Transfer pricing in the United States: overview

A Q&A guide to transfer pricing in the United States. This Q&A provides a high level overview of the key practical issues in transfer pricing, including: international and local legislation, transfer pricing policy, pricing methodologies, regulatory practice and procedure, courts and dispute resolution, case law and revenue authority decisions, pricing adjustments, anti-avoidance, penalties, and proposed reform. The Q&A is part of the global guide to transfer pricing.

Contents

Transfer pricing: general overview

1. What are the main characteristics of transfer pricing law and policy in your jurisdiction?

The US has an extensive system of laws and practices designed to preserve the US tax base by preventing income from being shifted among related parties through the inappropriate pricing of related party transactions. The US transfer pricing regime seeks to ensure that goods and services transferred between related companies are done so at an arm's length and are priced based on market conditions that permit profits to be reflected in the appropriate tax jurisdiction. Where the results of a transaction do not reflect an arm's length price, the US tax authority can:

  • Reallocate the income to reflect the appropriate price.

  • In some cases, impose monetary penalties for substantial or deliberate inaccuracy.

The US Congress has enacted legislation and the US Treasury Department has promulgated regulations to control transfer pricing, all of which are administered and enforced by the Internal Revenue Service.

 
2. What have been the main developments of significance for transfer pricing law and practice in your jurisdiction in the past 12 months?

Large multinational companies continue to face pressure and heightened scrutiny relating to the accuracy of prices charged for transactions with related parties. The Internal Revenue Service continues to audit and litigate transfer pricing cases. An example is the recently decided Medtronic case (see Question 15, Cases of interest ( www.practicallaw.com/w-006-9130) ).

Numerous other regulatory and legislative developments also occurred, including:

  • An update to the US Model Income Tax Treaty.

  • The enactment of country-by-country reporting regulations.

  • The issuance of final regulations dealing with debt-to-equity characterisation issues and transfers of certain intangibles to foreign corporations.

These developments are discussed in more detail in this chapter.

 

Transfer pricing legislation

Federal or national legislation

3. What is the main federal (national) legislation regulating transfer pricing in your jurisdiction?

Primary legislation

In the US, federal tax legislation is contained in the Internal Revenue Code (IRC). Specifically, section 482 of the IRC governs transfer pricing. The US Congress enacted section 482 to prevent tax avoidance by ensuring income is clearly reflected by related parties and to place a controlled taxpayer on tax parity with an uncontrolled taxpayer. Section 482 of the IRC establishes a general standard applicable to transactions between related parties, and an additional standard to be satisfied with respect to transfers of intangible property.

The general rule of section 482 authorises the Internal Revenue Service (IRS) to reallocate income, deductions, credits or allowances among the members of a controlled group of entities to ensure clear reflection of income or to prevent tax avoidance. Although not explicitly stated, the statutory language embodies the arm's length principle by authorising adjustments to the taxable income of a controlled taxpayer to reflect the income that would have been realised if the transaction was between uncontrolled parties.

Section 482 also provides an additional test for transfers of intangible property (IP). Income with respect to the transfer (or licence) of IP must be "commensurate with the income" attributable to the IP. Under the commensurate-with-income standard, actual profits realised from the exploitation of an intangible must be considered in determining an arm's length price for the transfer of the intangible. The amount of the compensation should therefore reflect changes in the income attributable to that intangible over time.

Section 482 applies when two or more entities are commonly controlled directly or indirectly, whether legally (or not) enforceable or whether exercisable or exercised. Regulatory guidance provides that section 482 applies to all transactions between related parties and commonly controlled parties, regardless of taxpayer intent. A taxpayer cannot compel the IRS to apply these provisions or to self-initiate transfer pricing adjustments in later years.

Secondary legislation

Rules governing transfer pricing are contained in the regulations promulgated by the US Treasury Department and administered by the IRS under section 482 of the IRC (Regulations 1.482-1 to 1.482-9) (Treasury Regulations). The Treasury Regulations are the centre of the transfer pricing regime in the US and serve as the main source of interpretation of the arm's length standard and the commensurate-with-income standard. They require that a taxpayer select the best pricing method available to test the arm's length nature of transfer prices based on all the facts and circumstances.

Under the Best Method Rule set out in section 1.482-1 of the Treasury Regulations, the taxpayer must use the most reliable measure of an arm's length result by reference to the comparability and quality of the data and assumptions available. In determining the most accurate method, taxpayers must use a variety of factors set out in the Treasury Regulations to evaluate the:

  • Comparability of uncontrolled transactions.

  • Quality of the data and assumptions.

The flexible application of the arm's length standard embodied in the Treasury Regulations can result in more than one arm's length price for a given transaction. Therefore, taxpayers are accorded relief from section 482 reallocations in certain circumstances where the results are within an arm's length range.

State or local transfer pricing legislation

4. What additional regional (local state) legislation and revenue authorities are relevant to transfer pricing in your jurisdiction?

Legislation

In the US, individual states enact their own corporate income tax rules, which include the power and authority to regulate transfer pricing. The state rules focus on the shifting of income and deductions from a high-tax state to lower-tax states. Although the focus of most multinational businesses is on the relationship with the Internal Revenue Service (IRS), the state-by-state approach to transfer pricing methodologies must not be ignored. Each state is a sovereign taxing jurisdiction with the authority to disregard the conclusions reached by the IRS with respect to the appropriateness of a particular transfer pricing method.

The starting point for calculating state taxable income in many states is federal taxable income. If the IRS audits a multinational business and proposes changes to federal taxable income, these changes have a direct impact on the state income tax returns for the business for each of the affected years. Most states have a law requiring a business to amend filed state returns to reflect federal changes. For example, the laws of the Commonwealth of Massachusetts are typical in this regard (see Mass. Gen. L. Chapter 62C § 30 (requiring a taxpayer to report changes in federal taxable income within one year of the date of notice of the federal government's final determination)). If the federal change increases federal taxable income, the failure to file an amended state return most often results in the imposition of additional penalties and interest. While any change resulting from an adjustment to the transfer pricing methodology of a business will require the filing of amended state tax returns, it does not follow that just because the IRS agreed with the transfer pricing methodology of a business, that the state is bound to follow the federal determination (see, for example, N.J. Dep't of Taxation Technical Advice Memorandum (TAM) 2012-1, 16 February 2012).

States employ various approaches to challenge the transfer pricing methodologies of multinational businesses. The primary concern of state taxing authorities is the payment of deductible expenses from a business in the state to an affiliated company outside the state. These deductible expenses are the subject of almost every transfer pricing arrangement and relate to payments for royalties, interest and management fees. While the completeness of the transfer pricing agreement between the affiliates is important, states will also attack the arrangement under one of several doctrines, including the "business purpose", "economic substance" and "sham transaction" doctrines. Each of these approaches looks to the substantive aspects of the transaction. There are numerous state court cases that relate to challenges by state taxing authorities employing these doctrines.

Revenue authorities

Each of the 50 US states has its own internal statutes, regulations, court cases, and other authority governing transfer pricing issues.

International transfer pricing treaties and agreements

5. What are the main international treaties and agreements that apply in your jurisdiction?

The US has income tax treaties with over 60 countries, with several new treaties and protocols to existing treaties under consideration. US income tax treaties often contain an "Associated Enterprises" article that addresses business dealings between related persons. In general, the Associated Enterprises article echoes the arm's length principle reflected in the US transfer pricing rules under section 482 of the Internal Revenue Code (see Question 3 ( www.practicallaw.com/w-006-9130) ). This concept is also used in the new US Model Income Tax Convention released on 17 February 2016 (US Model Treaty). Under Article 9 of the US Model Treaty, each contracting state has the authority to make adjustments to the income of persons subject to its taxing jurisdiction in any situation where the related parties make intercompany arrangements that are not at arm's length.

