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By David Ernick, Esq. PricewaterhouseCoopers LLP Washington, D.C.
The U.S. rules for transfer pricing are set forth in §482 , which authorizes the IRS to allocate gross income, deductions, credits, and other allowances among two or more organizations, trades, or businesses under common ownership or control whenever “necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.” The objective of §482 is to place “a controlled taxpayer on a tax parity with an uncontrolled taxpayer by determining the true taxable income of the controlled taxpayer.” “True taxable income” is determined by comparing transactions between commonly controlled taxpayers against comparable transactions between unrelated persons dealing at arm's-length.
The arm's-length standard thus is set forth in the beginning of the §482 regulations, as the foundation upon which the rules are constructed. Reg. §1.482-1(b)(1) makes it clear that the arm's-length standard must be applied “in every case.” Determining whether the arm's-length standard has been met necessarily requires that empirical evidence of how unrelated parties price transactions cannot be ignored.
The arm's-length standard has long been the bedrock of the transfer pricing rules in the United States, and has also evolved into a nearly worldwide standard for allocating income among members of a multinational enterprise. However, temporary regulations issued under §482 (T.D. 9738) (the “Temporary Regulations”) on September 14, 2015, raise questions about whether a fundamental change in transfer pricing under the §482 regulations is intended.
Instead of the traditional focus on ensuring that related parties achieve pricing consistent with the arm's-length standard, Reg. §1.482-1T(f)(2)(i)(A) provides that arm's-length compensation must be consistent with, and must account for all of, the “value” provided between the parties in a controlled transaction, without regard to the form or character of the transaction.
No definition of the term “value” is provided, although it is clear that the concept of “value” is meant to be an integral part of the new paradigm. The Temporary Regulations reference “value” — in various iterations, such as “value provided,” “transfer of value,” “all value,” “any value,” “full value,” “overall value,” “interrelated value,” and “embedded value” — 45 times (including the Preamble), which is striking in such a relatively short set of regulations. The repeated references seem to indicate that this is an important new concept to be incorporated into the transfer pricing rules.
In trying to surmise the intended meaning of “value” in the Temporary Regulations, several possibilities are plausible. It could be that “value” is intended to mean exactly the same thing as arm's-length pricing. That definition is supported by the statement in Reg. §1.482-1T(f)(2)(i)(A) that “all value provided between controlled taxpayers in a controlled transaction requires an arm's-length amount of compensation determined under the best method rule of §1.482-1(c) .” It could be that “value” is used loosely to mean the same thing as arm's-length pricing, and that, that statement is intended to be tautological.
However, it also could be the case that “value” is intended to mean something different than arm's-length pricing. It could be that “value” is intended to refer to “fair market value,” which is defined explicitly for purposes of the estate and gift taxes. If that is the case, it is uncertain if “fair market value” and arm's-length pricing are the same thing.
It could also be that the Temporary Regulations intend the concept of “value” to be defined as it is in economics generally — by reference to the benefit provided by a good or service to any particular owner of goods or user of services. In that sense of the word, “value” would mean something different than arm's-length pricing.
For example, basic economic theory holds that price is not determined by value, but rather by the intersection of the supply and demand schedules. Value plays a role in that determination, by determining what the demand part is. Very simply, a supply schedule shows the relationship between the price of a good and the quantity supplied. As a general matter, firms will produce additional output while the cost of producing an extra unit of output is less than the price they would receive. Thus, as the price of a good decreases, the amount supplied will drop.
Also, a demand schedule represents the amount of goods that buyers are willing and able to purchase at various prices; as price decreases, consumers will buy more of the good. The demand schedule is determined by consumers' marginal utility — that is, the utility or “value” of that good to any particular consumer. Under traditional economic models of price determination in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded will equal the quantity supplied, resulting in an economic equilibrium for price and quantity transacted.
