January 1999
DHL - A Strategy Lesson in Transfer Pricing Controversy
In DHL Corp., et al. v. Commissioner, T.C. Memo. 1998-461, released in the twilight hours of 1998, the Tax Court (Judge Gerber) handed the taxpayer what appeared to be a significant defeat in a transfer pricing dispute. In this report, I shall not restate the detailed facts of the case. Those facts are, of course, critical in transfer pricing and other fact dependent cases. However, those particular facts are unlikely to be encountered in other transfer pricing cases. So I will here deal with some larger issues that are likely to be presented in other transfer pricing cases. Those issues involve the burden of proof issue the Court resolved first in its opinion, a brief review of the penalty applied, and the issue of whether, despite the facial loss, DHL really won.
Burden of Proof and Taxpayer NonCooperation.
Jim Fuller, the foreign tax guru, is reported to have made the following comment regarding the Tax Court’s resolution of the burden of proof:
Fuller also said he was "a little bit confused" by the court's standard for whether IRS was arbitrary, capricious, or unreasonable in making its assessment. IRS in its deficiency notices determined the trade name was worth between $500 million and $600 million, while DHL reported a value of $20 million on its return. DHL's number was substantially closer to the $100 million value the court determined, yet IRS was not found to be arbitrary or unreasonable, he said.
See Moses, Practitioners Say DHL Case First Where 40 Percent Penalty Upheld Author, 03 DTR G-1 (1/6/99).
Before moving to the burden of proof analysis, I can identify a typical phenomenon in transfer pricing cases. The IRS makes an extremely aggressive determination. The case is ultimately resolved for a fraction – somewhere in the 5-25% range of the IRS’s initial determination. On its face, can it be said that a determination that much out of whack with the real value is not arbitrary, capricious or unreasonable? Set aside that I have just injected some transfer pricing jargon ("arbitrary, capricious or unreasonable") into the question, and just answer the question from a lay or businessman’s standpoint. Is a valuation 4 to 20 times off the mark arbitrary, capricious or unreasonable?
The standard statement of the burden of proof in transfer pricing cases includes the following repeated rotely by the Tax Court in DHL: "taxpayers generally bear a heavier than normal burden of proving that the Commissioner's section 482 allocations are arbitrary, capricious, or unreasonable." I shall hereafter refer acronymically to this standard as "ACU." This burden, and the inquiry it requires, is a significant one (if for no other reason than the solemnity with which it is routinely pronounced), but I explore here the consequences of the burden and the inquiry. What actually happens if the taxpayer fails to establish that the determination is ACU? Can the taxpayer then establish some lower number as being the correct arm’s length price (on the notion that, even if the determination is not arbitrary, capricious or unreasonable, it is still wrong and the right answer should prevail)? What happens if the taxpayer achieves the holy grail – i.e., the Court finds the Commissioner’s determination to have been arbitrary, capricious or unreasonable. Does or should the taxpayer then win completely, because the determination then drops off the court’s map and there is no basis to hold for the IRS? Is the IRS then allowed to develop and litigate a trial position that is not arbitrary, capricious or unreasonable? If so, who bears the burden of proof, often referred to in this context as the risk of nonpersuasion (i.e., the risk that the Court will not be persuaded to find a number to the party’s liking)?
In real transfer pricing litigation (and in other valuation disputes), the parties’ opening salvos are often wildly disparate. The stages of trial resolution of the dispute are similar to and emulate the stages that would occur in a hypothetical sale of the underlying property or services being valued. Usually, but not always (e.g., Nestle Holdings, Inc. v. Commissioner, 152 F.3d 83 (2d Cir. 1998), the IRS wants a higher value and is thus like a seller of the asset or services posturing for higher value. In that case, the taxpayer will be like a buyer, posturing that the property or services are not worth nearly so much. (As in Nestle Holdings, the roles can be reversed in transfer pricing cases.) The process determines where, within a fair range, the deal would be struck if both parties negotiated in good faith, considering all relevant facts and circumstances. The difference in transfer pricing (and other valuation) litigation, where the parties are not compelled to pursue the process in good faith, is that the Court will "strike" the deal if the parties cannot or will not.
