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In this edition: the U.S. Court of Appeals for the Eighth Circuit remands the Medtronic case back to the Tax Court for comparability analysis; the U.S. Tax Court found in favor of Illinois Tool Works Inc. in an intercompany debt dispute with the Internal Revenue Service; the U.S. Court of Appeals for the Ninth Circuit overturned the earlier Tax Court decision in the Altera case but then withdraws its opinion; the Australian Taxation Office published draft schedule 2 on related party derivative arrangements; and the Inland Revenue Authority of Singapore published the third edition of the e-tax guide on Country-by-Country reporting guidance.
On August 16, 2018, the U.S. Court of Appeals for the Eight Circuit (the “Appellate Court”) released its opinion, No. 17-1866, vacating the U.S. Tax Court’s (the “Tax Court”) January 25, 2017 order in the Medtronic Case and remanded further proceedings. The original case pertained to 2005 and 2006 royalty rates paid by Medtronic Puerto Rico Operations Co. (“MPROC”) to Medtronic US for the intercompany license of intangibles, including technical information and trademarks, to manufacture medical devices and leads.
In June 2016, the Tax Court found that the best method to determine an arm’s length royalty rate for intercompany license agreements between Medtronic US and Medtronic Puerto Rico was the comparable uncontrolled transaction (“CUT”) method and relied on certain agreements that the taxpayer had identified in their own application of the CUT method. Specifically, in its application of the CUT method, the Tax Court used a 1992 agreement between Medtronic and Pacesetter, which was entered into as part of a litigation settlement, as an appropriate CUT. The Tax Court made several substantial adjustments to the base royalty rate identified in the Pacesetter agreement in its application of the CUT.
In the tax court case, the IRS had argued that the CUT method could not be reliably applied to the intangible transactions between Medtronic US and MPROC and instead applied a CPM to establish arm’s length returns to MPROC. The IRS had argued that all of the agreements used by the taxpayer in their application of the CUT had differences relative to the intercompany intangible license which made them inappropriate for the reliable application of the CUT method. On June 21, 2017, the IRS filed a Petitioner Brief with the Appellate Court alleging that the adjustments ordered by the Tax Court were inadequate, that the comparable profits method (“CPM”) was the best method rather than the CUT method, and that the royalty rate from the Pacesetter agreement was not commensurate with the income attributable to the intangibles covered in the license.
In its review, the Appellate Court determined that the U.S. Tax Court’s finding that the Pacesetter agreement could be used in the application of the CUT method was based on an insufficient factual record. The appellate opinion found that the Tax Court did not conduct the comparability analysis for the Pacesetter agreement relative to the intercompany intangible license that was required by the regulations under Section 482.
The Appellate Courts’ opinion found the following facts potentially affecting the comparability of the Pacesetter Agreement were not addressed:
These four factors cited by the Appellate Court raised comparability considerations that must be addressed in the application of the CUT method.
In addition to the concerns expressed about the Tax Court’s application of the CUT method, the Appellate Court noted that the Tax Court rejected the IRS’ position in part on the basis that it hadn’t given proper recognition or weighting to the risks incurred by MPROC, but did not itself make a specific finding on the amount of risk and product liability expense that would be properly attributable to MPROC. The Appellate Court’s opinion stated that such a factual finding would be necessary to evaluate the Tax Court’s findings on this point.
The Appellate Court remanded the case back to the Tax Court “for further consideration in light of the views set forth in this opinion.”
In an opinion published August 6, 2018, the U.S. Tax Court (the “Court”) found in favor of Illinois Tool Works Inc. (“ITW” or the “Company”) in an intercompany debt dispute with the Internal Revenue Service (“IRS”). The decision eliminates a $70 million tax deficiency and associated $14 million penalty assessed by the IRS after it claimed, among other things, that the Company had inappropriately classified a dividend from one of its foreign subsidiaries as an intercompany loan.
The transaction in question occurred in the 2006 tax year when one of ITW’s foreign subsidiaries issued a $357 million intercompany term note to its holding company, which in-turn distributed the capital back to its U.S. parent as a non-taxable return of capital. The proceeds were then contributed to ITW’s cash pool and ultimately used to pay down commercial paper ITW had issued to finance prior acquisitions. In 2008, the IRS determined that the return of capital was taxable on multiple bases. The IRS first asserted that the initial transfer between ITW’s foreign subsidiaries was a dividend rather than an intercompany loan and, in turn, the distribution to the domestic entity was a taxable dividend under sections 301(c)(1) and 316. Additionally, the IRS determined that ITW had failed to provide evidence of the U.S. parent’s basis in its foreign subsidiary, so that the distribution, even if not defined as a dividend, would be taxable as a capital gain.
The Court heard expert testimony to address the following concerns:
The Court found in favor of ITW in determining that the loan did exhibit characteristics of bona fide debt based on 10 of the 14 characteristics examined.