A key consequence of determining market prices by reference to the intersection of the supply and demand schedules is that the price at which a consumer could purchase a good in an open, competitive market can vary from its value, and that consumers may assign many different “values” to the exact same good, depending on their own unique circumstances and the marginal utility of that good to them. Where the marginal utility, or value, of a good to a consumer is below the price, that consumer will not purchase the good. Where the marginal utility, or value, of a good to a consumer is equal to or greater than the price, the consumer will purchase the good. “Consumer surplus” is the term economists use to describe the monetary gain obtained by consumers who are able to purchase a good for a price that is less than the highest price that they would be willing to pay for it.
For example, if a potential purchaser would value Widget at $10 based upon the benefit it could receive from using Widget in its business, it would be willing to pay anything less than or equal to $10 for it. If the market price is $6, that purchaser will purchase Widget and enjoy $4 of consumer surplus. But other potential consumers may have a different utility and assign a different value to Widget. Those who have a lower value would enjoy less consumer surplus, and those who assign a value to Widget of less than $6 would not purchase it at a $6 price.
Without further clarification in the final regulations, concern arises that in examinations IRS agents will apply the new “all value” concept in the Temporary Regulations in the economics sense of that term, inconsistently with the concept of arm's-length pricing. Example 6 in the Temporary Regulations illustrates just such a situation.
In that example, P conducts a business from the United States, and in setting up new foreign operations engages in a series of related-party transactions. First, on Date X, Year 1, P contributes (in a §351 transaction) the foreign rights to conduct a business, including the foreign rights to certain intangibles, to newly incorporated S1. Second, on later Date Y, Year 1, P and S1 enter into a cost sharing arrangement (“CSA”) to develop and exploit the rights to conduct the business. Under the CSA, P is entitled to the U.S. rights to conduct the business, and S1 is entitled to the rest of world rights to conduct the business. Third and finally, after Date Y, P performs certain support services (including R&D, marketing, manufacturing process enhancement, and oversight activities) to maintain and improve the intangibles transferred to S1.
The example concludes that rather than determining the arm's-length prices of the three separate transactions at the times at which they were entered into, the IRS instead may consider the economic substance of the entire arrangement between P and S1, including the parties' actual conduct throughout their relationship. That approach reflects a significant departure from the traditional “ex ante” approach in the §482 regulations of determining arm's-length pricing at the time transactions are entered into. It seems to incorporate the “ex post” version of determining pricing from the commensurate-with-income rules, which look to events occurring subsequent to the date of related-party transactions.
It also is notable that instead of determining arm’s-length pricing (arm's-length price is not mentioned in the example), Example 6 concludes that the IRS may impute one or more agreements between P and S1, in order to reflect “the full scope of the value provided between the parties.” (Emphasis added.) One agreement that the example purports to give the IRS the authority to create is a transfer of intangibles (a “PCT” under the cost sharing regulations) on Date Y because of the support services that will be provided over some period of time after Date Y.
The example thus represents an intended meaning of the term “value” inconsistent with the traditional understanding of the term “arm's-length price.” Rather than focusing on determining arm's-length pricing of what was transferred at the times at which separate transactions were entered into, the example instead takes an aggregate analysis of a series of transactions that occurred over an undefined period of time, and focuses on the ultimate “value provided” to the transferee. Such an ex post analysis necessarily ignores the fact that risks have played out over that period of time, in ways in which parties determining arm's-length pricing on an ex ante basis could not account for at the time the transactions were entered into. That constitutes a commensurate-with-income type of analysis, which the Temporary Regulations appear to attempt to deem consistent with the arm's-length standard. The example also ignores any contributions to the development of both the intangibles transferred and the foreign operations of the business made by S1 after the date of the related-party transactions.
Consequently, it would be useful if the final regulations provided a more precise definition of “value” that is consistent with the arm's-length standard. The Temporary Regulations' requirement that arm's-length compensation be consistent with the “value” provided in a transaction between related parties risks creating confusion and uncertainty where, as is typically the case, the definition of “value” is different from the price charged in an arm's-length transaction. The ex post, commensurate-with-income type of approach in Example 6 to defining “valued provided” appears inconsistent with recent case law, which holds that determination of whether the arm's-length standard has been met necessarily requires that empirical evidence of how unrelated parties price transactions not be ignored.
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