Transfer Pricing Litigation: Where Are We Headed? (Transcript)

0:00:03.0 Cara Griffith: Welcome everyone. I'm Cara Griffith, the president and CEO of Tax Analysts. Thank you for joining us today as we discuss recent trends in transfer pricing litigation. Today's event is another in our series of public discussions that we call Taxing Issues. We launched this series in 2020 as another of our efforts to encourage debate on tax issues. We've been bringing the tax community together with leading policymakers and experts for bipartisan discussions on the future of tax policy. While we will occasionally hold in-person events, as we did during the ABA Tax Section meeting last month, we will continue to hold discussions mainly in a virtual format, and we welcome your feedback on how to make them more interactive. We also welcome your suggestions on future webinar topics. You can send your feedback and suggestions to events@taxanalysts.org. I also want to bring your attention to the fact that there are some background slides available for today's discussion. You can find the slides at the bottom of the viewing page. While the panelists won't be going through the slides, they provide useful background on the cases we'll be discussing. And my last housekeeping note is that we encourage questions for today's event.

0:01:12.9 CG: Thank you to those of you who emailed questions in advance. Please use the chat feature to submit questions during today's event. For our panel discussion, I will begin by asking a few questions and then I will turn to questions from you, our audience, and I promise to get to as many of your questions as time permits. And now on to the topic at hand: transfer pricing. The tax technicians tell us that transfer pricing refers to the price that one of a company's subsidiaries charges to another subsidiary for a transaction between them, like buying goods or delivering services. The critics have a different definition. They view transfer pricing basically as a technique that U.S. multinationals use to shift profits from where they really do business to tax havens where they don't. So, not surprisingly, the IRS is routinely engaged in lengthy and complex transfer pricing audits. Although some audits are resolved before litigation, some are not. There's been a long string of cases that have made headlines, at least in our world. Litigating transfer pricing disputes is a key part of the IRS's enforcement strategy. But for many years, the taxpayers almost always came out on top.

0:02:22.7 CG: For decades, in fact, taxpayers enjoyed a nearly uninterrupted streak of wins, which means that by definition, the IRS suffered a nearly uninterrupted streak of losses. The agency lost several high-profile cases involving large amounts of money. For example, in litigation before the Tax Court, the IRS lost in Altera in 2015, in Medtronic in 2016, and in Amazon in 2017. But more recently, things have changed in a big way. Although the Ninth Circuit Court of Appeals upheld the Amazon opinion, the Ninth Circuit reversed the Tax Court's ruling in Altera in 2019, and the Eighth Circuit vacated the Tax Court's ruling in Medtronic in 2018. Since then, the IRS has continued its winning ways, and even at the Tax Court. In November of 2020, the Tax Court upheld nearly $10 billion in transfer pricing adjustments against Coca-Cola, which meant that the company owed more than $3 billion in taxes. And this past [October], the court rejected Coca-Cola's motion for reconsideration. Now perhaps the IRS is just more aggressive these days than it has been in the past. Early in his tenure, Commissioner Charles Rettig said that "when the IRS" — and I'm quoting here — "brings five transfer pricing cases and the court rules against us, you don't have a commissioner who thinks we lost. We're going to wonder why we didn't bring 10."

0:03:46.0 CG: Of course, whether the IRS will continue its winning ways remains to be seen. The Tax Court conducted a second trial in the Medtronic case, and this past April, Amgen announced that the IRS is demanding more than $3 billion in back taxes. Both cases involve the allocation of profit to a Puerto Rican manufacturing subsidiary and whether the returns that the company initially allocated are reasonable in light of transfer pricing regulations. Taxpayers are going to need to see how all of these cases are resolved and use that information to predict how the IRS will conduct transfer pricing audits in the future. And thankfully, we have a terrific panel today to discuss these cases and these issues and provide insight into what we might see going forward. Let me introduce them. First, we have Marissa Rensen. She's a managing director with KPMG. Marissa also previously spent quite a bit of time with the IRS.

0:04:37.0 CG: Next, we have Matthew Frank, a partner with Steptoe & Johnson. Matthew has a robust career that has included in-house, government, and advisory roles. And finally, we have Ryan Finley, contributing editor for Tax Notes International and our own in-house transfer pricing guru. I want to thank all three of you for joining us today. This is going to be a fun and very interesting conversation, I have no doubt. Marissa, let me start with you. I have to say, it is really interesting to me that the IRS has gone from losing the majority of its transfer pricing cases and desperately seeking a win — any win — and now they're on a winning streak. So, from your perspective, are we actually seeing a new trend? And perhaps you could help us by providing some historical background into how we got to where we are.