Specifically, the Court determined that there was sufficient evidence supporting debt characterization for reasons including:
While the Court did find in favor of the IRS on the “extent of shareholder control” factor (i.e., common ownership that may interfere or impede the possibility of demanding payment on the note), this finding was not heavily weighted because of the binding nature of the intercompany promissory notes, and the investment grade rating of the debt. Importantly, the Court rejected the IRS’ argument that a borrower’s ability to pay cannot be derived from a related, lower-tier lender’s income – instead the Court asserted that a third party would consider that cash flows from a holding company’s subsidiaries and hence the borrower’s ability to repay could, in fact, be tied to cash flows expected to be derived from the lower-tier subsidiaries of the borrower.
The IRS also urged the deployment of one or more anti-tax-avoidance doctrines to recharacterize the repatriation of funds as a dividend. Specifically, the Court examined the transaction in the context of the economic substance doctrine, the step transaction doctrine, the conduit doctrine, and “Subpart F Avoidance.” The premises of deploying any of these doctrines, however, was theoretically at-odds with the Court’s finding of the transaction to be bona fide debt. Based on this and additional structural rationale, such as the fact that the transaction was seen to materially change the economic situation of the parties and could not have been achieved more directly, the Court found in favor of ITW on all four of the judicial doctrines.
Lastly, the IRS urged that if the transaction were deemed bona fide debt, that the company did not substantiate basis in its foreign subsidiary and, as such, the distribution should be treated as a taxable capital gain. The Court relied on a basis study completed by a summary witness. In its entirety, the study provided evidence of over four times the necessary amount needed to cover the transaction, however, the Court was able to rely upon three specific capital contributions that provided, in sum, sufficient basis. The IRS contended that ITW’s tax returns and related workpapers were unreliable sources to verify basis, however, was not able to point to any specific evidence for this claim. Ultimately, even if some of the records of basis transactions was poor, the Court found that there was enough evidence to impute sufficient basis.
Given the Court’s finding that there was no recharacterization, it determined that the Company was not liable for any deficiency for 2006 or any accuracy-related penalty.
The Court’s decision in favor of ITW is a reinforcement of the importance of careful and well-documented cross-border financing. Additionally, the court’s opinion established the acceptability of a borrower utilizing cash flows from the subsidiary lender in intercompany debt financing transactions.
Altera, a semiconductor company, now a subsidiary of Intel, has been in a dispute with the IRS over its non-inclusion of stock-based compensation (“SBC”) costs in the payments made under its intangible development cost sharing arrangement (“CSA”). Altera’s position in this matter was based on its belief that including SBC did not meet the regulatory arm’s length standard despite clear regulatory requirements to the contrary for the periods concerned. The case had moved through the Tax Court with a win for Altera, which the government had appealed to the United States Court of Appeals for the Ninth Circuit (“Ninth Circuit”).
On July 24, 2018, the Ninth Circuit had released a decision on the appeal (see that decision here)3. This case focused on the validity of amendments made to the cost sharing regulations in August of 2003 (“2003 CSA SBC Regulations”) which explicitly required the inclusion of SBC costs in intangible development cost (“IDC”) pools for CSAs. In a 2:1 majority decision, the Ninth Circuit had overturned the earlier Tax Court decision and found that Treasury had met the requirements of the Administrative Procedures Act (“APA”) in promulgating the 2003 CSA SBC Regulations and therefore those regulations were valid, enforceable and IRS proposed adjustments to Altera were appropriate.
In that majority opinion that had been issued, the Ninth Circuit provided a detailed account of the rule making process around the 2003 CSA SBC Regulations as well as its interpretation of the legislative, regulatory, and court finding history under Internal Revenue Code (“IRC”) §482 and its predecessors. The court’s analysis especially focused on the evolution of the tax code, related Congressional intent, and Treasury regulations as a result of the Tax Reform Act of 1986, which led to the addition of the commensurate with income (“CWI”) language in IRC §482 applicable to intangibles to counter perceived abuses related to taxpayer transfer pricing and activity around intangibles and intangible development. It also pointed to the detailed review in the transfer pricing “White Paper” presented to Congress in 1988 and Treasury’s subsequent rewrite of its regulations under IRC §482 which were finalized in 1994 generally, and for cost sharing in 1995. The opinion noted that Treasury wrestled with the difficulty in finding reliable comparable transactions between unrelated parties for often unique intangibles in these regulations by clarifying the standard of comparability for the use of transactional methods and including specified non-transactional methods aimed at determining an arm’s length result in the absence of more reliable uncontrolled comparable transactions. It interpreted the 1995 CSA Regulations as providing for such a method that sought to determine an arm’s length result consistent with Congressional intent and therefore standards of comparability more relevant to transaction-based methods were less relevant to cost sharing arrangements. The court also looked at negotiated tax treaties, specifically highlighted the U.S.-Poland tax treaty (2013) noting the primacy of the arm’s length standard and its intended consistency of the CWI rules with the arm’s length standard in the technical explanations, but did not see an irreconcilable conflict. The Ninth Circuit found Treasury acted reasonably in adapting its regulations to account for changing circumstances, specifically in its promulgation of the 2003 CSA SBC Regulations to address the increased use of employee stock-based compensation by many companies, especially those in technology industries. The Ninth Circuit looked at the rule making process behind the 2003 CSA SBC Regulations and found that Treasury was not arbitrary or capricious and did not ignore evidence and commentary presented to it as part of the proposed rule making process that unrelated parties would not share such costs; rather Treasury did not believe the evidence of activities between unrelated parties were in sufficiently comparable situations to those in related party cost sharing arrangements.