 
6. What impact do international treaties and agreements have in your jurisdiction?

The Associated Enterprises article of most US income tax treaties (see Question 5 ( www.practicallaw.com/w-006-9130) ) provides that profits must be allocated among related business enterprises in a manner that reflects the result that would occur if independent business enterprises were involved. In addition, a reallocation of income by one contracting state to this state can result in a corresponding reallocation by the other state if it agrees with the reallocation. If the other state does not agree with the reallocation, the two countries should endeavour to reach an agreement under the mutual agreement procedures contained in the tax convention. Taxpayers can face double taxation if the countries fail to reach a compromise. A Mutual Agreement Procedure article allows a taxpayer to request assistance from a competent authority of a contracting state where the actions of the US, the contracting state, or both, result or will result in taxation that is contrary to the treaty.

 

Transfer pricing policy

7. What is the overall national transfer pricing policy in your jurisdiction?

In recent years, the Internal Revenue Service (IRS) has emphasised efforts to increase efficiency in administering transfer pricing matters and enhanced enforcement of the transfer pricing rules vis-à-vis streamlined taxpayer audits. Most recently, the IRS restructured its transfer pricing operations and revamped the transfer pricing audit process.

Overall national policy announcements

The IRS is firmly committed to employing the arm's length principles embodied in section 482 of the Internal Revenue Code. The US looks to its own rules and laws (that is, section 482 and the Treasury Regulations) in resolving transfer pricing disputes without using guidelines laid out by other organisations, such as the Organisation for Economic Co-operation and Development (OECD). For example, in its BEPS 2015 Final Reports, the OECD provided guidance for applying the arm's-length principle. Shortly thereafter, the US Treasury responded that, to the extent that they thought these rules were clarifying the arm's-length standards that are already embodied in US regulations, they were not anticipating having to make substantial changes to US regulations.

National revenue authority initiatives

There is an increasing political and administrative focus on transfer pricing in the US, as part of efforts to defend the US tax base. The IRS has been focusing on increasing resources in this area and recently announced it was realigning and consolidating transfer pricing resources under the Large Business & International Division (LB&I). The purpose of the restructuring reflects the US Government's efforts to provide consistent and efficient outcomes and encourage collaboration with taxpayers.

Administrative statements and guidance

In February 2014, the IRS released the Transfer Pricing Audit Roadmap (Audit Roadmap), which provides administrative guidance regarding transfer pricing audits (www.irs.gov/businesses/corporations/transfer-pricing-audit-roadmap-now-available). The Audit Roadmap provides taxpayers with guidance on new features of the transfer pricing audit process and signals the IRS's continued efforts to:

  • Enhance the efficiency and effectiveness of the audit process.

  • Focus resources on the most important cases.

The IRS has also proposed new administrative guidance to update the rules and procedures applicable to transfer pricing. In recent years, the focus has been on improving the advanced pricing agreement programme and the competent authority procedures as a result of the IRS's restructuring of its transfer pricing operations. For example, on 12 August 2015, the IRS published Revenue Procedure 2015-40, 2015-35 I.R.B. 236, which finalised a draft of the Revenue Procedure that was proposed earlier in Notice 2013-78, 2013-50 I.R.B. 633. Revenue Procedure 2015-40 provides guidance on requesting and obtaining assistance from the US competent authority, acting through the Advance Pricing and Mutual Agreement Program and the Treaty Assistance and Interpretation Team within the IRS's LB&I.

 
8. What are the main transfer pricing methodologies that are used to determine an arm's length price in your jurisdiction?

In evaluating the arm's length nature of an amount paid in a related party transaction, the Treasury Regulations describe specific pricing methods for different types of transactions. Specifically, the Treasury Regulations enumerate the following transactions:

  • Transfer of tangible and intangible property.

  • Cost sharing arrangements.

  • Rendering of services.

  • Loans or advances.

  • Use of tangible property.

Once a transaction is characterised, the Treasury Regulations specify which transfer pricing methodology (TPM) can be used to arrive at the appropriate price. The Best Method Rule generally requires application of the TPM that, under the facts and circumstances, provides the most reliable measure of an arm's length price. There is no strict priority of methods, and no method will invariably be considered to be more reliable than the others (section 1.482-1(c), Treasury Regulations). Further, an arm's length result can be determined under any method without establishing the inapplicability of another method. However, if another method is subsequently shown to produce a more reliable measure of an arm's length result, this other method must be used.

Transfers of tangible property

The regulations governing the transfer of tangible property specify both transactional methods and profit-based methods to evaluate the arm's length nature of a charge. These methods include the:

  • Comparable uncontrolled price (CUP) method.

  • Resale price method (RPM).

  • Cost plus method.

  • Comparable profits method (CPM).

  • Profit split method (comparable and residual).

In addition, the Treasury Regulations permit a taxpayer to use unspecified methods to evaluate arm's length prices.

The CUP method compares the amounts charged for the tangible property in controlled taxpayer transactions with comparable third-party transactions (section 1.482-3(b), Treasury Regulations). The CUP method is generally the most reliable measure of an arm's length result if the transaction is identical or highly comparable in terms of products or functions.

The RPM compares the gross profit margins earned in controlled and uncontrolled transactions (section 1.482-3(c), Treasury Regulations). The RPM is most widely used by sellers or related-party distributors that do not add substantial value to the products purchased. The analysis under RPM requires a comparison of contractual terms, risks borne, and functions performed in the controlled and uncontrolled transactions.

The cost plus method compares gross margins between controlled and uncontrolled transactions, and adds the appropriate gross profit to the controlled taxpayer's cost of producing the property sold to arrive at the arm's length sale price (section 1.482-3(d), Treasury Regulations). This method is most widely used to determine the mark-up earned by manufacturers selling to related parties.

The CPM assesses whether the amount charged in a controlled transaction is arm's length based on objective measures of profitability (profit level indicators) derived from an uncontrolled taxpayer in a similarly situated business under similar circumstances (section 1.482-5, Treasury Regulations). Comparability under this method requires a detailed analysis of functions performed, risks borne, and assets employed.

The profit split method determines the arm's-length transfer price of certain transactions by allocating the combined operating profits (or losses) arising from the covered activity in proportion to the relative contribution of each of the parties (section 1.482-6, Treasury Regulations). The allocations used under this approach must be made in accordance with either the comparable profit split method or the residual profit split method.

Taxpayers can also use unspecified methods to determine arm's length prices. One unspecified method contained in the Treasury Regulations is a bona fide offer from an unrelated party that is used to establish the base of an arm's length range of prices.

Transfers of intangible property

In general, the arm's length consideration for the transfer of an intangible must be commensurate with the income attributable to the intangible. The Treasury Regulations define an intangible as an asset that both:

  • Derives its value not from its physical attributes but from its intellectual content or other intangible properties.

  • Has substantial value independent of the services of any individual.

The pricing methods for intangibles are similar to the methods for services and tangible property (see above, Transfers of tangible property). The four methods listed in section 1.482-4 of the Treasury Regulations are the:

  • Comparable uncontrolled transaction (CUT) method.

  • Comparable profits method (CPM).

  • Profit split method (comparable and residual).

  • Unspecified methods.

Taxpayers must use the best method for pricing intangibles.

The CUT method compares the amount charged in a controlled transfer of intangible property to the amount charged in a comparable uncontrolled transaction. In applying the CUT method, a comparable intangible must be used in connection with similar products or processes within the same general industry or market. The CPM, profit split method and unspecified methods applicable to intangible property are analogous to the transfer pricing methods applied to tangible property.

The sections of the Treasury Regulations governing transfers of intangible property also interpret the statutory "commensurate-with-income" standard. In general, transfer pricing methods for intangibles must take into account the actual income earned by an intangible over its life. Taxpayers can obtain relief from future periodic adjustments under certain circumstances, depending on the transfer pricing method selected.

