Tax Law Conference Presented by the Federal Bar Association Section on Taxation Transfer Pricing Developments March 9, 2018

Transcription

1 Tax Law Conference Presented by the Federal Bar Association Section on Taxation Transfer Pricing Developments March 9, 2018 Moderator: Speakers: Richard Slowinski, Partner, Baker McKenzie Kevin Nichols, Senior Counsel, Office of Tax Policy, US Dept. of Treasury Robert Kelley, Attorney, Branch 6, Office of Associate Chief Counsel (Int l), IRS John Breen, Counsel, Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates Lori Hellkamp, Partner, Jones Day I. Potential Implications of Tax Reform on Transfer Pricing A. Definition of intangible asset i. Valuation of IP transfer on aggregate basis ii. Use of realistic alternatives B. Impact of tax reform on taxpayers transfer pricing approaches II. OECD BEPS Transfer Pricing Developments A. Taxation of the digital economy B. Key areas for US and Western European jurisdictions (e.g., sourcing, residency, valuation, characterization) C. Potential implications for taxpayers i. Taxation of financial transactions D. Impact of updated OECD Transfer Pricing Guidelines on tax audits E. OECD launch of International Compliance Assurance Programme (ICAP) pilot III. Recent Transfer Pricing Cases A. Key trends from recently-decided and pending transfer pricing cases USP licensed IP to its foreign subsidiary, FS i. Altera Altera Corp. v. Comm r (2015, appeal pending)

2 Section 482 generally requires that royalty income from a controlled party be commensurate with the income attributable to the IP, which could result in most of the income being shifted to USP, the IP owner USP and FS entered into a cost sharing agreement with respect to the continued research and development of the IP By jointly developing the IP under a qualified cost sharing arrangement (a QCSA), USP and FS would each have a right to use the jointly developed IP Stock-based compensation USP paid its employees was not subject to the cost sharing agreement IRS took the position that FS should share costs of stock-based compensation under the Section 482 Regulations then in effect (see Treas. Reg A(d)(2)(i)) The IRS issued a notice of deficiency allocating $80MM of income from FS to USP to account for FS s share of the stock-based compensation. Taxpayer won in the Tax Court, and the case is now on appeal and pending in the 9th Circuit Key Holdings: The 2003 Section 482 Regulations on stock-based compensation are legislative Regulations (i.e., if valid, they would have the force of law rather than merely provide an explanation of existing law) and are subject to the notice and comment requirements of the Administrative Procedures Act (the APA) this was contrary to Treasury s position that most Regulations are merely interpretive Treasury was required to engage in reasoned decision-making in promulgating the Regulations, which it failed to do because it (1) failed to examine relevant data, (2) failed to rationally connect its conclusion with facts it found, (3) failed to respond to significant comments and (4) reached a conclusion contrary to the evidence October 2016 the Treasury Decision ran to more than 500 pages with approximately 300 of these dedicated to summarizing and responding to comments received on the proposed Regulations IV. Amazon Amazon.com Inc. v. Comm r (148 T.C. No. 8, 2017) USP transferred IP to its foreign affiliate, FS, and USP and FS entered into a cost sharing agreement related to future intangible development costs The IRS issued NODs relating to USP s buying valuation on transferring the IP to FS and the cost sharing agreement The IRS s position is that (1) USP s brand was itself an important part of the business s growth and (2) after determining that most of the IP, including trademarks, patents, and technology, would hold their value for decades, the value of the IP was significantly higher than claimed by USP

3 USP contended that the useful life of the IP was much shorter, given the high failure rate of technology companies and that FS s share of intangible development costs was much higher than determined by the IRS Judge Lauber rejected the position of the IRS s economists that assumed perpetual life for the intangibles at issue Amazon argued that the transferred marketing intangibles had a limited useful life of 8 to 20 years. The court adopted a useful life of 20 years Lauber s decision was also based on Amazon s experts testimony that the company s success in Europe was based on short-live technology assets The court did not adopt Amazon s CUT analysis, finding it did not meet the arm s length standard The court applied its own analysis, based on the taxpayer s CUT calculations but with appropriate upward adjustments in numerous respects Computations are due June 28, and the IRS has 90 days from the date decision documents are filed to appeal. Ultimately, this was another transfer pricing taxpayer win and a decisive one at that V. Eaton In the underlying case, Eaton sought to enforce two advance pricing agreements that the IRS ignored (after it determined that Eaton had breached their terms) Eaton challenged the $368 million in adjustments arising from the advance pricing agreement cancellations and lost an important motion for partial summary judgment before Tax Court Judge Diane L. Kroupa in 2013 On competing motions for partial summary judgment Eaton had argued that the IRS should be bound by normal contract principles, with the party exercising a provision allowing the contract to be cancelled having the burden of proof with respect to the conduct allegedly justifying the cancellation The IRS argued, and Judge Kroupa accepted, that revenue procedures determine how advance pricing agreements are administered, the cancellations were administrative determinations, and thus the Tax Court was limited to deciding whether the IRS abused its discretion to cancel the advance pricing agreement Judge Kroupa left the Tax Court in June 2014 and was indicted and pled guilty to tax fraud in 2016 On June 9, 2016, Eaton filed for reconsideration of Judge Kroupa s prior ruling on the advance pricing agreement burden of proof issue (this was over 1,000 days beyond the normal period for filing such a motion) In an October 2016 hearing before Judge Kerrigan on Eaton s motion for reconsideration, the IRS argued that overturning