A dissent from Justice O’Malley finds that the majority has gone out of its way to justify the agency’s rulemaking based on grounds that weren’t invoked when the rules were being made – a direct violation of what is permissible under case law. In enacting the 2003 amendments to the cost sharing rules, Treasury repeatedly stated that they believed they were being consistent with the arm’s length standard – something that’s not true based on the finding of Xilinx.
If this opinion had been left in place, it could potentially have had major repercussions for many companies’ transfer pricing positions, particularly for those companies with significant SBC costs that had been those from their intangible development cost pools within CSAs. However, the Ninth Circuit withdrew its opinion August 7, 2018, just two weeks after it was issued. Judge Stephen Reinhardt, who had sided with the majority in overturning the Tax Court’s opinion, had passed away in March – months before the opinion was issued. It is unclear why this led directly to the need to withdraw the opinion, as it is not unusual for opinions to be issued after judges participating in the opinions have passed. Nonetheless, the case will be reheard by a reconstituted panel of three judges (including the two surviving justices from the original appellate opinion) on October 16, 2018. It seems likely that Judge Susan Graber, the new member of the three-judge panel, will ultimately decide the case given that the other two justices were on opposite sides of the now withdrawn opinion that was issued in July 2018.
The Australian Taxation Office (“ATO”) focus on intercompany financial transactions continues with the publication of the draft Schedule 2 to Practical Compliance Guideline PCG 2017/4 on related party derivative arrangements on August 1, 2018.
Schedule 2 to PCG 2017/4 sets out 14 indicators for self-assessing the compliance risk associated with related party derivative arrangements by reference to:
The draft schedule appears to go beyond the scope of the PCG insofar as it affects derivatives not associated with financing arrangements such as total return swaps.
Similar to Schedule 1 to PCG 2017/4 dealing with related party debt funding, the risk framework for derivative arrangements is made up of five color-coded risk zones ranging from green zone (low risk) to red zone (very high risk). The risk indicators are expressed as binary (‘yes/no’) questions, with the answer determining the score for each indicator, and the overall score for all indicators determining the taxpayer’s risk zone. A risk assessment is performed for each individual derivative arrangement, with the overall assessment of risk based upon the arrangement with the highest risk score.
The draft schedule states the ATO is likely to consider the derivative arrangement as very high risk where it is not back-to-back with an unrelated third-party transaction reflecting the same terms.
Schedule 2 is proposed to have effect from January 1, 2019 and will apply to both existing and new related party derivative arrangements. Taxpayers required to complete a Reportable Tax Position (“RTP”) schedule will need to disclose their self-assessed risk zone in the RTP schedule.
Taxpayers should assess all current and prospective derivative arrangements with international related parties against the risk framework set out in the Schedule. Taxpayers whose arrangements would be identified as risky under this schedule who wish to avoid scrutiny and possible audit by the ATO may choose to restructure their arrangements in order to reduce the assessed risk of such arrangements. Alternatively, taxpayers who choose not to restructure should be prepared to defend their arrangements or engage with the ATO.
The ATO focus on intercompany financial transactions will continue with the foreshadowed release of guidance later this year on related party interest-free loans, the interaction between tax debt and equity rules and transfer pricing rules, as well the operation of the thin capitalization arm’s length debt test.
The Inland Revenue Authority of Singapore (“IRAS”) published the third edition of the e-tax guide on Country-by-Country (“CbC”) reporting guidance on August 7, 2018. This guidance provides updates to the first edition from October of 2016 and the second edition from July of 2017 with more clarifications on how taxpayer should comply with the requirements to complete CbC Report.
As was true for these prior releases, the Updated Guidance on CbC Reporting is applicable to the MNE group which meets all of the following conditions:
CbC reports must be submitted based on the format specified in Paragraph 5 of the Updated Guidance on CbC Reporting. Reporting Entities are expected to have processes in place to collate and prepare the required data in accordance with the prevailing CbCR XML Schema. Data submitted to IRAS in any other format will not be accepted.
IRAS does not currently demand for secondary mechanism on Singapore subsidiaries of foreign MNEs in the Updated Guidance on CbC Reporting, yet it will monitor developments and assess if there is a need to trigger secondary mechanism.
As compared to the previous editions, this edition provides further guidance on the use of rounded figures in an updated Frequently Asked Questions. Companies can report rounded figures in their CbC report if the source data from which those amounts have been obtained consist of rounded figures. Companies should ensure that the rounding does not have a material impact in terms of understanding the CbC report.
1 The Tax Court case was Medtronic, Inc. & Consolidated Subsidiaries (“Medtronic”) v. Com’r, The original Tax Court decision can be found here. The Appellate Court’s full opinion can be found here.
2 The Tax Court case is Illinois Tool Works. v. Com’r., See the decision (T.C. Memo 2018-121) here.
3 The Tax Court Case was Altera Corp. v. Com’r., 145 T.C. 91 (2015)
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