0:05:23.0 Marissa Rensen: Alright. So, Cara, as you mentioned, there were decades of IRS losses, but I think what was really in people's minds over the last 15 years were a couple more recent and very material losses. So, I'll briefly take us through maybe some of that more recent history. So again, one of the biggest losses that was impacting kind of the day-to-day ongoings at the IRS was the loss in Veritas in the Tax Court in 2009. So, this was a case that involved — it was a cost-sharing case, involved a buy-in, and really the issue was the valuation of that buy-in. And at the heart of the issue was really whether compensation was required for some of the softer intangibles that were not listed on the list of intangibles in the regulations that were referenced by the cost-sharing regulations. So, a pretty technical issue, but it really came down to a question of what each party was valuing. So, the taxpayer made a rather really technical argument about what actually is required to be valued. And the IRS's position was a kind of more economic position based on the concept that maybe a part of a business was transferred. Ultimately, the court rejected the IRS's argument and its akin-to-a-sale-of-business argument and held that the IRS abused its discretion. Now, this was maybe a relatively discrete issue, but it had a very big impact on what was happening within the IRS, particularly in Appeals.

0:06:52.0 MR: These buy-in fact patterns were very common within the IRS — a big source of controversy — and many of these cases were decided in favor of the taxpayer in IRS Appeals because of the loss in Veritas. And then continue on over this trend, we had the loss in Xilinx for the IRS in the Ninth Circuit in 2010 where it ended up as in the Ninth Circuit. Again, a relatively narrow issue dealing again with cost sharing, this time with the treatment of stock-based compensation and the cost pool. Again, a relatively narrow issue. But the problem for the IRS really came down to the reasoning of the court. The court held for the taxpayer but under a theory that the arm's-length standard essentially requires transactions be priced based on how parties operating at arm's length would behave. And this focus on the behavior of uncontrolled parties created a lot of problems for the IRS that are much broader than this specific issue.

0:07:53.0 MR: It basically allowed taxpayers to take positions that even in transactions that would not maybe happen between our controlled parties, they could use comparables that were close enough in their view, without how the IRS would probably describe it, but in the IRS's view were not actually comparable. So again, these cases created a problem for the IRS largely in Appeals because they create a large hazard of litigation for the IRS. And there was a perception that with these big lawsuits, the IRS wouldn't be able to win a transfer pricing case, even in cases that are very factually different. Couple more losses, I won't dwell on them, but there was the Altera case in the Tax Court. Largely the same issue as in Xilinx, but under a new regulation.

0:08:39.0 MR: There was the Tax Court decision in Medtronic — not a cost-sharing case, but another loss for the IRS, largely focused on the choice of methods. The IRS was trying to defend its use of the [comparable profits method], which is a very commonly used method. And the court rejected that. And there was the Amazon case, which was very similar to the Veritas case but with more factual development. But again, a loss for the IRS. So again, I think the big problem here was that it was just the ripple effect that these losses were having on the administrative level. And to my mind, where things start to turn around a little bit for the IRS was with the [2017 Tax Cuts and Jobs Act]. So the TCJA added a third sentence to section 482. It basically codified the realistic alternatives and aggregation rules that the IRS often pointed to. It amended the definition of intangible property in section 367.

0:09:34.0 MR: So it added goodwill, going concern, and workforce in place. It also added a broader catch-all phrase. And interestingly, there was a footnote that called out the Veritas and Amazon cases. So you could argue with this either way, you could argue that the change in law suggests that maybe the IRS was wrong and needed a legislative change, but I think either way, it was kind of a moral victory for the IRS that at least going forward, a lot of these disputes would be settled in ways that are more favorable to the IRS's historic position. More recently — I'm just going to touch on this high level: In Medtronic, the Eighth Circuit reversed the Tax Court and remanded for additional factual development. The Altera Ninth Circuit reversal was another big win for the IRS, basically upholding the IRS's interpretation of the arm's-length standard as something that really could be based more on economics rather than the behavior of uncontrolled parties.