Cost-sharing arrangements (CSAs)

In 2011, the IRS and Treasury Department issued final cost sharing regulations contained in section 1.482-7 of the Treasury Regulations. A CSA is an agreement under which controlled parties agree to share the costs and risks of developing an intangible in proportion to their share of reasonably anticipated benefits. In determining the participants' share of reasonably anticipated benefits (RAB share), the Treasury Regulations require taxpayers to determine and use the most reliable estimate of reasonably anticipated benefits. The permissible bases for measuring a taxpayer's RAB share include:

  • Units used, produced or sold.

  • Sales or revenues generated.

  • Operating profit.

In a CSA, all the participants are considered to have an ownership interest, so that each can exploit the intangible without paying a royalty. A CSA does not, however, create a partnership, nor does it cause a non-US participant to become engaged in a US trade or business. The IRS can apply the Treasury Regulations to any arrangement that in substance constitutes a CSA, even if a taxpayer fails to comply with the specific requirements.

Controlled service transactions

Regulations 1.482-9 deal with the treatment of controlled service transactions. The Regulations provide that an arm's length charge in a controlled services transaction must be determined under one of six specified methods or a seventh unspecified method. The transfer pricing methods for services are the:

  • Services cost method (SCM)

  • Comparable uncontrolled services price method.

  • Gross services margin method.

  • Cost services plus method.

  • Comparable profits method.

  • Profit split method.

As with other controlled party transactions, each method is subject to the general provisions of section 482 of the Internal Revenue Code, including the Best Method Rule, the comparability requirements and the arm's-length range.

Under the SCM, the arm's length charge for a controlled services transaction is determined by reference to total services costs, without a mark-up. The Treasury Regulations also incorporate cost-sharing concepts to intercompany services by allowing services to be shared by controlled parties for the overall benefit of the group in a shared services agreement (SSA). Under an SSA, the arm's-length charge to each participant is the portion of the total costs of the services otherwise determined under the SCM that is properly allocated to the participant. A qualified SSA requires both:

  • Two or more participants, including all controlled taxpayers that benefit from one or more SSA services.

  • That each covered service deliver a benefit to at least one participant.

For services that do not qualify for the SCM, the Treasury Regulations provide five additional methods to determine the arm's length nature of a controlled services transaction, and allow the use of an unspecified method. Most of the methods described are adaptations of the methods used in evaluating tangible property transactions in the services context.

Intercompany loans

Generally, where one member of a group of controlled entities makes a loan or advance directly or indirectly to, or otherwise becomes a creditor of, another member of the group and either charges no interest or interest at a rate that is not equal to an arm's length rate, the IRS can make an appropriate allocation to reflect an arm's length rate of interest for the loan or advance (Treasury Regulations). The key determination is whether the interest rate charged on the principal amount of bona fide debt between members of a group of controlled entities is appropriate.

9. To what extent, if any, does your jurisdiction follow the OECD transfer pricing guidelines?

In the US, the OECD transfer pricing guidelines do not play a major role. There are no references to the OECD guidelines in section 482 of the Internal Revenue Code and the Treasury Regulations. The Internal Revenue Service has specifically instructed that, outside of the competent authority process under a treaty, tax administrators must enforce compliance with section 482 and the Treasury Regulations without reference to the OECD transfer pricing guidelines.

 
10. Is it possible to obtain any clearances or advance pricing agreements from the revenue authorities in respect of transactions?

Clearances

Under certain procedures set out by the Internal Revenue Service (IRS) each year, a taxpayer that is uncertain of the specific US tax consequences of a transaction can request the IRS to issue a private letter ruling (PLR) to the taxpayer describing the US tax outcomes (Revenue Procedure 2017-1). PLRs interpret and apply tax laws to the taxpayer's specific set of facts as stipulated in the taxpayer's ruling request, and are generally respected by the IRS in examining the taxpayer's tax return. The IRS does not always rule on the issues requested, however, and in the transfer pricing context, advance pricing agreements, discussed below, represent a means of resolving transfer pricing matters.

Advance pricing agreements (APAs)

A taxpayer can enter into an APA with the Internal Revenue Service (IRS) under which both parties agree to the arm's length pricing methods for intercompany transactions. An APA can involve the taxpayer and the IRS, as well as one or more other foreign tax authorities. The term of an APA is generally five years. Although initially designed as a prospective device to eliminate the costs and risk of complying with future examinations, taxpayers can now use APAs to resolve pending examination disputes, in which case the methods agreed on under the APA are rolled back to the open audit years.

 
11. Where the revenue authorities make a transfer pricing adjustment, what is the effect of that adjustment on other party to the transaction?

A transfer pricing adjustment to the income of a related party requires a correlative adjustment to the income of the other related party. If the transaction is purely domestic, an increase in tax liability of one party signals the decrease in tax liability of another. Where the transaction is cross-border, however, the US may not have tax jurisdiction over a foreign related party. In this case, the foreign corporation's income will only sustain a correlative adjustment if the income derived by the foreign corporation is relevant for US tax purposes.

 
12. What are the reporting and other administrative obligations that apply to help the authorities evaluate transfer prices?

There are various other reporting obligations to help the US authorities evaluate transfer prices. For example, domestic corporations that are 25% or more foreign-owned are subject to specific information reporting and record-maintenance rules requiring the reporting of certain transactions with related parties (section 6038A, Internal Revenue Code (IRC)). These corporations must file IRS Form 5472 to comply with their reporting requirements. Recently enacted final regulations extend these reporting requirements to foreign-owned single member US limited liability companies which, prior to the enactment of the final regulations, had little to no US federal income tax reporting obligations. Foreign corporations engaged in a US trade or business are subject to similar information reporting and record maintenance rules (section 6038C, IRC) and must also file a US income tax return (IRS Form 1120-F) each year that the corporation is so engaged, whether or not it had gross income from that trade or business.

Certain transfers by US persons to foreign corporations are also subject to reporting requirements (section 6038B, IRC). In particular, when a US person transfers property to a foreign corporation in certain specified non-recognition transactions, the transfer must generally be reported on IRS Form 926. Information required to be reported may include data regarding any transferred assets, as well as information regarding the transaction itself. Additionally, in certain transactions where stock of a domestic corporation can be transferred to a foreign corporation on a tax-free basis, the transferor must provide notice to the IRS as provided in the regulations promulgated under section 367 of the IRC (commonly referred to as a Section 367(a) Notice).

Additionally, the transfer pricing penalty provisions are triggered when, among other things, a taxpayer fails to comply with requirements to contemporaneously document that its transfer pricing was on an arm's-length basis and fails to timely provide the Internal Revenue Service with this documentation.

 

Transfer pricing courts and dispute resolution

National courts and transfer pricing dispute resolution

13. What are the relevant national courts and what dispute resolution mechanisms exist for transfer pricing issues in your jurisdiction?

The first stage of a transfer pricing dispute is an Internal Revenue Service (IRS) audit, followed by a proposed adjustment by the IRS. If the taxpayer disagrees with the IRS's reallocation, the taxpayer can request a conference with the Appeals Office of the IRS (or commence a competent authority process if a treaty jurisdiction is involved).

If the IRS finds against the taxpayer, or if the taxpayer deliberately chooses to bypass the appeals process, the next step would be to petition the US Tax Court to seek a redetermination of the deficiency. Alternatively, the taxpayer can pay the tax and file a claim for refund with the IRS. If the refund is denied, or the taxpayer does not hear from the IRS, the taxpayer can sue for a refund in the district court or in the Court of Federal Claims. Once the matter is in the judicial system, the taxpayer can appeal the Tax Court's decision to a US circuit court, and ultimately to the Supreme Court of the US.

