Section 482 Allocations: General Principles in the Code and Regulations (Portfolio 551)

Tax Management Portfolio, Section 482 Allocations: General Principles in the Code and Regulations, No. 551-2nd, examines the history of §482 and the regulations thereunder, explores the relationship between §482 and general federal income tax principles and doctrines, and analyzes the general principles in the Code and regulations dealing with §482. To view this Portfolio, visit Bloomberg Tax for a free trial.

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Description

Tax Management Portfolio, Section 482 Allocations: General Principles in the Code and Regulations, No. 551-2nd, examines the history of §482 and the regulations thereunder, explores the relationship between §482 and general federal income tax principles and doctrines, and analyzes the general principles in the Code and regulations dealing with §482.

This portfolio is a companion to 552 T.M., Section 482 Allocations: Specific Allocation Methods and Rules in the Code and Regulations, and 553 T.M., Section 482 Allocations: Judicial Decisions and IRS Practice.

This portfolio may be cited as Lepard, 551-2nd T.M., Section 482 Allocations: General Principles in the Code and Regulations.

Authors

Brian D. Lepard

Brian D. Lepard is Law Alumni Professor of Law at the University of Nebraska College of Law, where he has taught the basic course on federal income taxation and courses on international aspects of U.S. income taxation, corporate tax, partnership tax, tax policy, and business planning. He is the author of Tax Management Portfolio No. 551, Section 482 Allocations: General Principles in the Code and Regulations, Tax Management Portfolio No. 552, Section 482 Allocations: Specific Allocation Methods and Rules in the Code and Regulations, and Tax Management Portfolio No. 553, Section 482 Allocations: Judicial Decisions and IRS Practice.

Professor Lepard has written additional scholarly works on transfer pricing, including a chapter in his book, Customary International Law: A New Theory with Practical Applications, published in 2010 by Cambridge University Press. He is the principal co-author of BNA's Health Law & Business Portfolio No. 2000, Unrelated Business Income Tax Issues in Health Care (1996). Before becoming a professor of law he worked for six years as an associate at the Philadelphia law firm of Dechert Price & Rhoads, where he practiced tax law with an emphasis on the international aspects of U.S. income taxation and the taxation of exempt organizations.

Author's Note: I am grateful to Prof. Reuven Avi-Yonah of Michigan Law School for inviting me to take on this project and for his helpful advice, to Leonard Silverstein for his patient encouragement and support, to my research assistants, Michael Suberly and Paul Butler, for their invaluable assistance in the research and preparation of the portfolio, and to my secretaries, Darlene Svancara, Vicki Lill, Marcy Tintera, Bambi King, and Ann Chalupa, without whose help the manuscript could not have been completed. I also appreciate the support of Deans Nancy Rapoport, Steven Willborn and Susan Poser of the University of Nebraska College of Law and the financial support for the research of the portfolio provided by the Ross McCollum Fund.

