It Ain t Over Till It s Over: Federal Tax Implications Of Implementing a Sustained Transfer Pricing Adjustment

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1 Tax Management Transfer Pricing Report Reproduced with permission from Tax Management Transfer Pricing Report, Vol. 23 No. 13, 10/30/2014. Copyright 2014 by The Bureau of National Affairs, Inc. ( ) It Ain t Over Till It s Over: Federal Tax Implications Of Implementing a Sustained Transfer Pricing Adjustment The authors present six scenarios illustrating the potential tax, customs and financial statement implications of a sustained transfer pricing adjustment. In this, the first of four articles, they set the stage for examining in greater depth how to cope with a situation that, in the current global environment, is becoming increasingly common. BY STEVEN C. WRAPPE, ERIN COLLINS AND CAMERON TAHERI Steven C. Wrappe is a principal in KPMG LLP s economic and valuation services practice, serving as the national leader for transfer pricing dispute resolution (TPDR) and the deputy head of global TPDR. Erin Collins is a managing director in the firm s tax controversy services practice, and Cameron Taheri is a senior manager in the economic and valuation services practice, serving in the TPDR group. This article represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with a company s tax adviser. T ransfer pricing enforcement continues to escalate globally. Taxing authorities around the world are ramping up transfer pricing audits of multinational enterprises for various reasons, including the perception by some taxing authorities that certain multinational companies may be using transfer pricing principles to concentrate income in low-tax jurisdictions. Indeed, an objective of the Organization for Economic Cooperation and Development s Action Plan on Base Erosion and Profit Shifting (BEPS) is to better coordinate the efforts of competing taxing authorities to prevent the perceived shifting of profits through tax planning. Among the reasons the Internal Revenue Service reorganized and increased staffing to its Large Business and International division was to address transfer pricing issues, and now there are more U.S. transfer pricing cases headed to litigation than ever before. 1 The 1 See IRS Announcement IR , 8/4/10; also see Tax Court Roundup: IRS Smacks Down Eaton, Defends Penalty in Illinois Tool Works, 23 Transfer Pricing Report 706, 10/2/14, Copyright 2014 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. ISSN

2 2 number of U.S. mutual agreement procedure cases recently climbed sharply, increasing 47 percent from 2012 to Globally, cases submitted for MAP also have increased by 21 percent in 2011 and an additional 3 percent in Further, the OECD s current focus on BEPS, particularly its emphasis on country-by-country reporting, is expected to produce additional transfer pricing examinations and adjustments. 4 In the context of this increase in examinations and proposed adjustments, taxpayers will continue to strive to achieve a no change resolution of their transfer pricing examinations, but should expect to see an increasing number of sustained adjustments going forward. Taxpayers that ultimately find themselves with a sustained transfer pricing adjustment, however small, should be prepared to follow through with an implementation process that requires additional administrative effort along with the potential for additional federal and state tax, customs duties and interest. The Four Areas Possible taxpayer efforts and exposures of implementing a transfer pricing adjustment arise in four areas: federal tax, state tax, customs and financial accounting. 1. Federal Tax Taxpayers receiving an adjustment have the following federal tax obligations: s Decide when and how to seek correlative relief. s Decide and make conforming adjustments. s Recalculate U.S. federal and foreign tax attributes including foreign tax credits, business credits, deductions under Internal Revenue Code Sections 199, adjustments under Section 1059A and net operating losses in light of changes to taxable income resulting from the transfer pricing adjustment. s File amended U.S. federal and foreign tax returns, observing applicable statute of limitations rules. 2. State Tax For state tax purposes, companies receiving an adjustment should take the following steps: s Determine impact of changed U.S. federal income on the various state returns. s Recalculate state tax attributes, including net operating losses and credits. s File amended state tax returns, observing applicable statutes of limitations rules. 3. Customs For customs purposes, the following steps are required: which lists 23 separate transfer pricing disputes pending in federal and state courts. 2 See U.S. Competent Authority statistics for the period Oct. 1, 2012, through Dec. 31, 2013, 23 Transfer Pricing Report 217, 5/29/14. 3 See the OECD s MAP statistics, available at See BEPS Could Lead to International Chaos if not Managed Well, IRS Official Cautions, 23 Transfer Pricing Report 3, 5/1/14. s Determine the impact of the changed U.S. federal taxable income on the customs analysis. s Recalculate the customs valuation, as necessary. s File a voluntary disclosure letter detailing the outcome. s File in compliance with the reconciliation program, if relevant. 4. Financial Accounting Taxpayers receiving an adjustment should take the following steps regarding their financial accounting: s Make reporting decisions regarding uncertain tax positions, including issues mentioned above. s Make entries to correct financial statements. This and future articles will explain the potential federal tax, state tax, customs and financial statement implications of a sustained transfer pricing adjustment. A basic example will illustrate the federal tax implications, and will be modified throughout the series to demonstrate differing applications of state tax and customs rules. Finally, all of these adjustments will need to be reflected in the reported financial statements. Basic Example The basic example involves a U.S. parent and U.S. and U.K. subsidiaries. In the transaction at issue, U.S. Sub purchases shoes from U.K. Sub for $100. The transaction is examined, and a transfer pricing adjustment is proposed and agreed. Two variables the country making the adjustment and the ownership relationship between the parties can be changed to present six different fact scenarios that demonstrate many of the important federal tax implications. The federal tax issues concentrate on three adjustments made in the context