If Section 482 litigation were like other tax litigation, the issue would simply be to determine the correct "arms-length price" for the property or services in question. In run of the mill tax litigation, the taxpayer bears the burden of proof (persuasion) regardless of whether the IRS’s determination was ACU. The right result would prevail, with the risk to the taxpayer as to valuation issues that it will not achieve a number that the Court cannot find by a preponderance of the evidence. (From a litigation perspective, this means that the taxpayer gets the result that a preponderance of the evidence demonstrates is correct, and cannot achieve a number when the trier of fact is in a state of equipoise as to the number, meaning that it cannot find the number by a preponderance of the evidence. I shall return to this theme below.)
But that is not how the Section 482 inquiry has been traditionally formulated. Section 482 is a discretionary provision – it applies only upon the IRS’s exercise of discretion (another overbroad statement but true during the period that the Section 482 burden of proof standards were developed). Accordingly, the courts developed the threshold requirement that, in order for the taxpayer to get into "arm’s length price" ballpark, the taxpayer had at the beginning to show that the IRS’s determination was ACU. The notion was that, in order for the taxpayer to prevail, in whole or in part, the taxpayer must make a threshold showing that the IRS’s determination was ACU, which is not the same as just showing that it was incorrect. Taking that notion at its face, one would think that, failing that showing, the taxpayer would not be permitted to show that the taxpayer’s valuation or some point in between the taxpayer’s valuation and the IRS’s determination was the correct one. Stated otherwise, if the taxpayer fails to show that the IRS’s determination was ACU, the determination in the notice of deficiency would (at least conceptually) be sustained.
But, the dynamics of moving from notice of deficiency to litigation (just as the dynamics of moving forward in negotiations to buy and sell) means that the parties’ respective valuations become more refined and should tend to converge (at least if both sides act reasonably). Does that mean, per se, that the opening position, either stated by the taxpayer in its return or the IRS in its notice of deficiency is per se arbitrary, capricious or unreasonable? Certainly not per se. So, at least conceptually, the mere fact that the IRS during the litigation process might retreat from its opening notice of deficiency valuation, and retreat significantly, does not mean per se that its opening valuation was arbitrary unreasonable or capricious. More facts are needed.
The question I address first is why is it important to even address the issue of whether the IRS determination is ACU, if the ultimate determination is based upon the arm’s length price? Why not just move to the latter issue without wasting time determining whether the determination was ACU, an inquiry normally not made or permitted in tax cases.
The DHL opinion suggests that DHL pursued the ACU attack in order to "assert that their burden in these cases should be to show, by only a preponderance of the evidence, that the prices with any commonly controlled entities were consistent with an arm's- length price." This suggests that DHL believed that, unless it were successful in convincing the court that the determination was ACU, it would lose without even reaching the inquiry of what the arm’s length price should be – whether that price were the originally reported price or some point in between that price and the price in the determination -- and applying the tax result accordingly.
Is DHL’s assumption correct? In DHL itself, the Tax Court found that the IRS's determination, although clearly erroneous, was not ACU. The Tax Court nevertheless, resolved the inquiry as to the correct arm’s length price and applied the tax consequences accordingly without automatically sustaining either the IRS’s determination or its lower litigating position and without, seemingly, in any way punishing DHL for failing to meet the ACU burden.
Let’s look at the dynamics in DHL on the trademark valuation issue. The taxpayer’s return reporting valuation was $20 million; the IRS’s notice of deficiency was $500-600 million; at trial, the IRS retreated to a $300 million value and the taxpayer stuck to its return reporting position. The taxpayer urged that the Commissioner’s retreat to $300 million showed the original valuation to be ACU. The Court rejected that argument because the taxpayer had been dilatory and uncooperative in providing information during the audit process and refused to extend the statute of limitations, so that the IRS was forced to issue the notice of deficiency on the basis of the limited information it had at the time the notice was issued. The Court rejected a related argument that the IRS’s failure to provide the taxpayer a report of its valuation prior to or contemporaneous with the notice of deficiency rendered the notice ACU because the taxpayer’s noncooperation strategy prevented the IRS from being able to do that. The Court, in effect, said it would not permit the taxpayer to benefit from pursuing a strategy of noncooperation in the audit process to force the IRS to make its determination on information that subsequently proves to have been inadequate.
The Court nevertheless proceeded to determine the correct valuation, just as it does in any valuation case where the ACU of the IRS determination is not relevant. What this means is that the ACU inquiry, in DHL, was irrelevant to the outcome. The taxpayer and IRS achieved or suffered the same result they would have had the ACU inquiry never been made. What then, I ask, is the purpose of the ACU inquiry in Section 482 cases?