Advance pricing agreements (APAs) may also play a role in the dispute resolution process. APAs are designed to help taxpayers voluntarily resolve actual or potential transfer pricing disputes and can act as an alternative to the traditional examination process (see Question 10 ( www.practicallaw.com/w-006-9130) ).

International courts and transfer pricing dispute resolution

14. What international dispute resolution methods are available in your jurisdiction, and which are preferred for transfer pricing issues?

Where the application of the US transfer pricing rules and those of a treaty partner country leads to double taxation, a taxpayer can request assistance from a competent authority to eliminate double tax under the mutual agreement procedure article of a bilateral tax treaty. In general, taxpayers are encouraged to request competent authority assistance as soon as possible after the taxpayer determines it has been denied treaty benefits or has been taxed in violation of a tax treaty, to prevent being precluded from relief.

 

Transfer pricing case law

15. What are the most significant case law developments on transfer pricing in your jurisdiction?

In the US, the Treasury Regulations and practice have evolved from a set of major cases. One of the most highly scrutinised areas is pricing of intangibles developed through cost sharing arrangements. Although taxpayers have recently enjoyed more victories in high-profile transfer pricing cases, historically the government has prevailed over taxpayers. Some recent notable cases are discussed below.

Cases of interest

Medtronic. In 2016, the US Tax Court issued a decision in Medtronic, Inc. and Consolidated Subs. v Commissioner, TC Memo 2016-112 (9 June 2016), a case involving a US medical device manufacturer and royalty payments received from its Puerto Rico-based subsidiary company. Medtronic, the US parent corporation of the international medical technology group, indirectly owned a Puerto Rico-based manufacturing entity, Medtronic Puerto Rico Operations Co. (MPROC), which was responsible for manufacturing various medical device pulse generators (devices) and physical therapy delivery units (leads). With regard to these products, Medtronic was responsible for clinical studies, research and development, and quality control, among other things. MPROC was responsible for business profitability, quality compliance, innovation, and supplier relationship management, among other things. Medtronic and MPROC entered into licence agreements for the intangible property necessary to manufacture and sell the devices and leads, granting MPROC the exclusive right to use, develop, and enjoy the intangible property for sale to customers. In exchange for these rights, Medtronic received a 29% royalty on the sales of devices and a 15% royalty on the sale of leads.

The Internal Revenue Service (IRS) argued that Medtronic should have received higher royalties from MPROC, contending that the comparable profits method (CPM) was the best method to determine arm's length royalty rates, and not the comparable uncontrolled transactions (CUT) method which was used by Medtronic. In its 144-page ruling, the Tax Court sided with Medtronic, finding that the taxpayer's CUT method was appropriate and that the IRS's adjustments were arbitrary, capricious, and unreasonable. In reaching its conclusion, the Court took issue with the IRS's analysis, which attributed only a single function – finished product manufacturing – to MPROC. The Court found that MPROC was "involved in every aspect of the manufacturing process" and that, accordingly, the IRS's transfer pricing analysis placed too little emphasis on MPROC's role in ensuring that the products were of good quality, and therefore provided too low of a return to the Puerto Rico subsidiary. In particular, the Court emphasised that MPROC played a crucial role because of the importance of product quality in the medical device industry. Finding that the underpinnings of the IRS's analysis were unreasonable, the Court concluded that:

  • The commensurate-with-income standard of section 482 of the Internal Revenue Code did not require use of the CPM or any other specific method to reach an arm's length result.

  • Medtronic had satisfied its burden proving that the IRS's allocations were arbitrary or unreasonable.

Although the Court ultimately rejected the IRS's application of the CPM, it adjusted the rates determined by Medtronic under its application of the CUT method, increasing the royalties charged by Medtronic to MPROC from 29% to 44% for devices, and from 15% to 22% for leads. These increases reflected the Court's belief that certain adjustments were required to account for variations in profit potential. In particular, the Court noted that Medtronic's analysis lacked an examination of the profit potential of the comparable transactions and did not account for the different technologies involved. The Court also noted important differences between the licensing arrangements at issue and the licensing arrangements involved in previous agreements that Medtronic sought to use as comparable transactions under the CUT method.

Altera. In Altera Corporation and Subsidiaries v Commissioner, 145 TC No. 3 (27 July 2015), the Tax Court addressed the issue of whether stock-based compensation costs of related parties should be included in a cost-sharing arrangement, an issue that had been previously litigated in a case involving an earlier version of the relevant law (see Xilinx Inv. v Commissioner, discussed below). The taxpayer, Altera US, which was in the business of developing, manufacturing, marketing, and selling certain hardware and software, entered into a technology research and development cost-sharing agreement (R&D CSA) with a Cayman Islands subsidiary, Altera International, under which Altera US granted stock options and other stock-based compensation to various employees who performed R&D activities that were subject to the agreement. Under the R&D CSA, Altera International made payments to Altera US totalling more than US$640 million.

The IRS audited Altera US and issued notices of deficiency for the tax years 2004 to 2007, making section 482 allocations to increase Altera International's payments to Altera US for stock-based compensation in excess of US$80 million for the years in question. The Tax Court rejected the IRS's position that the stock-based compensation costs should have been included in the CSA. It found that the applicable regulations which required stock-compensation to be included in a CSA were invalid because the Treasury had not adequately considered the evidence presented by commentators during the rule-making process.

The IRS has appealed the Tax Court's decision to the Ninth Circuit Court of Appeals (see Altera Corp., doc. nos. 16-70496, 16-70497 (9th Cir. 2016)).

Veritas Software. In 2009, the US Tax Court decided Veritas Software Corporation v Commissioner, 133 T.C. No. 14, 133 T.C. 297 (2009), dealing with a buy-in payment for pre-existing intangibles. The taxpayer, Veritas Software Corp., was a major developer and manufacturer of computer software that entered into a CSA and technology licensing agreement with its foreign subsidiary. In exchange for a US$166 million lump sum buy-in payment, the subsidiary was granted rights to use the intangibles. The IRS made a section 482 adjustment to the buy-in payment using a different pricing method and assessed a deficiency. The taxpayer petitioned the Tax Court for a redetermination of the deficiency and penalties, arguing the Commissioner made erroneous allocations for the lump sum buy-in payment and cost-sharing allocations.

The Tax Court rejected the IRS's determination and held that the CUT method was the best method for determining a buy-in payment relating to the transfer of intangibles between a subsidiary and parent. The court also held that the IRS had:

  • Based its adjustments on intangibles developed after the buy-in payment.

  • Included accounts in the calculation that were not actually transferred.

  • Employed a number of erroneous variables in making the adjustments.

Xilinx, Inc. In 2005, the Tax Court decided Xilinx, Inc. v Commisioner, 125 T.C. 37 (2005), aff'd, 598 F.3d 1191 (9th Cir. 2010), holding that the IRS erroneously allocated stock-based compensation as part of the cost-sharing pool of expenses. Xilinx entered into a CSA with Xilinx Ireland, its wholly-owned Irish subsidiary, which required each party to make buy-in payments and fund a portion of the total research and development costs in proportion to its reasonably anticipated benefits from the intangibles developed under the CSA. Both Xilinx and Xilinx Ireland granted employee stock options to their employees but neither party included the amounts in the expenses shared in the CSA. The IRS issued a deficiency on the basis that the employee stock options were costs that must be shared under the CSA regulations.

The Tax Court held that IRS's allocations did not comply with the basic arm's length standard of the regulations because unrelated parties would not agree to share in stock-based compensation costs when entering into a CSA.

The Ninth Circuit of the US Court of Appeals originally reversed on the grounds that the arm's length standard did not apply to the cost-sharing regulations, but subsequently withdrew its opinion and affirmed the Tax Court's decision in favour of the taxpayer. The Circuit Court resolved that the purpose of the arm's length standard applied because regulations were too ambiguous in determining the costs that must be shared between controlled parties in a CSA relating to intangible product development.