of implementing a change to a taxpayer s transfer price: s the primary adjustment, made by the tax authority (and sometimes by the taxpayer) to correct a transfer price under Section 482 or the transfer pricing statute of another tax jurisdiction; s the correlative adjustment, the corresponding adjustment made to the other related party to eliminate double taxation; and s the conforming adjustment, which recharacterizes the corrected transaction to conform tax and accounting books after primary and conforming adjustments. The Primary Adjustment Section 482 authorizes the Secretary of the Treasury to allocate or apportion income, deductions, allowances or credits between controlled entities if, in his judgment, the adjustment is necessary to prevent evasion of tax or clearly reflect the income of the related taxpayers. By regulation, the Secretary has clarified that this discretionary authority may be exercised to ensure section 482 places a controlled taxpayer on a tax parity with an uncontrolled taxpayer by determining the true taxable income of the controlled taxpayer. 5 This is accomplished if the taxable income of the entity reflects that which would have been reported from the result of uncontrolled taxpayers transacting at arm s 5 Regs (a)(1) Copyright 2014 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. TMTR ISSN

3 3 Hypothetical Transfer Pricing AdjustmentScenarios U.K.Sub owns US Sub U.S. Parent U.K. Sub Cash Shoes Type #1 Scenario TP issue U.S. (shoes determined to be overpriced by $20) Primary adjustment: IRS adjusts U.S. Sub's income up Correlative adjustment: U.K. Sub adjusts income down Conforming adjustment: Deemed dividend from to U.K. Sub RevenueProcedure Relief: Treated as a loan from to U.K. Sub Type #2 Scenario TP issue U.K. (shoes determined to be underpriced by $20) Primary adjustment: HMRC adjusts U.K. Sub's income up Correlative adjustment : adjusts income down Conforming adjustment: Deemed contribution from U.K. Sub to Revenue Procedure Relief: Treated as a loan from U.K. Sub to length. In the event of a mis-pricing of property or services in transactions between commonly controlled entities, the Secretary may exercise his discretion to adjust the prices used by the parties to report income in order to increase (or decrease) 6 the taxable income reported by the taxpayer on account of the transaction, irrespective of the prices actually charged. 6 In addition to the potential tax due, the taxpayer may also have additional interest due and accuracy related penalties. These will not be addressed in this article, but should be considered in settling a transfer pricing adjustment. Where the IRS has exercised its discretionary authority to reallocate income or expenses among controlled parties, this is defined in the regulations as the primary adjustment. 7 7 The OECD Center for Tax Policy and Administration s glossary of terms (available at glossaryoftaxterms.htm) defines a primary adjustment as an adjustment that a tax administration in a first jurisdiction makes to a company s taxable profits as a result of applying the arm s length principle to transactions involving an associated enterprise in a second tax jurisdiction. TAX MANAGEMENT TRANSFER PRICING REPORT ISSN BNA TAX

4 4 U.S.Sub owns U.K. Sub U.S. Parent Cash Shoes U.K. Sub Type #3 Scenario Type #4 Scenario TP issue U.S. (shoes determined to be overpriced by $20) TP issue U.K. (shoes determined to be underpriced by $20) Primary adjustment: IRS adjusts 's income up Primary adjustment:hmrc adjusts U.K. Sub's income up Correlative adjustment:u.k.sub adjusts income down Correlative adjustment:u.s.sub adjusts income down Conforming adjustment:deemed contribution from to U.K. Sub Conforming adjustment: Deemed dividend from U.K. Sub to Revenue Procedure Relief: Treated as a loan from to U.K. Sub Revenue Procedure Relief: Treated as a loan from U.K. Sub to Subject to limitations, the taxpayer may initiate a primary adjustment. Taxpayers are permitted to report the results (income, expense, credit) of transactions between controlled entities using assumed price terms that are different from those actually charged if necessary to reflect the results of parties transacting at arm s length. If the taxpayer wants to reduce taxable income that would otherwise result based on the prices actually charged in controlled transactions, the Section 482 adjustment must be made on a timely filed (including extensions) original income tax return, but the taxpayer can increase U.S. taxable income at any time by using Section 482 transfer pricing principles to depart from prices actually charged. 8 These voluntary changes also are included in the definition of a primary adjustment. Focusing on the Type 1 scenario above, an international examiner from the IRS s LB&I division audits s tax returns for the 2010 through 2013 tax years. Specifically, the IRS is concerned with s purchase of shoes from U.K. Sub for distribution. U.S. Sub s transfer pricing documentation for the applicable years provide that its operating margin for its distribution activities is arm s length. The IRS, however, disagrees with s documentation, and believes that is earning too low an operating margin for 8 Regs (a)(3) Copyright 2014 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. TMTR ISSN

5 5 Ownership- and U.K. Sub owned directly by U.S. Parent U.S. Parent Shoes U.K. Sub Cash Type #5 Scenario TP issue U.S. (shoes determined to be overpriced by $20) Primary adjustment: IRS adjusts U.S. Sub's income up Correlative adjustment: U.K. Sub adjusts income down Conforming adjustment: Deemed dividend from to U.S. Parent anddeemedcontribution from U.S. Parent to U.K. Sub Revenue Procedure Relief: Treated as a loan from to U.K. Sub its distribution activities, and determines that the purchase price of the shoes should be decreased. Based on its economic analysis, the IRS believes that a higher operating margin for is arm s length. As a result, the IRS makes an adjustment to U.S. Sub s taxable income for to reflect the decreased purchase price of the shoes, which is the primary adjustment. In order to arrive at its adjustment, the IRS decreased the purchase price of the shoes from $100 to $80 for each of the four years, with the $20 difference representing the primary adjustment in each year. Through the IRS-initiated primary adjustment, the tax liability of is adjusted. However, the actual payment representing the primary adjustment remains Type #6 Scenario TP issue U.K. (shoes determined to be underpriced by $20) Primary adjustment: HMRC adjusts U.K. Sub's income up Correlative adjustment: adjusts income down Conforming adjustment: Deemed dividend from U.K. Sub to U.S. Parent and deemed contribution from U.S. Parent to Revenue Procedure Relief: Treated as a loan from U.K. Sub to in the hands of U.K. Sub, when in fact these funds should be in the hands of but for the transfer pricing misstatement. In Scenario 1, U.K. Sub already has paid tax on an additional $20 of profits in each year. Therefore, and U.K. Sub would pay tax twice on this amount unless they seek a correlative adjustment to relieve double taxation through MAP. There also are additional income tax consequences in both jurisdictions that may arise from the primary adjustment unless a conforming adjustment is made to settle the accounts. Seeking Correlative Relief When a primary adjustment is made, a correlative adjustment is necessary to decrease the taxable income TAX MANAGEMENT TRANSFER PRICING REPORT ISSN BNA TAX

