Transfer Pricing Times: Volume XII, Issue 8
In this Edition: Tax Court Rules in Altera’s Favor and Against Requirements that Stock-Based Compensation be Included in Intangible Development Cost Pools in Cost Sharing Transactions.
On July 27, 2015 the US Tax Court released an opinion in Altera Corp. v. Commissioner., U.S. Tax Court, No. 6253-12, No. 9963-12 (“Altera case”) finding invalid the 2003 rule (U.S. Treas. Reg. §1.482-7(d)(2)) requiring stock-based compensation (SBC) costs to be included in qualified cost sharing pools.
From a transfer pricing perspective, the Altera case may be seen, in part, as a sister case to Xilinx Inc. v Commissioner, 124. T.C. 27 (2005), aff’d, 598 F.3d 1181 (9th Cir. 2010) (“Xilinx case”). Prior to the issuance of revised regulations in 2003, the US cost sharing regulations did not explicitly discuss the treatment of SBC. The IRS took the position that such costs needed to be included in cost sharing pools even in the absence of guidance explicitly stating so. In the Xilinx case, the tax court found (and the appeals court affirmed) in favor of the taxpayer, and concluded that requirements to share such costs would be at odds with the arm’s length standard embedded in Section 482. This finding was based on several evidentiary points, including many arrangements and agreements identified by the taxpayer in which third parties were jointly developing intangibles in some form, but did not share SBC costs.
In July of 2002, treasury issued a notice of proposed rulemaking that proposed to amend the cost sharing regulations so that the requirement to include costs would be explicit within those regulations. Opportunities for the public to comment on the proposal were provided, and a public hearing was held. Numerous commentators argued that the proposed rule would be at odds with the arm’s length standard, using evidence and argument akin to that presented during the Xilinx trial. The final rule requiring the inclusion of SBC in cost sharing pools was issued in 2003.
Altera had a longstanding cost sharing arrangement, and did not include SBC in its cost sharing pool, even after the revision to the rules requiring such inclusion was finalized. The IRS adjusted Altera’s income for the 2004 through 2007 period, largely associated with the exclusion of SBC costs. Altera filed a petition with the tax court that argued the 2003 rule was invalid.
The tax court’s summary judgement finding in the Altera case does not make redeterminations of fact as to whether or not sharing of SBCs is or is not consistent with the arm’s length standard, these were not in dispute. Rather, the opinion in the Altera case seems largely to depend on findings of whether or not the treasury engaged in reasoned decision making when it issued the final regulations given the lack of any evidence that SBC’s are actually shared between third parties. The court found that treasury did not adequately respond to the substantial public commentary in making the 2003 change to the rules, and did not have a reasonable basis to conclude that the revised regulations were consistent with the arm’s length standard in light of the available evidence.
The Altera decision is notable for many reasons. The first is that it invalidates the 2003 cost sharing regulations specifically, and by association the current regulations which contain the exact same rule making, and probably means that taxpayers no longer have to share SBC’s in cost sharing arrangements in tax return filings. This has both cash tax and tax accounting implications.
The second, generally speaking, is that it appears to be giving taxpayers broader opportunities to attack final tax regulations on the basis that those regulations don’t meet reasoned decision making standards established under case law (i.e., the “State Farm” standard established in the 1983 Supreme Court case Motor Vehicle Mfrs. Ass’n of the U.S. vs. State Farm). The IRS had argued for a different standard that it had interpreted to provide much broader deference to treasury’s rulemaking.
The third (and related) reason is that the decision may open the door to many other transfer pricing regulatory challenges and/or positions taken by taxpayers that are contrary to explicit language in the US transfer pricing regulations. Such challenges might include challenges to requirements to include SBC in cost-based service charges, and could potentially include other features of the regulations (such as ex post periodic adjustment provisions for intangible prices) that some taxpayers have argued are inconsistent with observed arm’s length behavior.
Lastly, if confirmed and upheld, the decision may well have later impacts on income recognition for cash tax and tax provisions for financial accounting purposes related to claw backs of previously shared SBC’s.
Companies may need to consider updating their cost sharing arrangements in light of the Altera decision, and may want to consult with their advisors to better understand the repercussions of the Altera decision given their specific transactions, facts, circumstances, and intercompany agreement terms they have. The IRS has yet to indicate their response to the decision.
For more information, a complete copy of the decision is available here.
Recap on the 2015 NABE Transfer Pricing Symposium
In late July, the National Association of Business Economists (NABE) convened in Washington, D.C. for its fifth annual Transfer Pricing Symposium, which once again drew leading professionals from business, government and consulting to debate some of the most pressing economics topics in the field of transfer pricing. The themes for this year’s Symposium, co-chaired by Jill Weise of Duff & Phelps, Karen Kirwan of EY, and Thomas Herr of KPMG, centered around value creation and profit splits within global value chains. These topics were selected in light of recently published discussion drafts and public consultations on intangibles, risk and capital by the Organization for Economic Cooperation and Development (OECD) Working Party No. 6, under the international project to combat Base Erosion and Profit Shifting (BEPS).