Pending cases

Some other pending cases of note include:

  • Amazon.com, Inc. & Subsidiaries, TC docket no. 31197-12.

  • Guidant LLC, TC docket no. 5989-11.

  • Eaton Corporation and Subsidiaries, TC docket no. 28040-14.

 

Transfer pricing adjustments

Adjustments and penalties

16. Where the revenue authorities make an adjustment of the transfer prices for tax purposes, can any other penalties also be imposed in addition to that adjustment?

There are various penalties applicable in the transfer pricing context, including:

  • An accuracy-related penalty for underpayments of tax in transfer pricing matters (section 6662, Internal Revenue Code (IRC)).

  • Reporting penalties for failure to report certain intercompany transactions (section 6038A, IRC).

  • General civil and criminal tax penalties and interest charges.

Accuracy-related penalty for underpayments

Various penalties apply for accuracy-related underpayments of tax in the transfer pricing context, unless a taxpayer can demonstrate and provide the Internal Revenue Service (IRS) on request contemporaneous documentation supporting a particular pricing methodology. A penalty applies to any portion of underpayment attributable to any of the following:

  • Substantial and gross valuation misstatements.

  • Substantial understatements of tax.

  • Negligence.

  • Tax understatements attributable to any undisclosed foreign financial asset.

  • Tax underpayments attributable to any transaction lacking economic substance.

Generally, the penalty for misconduct is 20%, but can double to 40% in certain circumstances. The underpayment of tax liability is the base for assessing the penalty.

In most cases, the taxpayer can avoid the accuracy-related penalty by showing good faith and reasonable cause. Therefore, the importance of complying with the disclosure requirements of the IRC cannot be understated, particularly in the transfer pricing context. Proper documentation is one of the most important tools for defending against a transfer pricing penalty.

A substantial valuation misstatement exists where either (among other things):

  • The price for any property or services (or for the use of property) claimed on any return in connection with any transaction between controlled taxpayers is 200% or more (or 50% or less) of the correct arm's length amount (transactional penalty).

  • The net section 482 transfer price adjustment for the taxable year exceeds US$5 million or 10% of the taxpayer's gross receipts (net adjustment penalty).

The penalty is 40% in the event of a gross valuation misstatement, which occurs where either:

  • The percentages are 400% or more (or 25% or less).

  • The net section 482 transfer price adjustment is US$20 million or 20% of the taxpayer's gross receipts.

Intercompany information reporting penalties

The IRC also imposes a reporting obligation on 25% or greater foreign-owned domestic corporations. Generally, a reporting corporation must file a separate annual information return for each related party with which it enters into a reportable transaction during the year (section 6038A, IRC). A reporting corporation that fails to provide the IRS with the required information is subject to a US$10,000 penalty with respect to each year for which the failure occurs. The failure to report may be excused by showing reasonable cause. Foreign corporations engaged in a US trade or business are subject to similar penalties for failure to comply with the reporting requirements imposed by section 6038C of the IRC.

General civil and criminal penalties

In addition to the transfer pricing penalties and reporting penalties, several general criminal and civil tax penalties can apply in a transfer pricing context. Penalties include:

  • Failure to file penalty.

  • Failure to pay penalty.

  • Failure to pay estimated tax penalty.

  • Preparer penalties.

 

Transfer pricing development and reform

17. Are there any current trends, developments or reform proposals that have or will affect the area of transfer pricing in your jurisdiction?

There have been numerous international developments regarding the application of the general arm's length standard in the transfer pricing arena. For example, in its 2015 Final Reports on Base Erosion and Profit Shifting (BEPS) Actions 8, 9 and 10: Aligning Transfer Pricing Outcomes With Value Creation, the OECD touched on subjects including:

  • Profit split methods.

  • Contractual allocations of risks.

  • A series of matters specifically involving intangibles.

The US has continued to evaluate transfer pricing disputes under its own regime, but, on the whole, has maintained that the OECD guidelines are consistent with general US Treasury Regulations.

 

Tax avoidance: general overview

18. What have been the main national and international trends affecting tax enforcement and anti-avoidance practice in your jurisdiction in the past 12 months?

Global tax transparency continues to dominate tax reporting and anti-avoidance practices in the US. Measures such as the Foreign Account Tax Compliance Act, enacted in 2010, and the OECD's Common Reporting Standard, continue to affect taxpayers.

 
19. How does your jurisdiction make the distinction between abusive tax avoidance and legitimate tax planning?

In response to the relentless expansion of US tax laws since the inception of the modern federal tax system, taxpayers and their advisers have answered by developing countless tax planning strategies, structures and techniques designed to reduce tax liabilities. The conduct of taxpayers and their advisers has been the subject of extensive discussion regarding the legality and ethics of elaborate tax planning measures. The courts have commented on the issue on many occasions, and the classic statement on the matter was expressed in Helvering v Gregory, 69 F.2d 809 (2nd Cir 1934), aff'd, 293 US 465 (1935), an early case involving a transaction structured to comply with tax-free corporate reorganisation rules. In a decision favouring the government, the Court of Appeals for the Second Circuit stated that "a transaction, otherwise within an exception of the tax law, does not lose its immunity, because it is actuated by a desire to avoid, or … to evade, taxation". The Court held that taxpayers can arrange their affairs so that their taxes are as low as possible and are not bound to choose the pattern that will best pay the Treasury.

While the statement in Gregory is still valid, a more recent authority on the topic demonstrates greater attention to the difference between legitimate tax avoidance and illegal tax evasion. For example, in Part 9 of its Internal Revenue Manual (IRM), the Internal Revenue Service (IRS) has stated that avoidance of taxes is not a criminal offence and that any attempt to reduce, avoid, minimise or alleviate taxes by legitimate means is permissible. The IRS explained that the distinction between avoidance and evasion is fine, yet definite. A person who avoids tax does not conceal or misrepresent, but shapes events to reduce or eliminate tax liability and, on the occurrence of the events, makes a complete disclosure. By contrast, evasion involves deceit, subterfuge, camouflage, concealment, or some attempt to colour or obscure events or to make things seem other than they are.

There are many examples of tax planning techniques involving complex concepts, or the combination of multiple provisions of the tax law, to enter into economic arrangements on a tax-free or tax-efficient basis which are generally accepted by the IRS, the courts or the tax practitioner community as being legitimate tax avoidance measures. Some examples of accepted planning techniques include:

  • The issuance of profits interests in partnership entities.

  • "Check-the-box" elections and "check-and-sell" transactions.

  • The use of instalment sales to defer tax on the sale of property, where a portion of the sales price is paid in subsequent tax years.

  • Corporate reorganisation transactions where tax is deferred in the sale or merger of a corporation to the extent that the consideration consists of stock of the acquiring corporation.

  • Corporate spin-off or split-off transactions, where a corporation with at least two historic active businesses can distribute one of the businesses to its stockholders without triggering taxable income at the corporate level on the distribution of appreciated assets, or at the stockholder level with respect to the value of the assets distributed.

 
20. Do the revenue authorities in your jurisdiction offer any guidance on the distinction between legitimate tax planning mechanisms and abusive or aggressive tax avoidance?

The Internal Revenue Service (IRS) offers guidance in its Internal Revenue Manual (IRM). The IRM indicates that, for example, the creation of a bona fide partnership to reduce the tax liability of a business by dividing the income among several individual partners is tax avoidance. The IRM states, however, that the facts of a particular investigation may show that an alleged partnership was not, in fact, established and that one or more of the alleged partners secretly returned their share of the profits to the real owner of the business, who, in turn, did not report this income. This would be an example of attempted evasion.