6 6 of the other related party such that the related party s tax liability reflects and is consistent with the primary adjustment. Failure to make a correlative adjustment forces the taxpayer to pay tax on the increased income related to the primary adjustment even though the taxpayer s related party already paid tax on that same item of income. Thus, correlative adjustments are needed to avoid double taxation. Regs (g)(2) provides the basis for the IRS to make correlative adjustments. The regulation states that when a primary adjustment is made by the IRS, appropriate correlative adjustments also will be made to any other member of the group affected by the adjustment. For example, if the IRS makes a primary adjustment, the IRS will not only increase the income of one member of the group, but correspondingly decrease the income of the other member. This correlative adjustment is for U.S. purposes only. 9 In addition, where appropriate, the IRS may make such further correlative adjustments as may be required by the initial correlative adjustment. For U.S. income tax purposes, a correlative adjustment may be made only when a final determination of the primary adjustment is made. This is in the following circumstances: s assessment of tax after execution of Form 870; s the acceptance of Form 870-AD; s the payment of the deficiency; s a stipulation in the U.S. Tax Court; or s a final determination of tax liability by offer-incompromise, closing agreement, or final resolution in a judicial proceeding. 10 The competent authority process allows taxpayers to seek double tax relief in the event of a transfer pricing adjustment. 11 The MAP article, which is contained in all U.S. income tax treaties, provides the basis for the competent authorities of each state to resolve a case by mutual agreement to prevent taxation that is not in accordance with the treaty, and primary adjustments that produce double taxation that are inconsistent with the purpose of the treaty. 12 In the Type 1 scenario, and U.K. Sub may apply for competent authority assistance from the IRS and HMRC allowing the respective tax authorities to resolve the transfer pricing dispute under the MAP article of the U.S.-U.K. Income Tax Treaty. 13 The U.S. Competent Authority is either the Secretary of the Treasury or his delegate. The Treasury Department and IRS have delegated this authority to the Deputy Commissioner (International) in LB&I, and aspects of this authority have been delegated to the directors of Transfer Pricing Operations (TPO) and the Advance Pricing and Mutual Agreement (APMA) Program that are part of LB&I. APMA has primary responsibility for cases arising under the business profits and 9 The authority of the Secretary to make a correlative adjustment is limited to computation of U.S. income and tax. As a result, a correlative adjustment made on the federal income tax return only may result in increased foreign tax credits for U.S. income tax purposes. 10 Regs (g)(2)(iii). 11 If the IRS makes an adjustment regarding a transaction with a related party located in a non-treaty jurisdiction, then the competent authority process is unavailable. Nonetheless, the taxpayer still will be required to go through the process described in the rest of the article but will do so on the taxpayer s federal income tax return and correlative relief in the nontreaty country may not be available. 12 See Article 25 of the U.S. Model Income Tax Convention. 13 U.S.-U.K. Income Tax Treaty, Article 25. associated enterprises articles of U.S. income tax treaties, which comprises transfer pricing allocation cases. Rev. Proc , C.B. 1035, provides the procedures for requesting competent authority assistance. 14 Competent authority assistance is available only when the U.S. has an income tax treaty with the other country. In a case involving a U.S.-initiated adjustment, a request for competent authority assistance may be submitted as soon as practicable after the amount of the proposed adjustment is communicated in writing to the taxpayer (for example, in an IRS notice of proposed adjustment). 15 In the case of a foreign examination, a request may be submitted as soon as the taxpayer believes such filing is warranted based on the actions of the country proposing the adjustment. 16 A taxpayer must file a request for competent authority assistance within the applicable period as provided in the income tax treaty under which the request arises. The deadline under a number of tax treaties is three years from when the taxpayer is notified that double taxation will occur, and other tax treaties have longer deadlines that range from four to six years (for example, the U.S.-Canada Income Tax Convention requires that the taxpayer notify the competent authorities by six years from the end of the taxable year under assessment), while others do not have a deadline. 