In Pikeville Coal Co., et al. v. United States, (Ct. Fed. Cl. 1/14/97), unofficially reported at 97 TNT 15-8 (1/23/96) and 79 AFTR2d Par. 97-353, the taxpayer sold coal to its Canadian parent corporation for amounts that appear to have been significantly in excess of the fair market price. It is unclear from the opinion precisely why the phenomenon occurred. The IRS proposed to lower the price, thus reducing the taxpayer's U.S. taxable income and U.S. tax. The taxpayer was not displeased with that adjustment. But, the taxpayer wanted more, urging that the IRS's reductions did not lower the sales price to the real fair market price for the coal in question. The IRS refused further reductions. The taxpayer settled in appeals pursuant to a Form 870-AD that specifically reserved the taxpayer's right to file a claim for refund urging that the sales price as adjusted by the IRS was still too high. This case ensued. The case involved some skirmishes that are not relevant to the point we wish to make here -- i.e., whether the taxpayer can insist that, when the IRS does propose a 482 adjustment, it must go the whole nine yards rather than stopping somewhere in between. It is, of course, black letter law that a taxpayer may not force the IRS to make a 482 adjustment. But, if the IRS chooses to make a 482 adjustment, can the taxpayer insist that the chips fall where they may by reference to the key benchmark -- fair market price -- even if that requires a larger adjustment than the IRS proposes. Harkening to the black letter law forbidding a taxpayer to assert 482, one could -- and the IRS did in its motion for summary judgment -- make the argument that the taxpayer is precluded from insisting upon a larger adjustment. The Court, in somewhat obtuse language, seems to have rejected the IRS's position and ruled that "trial is necessary to determine the fair market value of plaintiff's coal and the reasonableness of the Commissioner's section 482 allocation." This seems to offer the taxpayer some hope that, should it enter persuasive evidence that the fair market price was indeed lower than the IRS determined, it may prevail. (By way of aside, the taxpayer adopting an IRS tactic also attempted to justify the result under Section 61 which, of course, does not require IRS discretion (as does 482), which the Court rejected because it viewed 482 as governing, and also sought some sustenance in the Danielson rule, which the Court also rejected as not being applicable to contractual relationships between related parties.) (Posted 1/23/96)
Update on Pikeville: The Government was displeased with the Court's blessing of the taxpayer's affirmative use of Section 482 and expressed its displeasure with a motion to reconsider. In acting on that motion, the trial court quoted the Government as urging that the court "does not have the Commissioner's authority to reallocate income" under section 482 and "is authorized only to approve or disapprove the reallocation that the Commissioner made." The Court did not buy into that notion, reasoning that if that were the general rule, this is a novel case because here the IRS had made a Section 482 adjustment in the taxpayer's favor. Government counsel admitted at the hearing on the summary judgment motion that this is the first instance of which such counsel was aware of a pro-taxpayer Section 482 adjustment. Seizing upon the novelty of the situation, the trial court apparently perceived that its response too could be novel. Further, the Court reasoned, once the IRS has made an adjustment, if the taxpayer is able to show that the correct transfer price and thus the true income is different than asserted by the IRS, the courts have redetermined the correct income under Section 482 principles. Hence, the Court refused to reconsider and amend its earlier decision. The Court of Federal Claims trial judge's decision is reported at 97 TNT 31-8, 11/14/97.
- This is a truly amazing role reversal. Section 482 is a discretionary provision that the IRS historically invokes against a taxpayer. The discretionary nature of Section 482 means that the IRS has every right to require the taxpayer to lay in the bed he has made, subject only to taxpayer-favored adjustment under the competent authority provisions if the treaty country on the other side of the transaction requires additional tax from that taxpayer and the taxpayer asks that treaty country to invoke the competent authority procedures. Here, the IRS made a pro-taxpayer adjustment in the U.S. without any indication that Canada had increased the related party's taxes. We are aware of no reported decision where that has happened, which is not surprising because a taxpayer may be happy to get any adjustment in its favor. Of course, the taxpayer could rattle the cage of the treaty country (in this case Canada) for it to assert more taxes there, thus opening up the competent authority opportunity to maneuver the IRS into making a consistent U.S. adjustment. But that would mean that, in order to obtain the U.S. adjustment, the taxpayer must incur additional treaty country (here Canada) tax. If the taxpayer can get the U.S. to make the favorable adjustment unilaterally, the related taxpayer simply may not have to incur that Canadian tax cost that normally attends competent authority relief. Moreover, and in any event, the statute of limitations on additional assessments in the treaty country (Canada) may have lapsed, in which case the treaty country (Canada) would be prohibited from making additional assessments, thus eliminating this essential predicate to Canada invoking the competent authority procedures.
