRS litigating positions that are set forth in the cost-sharing Coordinated Issue Paper (CIP) published in 2007. The memo explains that the "income method" theories set forth in the CIP should not be limited to cost-sharing situations, but should apply more broadly, including situations where a U.S. pharmaceutical company "gives" an opportunity to a foreign affiliate to develop intangibles. The memo then goes on to say:
One thus needs other methods. More than that, one needs a new approach to valuation, relying less on comparables and more on fundamental financial principles. (One normally cannot find good comparables for the rights to further develop a company's core valuable intangibles, because such rights normally have a unique profit potential not directly reflected in the marketplace. See CIP, section III.C.) [redacted data] … [T]he IRS position is that the economic result should control: there is in general no legal loophole to avoid full economic compensation, and methods that deny full compensation should be rejected.
A prime reason for the appointment of a Transfer Pricing Director and the search for litigation "winners" would appear to be the recent IRS losses in the Veritas Softwareand Xilinxcases. In Xilinx,the taxpayer submitted evidence that third parties acting at arm's length in circumstances comparable to a cost-sharing arrangement would not share the cost of stock options as an intangible property development cost. The IRS argued in Xilinxthat whether parties at arm's-length would share stock option expense was irrelevant because, by incorporating the commensurate-with-income standard into §482 in 1986, Congress envisioned that an arm's-length result could be determined by "…economic analysis… that is not grounded solely in comparison to uncontrolled transactions." The decisions of both the Tax Court and the Court of Appeals in Xilinx soundly reject this assertion by the IRS.
Rejection by the courts of transfer pricing adjustments based upon IRS assertions of what parties would do if they were dealing at arm's length and acting as rational economic beings is nothing new. The Second Circuit rejected similar arguments in the U.S. Steelcase as did the Tax Court and the Second Circuit in the Bausch & Lombcase. Similarly, in a long line of cases the Tax Court rejected the notion that controlled license transactions should be treated as if the controlled parties had entered into a contract manufacturing arrangement, because contract manufacturing was the preferred transaction if parties were acting at arm's length under similar circumstances. The cases that rejected the IRS arguments began with the Eli Lillycase and were followed by the G.D. Searle, Bausch & Lomb, and Sundstrandcases.
Likewise, courts have rebuffed IRS efforts to require taxpayers to adhere only to transfer pricing methods that comport with economic theory:
[T]he more imperfect the market, the more likely it is that "arm's length" transactions will take place at prices which are not perfect market prices. To use §482 to require a taxpayer to achieve greater fidelity to abstract notions of a perfect market than is possible for actual non-affiliated buyers and sellers to achieve would be unfair ….1
To posit that B&L, the world's largest marketer of soft contact lenses, would be able to secure a more favorable price from an independent manufacturer who hoped to establish a long-term relationship with a high volume customer may be to recognize economic reality, but to do so would cripple a taxpayer's ability to rely on the comparable-uncontrolled-price method in establishing transfer pricing by introducing to it a degree of economic sophistication which appears reasonable in theory, but which defies quantification in practice.2
Following the loss in the Veritas Software case, the IRS published an AOD in which the IRS disagreed with both the factual findings and the legal conclusions of the Tax Court. IRS officials have indicated that they are looking for other cases to litigate the issues that were lost in Veritas Software. While the loss in Veritas Softwareis partly attributable to the facts in that case, especially the short commercial useful life of the pre-existing intangibles that were transferred, the IRS presented, and the Tax Court rejected, the full range of arguments set forth in the cost-sharing CIP. Similar to the excerpt from the recent CCA quoted above, the IRS arguments in Veritas Softwareconflated the identification of the "intangible property" that was subject to §482 with the determination of the value of the transferred "intangible property." Thus, the IRS argued all projected income in excess of a routine return that was assumed to arise in the future for an indefinite period was deemed to be attributable to the transferred platform contributions. The Tax Court rebuffed these arguments pointing out that intangible property subject to §482 was a statutorily defined term that excluded, for example, income attributable to services, income arising from goodwill and going concern value, and income attributable to the efforts of the transferee.
Choosing a "better" factual vehicle is not going to change a "loser" for the IRS into a "winner" if the IRS presents the same legal arguments about the arm's-length standard to support the foregone profits and income method theories that were made in Xilinxand Veritas Software. The basic reason for those losses was that the legal theories upon which the IRS adjustments were based are not sound. To return to Mr. Maruca's stated mission and to the originator of the theory of relativity:
"We cannot solve our problems with the same thinking we used when we created them."Albert Einstein
This commentary also will appear in the September 2011 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Maruca and Warner, 886 T.M., Transfer Pricing: The Code, the Regulations, and Selected Case law,and Stark and Blanchard, 893 T.M., Transfer Pricing: Litigation Strategy and Tactics, and in Tax Practice Series, see ¶3600, Section 482 — Allocations of Income and Deductions Between Related Taxpayers.
1 U.S. Steel Corp. v. Comr., 617 F.2d 942, 949-51 (2d Cir. 1980).
2 Bausch & Lomb v. Comr., 92 T.C. 525, 588 & 591 (1989), aff'd, 933 F.2d 1084 (2d Cir. 1991).
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