17 A request for U.S. Competent Authority assistance must be in the form of a letter addressed to the Deputy Commissioner (International), LB&I. 18 It must be dated and signed by a person having the authority to sign the taxpayer s federal tax returns. The information required for requesting competent authority assistance is detailed in section 4.05 of Rev. Proc The information required mainly provides identifying information about the taxpayer, with the exception of section 4.05(3), which asks the taxpayer to provide a brief description of the issues for which competent authority assistance is requested, including a description of the relevant transactions, activities or other circumstances involved in the issues raised and the basis for the adjustment, if any. This part of the request is the taxpayer s opportunity to present its story to the U.S. Competent Authority. Once the taxpayer s competent authority request is filed, the request is assigned to an APMA team leader. Generally, the team leader will review the request, ask for further information, communicate with the taxpayer through phone calls or meetings, and then proceed with negotiating the case with the treaty partner. During the negotiations, the two governments decide the amount of the primary adjustment that survives, how much is withdrawn, and the amount of correlative relief provided. If a multiple-year adjustment survives, the competent authorities, on occasion, will decide to implement the adjustment in a single year the last year of 14 This guidance will be superseded when the draft revenue procedure on requesting competent authority assistance released Nov. 22, 2013 Notice , I.R.B. 633 is finalized. 15 Rev. Proc , section Id. 17 See Article 26 of the U.S.-Canada Income Tax Convention. For an exhaustive list of the notification deadlines under various income tax treaties, see Marc M. Levey and Steven C. Wrappe, Transfer Pricing: Rules, Compliance and Controversy, CCH, 4th ed., pp (2013). 18 Rev. Proc , section Copyright 2014 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. TMTR ISSN

7 7 the proposed adjustment. By agreeing to single- year implementation, the taxpayer s interest payments on the underpayment of tax are minimized in the local country that proposed the primary adjustment. Singleyear implementation also minimizes any currency fluctuations that have taken place during the relevant years for a multiple-year adjustment. One side note: Under many, but not all, U.S. income tax treaties, amended returns may be filed for years in which the statute of limitations is closed, even where no protective refund claim has been filed. In these cases, the treaty acts as an override to domestic limitations statutes to allow the competent authority to implement a MAP agreement. It is important to review the details of the specific income tax treaty under which competent authority assistance is requested. Furthermore, once a competent authority settlement is reached, any adjustment that survives will be reflected in the currency of the original transaction and, if necessary, converted using the average foreign exchange rate for the year at issue. Therefore, if there has been any currency fluctuation from the year at issue until the time of the competent authority resolution, then that foreign exchange gain or loss will be borne by one of the related parties. In some MAP agreements, the competent authorities agree on the party that will bear the foreign exchange gain or loss. It is important to consider which party will bear the foreign exchange gain or loss when resolving a MAP. In the Type 1 scenario, the U.S. and U.K. competent authorities would negotiate to determine whether the purchase price for the shoes should be $100, $80, or some price in between. Assuming that HMRC agrees with the IRS s analysis, it would permit U.K. Sub to make a correlative adjustment to decrease its taxable income by $20, the amount of the IRS-initiated primary adjustment, thereby eliminating double taxation. In the Type 2 scenario, where there is a U.K.-initiated primary adjustment, if the competent authority settlement results in a correlative adjustment to taxable income in the U.S., then the taxpayer may implement this adjustment in one of two ways. First, if the taxpayer currently is under audit, it may ask the IRS examination team to recompute its tax liability for the affected years. Second, the taxpayer may file amended returns for the affected years. An amended return may be filed even for years when the statute of limitations is closed, because the original competent authority request acts as a protective claim for refund with respect to issues raised in the original request and within the jurisdiction of the U.S. Competent Authority. 19 Taxpayers have many factors to consider about whether to seek a correlative adjustment through the competent authority process. As previously mentioned, a U.S. income tax treaty must be in place for correlative relief to be available. Also, taxpayers need to weigh whether the cost of pursuing competent authority assistance outweighs the benefit of double tax relief. This is a concern where the primary adjustment may be de minimis. In the event of a foreign-initiated adjustment, taxpayers also consider the fact that not pursuing competent authority relief may result in a denial of foreign tax credits. Regs (e)(5) provides that a payment of tax may be considered voluntary if the taxpayer has not 19 See Rev. Proc , section 9.02(2). exhausted all effective and practical remedies, including invocation of competent authority procedures available under applicable tax treaties, to reduce, over time, the taxpayer s liability for foreign tax. Typically, taxpayers choose to pursue competent authority relief on transfer pricing adjustments between treaty partners that are high-tax jurisdictions. If a taxpayer decides not to pursue correlative relief, it will face double taxation on the amount of the primary adjustment. Further, any foreign tax credits related to that item of income may be denied as a voluntary payment. If a taxpayer decides not to pursue correlative relief, from a U.S. tax perspective, it must nonetheless make a conforming adjustment, discussed in detail below. Conforming or Secondary Adjustments When a primary adjustment is made, the actual payment representing the adjustment remains in the hands of the related party. A correlative adjustment would decrease the taxable income of the related party to eliminate double taxation, but the additional payment still is in the accounts of the related party. In the Type 1 scenario, still would have an asset of $20 that should rightfully belong to U.K. Sub. A conforming or secondary adjustment is necessary to eliminate the amount from the taxpayer s financial books and tax accounts that result from the primary adjustment. If no conforming adjustment is made, the related party would retain the additional funds without having to pay any withholding tax on the original payment, thereby receiving a tax benefit from the transfer mis-pricing. The primary and correlative adjustments shift the funds between the taxpayer and its related party for tax purposes only. The financial books still will show the original transfer price charged, which is considered excess funds on one side of the transaction. The default position for U.S. income tax is that the excess funds would be characterized either as a deemed distribution or dividend, or a capital contribution. Regs (g)(3) describes conforming adjustments as the appropriate adjustments that must be made to conform a taxpayer s accounts to reflect adjustments made under Section 482. Such adjustments may include the treatment of an adjusted amount as a dividend or a capital contribution, as appropriate. As discussed below, under the applicable IRS procedures currently, Rev. Proc , I.R.B. 296 the taxpayer elects to repay the allocated amount without further income tax consequences that is, the taxpayer avoids the deemed distribution/dividend or capital contribution. In the Type 1 scenario, the additional funds would be considered a deemed dividend from to U.K. Sub. This deemed dividend would be subject to additional withholding tax as reduced by any applicable income tax treaty. 