Table of Contents

Detailed Analysis
I. Introduction
A. The Function of §482 and a Brief History
1. The Code
2. Congress's Purposes in Enacting §482
3. The Regulatory History
B. An Example of Income Shifting and Possible Incentives for Income, Deduction, or Credit Shifting
C. An Overview of Alternative Allocation Methods
1. A Continuum of Allocation Methods
2. Consolidation
3. Formulary Apportionment of Total Profits
4. Formulary Apportionment of Transactional Profits
5. Formulary Apportionment of Individual Items of Gross Income
6. Formulary Apportionment of Individual Deduction Items
7. Transactional Profit Split Methods
8. The Comparable Profits Method
9. Deemed Transfer Prices
10. Traditional Arm's-Length Methods of Determining Transfer Prices
a. The Comparable Uncontrolled Price Method
b. The Resale Price Method
c. The Cost Plus Method
D. IRS Practice in Pursuing Domestic §482 Cases
E. Organization of the Portfolio
II. A Brief History of §482
A. Early Predecessors
B. The 1954 Code
C. The 1986 Code
III. A Brief History of the Regulations Under §482
A. Introduction
B. The Pre-1962 Regulations
C. The 1962 Regulations
D. The 1965 and 1966 Proposed Regulations
E. The 1968 Regulations
F. The 1986 Legislation and the 1988 “White Paper”
G. The 1992 Proposed Regulations
H. The 1993 Temporary Regulations and Proposed Regulations
I. The 1994 and 1995 Final Regulations and Regulatory Developments Through 2004
J. Regulatory Developments After 2004
K. The Authority of the Regulations
L. Summary
IV. The Statutory and Regulatory Context for §482: An Overview of General Federal Income Tax Principles and Doctrines
A. Introduction
B. Distinguishing Unrelated Taxpayers, Related but Uncontrolled Taxpayers, and Controlled Taxpayers
C. General Principles Applying to All Taxpayers
1. Overview
2. The Separate Taxable Entity Principle
a. In General
b. The Assumption that Taxpayers Have an Incentive to Maximize Their Economic Gain Relative to Other Taxpayers
c. Tax Advantages that Can Be Gained by Shifting Income, Deductions, or Credits Among Different Taxpayers
d. Exceptions to the Separate Taxable Entity Principle
(1) Statutory Exceptions
(2) Regulatory and Judicial Exceptions
(a) Tax “Evasion” Versus Tax “Avoidance”
(b) The Sham Entity Doctrine
(c) The Sham Transaction Doctrine
(d) The Substance over Form Doctrine
(e) The Economic Substance Doctrine
(f) The Business Purpose Doctrine
(g) The True Earner Principle
(h) The Assignment of Income from Property Doctrine
(i) The Step Transaction Doctrine
(j) Congressional Intent
3. The Realization Principle
a. In General: Separate Entities Are Only Taxed on Income Realized and Can Only Deduct a Loss Sustained
b. Relevant Code and Regulations Provisions Relating to Income
c. Relevant Code and Regulations Provisions Relating to Losses and Deductions
d. The Principle that the Amount, Character, and Timing of Realized Income or a Realized Deduction Depends on the Type of Transaction that Generated It
(1) Income from and Expenses of Compensation for Services
(2) Income from and Expenses of a Trade or Business
(3) Income and Expense from the Sale, Exchange, or Other Disposition of Property
(4) Income and Expense Related to the Sale of a Business
(5) Interest Income and Expense
(6) Rental Income and Expense
(7) Royalty Income and Expense
(8) Dividend Income and Expense
(9) Income and Expense from the Discharge of Indebtedness
(10) Income and Expense Related to the Distributive Share of Partnership Gross Income
(11) Income and Expense Related to an Interest in an Estate or Trust
(12) Other Forms of Income
(13) Summary
4. The Recognition Principle: Code Provisions Affecting Whether and When Realized Income Is Recognized
5. Accounting Requirements
a. The Clear Reflection of Income Requirement in §446(b)
b. Primary Annual Accounting Methods
c. Appropriate Matching of Income and Deductions
d. Interpretation of the Clear Reflection of Income Requirement
6. A Principle of No Imputed Income
a. The Principle of No Imputed Income from Foregone Transactional Opportunities
b. The Principle of No Imputed Income from Foregone Revenue Opportunities