- If the treaty country (Canada) does not (either because it chooses not to or cannot because the statute of limitations has expired) assert additional tax, the taxpayer is blessed with "found money" in the U.S. -- i.e., a cost free refund of U.S. tax that is not offset (as it usually would be) with additional taxes in the treaty country. Since the every essence of the tax treaties is that refunds in one country follow only if there are additional tax costs in the other, any refund to the U.S. taxpayer would be an act of undeserved grace that the IRS set in motion by making the initial Section 482 adjustment when it simply did not have to do that. Having "found" this chunk of money, the taxpayer simply decided that it wanted the whole cahuna. Given the amounts involved (including the interest on the amounts given the age of the tax years involved), it was worth even a whole bunch of legal fees to test the parameters of Section 482. The gambit seems to have paid off (at least for now).
- The real kudos belong not only to the lawyers who have persuaded the Court of Federal Claims to give this taxpayer a shot at the whole cahuna, but to the unknown person in the taxpayer's organization or among its tax professionals who convinced the IRS to make the initial Section 482 adjustment. This person is entitled to be put on the front cover of some tax publication as man or woman of the year.
- The cases upon which the Court relies merely held that where the IRS had made too large an adjustment in the IRS's favor but the taxpayer's return reporting position based on its actual transfer pricing is also wrong, the court can reach a decision between the two erroneous extremes. In that case, all the court is doing is adjusting downward the IRS's act of discretion under Section 482. No cases have suggested, however, that a court could go beyond the adjustment asserted by the IRS, probably because, until Pikeville, no situation like that has been presented and because it does raise the issue now presented of whether that would be pre-empting the Commissioner's exercise of discretion.
- The IRS's practical solution to any concerns should Pikeville stand is simply never to make a pro-taxpayer adjustment under Section 482.
- Pikeville invites the question of whether the Pikeville principle could apply where the IRS makes a Section 482 adjustment in the IRS's favor, but in contesting that position, the taxpayer asserts that, not only is the IRS's position on transfer pricing wrong, the taxpayer's own original transfer pricing used in computing tax on the original return was wrong in the IRS's favor and force an adjustment on the IRS. For example, say widgets were sold by the U.S. affiliate to an Australian affiliate for $1.00 per unit and that price was used in reporting on the U.S. and the Australian returns. The IRS seeks to move the price to $1.10 per unit. Having forced the taxpayer to inquire into the "arm's length" price, the taxpayer's economist developed a persuasive model that the correct arm's length price is $0.90 per unit. Since the IRS made the initial Section 482 adjustment, can the taxpayer, by litigation, force a Section 482 adjustment in its favor or is the taxpayer's opportunity for relief spent by merely avoiding the IRS's proposed adjustment? That's a good question that the reasoning in Pikeville suggests should be answered in the affirmative. Given the uncertainty that often attends transfer pricing determinations, this would be a very good result indeed.
- But, in the final analysis, the IRS could still decline to start the ball rolling by making an initial adjustment. In that case, a taxpayer has no U.S. recourse to the overpayment of U.S. taxes as a result of good faith but improper transfer prices. After Pikeville, we doubt that the IRS will again make a pro-taxpayer Section 482 adjustment, but this will still leave open the question of whether, the IRS having made what is initially an anti-taxpayer Section 482 adjustment, the taxpayer can then, in an appropriate case, force a pro-taxpayer adjustment resulting in a U.S. refund.
Posted 2/14/96
In ASAT, Inc. v. Commissioner, 108 T.C. No. 11 (3/31/97), the Tax Court (Judge Vasquez) gave the IRS a significant victory in its transfer pricing attack on foreign owned domestic corporations. Section 6038A and the underlying Regulations provide record-keeping and reporting requirements for foreign owned domestic corporations. Section 6038A further requires the domestic corporation to either (1) obtain the foreign corporation's agreement that the domestic corporation may act as the foreign corporation's "limited agent" for IRS investigation, including summonses, purposes or (2) failing such agreement, be subject to the IRS's discretion as to the domestic corporation's deductions for transactions with the related party or cost of goods sold for inventory acquired from the related party. The latter is referred to as a noncompliance penalty. The statute says that the noncompliance penalty "shall be the amount determined by the Secretary in the Secretary's sole discretion from the Secretary's own knowledge or from such information as the Secretary may obtain through testimony or otherwise."