20 Furthermore, there would be a decrease in earnings and profits of in the amount of the deemed dividend for U.S. tax purposes and there would be an increase in the E&P of U.K. Sub for U.S. tax purposes; however, no additional tax would arise because U.K. Sub is not a U.S. taxpayer. In the Type 2 20 Under the U.S.-U.K. Income Tax Treaty, wholly owned subsidiaries generally are not subject to withholding tax on dividends. The discussion of withholding tax is relevant to the many U.S. income tax treaties that have positive withholding taxes on dividends. TAX MANAGEMENT TRANSFER PRICING REPORT ISSN BNA TAX

8 8 scenario, the additional funds would be considered a capital contribution from U.K. Sub to. In the Type 3 scenario, the additional funds would be considered a deemed dividend from U.K. Sub to ; while in the Type 4 scenario, the additional funds would be considered a capital contribution from to U.K. Sub. In the event of a primary adjustment between brother-sister corporations, such as the Type 5 or 6 scenario, the additional funds could be characterized as a deemed distribution up the ownership chain to the parent corporation, followed by a capital contribution down the ownership chain from the parent corporation to the other subsidiary. From a compliance perspective, even if correlative and conforming adjustments are made, tax attributes such as E&P, foreign tax credits, business credits, Section 199, Section 1059A and net operating losses will need to be recomputed to correctly reflect the primary adjustment. For example, for purposes of calculating the foreign tax credit limitation, a taxpayer will need to recalculate the numerator that includes taxable income from sources outside the U.S. as well as the denominator that includes taxable income from U.S. and foreign sources. After reviewing the U.S. income tax consequences, if a conforming adjustment is not made, the taxpayer also needs to consider the foreign income tax consequences. Conforming Adjustments: Foreign Authorities Positions In the Type 1 scenario, the IRS increased s taxable income and HMRC agreed to provide correlative relief in competent authority negotiations, thereby decreasing U.K. Sub s taxable income. If decides not to make a conforming adjustment, there would be no U.K. tax consequences. Conforming adjustments are not recognized for U.K. tax purposes; therefore there would not be any tax effect for the U.S. Sub or U.K. Sub for U.K. tax purposes. However, HMRC will accommodate the IRS perspective and agree to make conforming adjustments when requested by the IRS in a MAP. Generally, the U.S. has been the leader in deeming that conforming adjustments need to be made after a transfer pricing primary adjustment. Some jurisdictions have followed suit, while others have been more laissez-faire. For example, Japan is similar to the U.K. in not requiring conforming adjustments, while Canada and the Netherlands are more in line with the U.S. in requiring conforming adjustments to avoid collateral income tax consequences. 21 With respect to countries located in the European Union, the EU Joint Transfer Pricing Forum issued a report that provides guidance to member states on practical solutions for issues that arise from not making conforming adjustments. 22 The report provided that if the finding of a deemed dividend or capital contribution is 21 See Rene Fleming and others, Non-U.S. Mechanisms for Relief from Further Income Tax Consequences Resulting from a Transfer Pricing Adjustment, 19 Transfer Pricing Report S-15, 9/23/ EU Joint Transfer Pricing Forum, Report on Compensating Adjustments, Meeting of Oct. 25, The report was adopted by the European Commission in June See 22 Transfer Pricing Report 1209, 2/6/14; 23 Transfer Pricing Report 270, 6/12/14. not compulsory, it is recommended that EU member states refrain from making such an adjustment when it would lead to double taxation. 23 Where it is compulsory under the legislation of a member state, it is recommended that member states provide for ways and means to avoid double taxation (for example, by endeavoring to solve it through a MAP, or by allowing the repatriation of funds at an early stage, where possible). 24 Relief from Secondary Tax Consequences Rev. Proc gives taxpayers an alternative to the deemed dividend or capital contribution treatment, including associated income tax consequences of conforming adjustments. The guidance sets forth the U.S. procedures for the taxpayer election to characterize the conforming adjustment as an intercompany indebtedness transaction. It provides that a taxpayer will be able to repatriate the cash attributable to a primary adjustment through an account that will be free of the secondary income tax consequences that otherwise arise from the primary adjustment. 25 In the Type 1 scenario, the IRS increased s taxable income on its intercompany transactions with U.K. Sub. If decided not to pursue competent authority relief, it generally must follow Rev. Proc to avoid a deemed dividend to U.K. Sub and any withholding tax consequences. 