(1) The General Principle
(2) Statutory Exceptions to the General Principle
c. The Principle of No Imputed Income from Self-Performed Services or from the Use of Taxpayer-Owned Property
d. The Principle of No Imputed Income from Unrealized Appreciation
e. The Principle of No Imputed Income from Indirect Benefits
f. Policy Rationales for the Principle of No Imputed Income
7. A Principle of No Imputed Deductions
a. The Principle of No Imputed Deductions for Expenses of Foregone Transactions
b. The Principle of No Imputed Deductions for Transactional Expenses Not Incurred
c. The Principle of No Imputed Deductions for Unrealized Depreciation
d. Policy Rationales for the Principle of No Imputed Deductions
e. Exceptions to the General Principle of No Imputed Deductions
8. The Bargaining Flexibility Principle
a. Compensation for Services
b. Business Profits
c. Income from the Sale or Exchange of Property
d. Income from the Sale or Exchange of a Business
e. Interest on Loans
f. Rents
g. Royalties
h. Distributive Share of Partnership Gross Income
9. A Related Principle of Flexibility in the Use of Various Valuation Methods by the Parties or by Courts
D. General Principles Applying to Controlled Taxpayers
1. Why Controlled Taxpayers Must be Treated Differently from Unrelated Taxpayers
2. Employers and Employees
3. Corporations and Majority Shareholders
4. Partnerships and Controlling Partners
5. Trusts and Controlling Beneficiaries, Trustees, or Grantors
6. Summary
E. General Principles Applying to Related but Uncontrolled Taxpayers
1. Why Related but Uncontrolled Taxpayers Must Be Treated Differently from Unrelated Taxpayers or Controlled Taxpayers
2. Employers and Employees
3. Corporations and Minority Shareholders
4. Partnerships and Minority Partners
5. Trusts and Uncontrolling Beneficiaries, Trustees, or Grantors
6. Summary
V. The Use of Particular Allocation Methods in Other Provisions of the Code and Regulations
A. Introduction
B. Consolidation
1. Consolidated Returns of Corporations
2. Controlled Groups of Corporations
3. Qualified Subchapter S Subsidiaries
4. Consolidated Trusts
5. Analysis
C. Formulary Apportionment of Total Profits
D. Formulary Apportionment of Transactional Profits
E. Formulary Apportionment of Individual Income Items
F. Formulary Apportionment of Individual Deduction Items
G. Transactional Profit Split Methods
H. Analysis of Comparable Profits
I. Analysis of Fair Market Value
J. References in the Code and Regulations (Other than Under §482) to an Arm's-Length Price or Transaction
VI. Some Problems of Interpretation Under the Statute
A. Introduction
B. The Relationship of §482 to Other Code Provisions
C. Definitions of “Organizations, Trades or Businesses”
1. The Statutory Purpose of the Language: A Codification of General Anti-Tax Avoidance Principles for All Taxpayers or a Focus on Income Shifting Among Businesses Only?
2. The Provisions of the Regulations
D. Definition of “Owned or Controlled Directly or Indirectly by the Same Interests”
1. The Statutory Language
2. The Regulations
3. Definition of “Control”
4. Definition of “Ownership”
E. The Meaning of “Allocation”
1. The Creation of Income Doctrine and the Commissioner's Authority to Impute Unrealized Income
2. Allocation of Deductions as Well as Income
F. Tax Evasion Not a Prerequisite to an Allocation
1. The Statute
2. The Legislative History
3. The Regulatory History
G. Discretionary Application of §482
VII. Interpreting the Arm's-Length Standard in the Regulations
A. Introduction
B. Historical Evolution
1. International Codification Efforts During the League of Nations Era
2. The 1935 Regulations
3. The 1943 Mexico and 1946 London Models and the 1963 OECD Model Convention
4. The 1968 Regulations
5. The 1977 OECD Model Convention and the 1979 OECD Transfer Pricing Guidelines
6. The 1979 U.N. Model Convention
7. The 1988 White Paper
8. The 1992 OECD Model Convention and Its Successors, and the 1995 and 2010 OECD Transfer Pricing Guidelines
9. The 1994 Regulations
C. The Arm's-Length Standard and General Tax Principles and Doctrines