0:10:29.9 MR: The Amazon Ninth Circuit opinion was really more of a loss for the IRS, or maybe a little partial victory in that there was a footnote with some dicta that essentially suggested that the impact of this case might be limited to cases decided under the old version of the cost-sharing regulations and may not be precedential for future cases. And then the big one was the Coca-Cola case, which was just a very large, very large-dollar amount for sure, pretty big victory for the IRS. I think most significantly in upholding the IRS's use of the CPM, which again, [is a] pretty commonly used approach by the IRS. So, I do think that these, this history recently created a bit of a trend. Again, maybe not all complete victories, but much better than the historic position of many, various kinds of decisive losses. And so, I think one takeaway of this is that now I think it's a lot harder in Appeals for this perception that the IRS is just can't win a transfer pricing case to persist. And I think that that might — that will — change the dynamic to some degree, at least at the administrative level.

0:11:40.6 CG: Excellent. Thank you. And I want to ask a similar question to you [turning to Frank] that I asked to Marissa on whether or not this is a trend and to get your opinion on: Are we seeing a trend where the IRS is now winning, and in your opinion, if so, is it a positive trend that we are seeing?

0:11:57.3 Matthew Frank: Well, thanks, and thanks for inviting me to be here. I agree, Marissa laid out the history nicely. I guess I would say two things. One is the TCJA, I don't think it had any impact on the litigation we're seeing. All of the cases that have been decided, the most recent tax year at issue is 2009. So all the decided cases only bring us up through 2009 tax year. All the cases that are pending now, including Amgen and 3M and Facebook, those only bring us up to 2012. So those all obviously substantially predate TCJA. In terms of the history, I wouldn't call it a trend. You can acknowledge a victory or a couple victories, but I don't think there's a trend. Take the last 10 years or the last more than 10 years, there really only been three sort of traditional transfer pricing cases decided.

0:12:57.0 MF: And I'll supplement that with a couple more. Coca-Cola, Medtronic, and Amazon. So the IRS lost the first, it lost the second (although it gets a do-over because it was remanded), and it substantially won the third. And I say "substantially won" — I'm talking about Coca-Cola — because there was a substantial issue in there: the dividend offset issue worth $1.8 billion that it lost, which would be real money in any other case. The other two cases: Eaton. . . I mean, Eaton sort of goes under the heading "transfer pricing," but it's not a transfer pricing issue so much that's being decided there. They lost that, although that's on appeal, so anything might happen.

0:13:46.6 MF: And Altera, which they won in the Ninth Circuit after a lot of work. But you still have an adverse precedent in the Tax Court elsewhere. That’s a mixed bag. That's not a trend in my view. So I find the cases themselves very interesting, but I think the talk of a trend or streak is probably not merited.

0:14:15.7 CG: I have to say that's really interesting. And when you frame it in that way, it does look a lot different. I jotted down win, loss next to each case name, and it does look a lot different in that respect. Ryan, let's turn to you, and I'm going to ask sort of the same question in a slightly different way. So, we've had the IRS winning at least some cases recently. Is it that in fact the IRS is winning cases, or has the Tax Court gotten it wrong over the years and what we're really actually seeing is not necessarily a new trend but just that the courts have shifted their thinking in how they're deciding cases?

0:14:56.0 Ryan Finley: Well, I would say a couple things to that. First of all, I would say that even a mixed bag is probably a trend relative to what we saw before. I mean, 81 and 81 is a lot different from 10 and 152, right? Even if you look at the recent cases and say it's a mixed bag, I think that's still a departure from maybe if we had this conversation in, say, March of 2017, when Amazon decided the — or rather, the Tax Court decided the Amazon case. In terms of characterizing the trends as the IRS's wins versus the Tax Court's correcting its errors, I mean, obviously views differ on that.

0:15:50.0 RF: I think I would say, and maybe some others would say, that it seems like the commensurate with income standard in the statute was added in 1986 and the regulations that kind of give it effect that were for the most part finalized in 1994, that maybe courts have been giving them a little bit more of their due than they did before. In Altera, right? So, Altera, you can say Altera had a specific issue, and it was. It was a stock-based compensation and whether parties to a cost-sharing arrangement had to share it. But it gets at this issue of whether you have to interpret [section] 482 strictly, as kind of a comparables-based allocation concept, or whether income profit. . . . The reasonableness of the sharing of costs. It touches on this broader theme, I think. So, when you see it that way, when you see the IRS's win in Altera, the Eighth Circuit in Medtronic in 2018 saying that whatever happens on remand, the Eighth Circuit certainly rebuked the Tax Court for not adhering to the regulations’ comparability standards for sort of transactional methods.