The Court seems to suggest its irrelevance in the following quote, even while facially paying allegiance to the ACU burden: "Petitioners' burden is to show that each section 482 adjustment is arbitrary, capricious, and unreasonable. To do that, taxpayers normally show that the questioned transactions were conducted under an arm's-length standard." Assuming the Court makes the latter determination under a preponderance of the evidence standard, then the ACU inquiry is irrelevant.
Of course, this quote does not directly address the situation in DHL where the actual arm’s length price determined by the court was significantly higher than the price at which the transactions in question were reported. But, the Court made clear that its determinations of arm’s length pricing were based upon its actual findings, based on the preponderance of the evidence standard, with, of course, the risk of nonpersuasion being on the taxpayer. So, DHL in the final analysis appears to have been resolved just as any other valuation issue in a tax case -- i.e., the court found a value based on the preponderance of the evidence with the taxpayer bearing the risk of nonpersuasion as to the valuation it seeks to avoid.
My illustration as to how this plays out (adopting the DHL numbers solely for illustration) is as follows: The court starts by rejecting the obviously wrong parameters – the taxpayer’s $20 million proffer and the IRS’s $300 million trial proffer. The court then brackets towards the arm’s length range by similarly (albeit perhaps less easily) rejecting other numbers by a preponderance of the evidence. For example, the court could relatively easily conclude that $50 million would be an incorrect number and that $150 million would be an incorrect number. Similarly, the Court might be able to conclude, by a preponderance of the evidence that $89 million is an incorrect number, being too low, and that $101 million is an incorrect number, being too high. Based on this analysis, it might conclude that the range for a right number of $90-100 million. (The concept of ranges in valuations is known to all who play in this area.) Then, since this is a range, one could argue that the "right" result would be the mid-point -- $95 million. But, since it is a range in which any number in the range is a right number, the taxpayer has not established that by a preponderance of the evidence that any number less than $100 million is the right number and therefore the court could resolve the case on the higher point in the range in order to give the IRS the benefit of the taxpayer’s burden of proof. (This analysis would be similar to the interquartile analysis in the regulations.) Alternatively, the court might just decide at what it perceives is the mid-point – $95 million in this example -- because it is the feel good "right" result based on the evidence presented without skewing that result to resolve doubts against the taxpayer.
Although there are many variations on the foregoing dynamics of how courts reach the point in the range to make a bottom-line resolution of the case, the key point I make here is simply that DHL suggests that the Tax Court will reach the result regardless of the resolution of the ACU inquiry.
A related question, therefore, is whether, although the decision facially talks "punishment" of DHL for its pre-determination and even pre-trial intransigence, the bottom-line result in fact did really punish DHL? The Court after all resolved the case on the basis of all the evidence the parties put before it, despite the fact that the IRS was hampered throughout the process by taxpayer’s intransigence. If that is correct, despite the Court’s bemoaning of such tactics, it appears not to have really punished DHL for the conduct. Indeed, if it did not and future courts follow suit, intransigent taxpayers might be rewarded by keeping as much information from the IRS as possible, thus hampering the IRS's ability to rebut the evidence that the taxpayer puts into the record at trial. In other words, with the trial record in part shaped by the taxpayer's intransigence, the Court may be able to find in the taxpayer’s favor, as compared with the evidence that the Court would have had the taxpayer been fully cooperative.
The judicial solution to such gamesmanship is, of course, to resolve all doubts against the taxpayer to the extent that the Court can determine or divine that the taxpayer’s intransigence has negatively shaped the record before it. That may have been what happened in DHL, but the court did not expressly state that it did.
The Penalties
The Court applied Section 6662(h)’s 40% gross valuation misstatement penalty to the trademark adjustment. The Court rejected the taxpayer’s reasonable cause argument based upon its reliance upon an expert, concluding that "As this trial has again demonstrated, parties can find experts who will advance and support values that favor the position of the person or entity that hired them."
Did DHL Win or Lose?
Attempting to put the best spin on the case, DHL announced through a spokesperson that DHL "is pleased that approximately four-fifths of the adjustments proposed in IRS's statutory notice have been rejected," but added that it was disappointed with "certain aspects" of the court's ruling and "is considering all of its options with respect to those portions" of the opinion. See Moses, Practitioners Say DHL Case First Where 40 Percent Penalty Upheld Author, 03 DTR G-1 (1/6/99). Of course, the company externally will want to put the best spin on the matter, and internally the Tax Director (or other person shaping the course of the audit and litigation) will want to put the best spin on the matter. But, is this a fair spin?