4 Judge Kroupa s opinion would be prejudicial to the IRS, since it had built its case on the understanding that the burden of proof fell to Eaton to show an abuse of discretion by the IRS If the burden were to fall on the IRS, the IRS s approach to its petition, discovery, and interviews would have been very different VI. Mylan - Mylan Inc. v. Comm r (T.C. Memo ) IRS attacks USCo s treatment of a sublicense as a sale under the Danielson Rule, which generally requires taxpayers to accept the tax consequences of the form of the transaction In 2001, IPCo grants unrelated USCo an exclusive US license to import, use and sell, and to make, use and sell products containing, a particular drug In 2006, USCo grants an exclusive sublicense of the US license to unrelated ForCo, but (1) USCo retains certain co-development and copromotion rights and an option to launch a generic version of the drug and (2) under certain circumstances, rights to the sublicensed IP would revert to USCo In 2008, USCo and ForCo amended the sublicense eliminating USCo s co-development and co-promotion rights and option to develop a generic USCo treated the 2008 amendment as a sale of its interest (eligible for capital gains) The IRS determined that USCo was bound by its choice to style the agreement as a sublicense and should recognize ordinary income The IRS moved for summary judgement (there exists no dispute of any material fact and the moving party is entitled to judgment as a matter of law) under the Danielson Rule The Tax Court ruled in favor of USCo by distinguishing the case from Danielson In Danielson, the taxpayer sought to reform a contract to reallocate consideration between stock and a covenant not to compete, and the Third Circuit held that while the IRS or a court can attack the form of an agreement, the taxpayers who can control that form may not later attack it Here, the Tax Court determined that USCo was not attacking the form of the sublicense but the IRS s interpretation of the sublicense and characterization of the related payments The Tax Court found that terms such as exclusive license or exclusive sublicense often indicate a sale of IP when used in connection with a transfer of substantially all rights to such IP Whether the amended sublicense transferred substantially all of USCo s rights to the IP and whether the amended sublicense was actually a sale was a question of fact and therefore not a matter to be determined on summary judgment USCo sells IP in a repatriation structure or to accelerate FTCs

5 Character, source and basis recovery, as well as a CFC s deduction or amortization for U.S. E&P purposes, depend on whether transaction is characterized as a sale or license A sale typically generates capital gain, while a license generates ordinary income (a contingent payment sale can be treated as license) Tax law follows substance rather than form and a license may be a true sale Whether a transfer of IP rights constitutes a sale or license is determined under the all substantial rights test Transfer of IP rights constitutes sale only if exclusive and perpetual right to use IP and to make, use and sell the claimed technology or product in a particular geographic territory is transferred Transfer of a non-exclusive right to use IP, particularly for a period less than the estimated useful life of the asset, generally results a license of the asset and payments received by transferor/licensor constitute royalties (ordinary income) VII. Medtronic - Medtronic Inc. v. Comm r (T.C. Memo ) USP licensed intangibles to FS that FS used to manufacture medical devices and leads, which FS distributed to SalesCo, a US subsidiary of USP that performs sales and related functions The IRS assessed USP a $2.7B transfer pricing adjustment related to the IP licensing and manufacturing agreements between USP and FS USP asserted that the pricing was arm s length and reflected entrepreneurial risks assumed and functions performed by FS Following an audit of USP s tax returns, USP and the IRS entered into a memorandum of understanding ( MOU ) agreeing to increase the royalties paid by FS to USP When the IRS audited USP s later returns, it proposed adjustments based on royalties higher than those set forth in the MOU The IRS first argued that the new royalties were consistent with the methodology of the MOU and ultimately abandoned the MOU entirely, determining royalties even higher than those originally proposed and issued a notice of deficiency ( NOD ) with adjustments The Tax Court essentially ruled for the taxpayer, holding that the IRS s application of the comparable profits method ( CPM ) was arbitrary and capricious, but also that USP s use of the comparable uncontrolled transaction ( CUT ) methodology was unsatisfactory The Tax Court applied its own adjustments to USP s original CUT method to arrive at its own decision of the appropriate arm s-length pricing

6 Practice point: This represents another blow to the IRS s use of the CPM, demonstrates some of the failings of the CUT method and shows that the Tax VIII. IX. Important takeaways from non-us transfer pricing cases Transfer Pricing Enforcement Developments A. Overview i. Focus is often on the tax-efficient movement of intangible property, but tangible property transfer pricing (e.g., bareboat charter rates) can be a significant issue as well B. Final and temporary regulations under Section 367(d) were released in December 2016 C. Section regulations regarding cost sharing arrangements D. Notice addresses contributions by US persons to controlled partnerships with foreign related partners and makes nonrecognition under Section 721 conditional upon certain substantive requirements (e.g., remedial allocations and no divergent allocations of deductions and profits) X. IRS campaigns A. IRS directives dated January 12, 2018 B. Mandatory transfer pricing IDR C. Application of sect. 6662(e) penalties D. Cost sharing arrangements (RAB shares, stock-based compensation) E. Changes to taxpayer s TPM XI. IRS APMA Developments A. Interaction of the BEAT and APAs/MAP agreements XII. Working with Rev. Proc Topics are subject to change based on developments.