US Transfer Pricing: Navigating Relevant Tax Law

Statute and Regulations

• The concept of Section 482 dates back to Regulation 41, Articles 77 and 78 of the War Revenue Act of 1917, which stipulated that related corporations file consolidated returns.
• The primary goals in enacting Section 482 were to prevent tax evasion by the manipulation of transactions between business entities controlled by the same person or persons and ensure that the tax liability of such controlled business entities is based on their “true” income.
• The regulations under Section 482 provide regulatory guidance to taxpayers and the government on issues and transactions between related parties.
• Detailed regulations have been issued about services, global dealing operations, cost-sharing arrangements (CSAs), and stock-based compensation.
• The current regulations start with the transfer pricing concepts and principles followed by specific rules and methods required to establish transfer pricing results.
• Certain terms that are now standard in transfer pricing worldwide were introduced and defined in the US.
• The IRS issues International Practice Units on international tax issues.
• TD 9738 was issued containing temporary regulations under Section 482 to clarify the treatment of controlled services transactions involving partnerships.

Case Laws

• The US is a common law jurisdiction and judicial decisions have precedent value
• Many Section 482 cases involve cross-border transactions between a US entity and one established in a foreign country
• The majority of decided cases have involved domestic transactions between US entities
• Over 250 court decisions have been handed down on the application of Section 482, and domestic cases continue to be litigated
• The promulgation of the 1994 regulations indicates that domestic transactions will continue to be examined under Section 482
• There is a large and growing body of case law that provides further guidance on the transfer pricing regime
• Case law shows that the courts accepted that applying the arm’s length standard was mandatory in all Section 482 cases after the 1968 regulations were issued
• Courts realized that the arm’s length standard and the 1968 regulations did not provide an answer to the problem of applying the arm’s length standard when no comparables exist
• Recent case law guides the actual application of methods
• The GlaxoSmithKline case concerned the transfer pricing of drugs marketed by Glaxo through a US affiliate, sold from the UK to the US at a transfer price deemed too high by the IRS. Glaxo’s position was that the price reflected the R&D carried out in the UK, whereas the IRS argued the value lay in marketing efforts in the US.
• The DuPont case involved transfer pricing adjustments using the resale price method. A Swiss subsidiary, DISA, was set up to distribute products in Europe, receiving 75% of total profits but only 26% of gross profits in reality. The IRS wanted to allocate part of DISA’s income to DuPont based on a rate-of-return approach.
• The Eli Lilly & Co v Commissioner case involved the manufacturing of products by a Puerto Rican affiliate. The court rejected a cost-plus method proposed by the IRS that did not allocate a return to the manufacturing intangibles, instead opting for a CP method with a 100% markup.
• In the Xilinx case, the Tax Court held that the participants in a cost-sharing arrangement did not need to share employee stock-based compensation costs under the 1995 cost-sharing regulations. The IRS argued that all costs related to intangible property covered by a CSA must be shared, but the Ninth Circuit later affirmed the Tax Court’s decision in favor of the taxpayer.
• The Veritas Software v Commissioner case involved a lump-sum buy-in payment made by Veritas to a related company, Veritas Ireland, under a cost-sharing agreement. The IRS claimed the payment understated the market value of royalties by $2.4 billion, but the Court found that the IRS used the wrong discount rate and growth rates in its calculations, and the taxpayer employed the CUT method to arrive at an arm’s-length buy-in amount.
• Altera Corp disputed with the IRS over whether employee stock option compensation should be included in shared intangible development costs in a cost-sharing agreement.
• In 2015, the Tax Court ruled that the regulation requiring related parties to share stock-based compensation in a CSA was invalid.
• In July 2018, the Court of Appeals overturned the decision and ruled that the Treasury’s rule was valid and complied with the Administrative Procedure Act.
• The Altera case was reheard in October 2018, and the Ninth Circuit issued a decision in June 2019, reversing the original 2015 decision of the Tax Court.
• The taxpayer requested an en banc review, which was denied in November 2019, and Altera filed an appeal with the US Supreme Court, which declined to review the case in June 2020.
• In February 2016, the Tax Court denied Guidant LLC’s motion for partial summary judgment.
• In June 2016, the Tax Court ruled in favor of Medtronic Inc in a dispute involving a Puerto Rican subsidiary and accepted the taxpayer’s CUT analysis with adjustments to increase the royalty rate.
• In August 2018, a US Federal Appeals Court vacated the decision in favor of Medtronic, ruling that the Tax Court did not sufficiently justify its conclusion that the CUT method was the best transfer pricing method.
• In 2017, the Tax Court rejected the IRS’s approach to pricing cost-sharing buy-in payments in the case of Amazon.com as inconsistent with the arm’s length standard.
• The US Tax Cuts and Jobs Act has broadened the definition of intangibles and given the IRS the authority to specify the method to determine their value.
• In 2019, the Court of Appeals for the Ninth Circuit issued a decision in favor of Amazon concerning the regulatory definition of intangible assets and their valuation under a cost-sharing arrangement.
• In 2018, the IRS filed a pre-trial memorandum against The Coca-Cola Company, claiming that the transfer pricing methods used were not in compliance with the arm’s length standard under section 482.
• In 2020, the U.S. tax court upheld the IRS adjustments on Coca-Cola, holding that the IRS did not abuse their discretion in employing the Comparable Profits Method.
• In 2021, Coca-Cola filed a Motion for reconsideration of findings or opinion, but the Tax Court effectively denied it.
• The case Eaton vs Commissioner concerned two APAs establishing a transfer pricing methodology for covered transactions between Eaton Corporation and its subsidiaries.
• In 2020, hearings began in the US Tax Court in Facebook Inc v Commissioner concerning the valuation of intangible assets transferred by Facebook Inc to an Irish subsidiary.