0:17:20.9 RF: So, I think maybe it's a little bit of a Rorschach test to say whether there's a trend and whether the Tax Court was wrong or fixing their mistakes. But I do think if you look at those cases, also the 2017 — it's a lower profile case — but that Wycoff case in 2017, where the Tax Court kind of brushed aside these general criticisms about the comparable profits method which, as Marissa mentioned, tends to come up in these cases a lot. It kind of brushed aside these arguments that the CPM is inherently inferior to transactional methods, and you saw that again in Coca-Cola in 2020. So, I think there are enough data points here to say that at least the conversation is quite different than it would have been, say, five years ago. And in my humble opinion, I would say it's probably — where we are now — it's probably more in keeping with the statute and the regulations than where we were before.

0:18:27.0 CG: So you mentioned the commensurate with income method, and so I wanted to ask you guys — I actually don't know the answer, so I'm going to be very interested in hearing yours. Do you think the commensurate with income [CWI] method is becoming more accepted now than it was before?

0:18:48.0 MF: It's certainly being written about. I mean, Ryan had a long piece last month on CWI and its impact — possible impact — on 3M. And I mean to say, Ryan, a bunch. Ryan's also written about CWI before. Stephen Curtis published a big thing in Tax Notes on CWI and Facebook, and he and Jeff Kadet have been sending comment letters to the IRS saying, "Get busy with CWI and periodic adjustments." In terms of whether it's being more accepted, I think there's a threshold question: What does CWI even mean? The IRS has had the long-standing position that it's consistent with the arm's-length standard, and the Ninth Circuit in Altera said yes, yes it is. Now, I think other people take the view that it's not consistent with the arm's-length standard; it's an override to the arm's-length standard. So, as I say, there's a threshold question. If you're going to ask, "Is CWI being accepted?" Well, first you have to define what is it. And I don't think there's any consensus on that, except the IRS sort of long-standing view, affirmed by the Ninth Circuit, that it's just consistent with the arm's-length standard.

0:20:13.3 MR: I think there's a different twist on the same point you've made now, that there are different kind of views of it. And I think one kind of perception of CWI is just really the periodic adjustment rule that the IRS can use kind of the actual economic results and use that to change — to reverse the transfer price and to make adjustments on that basis. I think the other is more of a bigger-picture kind of economic concept. And I do think the bigger-picture economic concept that the results of the price should match the economics is certainly being used more in courts. You see that in Altera. It's probably the IRS's argument in another case that's pending, Perrigo. I would be curious to hear from you, Matt, or others just using more of . . . The first category of more the periodic adjustment use of it, which . . . Personally, I have not seen a big uptake in that use of CWI rules. I do think that more broad economic interpretation of it seems to be gaining traction.

0:21:14.6 CG: So, Marissa, you brought up Perrigo. We could jump kind of in that direction as a pending case of interest that I wanted to get you guys' opinions on.

0:21:27.0 MR: Yeah, it's an interesting case. It’s a little bit different from some of the other ones that we've seen. Just kind of a quick background: The basic fact pattern there is you have Perrigo had entered into an agreement with the third party in Israel, Dexcel, to develop, manufacture, and sell in the United States a pharmaceutical product. And so, Perrigo transferred its rights to the agreement to a new [controlled foreign corporation] in Israel. And it also subcontracted with that CFC to perform under the agreement. So, my understanding was that the CFC didn't have any employees of its own, just had some board members. And so, this is a case where the IRS is making its alternative positions. One is based on just economic substance judicial doctrines that the CFC and the transfer wishes to not be respected. And another one is a transfer pricing argument based on the CWI rules, using the CPM to price the investment of the CFC in this contract. On the other side, you have the taxpayer’s position. Very interestingly, they are using the economic [inaudible], using a discounted cash flow method, which is something that you traditionally see the IRS doing. So, it's an interesting case, just very a little bit different from what we've seen.

0:22:50.5 MR: But interestingly, I think either way, there arguably is some benefit to the IRS from this case. Either the courts will presumably bless the discounted cash flow method or agree with the IRS. So, it's just an interesting case that's out there that could have some interesting impacts on other cases that are pending.