26 Some taxpayers choose to make conforming adjustments, even when not pursuing correlative relief, to avoid these further U.S. income tax consequences. Additionally, taxpayers may elect Rev. Proc treatment for taxpayer-initiated adjustments (discussed below). Regs (a)(3) permits a controlled taxpayer to report an arm s-length result for controlled transactions based on prices different from those actually charged. If the adjustment results in an increase in taxable income, the increased income may be reported by the taxpayer at any time. If the adjustment results in a decrease in taxable income, the arm s-length result may be reported on a timely filed return (including extensions). Taxpayers may elect Rev. Proc treatment for both IRS and taxpayer-initiated adjustments if they meet certain criteria. Eligibility and Procedure for Rev. Proc A taxpayer must be a U.S. taxpayer, defined as either a domestic corporation or a foreign corporation that is, or is treated as, engaged in a trade or business in the U.S., to be eligible for Rev. Proc It is not clear whether the IRS will allow a taxpayer to make a conforming adjustment if one of the parties to the transac- 23 Id. 24 Id. 25 See IRS Advice Memorandum , released 9/12/08, which interprets Rev. Proc as avoiding a subsequent taxable inclusion upon repatriation (or deemed dividend if the repatriation does not occur). 26 A conforming adjustment also may be treated as a loan. See Altama Delta Corp. v. Comr., 104 T.C. 424 (1995), at 3 Transfer Pricing Report 906, 4/26/95, which provides that the amount of sales proceeds transferred by one party to another in excess of arm s length transfer prices is in effect a loan Copyright 2014 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. TMTR ISSN

9 9 tion is not a corporation. 27 In the case of an IRSinitiated adjustment, the U.S. taxpayer must not be subject to the transactional or net adjustment penalties under Section 6662(e) or (h) and no part of the adjustment may be attributable to fraud. In the case of a taxpayer-initiated adjustment, the U.S. taxpayer must be bound by its election under the revenue procedure and (no part of the adjustment may be attributable to fraud. 28 Provided a taxpayer is eligible, and in the absence of a MAP agreement, the taxpayer must submit a number of documents to avail itself of Rev. Proc In the context of a MAP agreement, it generally is sufficient to include a request for such treatment in the submission asking for competent authority assistance to relieve double taxation. 29 To elect treatment under Rev. Proc , a taxpayer whose taxable income has been subjected to an IRS-initiated adjustment must file a request in writing with the IRS examination team before a closing action is taken on the primary adjustment. For these purposes, closing action means any of the following: (1) a taxpayer s execution and acceptance of a Form 870-AD, Offer to Waive Restrictions on Assessment and Collection of Tax Deficiency and to Accept Overassessment; (2) a taxpayer s execution of a closing agreement; (3) a stipulation to the Section 482 allocation in U.S. Tax Court; (4) expiration of the statute of limitation on assessments; or (5) a final determination of the tax liability for the year to which the allocation relates by offer-incompromise, execution of a closing agreement or court action. 30 Furthermore, the taxpayer s request must be signed by a person having the authority to sign the taxpayer s federal income tax returns and contain the following: (1) a statement that the taxpayer desires the treatment provided by section 4 of Rev. Proc ; (2) designation of the years for which such treatment is requested; (3) a description of the arrangements or transactions that gave rise to the primary adjustment; and (4) an offer to enter into a closing agreement with the IRS that will memorialize the treatment afforded under Rev. Proc If the IRS decides that Rev. Proc applies and if the amount of the primary adjustment has been agreed upon, then the IRS will enter into a closing agreement with the taxpayer. For taxpayer-initiated adjustments, a U.S. taxpayer must file a statement with its income tax return, reporting the primary adjustment that includes the following: (1) a statement that the taxpayer desires Rev. Proc treatment for the years indicated and acknowledges that it is bound by its election of such treatment; (2) a description of the arrangements or transactions, or the terms thereof, which gave rise to the primary adjustment; (3) the amount of the primary adjustment 27 See Rev. Proc , which provides that transactions with non-corporate persons are not covered by the revenue procedure, but will be the subject of further study by the IRS. 28 Id., section See Rev. Proc , section Rev. Proc , section (4) the amount and nature of any correlative adjustments made; (5) the amount and currency of, and parties to, any indebtedness created by Rev. Proc ; (6) the amount of interest on the account indebtedness in income, or deductible, and the years of such inclusion or deduction; (7) the amount of any foreign tax credit that the taxpayer will claim on the indebtedness; and (8) the manner of payment of the indebtedness and a statement that any such payment will occur within the 90 days. 31 Manner of Conforming Adjustments under Rev. Proc Rev. Proc permits taxpayers to make a conforming adjustment through an interest-bearing account receivable or payable in an amount equal to the primary adjustment for each of the years in which an adjustment is made. The account shall be deemed to have been created as of the last day of the taxpayer s taxable year for which the primary adjustment is made. 32 In addition, the account must bear interest at an arm s-length rate, computed in the manner provided in Regs (a)(2), from the day after the date the account is deemed to have been created to the date of payment. 33 The interest so computed shall be accrued and deducted by the obligor from taxable income for each taxable year during which the account is deemed outstanding. 34 The account must be paid within 90 days of execution of the closing agreement with the IRS. 35 The account must be expressed, both as to principal and interest, in the functional currency of a qualified business unit (QBU) through which the controlled transaction was carried out if the residence of such QBU is the U.S. 36 Under the offset rules of Rev. Proc , some or all of the account may be satisfied within the 90-day period by a payment in cash, an offset of the account against a debt between the U.S. taxpayer (or a member of its affiliated group) and the controlled entity, or by the issuance of a written term note. The account also may be satisfied, in whole or in part, by offsetting it with any capital contributions or distributions paid during either the year to which the adjustment relates or the year during which the tax return is filed. In the case of an offset of a capital contribution or distribution occurring during the year to which the adjustment relates, the account is treated as being satisfied as of the beginning of the day on which the account is deemed created. Payment of the account within the 90-day period must be in the form of money, a written debt obligation payable at a fixed date and bearing interest at an arm slength rate, or an accounting entry offsetting such account against an existing bona fide debt between the U.S. taxpayer (or member of its affiliated group) and the related person. In the case of an IRS-initiated adjustment, the U.S. taxpayer may use an offset only if the 31 Id., section Id., section 4.01(1). 33 Id., section 4.01(2). 34 Id. 35 Id., section 4.01(4). 36 QBU is defined in Regs , and functional currency in Regs (a)-1. TAX MANAGEMENT TRANSFER PRICING REPORT ISSN BNA TAX