In its explanation of the distinction between avoidance and evasion, the IRS illustrates the concept of legitimate avoidance by referring to the formation of a bona fide partnership that has the effect of allocating its income among different partners. This is a legitimate approach because it relies on the application of statutory provisions that expressly provide for the allocation of partnership income among partners. The example chosen by the IRS to illustrate the point is among the simplest possible, as it involves the application of only one tax law concept.

A link to the IRM can be found at: www.irs.gov/irm/.

Tax anti-avoidance provisions

21. Can you identify any direct or indirect impact in your jurisdiction of the OECD or other recent international initiatives to combat abusive tax avoidance?

The OECD states that it is "a forum in which governments can work together to share experiences and seek solutions to common problems". The OECD has undertaken a project to develop policies relating to base erosion and profit shifting (BEPS) strategies undertaken by taxpayers throughout the world to reduce their tax obligations. In 2013, the OECD published an Action Plan on BEPS describing 15 measures that it recommends member nations to implement to preserve the tax base. A copy of the plan can be found at www.oecd.org/tax/beps/action-plan-on-base-erosion-and-profit-shifting-9789264202719-en.htm. Overall, the BEPS initiative's concern with the preservation of the tax base is reflected in the US government's on-going efforts to reduce deferral opportunities. The OECD initiatives also had an impact on the enactment of US legislation, such as the "country-by-country" reporting regulations for large US-parented multinational enterprise groups with annual revenue of US$850 million or more, which were issued in final form in 2016.

 
22. Does your jurisdiction have GAAR designed to prevent or reduce abusive tax avoidance?

While the Internal Revenue Service (IRS) and the courts do not have a formal GAAR policy, they have applied different doctrines to deny taxpayers benefits sought through transactions that are structured to literally comply with statutory requirements, but which are perceived to violate the intention of applicable tax laws. These doctrines overlap in some aspects and it is sometimes difficult to draw clear distinctions between them. The doctrines used by the IRS and the courts to strike down taxpayers' attempts at tax avoidance can be grouped into broad categories, consisting of the:

  • Substance over form and step transaction doctrines, which reclassify the nature of transactions entered into by the taxpayer.

  • Sham transaction, economic substance and business purpose doctrines, which deny tax benefits arising from transactions that do not provide non-tax economic benefits and are entered into for the purpose of reducing taxes.

General substance over form doctrine

Most doctrines used by the IRS and the courts to set aside tax planning measures taken by taxpayers are rooted in substance over form concepts (see generally, Comm. v Court Holding Co., 324 US 331 (1945)). The courts often invoke the substance over form doctrine when a taxpayer has structured a transaction in a certain way solely in view of the tax advantages that flow from it. If a court believes that a tax motivation outweighs any profit objective and/or business purpose, it can decide that the "form" does not reflect the "substance" of the transaction in economic terms. In this case, the court will deny the sought-after tax benefits.

Step transaction doctrine

The step transaction doctrine is a substance over form rule that treats a series of steps as a single transaction if the steps are directed at achieving a particular result. The IRS and the courts apply the doctrine by determining the tax consequences of the transaction without regard to unnecessary intermediate steps. The transaction, stripped down to its bare essentials, can then yield tax results that are different than those originally intended by the taxpayer through inserting additional steps.

There is no universally accepted test as to when and how the step transaction doctrine should be applied to a given set of facts. The courts have applied three alternative tests in deciding whether to invoke the step transaction doctrine in a particular situation. These tests are the:

  • Binding commitment test, under which a series of transactions will only be stepped together if, at the time the first step is commenced, there is a binding legal commitment to undertake the subsequent step.

  • Interdependence test, under which a series of transactions will be stepped together if the steps are so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series.

  • End result test, under which a series of transactions will be stepped together when the intent at the outset was to achieve the particular result, and the separate steps were all entered into as a means of achieving that result.

Regardless of which of the three approaches is applied, the step transaction doctrine is subject to limitations that are described in the frequently cited Esmark case (see Question 24, Historic case law relevant to abusive tax avoidance).

Economic substance, business purpose and sham transaction doctrines

The IRS and the courts will generally rule against taxpayers claiming tax benefits if the tax benefits arise from a transaction or series of transactions that lacks economic substance apart from the federal income tax benefits arising from the transaction.

The economic substance doctrine is closely related to, and overlaps with, the business purpose doctrine. The two doctrines are frequently considered in the same cases. The business purpose doctrine considers the motives for entering into a transaction and whether the taxpayer was pursuing a valid business purpose apart from the reduction of federal income tax, which necessarily involves a subjective analysis. The courts will sometimes apply the doctrine to disallow tax benefits by dividing a transaction into two parts, one part involving activities with non-tax objectives and the other involving only those activities that have tax avoidance purposes. Transactions that lack economic substance and a business purpose are also referred to as economic shams. Economic shams are distinct from transactions that are fraudulent shams, which involve transactions that never really occurred.

The courts have blurred the concepts of economic substance and business purpose, with different courts applying these concepts in different ways. The courts have also been inconsistent regarding the degree of economic benefits that must be shown to establish that a transaction has economic substance. In response to these inconsistencies, Congress enacted section 7701(o) of the Internal Revenue Code to provide some uniformity in the application of certain aspects of the doctrine.

23. What are the legislative provisions that are designed to reinforce GAAR and any other abusive tax avoidance provisions?

Economic substance statute

In 2010, Congress enacted section 7701(o) of the Internal Revenue Code (IRC) to codify the criteria that must be satisfied to sustain tax benefits arising from certain transactions. Section 7701(o) applies in cases where the economic substance doctrine is relevant under the applicable common law in existence before the enactment of the statute. The statute defines the economic substance doctrine as the common law doctrine that denies tax benefits if a transaction or series of transactions lacks either economic substance or a business purpose. The legislative history of the statute states that the statute is not intended to alter the tax treatment of basic business transactions that are generally respected by the courts and the Internal Revenue Service (IRS), including:

  • The choice between capitalising a business enterprise with debt or equity.

  • A US person's choice between using a foreign corporation or a domestic corporation to make a foreign investment.

  • The choice to enter into a transaction or series of transactions that constitute a corporate organisation or reorganisation.

  • The choice to use a related-party entity in a transaction, provided that the arm's length standard section 482 of the IRC and other applicable concepts are satisfied.

Additionally, section 6662(b)(6) of the IRC was enacted to impose a penalty equal to 20% on an underpayment attributable to tax benefits disallowed because a transaction lacked economic substance or failed to meet the requirements of any "similar rule of law".

The IRS has published guidance in Notice 2014-58, 2014-44 I.R.B. 746, concerning the meaning of "transaction" and "similar rule of law" in applying the codified version of the economic substance doctrine. It may still be some time before section 7701(o) is litigated in the US judicial system. The codified version of the economic substance doctrine only applies to transactions entered into after the date of the statute's enactment (that is, 30 March 2010).

Debt versus equity classification (section 385, IRC)

Section 385 of the IRC was originally enacted in 1969 and authorises the IRS to issue regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated as stock or debt for federal tax purposes. The debt versus equity issue has numerous federal tax implications. For example, while a corporation can generally take a deduction for interest paid to its debt holders, it does not receive a similar deduction for dividends paid to its shareholders.

Because there were no regulations previously in effect under section 385, case law that developed before the statute's enactment controlled the characterisation of an interest in a corporation as debt or equity. The courts historically analysed whether an interest in a corporation should be treated as stock or indebtedness for federal tax purposes by applying various sets of factors to the facts of a particular case. Common factors enumerated by the courts include, but are not limited to the:

  • Name given by the parties to the instrument in question.

  • Presence or absence of a fixed maturity date.

  • Right to enforce payment of principal and interest.

Final regulations under section 385 were issued in 2016 (Final Regulations), which both:

  • Establish documentation requirements that must be satisfied for a purported debt instrument to be classified as debt for US federal tax purposes (Documentation Rule).