0:23:14.0 MF: My quick thoughts on Perrigo. I'm not the student of the case. It reminds me of Hospital Corp. because there are really two issues. One is the judicial doctrine. The IRS is arguing a sham and is trying to sham the transaction. And then you have the underlying transfer pricing issues. And so, for me, the headline will be whether the court — and by the way, it's in the Federal District Court, Western District of Michigan, not in the Tax Court. But the first question will be whether the judge accepts the IRS sham argument. And then the second question will be, if not, what the traditional transfer pricing result will be, which, as I say, has memories of Hospital Corp., at least as I view it. And that's fully tried, and that's a case that could be decided any day.

0:24:16.0 CG: It'd be interesting to get a case that — Ryan, I wanted to give you an opportunity too. Is Perrigo a case you're watching, or are there others that are of interest?

0:24:23.6 RF: Yeah, well, I'm certainly interested in Perrigo. It's interesting. And, you know, I'd be definitely interested to see what Matt and Marissa think about this. But I wonder if the government — and in this case, it's not your normal Tax Court litigating situation. I assume you have different personnel who are in charge of representing the United States versus those who would represent the IRS in the Tax Court. I wonder whether the decision to rely on economic substance and sham transaction doctrines has any connection to, organizationally, the people who are litigating a case, or is it just — is this like a perceived glitch in the [section] 482 regs that would allow this without using sort of a sham transaction doctrine? I'm not sure what.

0:25:22.4 MF: It was designated for trial, so we don't have maverick [Department of Justice] attorneys running off.

[laughter]

0:25:30.6 MF: And making these arguments.

0:25:32.5 RF: Right.

0:25:33.0 MF: And I assume when it was designated for trial, it was to make the sham argument. It'd surprise me if that weren't the case. I think it's unfortunate. Well, it's an unfortunate path to go sham rather than transfer pricing. But again, I'm not a student of the case. But this I'm sure is coordinated and not a . . .

0:26:00.7 RF: So, if it's a shame, is it a shame because the IRS is right under their alternative argument, Matt?

[laughter]

0:26:08.6 MR: I do. But personally, I think it would be a lot more interesting if it is a side entrance for pricing grounds. But either way, it's with another data point there, and the sham is one of many sham cases, if that's the way it goes down. But this side entrance for pricing grounds, I think that it provides an interesting decision on a case that — again, this idea of how much you can ascribe to taking on of risk in putting an investment. I think it's undisputed that there aren't any employees of this CFC, but they put in money, they're taking on risk, and that's kind of an open question in a lot of cases. And so, I think where the court comes down on that will be informative even in a very different fact pattern, so I think it'll be an interesting case. And then to get. . . . Personally, I hope it is a side entrance to transfer pricing grounds just for that purpose — the precedent it will create for both sides to have some guide posts in this area.

0:27:01.9 RF: It seems that the factual dispute is whether sort of the outcome of those risks was sort of preordained, right? And whether via the commensurate with income standard, we can just brush aside what you may have known or not known ahead of time and just sort of look at the ex post economic results of it. I agree that would be far more interesting than the court just saying that it was a sham, but I'm not sure how you . . . -yeah. Well, it'll be interesting to see what the court decides on that. I don't know.

0:27:43.4 CG: So, this sort of relates to a question that came in from a viewer, which was, does the trend toward using more realistic economic analysis and moving away from arm's-length formalism imply that transfer pricing controversies will eventually diminish? Curious to get any of your thoughts on that. Have you seen less transfer pricing cases in the. . . .

0:28:03.8 MF: There are a couple premises in that question I don't agree with, although I'd have to write them down to tackle them. So "arm's-length formalism" is the term that's used?

0:28:15.0 MR: Yes. "Arm's-length formalism" is the term that is used.

0:28:17.0 MF: I don't know what that means, but I think I don't like, I don't — I think I don't agree with it, even though I don't know what it means. I mean, arm's-length standard to me has always been very practical. And the virtue of the arm's-length standard is that it's practical. It's based on the marketplace. Now, you may have to make accommodations for the fact that arm's-length transactions — excuse me, related-party transactions — aren't mirrored in the marketplace, but still, you've got an actual real-life touchstone from which you proceed. And that to me is the opposite of formalism.