Highlights from the first day of the Symposium included a series of engaging debates among the panelists on a variety of fundamental issues at the center of the BEPS policy discussions on transfer pricing. Specifically, panelists debated preassigned “pro” and “con” positions regarding: (1) whether the capital employed by controlled parties should be weighted more heavily than the functions they perform when allocating profit in intercompany transactions; (2) whether written contracts that shift risks from one controlled party to another should be respected by tax authorities despite the absence of similar, observable arm’s-length contracts or the inability of a controlled party to perform the functions required under the contract; and (3) whether the comparable profits method/the transactional net margin method are reliable for the purposes of setting intercompany prices in developing countries for lack of comparables. The panelists elicited the complex and divisive nature of some of the most critical policy debates within the OECD’s BEPS project, namely, the degree to which capital investment and taxpayers’ contractual allocations of risk should be respected when pricing intercompany transactions, and the perceived inadequacy of commonly applied transfer pricing methods for determining profit allocations to the developing world.
Day 2 of the Symposium kicked off with a panel on the evolution of the “Commensurate with Income” (CWI) standard and its influence on BEPS special measures. Panelists discussed (1) the intrinsic tension between requirements under the arm’s length standard to price transactions on an ex-ante basis and the ex-post periodic adjustment provisions allowed under the CWI rules, (2) the IRS’s measured enforcement of these provisions since their introduction into the US transfer pricing regulations, and (3) the OECD’s recent embrace of similar rules in public consultations regarding the BEPS discussion draft on hard-to-value intangibles. Day 2 was also host to a transfer pricing challenge characteristic of prior NABE Transfer Pricing Symposiums. This year’s challenge required participating teams from seven firms to design an approach for calculating a profit split within a global value chain. Each approach presented to the judging panelists was unique in its own right, bringing to light the ambiguity and lack of certainty surrounding which qualitative and quantitative factors ought to be considered when splitting profits between controlled participants, and calling into question whether a multi-factor, “one-size-fits-all” profit split framework could be designed to allocate profits within a global value chain. Questions regarding the relative importance of capital versus functions when allocating profits between related entities often resurfaced in panelist discussions.
Other noteworthy sessions which took place during the afternoon of Day 2 and morning of Day 3 included panels on: (1) value creation and how to analyze it; (2) thinly capitalized structures and more broadly, the role and position of intercompany debt within capital structures; and, (3) the transfer pricing economist’s role in a post-BEPS world.
The Symposium concluded with an informative address from Robert B. Stack, Deputy Assistant Secretary for International Tax Affairs in the Office of Tax Policy at the US Department of Treasury, regarding expected forthcoming revisions to the OECD Guidelines from the BEPS project. Mr. Stack reassured participants in attendance that from a technical point of view, transfer pricing analyses should not change dramatically given the US Treasury’s success in reining-in a lot of concepts introduced in the BEPS discussion drafts that would have led to subjective and problematic interpretations. Mr. Stack also revealed that the forthcoming expanded guidance will respect related party contracts, so long as the controlled parties’ conduct are consistent with the terms of the contracts and that contractual allocations of risk are made to controlled parties that can control the risks and have the financial capacity to bear them. On the other hand, parties that contribute funding to a controlled transaction but do not control any of the risks associated with that capital investment will be afforded nothing more than a risk-free return. Mr. Stack concluded his address by noting that a key debate within Working Party No. 6 to be addressed next year is the extent to which risk-adjusted rates of return should inure to controlled parties that contribute capital and also “control” the capital investment, and the criteria which will constitute control for these purposes.
For more information, visit the NABE website here.
Ingersoll-Rand Settles with the IRS regarding Intercompany Debt Dispute
On July 17, 2015, Ingersoll-Rand plc and certain US-based subsidiaries reached an agreement with the IRS resolving disputes centered on certain intercompany debt. Specifically, the resolution covers all intercompany debt issued in relation to Ingersoll-Rand’s financial restructuring in 2001 associated with an inversion via the movement of its headquarters to Bermuda and related issues with debt outstanding during the subsequent ten-year period, including the recharacterization of certain distributions. The IRS has not challenged Ingersoll-Rand’s actual movement to Bermuda, but claimed that Ingersoll-Rand moved money via intercompany debt payments between Bermuda and its US-based subsidiaries, and back to Bermuda in a way that was designed to avoid US taxes.
While the resolution must be reported to and reviewed by the Congressional Joint Committee on Taxation before it can be formally finalized by the IRS, the resolution highlights treaty shopping issues associated with intercompany debt structures, as well as the risks associated with intercompany debt audits by the IRS. The settlement would require the taxpayer to pay $345 million in extra US taxes plus interest; while the original IRS proposal was the payment of an additional $774 million in extra US taxes.
For more information see the Ingersoll-Rand Form 8-K filed July 21, 2015 available here.