  • Recharacterise certain debt instruments as stock if the instrument is issued in certain specified transactions or is deemed to have funded certain specified transactions (Recharacterisation Rule).

The Documentation Rule provides minimum documentation requirements that must be met to classify certain related party interests as debt. In particular, sufficient documentation and information must be prepared and maintained to substantiate certain enumerated "indebtedness factors", namely:

  • An unconditional obligation to pay a sum certain.

  • Creditors' rights.

  • A reasonable expectation of the ability to repay.

  • Actions evidencing a debtor-creditor relationship.

The Documentation Rule currently only applies to interests issued by domestic corporations if one of the following thresholds is met:

  • The stock of any member of the expanded group is publicly traded.

  • All or any portion of the expanded group's financial results are reported on financial statements with total assets exceeding US$100 million.

  • The expanded group's financial results are reported on financial statements that reflect annual total revenue that exceeds US$50 million.

The Documentation Rule requirements apply to instruments issued on or after 1 January 2018.

The Recharacterisation Rule contains two parts: the General Rule and the Funding Rule. These two rules recharacterise purported debt in certain related party transactions involving distributions and reorganisations. Like the Documentation Rule, the Recharacterisation Rule only applies to domestic corporation issuers. The Recharacterisation Rule also contains a number of exceptions for more ordinary transactions. For example, certain "qualified short-term debt instruments" are excluded from the rules. Additionally, the first US$50 million of debt that would have otherwise been reclassified as stock under the Recharacterisation Rule is excluded from recharacterisation as equity. The Recharacterisation Rule applies to debt issued on or after 5 April 2016.

 
24. Identify and discuss any case law of interest concerning GAAR and any other cases dealing with abusive tax avoidance in your jurisdiction.

Current case law relevant to abusive tax avoidance

In CNT Investors, LLC v. Commissioner, 144 TC 161 (2015), the Tax Court addressed the differences between the sham transaction, economic substance, substance over form, and step transaction doctrines (see Question 22 ( www.practicallaw.com/w-006-9130) ). The case involved inflated partnership basis transactions (referred to as a "Son of BOSS" transaction). The Tax Court applied the step transaction doctrine to combine the transactions at issue and deny the taxpayer the sought-after benefits. In arriving at its decision, the Court navigated through the relationships between the various doctrines aimed at preventing tax avoidance.

Historic case law relevant to abusive tax avoidance

An often-cited case concerning the substance over form doctrine is Comm. v Court Holding Co., 324 US 331 (1945). In Court Holding Co., a corporation transferred its sole asset to its stockholder in a liquidating distribution, and the stockholder immediately sold the asset. The transaction had originally been negotiated as a sale of the asset by the corporation directly to the buyer, but was then restructured to avoid the application of corporate tax on the sale and to secure tax advantages on the liquidating distribution that were available under the laws applicable at that time. The government argued that the transaction should be treated as a sale by the corporation and not by the stockholder, relying on the fact that it was originally negotiated as a sale by the corporation and restructured only to provide a tax benefit. The Supreme Court ruled in favour of the government, holding that the incidence of taxation depends on the substance of a transaction, which must be viewed as a whole, and that each step, from the commencement of negotiations to the consummation of the sale, is relevant. The Supreme Court added that to permit the true nature of a transaction to be disguised by mere formalisms, which exist solely to alter tax liabilities, would seriously impair the effective administration of the tax policies of Congress.

The step transaction doctrine is subject to certain limitations (see Question 22, Step transaction doctrine). In Esmark v Comm., 90 T.C. 171 (1988), the corporate taxpayer entered into an agreement with a buyer to sell shares of the taxpayer's subsidiary. As part of the agreement, the buyer acquired shares of the taxpayer's stock on the open market under a tender offer. Immediately after completion of the tender offer and in accordance with the agreement of the parties, the taxpayer redeemed the shares acquired by the buyer in the tender offer in exchange for the transfer of shares of the taxpayer's subsidiary to the buyer. This structure was selected primarily to secure tax benefits for the taxpayer under rules that were applicable at that time. The IRS sought to recharacterise the transactions as a taxable sale of the subsidiary's shares to the buyer for cash, followed by a redemption of shares from the public by the taxpayer under a self-tender with the proceeds from the sale of the subsidiary.

The Esmark court rejected the IRS' position, stating that the step transaction doctrine "combines a series of individually meaningless steps into a single transaction", and that the IRS had "pointed to no meaningless or unnecessary steps that should be ignored". The Tax Court explained that:

  • There was no route to the results achieved that was more direct than the route followed.

  • The taxpayer was free to choose the route which provided the best tax result.

  • The recharacterisation proposed by the IRS did not just involve the combination of steps, but would have also required the invention of new steps.

The Esmark case describes limits on the step transaction doctrine that prevent the IRS from recasting the steps of a transaction when there is no alternative interpretation of the transaction which could involve fewer steps, and any alternative would require the invention of steps that did not in fact occur.

In Turner Broadcasting System, Inc. v Comm., 111 T.C. 315 (1998), the Tax Court further elaborated on the limits of the step transaction doctrine, stating that:

  • The IRS must provide a "logically plausible alternative explanation that accounts for all the results of the transaction".

  • The Tax Court will not disregard the form of the transaction if it accounts for the transaction at least as well as alternative rechararacterisations, even if alternative explanations can account for the results of the transaction.

 

Tax avoidance penalties

Civil and administrative penalties for abusive tax avoidance

25. What civil and administrative penalties can be imposed in abusive tax avoidance cases in your jurisdiction?

The Internal Revenue Code (IRC) and relevant regulations provide for civil and criminal penalties and interest relating to underpayments of tax and failure to file tax returns. Penalties that are relevant to tax avoidance transactions are outlined below.

General accuracy-related penalty

Section 6662 of the IRC imposes an accuracy-related penalty on certain underpayments of tax. The penalty rate is 20% of the amount of the understatement. The 20% penalty rate generally applies to understatements that are attributable to, among other things, negligence or disregard of rules or regulations, substantial understatements of income tax, and substantial valuation misstatements.

Higher accuracy-related penalties for gross valuation misstatements and non-economic substance transactions

The accuracy-related penalty rate under section 6662 of the IRC is increased to 40% to the extent of understatements attributable to, among other things, gross valuation misstatements and undisclosed non-economic substance transactions. An undisclosed non-economic substance transaction is a transaction lacking economic substance within the meaning of section 7701(o) of the IRC, or which fails to meet the requirements of any similar rule of law, if the relevant facts affecting the tax treatment of any portion of the transaction are not adequately disclosed in the return, nor found in a statement attached to the return.

Penalties for understatements of tax relating to listed transactions and reportable transactions

In addition to the accuracy-related penalties described above, section 6662A of the IRC imposes penalties for understatements of tax related to listed transactions and reportable transactions. The penalty is generally 20% of the amount of a reportable transaction understatement attributable to any listed transaction or any reportable transaction (other than a listed transaction), if a significant purpose of the transaction is the avoidance or evasion of federal income tax. The penalty rate is increased to 30% of the reportable transaction understatement if the transaction is not adequately disclosed.

A listed transaction is a transaction that either:

Reportable transactions are transactions that are included in any of the following categories:

  • Listed transactions (see above).

  • Confidential transactions that are offered to a taxpayer under conditions of confidentiality for which the taxpayer has paid an adviser a minimum fee.

  • Contractual protection transactions, under which:

    • a taxpayer or related party has the right to a full or partial refund; or

    • fees to certain tax advisers are contingent on the tax consequences or benefits of the transaction.

  • Loss transactions, in which the taxpayer claims a loss under section 165 of the IRC (relating to losses not compensated by insurance or otherwise) which exceeds certain dollar thresholds.

  • Transactions of interest, which are the same as, or substantially similar to, those identified by the IRS as transactions of interest.