10 10 offsetting entry, debt distribution or capital contribution occurs during the tax year in which the IRS executes the closing agreement. In the case of a taxpayerinitiated adjustment, the offset may be made in the original tax year or the filing year. Tax Effects of Conforming Adjustments under Rev. Proc If the taxpayer meets the requirements of Rev. Proc , the conforming adjustment will be free of the federal tax consequences that otherwise would apply. 37 However, the additional interest on the account receivable or account payable is taxable. A foreign tax credit shall be allowed for the repayment of principal and interest of the account subject to limitations in Section 901. Conforming Adjustments under an APA or MAP 37 See IRS Advice Memorandum , which interprets Rev. Proc as avoiding a subsequent taxable inclusion upon repatriation (or deemed dividend if the repatriation does not occur). 38 See Notice , which expressly states that the U.S. Competent Authority may determine it is appropriate to eliminate or modify the requirement for interest set forth in Revenue Procedure See Notice , I.R.B. 653, section 7.02(3), which eliminates the automatic interest free repatriation for unilateral APAs. As previously mentioned, Rev. Proc provides the procedures for requesting competent authority assistance. Section 10 of Rev. Proc provides that the competent authority may provide relief consistent with the principles of Rev. Proc , but the outcome is slightly different. It is within the discretion of the IRS to waive the interest requirement on a receivable that conforms the accounts for the resolution of a case in competent authority. 38 The taxpayer has 90 days from the date of the determination letter from the U.S. Competent Authority to make the conforming adjustment. In the event that the accounts are not conformed within this period, a deemed dividend or capital contribution is determined to have taken place in the current year. In the context of an advance pricing agreement, section 11.02(3) of Rev. Proc , C.B. 278, describes the procedures that taxpayers should follow to make a conforming adjustment to avoid any adverse tax consequences that would follow an APA primary adjustment. The treatment under the APA revenue procedure is consistent with the principles of Rev. Proc ; however, there is no requirement that the account created by the taxpayer be interest bearing. This is even the case in unilateral APAs, although the IRS is revisiting this issue. 39 Consequently, there are somewhat different results when conforming adjustments are made under Rev. Proc or in the context of a MAP or an APA. The account must be paid within 90 days of the later of: s the date for timely filing (with extensions) of the federal income tax return for the taxable year to which the APA primary adjustment applies, or s the APA s effective date. As with a MAP, if the accounts are not conformed within this period, a deemed dividend or capital contribution is determined to have taken place in the current year. Whether to Elect Rev. Proc Treatment Rev. Proc treatment provides the advantage of avoiding certain secondary tax consequences of conforming adjustments. For example, in the Type 1 scenario, there would be no deemed dividend or any additional withholding tax. However, taxpayers still face ancillary issues associated with the election. These side effects include, for example, that conforming adjustments made under Rev. Proc may affect a taxpayer s foreign tax credits under Section 902. Another such side effect is the interaction between Rev. Proc and the Section 965 dividends-received deduction (DRD). IRC Section 965 provided for a temporary 85 percent DRD for specific cash dividends received from controlled foreign corporations. This deduction applied for one year, The statute also provided that the DRD amount would be reduced dollar-for-dollar to the extent there was an increase in indebtedness between the CFC and the U.S. shareholder. The IRS issued notices and industry directives holding that an account receivable established under Rev. Proc will be taken into account in determining the amount of indebtedness for purposes of calculating the DRD. 40 This was followed by litigation in BMC Software Inc. v. Comr., 41 in which the Tax Court held in favor of the IRS that the accounts receivable made under Rev. Proc is related-party debt for purposes of IRC Section 965 based on general federal income tax principles and the dictionary definition of indebtedness. The taxpayer is appealing the judgment; arguments were heard Sept. 3.See 23 Transfer Pricing Report 567, 9/4/14. The resolution of BMC Software has taxpayers considering whether Sections 951 and 956 would apply in these circumstances. As a technical matter, it is possible that the IRS could use the BMC Software decision to make an argument that Sections 951 and 956 apply. However, such an application would be contrary to the purpose of Rev. Proc As a policy matter, the IRS position on Rev. Proc and Section 965 has been known since 2005 but the IRS has not changed its position on the application of Sections 951 and 956 since that time. Because the IRS could have pursued such an argument prior to the BMC Software decision, there is little reason to believe that decision will change the IRS s position. The authors are not aware of a circumstance where the IRS has pursued such an argument when taxpayers have elected Rev. Proc treatment. In sum, when deciding whether to elect Rev. Proc treatment, taxpayers need to determine whether any other federal income tax consequences may mitigate the benefits of such an election. For example, a payment would only be treated as a taxable dividend to 40 See Notice , I.R.B. 474; Notice , I.R.B. 1100; Notice , I.R.B. 471; Industry Directive #1 on Section 965 Foreign Earnings Repatriation (10/2/07); Industry Directive #2 on Section 965 Foreign Earnings Repatriation (4/21/08), Industry Directive #3 on Section 965 Foreign Earnings Repatriation (5/26/09) T.C. No. 5 (2013). See 22 Transfer Pricing Report 674, 9/19/ Copyright 2014 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. TMTR ISSN