What the report suggests is that the taxpayer may have lost the court battle, but won the war. Sophisticated taxpayers will recognize that a "victory" of the proportions suggested by DHL’s pronouncement may not be a victory at all. IRS transfer pricing determinations are often -- indeed usually -- full of water, a bubble that can be easily exploded in the IRS appeals process without contentious litigation that is extremely costly to a taxpayer (both in terms of outside fees and internal costs and distractions). Most transfer pricing disputes are resolved in Appeals, and the statistics of Appeals Office resolution produce a range of resolution consistent with the ultimate DHL "victory" in the hotly contested (and expensive) court litigation. That does not mean that DHL could have achieved that result in Appeals, but assuming $100 million is the correct number (or within the correct range, to be more precise), reasonable parties dealing with each other in good faith should be able to come to that range. Of course, an intransigent taxpayer such as DHL is unlikely to obtain a resolution in Appeals that Appeals would feel comfortable in accepting (simply because Appeals would not feel it has all the material information), and it appears DHL wanted the whole banana, a result that neither Appeals nor the Tax Court could accept. So, the lesson, I think, is that, although you might achieve some ultimate, albeit dubious, litigation benefits, some significant degree of cooperation at the administrative stage may actually produce as good a result as long and expensive and distracting litigation will produce.
If that phenomenon played out in DHL, DHL’s pronouncement should have been something as follows: "DHL is pleased that, through this long, costly and contentious litigation, it has achieved the same result that it could have achieved a long time ago at a fraction of the cost." I obviously cannot say that is a correct characterization of the results that DHL could have achieved. But, assuming that the Court correctly resolved the transfer pricing issue, it is hard to believe that parties dealing in good faith with fair sharing of relevant information could not have moved to that point in a more orderly, less expensive and less time-consuming manner. It is not enough in this regard to say that the IRS’s numbers were unreasonable, so that you can’t negotiate to the proper result with an unreasonable party. As the court found, the quantum of the IRS’s number, although wrong, resulted from the taxpayer’s intransigence.
And, when the penalties are considered, it can quickly be seen that DHL appears to be a much greater loser. As noted above, on the trademark issue, DHL suffered the 40% penalty. I obviously do not know whether, even in an Appeals resolution of the underlying transfer pricing dispute at the number finally determined by the court, the IRS would have asserted or waived the penalty. Certainly, the size of the adjustment would have raised the possibility of the penalty. But, my experience (far less than universal) is that such penalties do not materialize or can be avoided or substantially mitigated where the taxpayer deals in good faith in the audit and Appeals processes.
Accordingly, it appears to me, based upon my experience and the public information of which I am aware (the decision and the cited article) that DHL was a big loser in the court battle on the trademark issue and also did not win the war, except in the superficial sense that it obtained a transfer pricing result that was only about 16-25% of the IRS’s original determination, a result that most taxpayer’s achieve at far less cost and hassle. Systemically, of course, DHL was not a loser, for it got justice, and that is all it is entitled to when it enters the courthouse. Dollarwise, however, DHL appears to have achieved justice at costs that could have been avoided.
This report was prepared by John A. Townsend. For an earlier article by Mr. Townsend on the burden of proof issue discussed above, click here. For consideration of the related issue of abuse of discretion under Section 6038A, click here.
Tax Court Judge Tannenwald Dies
The Washington Post reported on 1/20/99 that Tax Court Judge Theodore Tannenwald died on 1/17/99. He was 82 years old. Judge Tannenwald had a distinguished career in many areas, scholastically, political, administrative and judicial. But across the tax bar, Judge Tannenwald will be remembered as a Tax Court judge -- an outstanding one and certainly within a handful of the best Tax Court judges we have ever seen or are likely to see. We will miss him.
The Washington Post on 1/21/99 reports that John Nolan, a leader of the national tax bar, died on 1/21/99. Nolan, a partner with Washington's Miller & Chevalier, was a leader in the corporate and international tax arena. He formerly served as Deputy Assistant Attorney General and was formerly president of the American Bar Association's Section of Taxation. He was known and respected throughout the tax bar.
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