1. Relationship of the Arm's-Length Standard with Principles and Doctrines in the Code Applying to All Taxpayers
2. Relationship of the Arm's-Length Standard with Principles and Doctrines in the Code Applying to Controlled Taxpayers
3. Relationship of the Arm's-Length Standard with Principles and Doctrines in the Code Applying to Related But Uncontrolled Taxpayers
D. Two Possible Interpretations of the Arm's-Length Standard
E. The Relationship Between the Arm's-Length Standard and Other Allocation Methods, Including Arm's-Length Methods
F. Some Specific Problems Relating to Interpretation of the Arm's-Length Standard
1. The Meaning of “Uncontrolled Taxpayers”: Does “Uncontrolled” Mean “Unrelated” or Could It Also Encompass “Related But Uncontrolled Taxpayers” or Even “Controlled Taxpayers”?
2. Role of the Actual Transaction Undertaken
3. A Focus on Results, Not Methods
VIII. The Structure of the 1994 Regulations and the Best Method Rule
A. The Purpose and Scope of §482
B. General Description of Categorical Transfer Pricing Methods
1. The Transactional Categories
a. Under the 1994 Regulations
b. Comparison with Earlier Regulations
2. Taxpayers Filing Consolidated Returns
3. Compulsory Consolidation No Longer Prohibited
C. The Arm's-Length Standard and Best Method Rule
1. In General
2. Comparison with Earlier Regulations
3. Determining the Best Method Under the Best Method Rule
4. Extent to Which Competing Transfer Pricing Methods Must Be Considered
5. Code Recharacterization of Transactions
6. Critique of the Best Method Rule
D. Comparability Under the Best Method Rule
1. In General
2. Comparability Factors
a. Functional Comparability
b. Contractual Terms
(1) General Rules
(2) Examples of the General Rules
(a) Differences in Volume
(b) Reliability of Adjustment for Differences in Volume
(c) Contractual Terms Imputed from Economic Substance
(d) Non-Arm's-Length Compensation
c. Risk Evaluation
(1) In General
(2) Examples
d. Economic Conditions
e. Property or Services
3. Special Circumstances
a. Market Share Strategy
b. Different Geographic Markets
(1) In General
(2) Example
c. Location Savings
(1) In General
(2) Example
4. Unacceptable Comparables
a. Illustration of a Transaction Not in the Ordinary Course of Business
b. Illustration of a Transaction Whose Principal Purpose Is to Establish an Arm's-Length Result
E. Data and Assumptions
F. The Arm's-Length Range and the Standard of Review
1. The Arm's-Length Range — In General
2. Selecting Comparables
3. Ranking the Reliability of Comparables
4. Limitation on Comparable Results Included in Arm's-Length Range
5. Definition of the Interquartile Range
6. Adjustments When Controlled Party Results Are Outside the Arm's-Length Range
7. Arm's Length Range Not a Prerequisite to Allocation
8. Examples of Application of the Arm's-Length Range
a. Selection of Comparables
b. A Case in Which the Arm's-Length Range Consists of All the Results
c. A Case in Which the Arm's-Length Range Is Limited to the Interquartile Range
d. Another Case in Which the Arm's-Length Range Is Limited to the Interquartile Range
G. Transactional Analysis Under §482
1. “Transaction” Defined
2. Aggregation of Transactions
3. Product Lines and Statistical Techniques
4. Consideration of Alternatives Reasonably Available to the Taxpayer
5. Consideration of Multiple Year Data
H. No Safe Harbor for Small Taxpayers

Working Papers

Table of Worksheets
Worksheet 1 Income Shifting Example
Worksheet 2 A Continuum of Allocation Methods
Worksheet 3 Consolidation Example
Worksheet 4 Formulary Apportionment of Total Profits Example
Worksheet 5 Formulary Apportionment of Transactional Profits Example
Worksheet 6 Formulary Apportionment of an Individual Item of Income Example
Worksheet 7 Formulary Apportionment of an Individual Item of Deduction Example
Worksheet 8 Transactional Profit Split Method (the Comparable Profit Split Method) Example
Worksheet 9 Comparable Profits Method Example
Worksheet 10 Deemed Transfer Price Example
Worksheet 11 Comparable Uncontrolled Price (“CUP”) Method Example
Worksheet 12 Resale Price Method Example
Worksheet 13 Cost Plus Method Example
Worksheet 14 The 1935 Regulations