Taxation & Estate Planning

IRS GETS HAMMERED IN TRANSFER PRICING CASE

By Charles Rubin

Transactions between related companies are subject to special scrutiny under Internal Revenue Code section 482, which requires that amounts paid between the companies be based on the "arms length" prices that unrelated companies would charge each other. Special rules exist under the Treasury Regulations for transactions involving the transfer of intangible property, and a further subset of those rules provides for a method where two related companies (typically one inside the United States and one outside the United States) engage in cost-sharing to jointly develop intangible property.

These cost-sharing rules were recently involved in a major Tax Court case. In the case, a US corporation entered into a cost-sharing arrangement with an Ireland affiliate. Since the US corporation had already developed some intangible property that was to be used in the venture, the Ireland affiliate was required to make a "buy-in" payment to the US corporation to compensate it for the existing intangible property that the US corporation brought to the venture. The US corporation and the Ireland affiliate constructed what they determine to be a reasonable "arms length" price of $166 million for the "buy-in" based on transactions that the US corporation entered into with unrelated parties.

The IRS challenge that price, and said that the buying payment should be an astounding 15 times higher at $2.5 billion and allocated income for the difference to the US corporation. The case eventually found its way into the US Tax Court for resolution.

Coming up with an arms length price for goods and intangibles is a conceptual exercise, with a lot of wiggle room in real-world implementation. This wiggle room also opens the door to reasonable disagreements between IRS and taxpayer experts as to what an appropriate arms length price should be in any particular situation.

Typically, these matters are negotiated and settled somewhere between the taxpayers position and the IRS' position, or when the court has to decide the issue it usually settles on a price somewhere between the two extremes.

In this case, however, the Tax Court completely sided with the taxpayer. Further, the Tax Court further embarrassed the IRS with a finding that the IRS's determinations were arbitrary, capricious, and unreasonable.

One take away from the case is that even if the taxpayer adopts a reasonable arms length price, the risk always remains that the IRS may challenge that price and that challenge may be entirely unreasonable. Another take away, however, is that the Tax Court has no difficulties in disregarding such unreasonable IRS activity and noting it on the public record.

VERITAS Software Corporation, Symantec Corporation (successor in interest), 133 TC No. 14 (2009)

Full post as published by Rubin on Tax on December 13, 2009 (boomark / email).