Because the domestic taxpayer failed to obtain timely the agreement for "limited agent" authority, the IRS made an adjustment increasing the domestic corporation's ("taxpayer's") income (a so-called "gross profit percentage," based on deductible payments to the parent or for cost of goods sold) from 6% to 15%. In setting the gross profit percentage, IRS personnel followed IRM procedures, drew upon its experience from the audit of a similarly situated taxpayer, consulted with an IRS agent and referred to an industry research study (MANA Research Bulletin). MANA is an acronym for Manufacturers' Agents National Association.
Congress intended Section 6038A to give the IRS more discretion than it has under Section 482. The taxpayer's burden to avoid an adjustment under Section 6038A is greater than the taxpayer's burden to avoid a Section 482 adjustment. Under Section 482, the taxpayer must show only that the IRS's determinations are "arbitrary, capricious, or unreasonable." The taxpayer can use any source to do that, and taxpayers at trial typically produce reams of information and expert testimony that was not available to the IRS in making its determination in the notice of deficiency. Under Section 6038A, by contrast, the plain language of the statute limits the "proof" to which the abuse test is applied to the information known to the IRS at the time of making the determination. The issue is whether the IRS abused its discretion by reference solely to that information. According to the legislative history, the limited proof must be "clear and convincing" that the IRS abused its discretion, not just more likely than not.
In ASAT, by the time of the audit, the foreign parent corporation had lost control of the domestic subsidiary through the issuance by the U.S. subsidiary of stock diluting the parent's ownership to 5%. The Court rejected the taxpayer's argument that the statute required control at the time of the audit rather than the time of the transactions (the tax years in issue). The Court also rejected the taxpayer's argument that the legal and practical impossibility of obtaining such a "limited agent" agreement for just a 5% shareholder rendered Section 6038A inapplicable.
Moving to the issue of abuse of discretion, the Court rejected the taxpayer's expert who, in traditional Section 482 style, considered evidence and factors other than the evidence and factors known to the IRS at the time of making the determination. The Court took pains to say that it was not holding that it would never consider an expert, but that the expert must be helpful in light of the standard the Court must apply (i.e., abuse of discretion based solely on the information known to the IRS).
The Court then reviewed the evidence available to the IRS when it made the determination and concluded that the IRS had not abused its discretion. In short, the taxpayer was required to report income that, arguably at least, it might not have had to report under Section 482. This was precisely the result Congress intended.
- Structure as a Commission. The obvious planning technique for taxpayers such as this is to structure the U.S. subsidiary's income as straight commission income. Section 6038A applies only to adjustments to cost of goods sold and deductions, not to the quantum of gross income. Indeed, given the somewhat confusing facts of ASAT (i.e., the IRS referred to the arrangement as a commission arrangement and the determination was based upon the economics of commissions), the Court took pains to create the concept of "gross profits percentage" and find that it was not a commission arrangement at all, but involved the U.S. subsidiary's payments to the parent. (See footnote 6 of the opinion; see also footnote 8.) Structuring the arrangement as a commission arrangement should solve the problem.
- Consider Treaty Relief. U.S. treaties provide that the transfer price is the price that would have obtained in an arm's length transaction. (E.g,, Article 9 (Associated Enterprises) of the U.S. Model Convention dated 9/20/96; see also Treasury Technical Explanation of the Convention.) The purpose of this standard is to insure consistent treatment in the countries taxing both sides of the transaction. The standard thus imposed by treaty does not even remotely hint at the spin provided in Section 6038A, which can (and undoubtedly will almost invariably) result in a transfer price that is not consistent with the arm's length standard (which was just the point of the taxpayer's expert testimony in ASAT which the Tax Court refused to consider). The treaty thus offers taxpayers two lines of attack:
- First, the taxpayer could argue that the treaty overrides Section 6038A, because the standard in the treaty is the arm's length standard. The theory is that the treaty override of domestic law imposes the only standard to which the taxpayer is subject. There are, of course, several problems inherent in this argument. At the most basic level, the treaty may pre-date Section 6038A, in which case the statute might override the treaty. (There is a whole body of not wholly consistent law on this subject, so I shall do nothing more than mention the problem.) More substantively, if the treaty standard can be demanded by the taxpayer, then it would appear that a taxpayer might have a right to a Section 482 adjustment. But it is black letter Section 482 law that a taxpayer cannot do that. I think that the treaty should be read as applying only when one of the two treaty countries attempts a Section 482 or 482-like adjustment, which is what the IRS did in ASAT. But, when the IRS chooses to make a Section 482 or 482-like adjustment, then it seems to me that the taxpayer affected and the related party in the treaty country are entitled to insist that it meet the treaty standard and that Section 6038A cannot be allowed to change that result. Of course, treaty countries will often have information exchange procedures so that the information the IRS felt it lacked may have been available through other methods.