11 11 the extent of the taxpayer s current E&P. Taxpayers also should consider the treaty rates on potential withholding tax as well as impact on the taxpayer s cash flow. The decision to elect Rev. Proc treatment should not be made in a vacuum. Other Federal Considerations Taxpayers should not overlook the implication or necessity of recalculating non-transfer pricing tax attributes resulting from a settlement, including foreign tax credits, resulting business credits, Section 199, Section 1059A, extraterritorial income benefits (ETI) and any net operating losses in light of sustained intercompany pricing adjustments. Business credits, Section 199, foreign tax credits, operating losses and ETI benefits all can be computationally adjusted in light of the primary adjustments. Depending on the facts and circumstances, these computational factors may influence a company s decision or approach to resolving its transfer pricing. As many companies are considering the practical consequences of settling transfer pricing issues, the interrelationship with these computational adjustments should not be overlooked and may make the settlement palatable by reducing the ultimate U.S. tax due. Although these adjustments may be favorable, they would not be considered for correlative or conforming adjustments or have an impact on the amount of a taxable dividend or computation of interest in a decision to elect Rev. Proc treatment. Another area that may be overlooked is the potential impact of Section 1059A, which generally provides that if a transfer price paid by an importer exceeds the value reported by the importer for customs purposes, the lower value reported to customs must be used for income tax purposes. However, Regs A-1(c)(2) recognizes that, when differences between valuations for customs purposes and income tax purposes result from real value added, a taxpayer may report different amounts for customs and income tax purposes without an adjustment under Section 1059A. 42 There are many considerations that must be taken into account if the U.S. parent or U.S. subsidiary is paying customs duty. Taxpayer-Initiated Adjustments 42 The impact of transfer pricing adjustments on custom duties will be addressed in a subsequent article in this series. 43 See Rev. Proc , section 2. Taxpayers have limited ability to use Section 482 affirmatively. Regs (a)(3) provides that if necessary to reflect an arm s-length transaction, a taxpayer may report on a timely filed U.S. income tax return the results of its controlled transactions based on prices different from those actually charged. Regs (a)(3) goes on to state that, other than this exception, Section 482 grants no other rights to a controlled taxpayer to apply it affirmatively and, therefore, no untimely or amended returns will be permitted to decrease taxable income. As a result, a taxpayer may increase its U.S. taxable income at any time but may only initiate a downward adjustment on its original return. 43 Recently, in Intersport Fashions West Inc. v. U.S., 109 A.F.T.R. 2d (Fed. Cl. 2012), a taxpayer challenged whether it was permissible to make a downward adjustment on an amended return to correct a mistake regarding its allocation method for restructuring costs. The court held for the U.S. government on a motion for summary judgment in finding that the plain language of Regs (a)(3) barred the taxpayer from decreasing its taxable income on an amended return. 44 While not specifically addressed in the decision, it appears open to question whether a purely mathematical error would have produced a different result. Rev. Proc , which governs procedures for requesting competent authority assistance, provides that U.S. Competent Authority assistance is available when the actions of the U.S., a treaty partner, or both will result in taxation not in accordance with the treaty. In the past, the IRS has not accepted taxpayer-initiated adjustments as actions eligible for relief under the MAP. However, the proposed revenue procedure for requesting competent authority assistance makes clear that requests for double-tax relief arising from taxpayerinitiated compensating adjustments will be considered on a case-by-case basis so long as the request does not evince after-the-fact tax planning or fiscal evasion. 45 This change in policy is an important feature of the proposed revenue procedure that is still in draft format. It is the authors experience that to date the IRS has considered this issue on a case-by-case basis. For countries located in the EU, the EU Joint Transfer Pricing Forum issued a report that provides guidance to Member States on practical solutions for issues that arise from compensating adjustments. 46 The report provides that a compensating adjustment initiated by the taxpayer should be accepted if the taxpayer: s made reasonable efforts, before the relevant transaction or a series of transactions, to achieve an arm slength outcome, as would normally be described in the taxpayer s transfer pricing documentation; s makes the adjustment symmetrically in the accounts of both member states involved; s applies the same approach consistently over time; s makes the adjustment before filing the tax return; and s is able to explain for what reasons his forecast did not match the result achieved, when it is required by the internal legislation in at least one of the member states involved. 47 Conclusion As many multinational enterprises are aware, transfer pricing adjustments are becoming more commonplace. After a transfer pricing adjustment is made, the implementation effort has only just begun. Taxpayers need to decide how to deal with the federal income tax consequences of a transfer pricing adjustment, including whether and how to pursue correlative relief and make conforming adjustments, as well as determine the potential impact on computational adjustments on net 44 For commentary, see Kerwin Chung, Cindy Hustad and and Alan Shapiro, Intersport Fashions: U.S. Claims Court Limits Taxpayer s Ability to Make Post-Return Adjustments, 21 Transfer Pricing Report 55, 5/3/12; Eric Ryan and Chris Kotarba, Intersport and Taxpayer-Initiated Transfer Pricing Adjustments, 21 Transfer Pricing Report 88, 5/17/ See Notice , sections 2.02, 6.02(13). 46 EU Joint Transfer Pricing Forum, Report on Compensating Adjustments; see note 22, above. 47 Id. TAX MANAGEMENT TRANSFER PRICING REPORT ISSN BNA TAX