Penalties for failure to disclose reportable transactions and listed transactions

Section 6707A of the IRC provides for a penalty for failure to disclose listed transactions and reportable transactions in an amount equal to 75% of the decrease in tax shown on the tax return attributable to the transaction if the transaction had been respected, subject to a maximum penalty of:

  • US$200,000 in the case of a listed transaction (US$100,000 in the case of a natural person).

  • US$50,000 in the case of a reportable transaction other than a listed transaction (US$10,000 in the case of a natural person).

The minimum penalty is US$10,000 (US$5,000 in the case of a natural person). This penalty applies in addition to all other penalties. The IRS can rescind the penalty if the violation does not involve a listed transaction and the IRS determines that rescinding the penalty would promote tax compliance and administration.

Fraud penalty

Section 6663 of the IRC imposes a penalty of 75% of the amount of an underpayment of tax that is attributable to fraud.

Exceptions to the imposition of penalties

The amount of an understatement subject to the accuracy-related penalty can be reduced in two situations (section 6662(d)(2)(B), IRC):

  • The understatement is reduced by the portion that is attributable to an item if there is substantial authority for the taxpayer's treatment of the item. The regulations promulgated under section 6662 state that there is substantial authority for a position only if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment.

  • The understatement can be reduced when the relevant facts affecting the item's tax treatment are adequately disclosed in the tax return or accompanying statement, and there is a reasonable basis for the tax treatment claimed. This reduction is not applicable to any item attributable to a tax shelter. For this purpose, a tax shelter is a partnership or other entity, an investment plan or arrangement or any other plan or arrangement, if its principal purpose is to avoid or evade federal income tax.

Additionally, the accuracy-related penalty is not imposed with respect to any portion of an underpayment if it is shown that there was reasonable cause for this portion and the taxpayer acted in good faith with respect to the portion (section 6664(c), IRC). This exception also applies to the fraud penalty. This exception does not apply to the portion of any understatement attributable to a transaction lacking economic substance. The determination of reasonable cause and good faith is made on a case-by-case basis taking into account all pertinent facts and circumstances. Generally, the most important factor is the extent of the taxpayer's effort to assess the proper tax liability.

There is also a reasonable cause exception to the imposition of the reportable transaction and listed transaction penalties. Under this exception, no penalty can be imposed with respect to any portion of a reportable transaction understatement if all of the following apply (section 6664(d), IRC):

  • There was a reasonable cause for that portion.

  • The taxpayer acted in good faith with respect to that portion.

  • The relevant facts affecting the tax treatment of the item are adequately disclosed in accordance with the regulations prescribed under section 6011of the IRC.

  • There is or was substantial authority for the treatment.

  • The taxpayer reasonably believed that the treatment was more likely than not the proper treatment.

Criminal penalties for abusive tax avoidance

26. What criminal penalties can be imposed in abusive tax avoidance cases in your jurisdiction?

Various sections of the Internal Revenue Code (IRC) may impose criminal penalties in abusive tax avoidance cases. For example:

  • Any person convicted of wilfully evading any tax imposed by the IRC can be fined up to US$100,000 or face imprisonment up to five years (section 7201, IRC).

  • Any person required to collect, account for, and pay over any tax imposed by the IRC who wilfully fails to collect, or truthfully account for, and pay over this tax can be fined up to US$10,000 or be imprisoned for up to five years (section 7202, IRC).

These penalties apply in addition to civil penalties (see Question 25 ( www.practicallaw.com/w-006-9130) ).

 

Tax avoidance developments and reform

27. Are there any current trends, developments or reform proposals that have or will affect the area of tax avoidance in your jurisdiction?

In recent years, the on-going discussion among politicians, representatives of the federal government, academics and other members of the tax community regarding tax avoidance has focused on preventing erosion of the US tax base through the use of structures and transactions that have the effect of shifting corporate profits out of the US to low-tax jurisdictions. Multiple proposals have been made, which are directed at eliminating perceived abuses and loopholes involving US international tax rules. Although the focus of anti-avoidance proposals has been increasingly directed toward reformation of US international tax rules, there also are many US domestic tax benefits and planning techniques that have drawn the attention of critics. Some recent proposals are outlined below.

Restriction of certain interest expense deductions of foreign and US multinationals

This proposal would:

  • Defer the deduction of interest expense allocable to stock of foreign subsidiaries to the extent the income of these subsidiaries is deferred until it is repatriated.

  • Limit the over-leveraging of a multinational group's US activities by restricting US interest expense deductions of the US subgroup to the amount of the US subgroup's interest income, plus the US subgroup's proportionate share of the group's net interest expense.

Expansion of anti-inversion rules

Under current anti-inversion laws and regulations, a foreign corporation that acquires a domestic corporation will generally be treated as a US corporation and subject to tax in the US on its worldwide income if, after the transaction, shareholders of the US corporation, before the restructuring, continue to own 80% or more of the restructured foreign corporation by reason of their prior ownership of stock of the US corporation, unless certain minimum requirements regarding non-US activities are satisfied. Since the inversion rules were first enacted in 2004, Congress and the IRS have continued their efforts to curb inversions. The US Treasury Department released additional regulations in 2016, further restricting the ability of a US company to "invert". Among numerous other provisions, the regulations provide rules that would:

  • Disregard certain stock of a foreign acquiring corporation that holds predominantly passive assets.

  • Require a foreign acquiring corporation to meet certain tax residency requirements in certain acquisitions involving both domestic and foreign targets.

  • Disregard certain stock of a foreign acquiring corporation if this corporation has recently acquired one or more US entities.

The new rules all have the common goal of making it more likely that a transaction will be treated as an inversion for US federal tax purposes.

Limit shifting of income through intangible property transfers

In 2016, the US Treasury finalised regulations under section 367 of the IRC. These rules require US taxpayers to recognise gains on transfers of foreign goodwill or going-concern value to a foreign corporation in certain non-recognition transactions.

Taxation of earnings from carried interests as ordinary income

Certain earnings of partnership entities allocated to partners who received their interests in the partnership in exchange for the performance of services may qualify for preferential long-term capital gains rates if the partnership disposes of capital assets held for more than one year. The proposal would tax a partner's share of income on an investment service partnership interest (ISPI) as ordinary income regardless of the character of the income at the partnership level. In addition, the partner would be required to pay self-employment taxes on this income, and the gain recognised on the sale of an ISPI that is not attributable to invested capital would generally be taxed as ordinary income, not as capital gain.

 

The regulatory authority

Internal Revenue Service (IRS)

W www.irs.gov

Outline structure. The IRS is a bureau of the Department of the Treasury. The IRS is headed by the Commissioner, who is in charge of overseeing the general operations of the IRS. The IRS functions under four major operating divisions: the Large Business and International division (LB&I), the Small Business/Self-Employed (SB/SE) division, the Wage and Investment (W&I) division, and the Tax Exempt & Government Entities (TE/GE) division.

Responsibilities. The IRS is responsible for collecting US tax payments and administering the laws of the Internal Revenue Code.

Procedure for obtaining documents. Various documents can be obtained from the IRS website.

 

Online resources

Internal Revenue Code of 1986 (Title 26 of the United States Code)

W www.law.cornell.edu/uscode/text/26

Description. This website provides access to the text of the Internal Revenue Code.

US Treasury Regulations (Title 26 of the Code of Federal Regulations)

W www.law.cornell.edu/cfr/text/26/chapter-I

Description. This website provides access to the text of the US Treasury Regulations.

Internal Revenue Service (IRS)

W www.irs.gov

Description. The IRS website is maintained by the IRS and contains IRS guidance and pronouncements, along with US tax forms and IRS publications, among other things.

 

Contributor profiles

Peter O Larsen, Partner

Akerman LLP

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Professional qualifications. Licensed to practise law, State of Florida

Areas of practice. Corporate tax; international tax and estate planning.

 
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