- Second, at least arguably, a taxpayer facing a transfer pricing adjustment driven by Section 6038A, should consider seeking competent authority relief, so that the standard applied on both sides is the arm's length standard alone, without any "penalty" for failure to comply. A consistent adjustment by the treaty country could eliminate or substantially mitigate the U.S. tax cost of the primary adjustment. However, the IRS may take the position that, since Section 6038A is designed to impose a penalty, a taxpayer will not qualify for competent authority relief.
- There is, of course, no treaty with Hong Kong, so these opportunities -- even if they are even viable -- were not available in ASAT.
- Avoid Suspicious Facts. The facts in ASAT are somewhat suspicious as to the dilution of the foreign parent's ownership, but the case does point out a real problem where a company with such foreign ownership is acquired. Obviously, the acquirer should be sensitive to the problems that might inhere in the seller's absence from the scene and disinterest in participating in any resolution of the acquired company's tax problems. There should be the standard indemnities, but with this particular sword of Damocles hanging over the head of the acquired company, perhaps some additional protective measures are in order.
- IRS Use of Other Taxpayer's Audit Information. In ASAT, the IRS used information determined in the audit of a third party, otherwise unidentified. The use of such third party information in an audit of another taxpayer is questionable for reasons that I have discussed elsewhere. See Townsend, Section 6103 and the Use of Third Party Tax Return Information in Tax Litigation, 46 Tax Lawyer 923 (Summer 1993).
In Inverworld, Inc. v. Commissioner, T.C. Memo 1996-301, 71 T.C.M. (CCH) 3231, the Tax Court pounded another blow to this already pummeled related taxpayers. See Inverworld, Ltd. v. Commissioner, ___ F.3d ___ (D.C. Cir. 1992), unofficially reported at 1992 DTR 228 d21 (11/25/92) (holding that taxpayer could not add to a petition in Tax Court $900 million issues from separate notice of deficiency for which no petition was filed). On 5/12/97, the Tax Court in a supplemental opinion to its 1996 opinion told these taxpayers that it meant what it said. Most importantly for present purposes, it addressed the taxpayers argument regarding correlative adjustments after a primary adjustment. We all know that, if as a result of a primary Section 482 adjustment, the related taxpayer on the other side of the transaction is entitled to a U.S. tax benefit, that related taxpayer can demand and receive a correlative adjustment so as to mitigate the tax cost to the family of taxpayers. For example, if the IRS insists that company X, a U.S. taxpayer, must include additional service income as a result of its dealings with company Y, also a U.S. taxpayer, company Y is logically entitled to additional deductions from that primary adjustment to company X. In Inverworld, the IRS made Section 482 adjustments to a U.S. company with respect to its dealings with a foreign parent. The foreign parent was held to be in a U.S. trade or business, thus subjecting it to net income tax with respect to its effectively connected income. The foreign parent, however, did not file a U.S. tax return, thus giving rise to the Section 882(c) penalty of gross income taxation through denying it deductions. The Tax Court held that, since it must be denied deductions under Section 882(c), the IRS need not make correlative adjustments. In its motion for reconsideration, the taxpayer urged that the regulatory provisions for the correlative adjustments required that the correlative adjustments be made regardless of Section 882(c). In its action on the motion for reconsideration, the Tax Court simply held that it meant what it said.
Waiver of Interest in Competent Authority
In an FSA (FSA 1998-59, reported at 98 TNT 101-56, the IRS advises that, although there is no basis for waiving interest on a deficiency under the Code, the U.S. Competent Authority may waive interest on a U.S. deficiency under its jurisdiction. The OECD comments that it may be appropriate to waive interest. See OECD Draft Report on Transfer Pricing Guidelines, reprinted at 95 TNT 52-50, at Ch. VII.C.iv.e. Taxpayers and their representatives should make this part of the checklist when they are making a competent authority request, particularly because interest may not be available from the treaty partners on any treaty partner refund resulting from an IRS initiated adjustment.