0:28:55.3 MR: Yeah. My perspective on this that the more exciting cases you have out there, the easier it is to resolve a case before it gets to that point, because you have these different data points to point to. So, I think, again, going back, kind of the IRS's problem before they started having some wins or partial wins was that all the cases that were out there supported the taxpayer's position. And so, they really had to go to court to be able to point to case law that would support their view and give them some bump in their adjustment as a result of hazards of litigation. But I think once you have more data points out there that you can point to, it becomes easier to resolve a case without going to that point of litigation because you can compare different cases and say, it's more like this one or that one. And both sides have cases they can point to. And personally, I think that makes it easier to resolve a case at the administrative level. I certainly don't think anyone wants to continue a train of litigating every single big case. It’s expensive. But once you've put in that effort and have the precedent, I do think it helps to resolve cases at a lower level.

0:30:02.0 CG: Do you think then — and this was one question we had talked about in advance — do you think that the government is choosing its cases more carefully then, so that it has the cases that it wants to be precedential?

0:30:13.7 MR: I think to some degree., I mean that the IRS can't . . . doesn't have perfect control over what cases makes it to court or not. And for one, it doesn't have control over which cases might settle in Appeals. It could designate a case, but short of that, it's somewhat out of the IRS's hands. That said, I do think that the cases that seem like they would be good candidates for litigation and that have the support of the IRS, they are being very careful about that. Making sure that they’re being staffed very well to being developed very well, putting their best people on it at the pallet level, same thing, you know, getting really great DOJ attorneys to argue. So, I think there is a lot of thought that goes into that. And if a case doesn't seem like it’s ready for litigation, then that might not be a good one to let go forward and to try to resolve again at an administrative level. So, I do think there is some degree of thought going into which cases get out of the door.

0:31:07.8 MF: I agree with Marissa. I mean, that the cases that the IRS truly chooses are the ones it designates. And I know of three: You've got Amazon.com, which it lost; Coca-Cola, which it mostly won; and Perrigo, which is to be decided. I don't know what the history of transfer pricing designated cases are prior to that. I don't know if that's information that's available. But it does seem to me, if we're talking about trends, I mean, I think these three recent designated transfer pricing cases are something new, and it's 1 and 1, with one to be decided.

0:31:52.0 CG: Correct, right. Ryan, I know you wanted to make sure that we brought up 3M. Do you want to take a lead on what is the blocked income exception at issue in 3M?

0:32:05.9 RF: Sure. So, 3M case. Many people have been very eagerly awaiting the outcome of for a little while. It's this blocked income issue which has to do with when — at least in this case, and as it normally comes up — foreign law prevents a subsidiary, affiliate — whatever — some related party — from paying the amount that under the [section] 482 regs and presumably under the treaty if there is one would be considered arm's length. So, in 3M — and this is often the case — it involves Brazil and a restriction on the royalties that can be paid. So, when Treasury and the IRS sort of overhauled the [section] 482 regs over the course of 93 and 94,

0:33:04.7 RF: they issued these blocked income rates and they provide a sort of a specific set of relatively strict conditions for when the IRS will say, "OK, fine. We will respect that. It's consistent with the arms-length standard that you aren't going to charge your affiliate this amount that foreign law won't allow." So those regs came a few decades, I get, well, I don't recall exactly when the First Security Bank of Utah case came out, but it's the only Supreme Court precedent relevant to section 482. And I believe it was 1968. Yeah. So, this . . . What's that?

0:33:56.6 MF: '72.

0:33:58.6 RF: '72, I'm sorry. Wow. I don't know where I'm coming up with '68, four years off. Anyhow, it was a while before, and this case and exactly the grounds on which this case was decided, it’s something that people kind of disagree on. But the result was the Supreme Court held that you cannot under [section] 482 allocate income to a party in a way that will be inconsistent with any legal prohibitions on the payment or receipt of that payment. Right? So, fast forward to 3M. In 3M, the dispute is whether these regs are valid under the [Administrative Procedure Act] and under Chevron and whether this First Security Bank case controls. So, it's a very interesting issue. I believe that it came up earlier than this case is holding up Coca-Cola because there was a blocked income issue in that case.

0:35:04.3 RF: So, it was stayed pending 3M. An opinion could come any day, it could come awhile from now. No one really knows. But it's a very interesting issue. Whether things like — you could debate whether sort of broader issues like whether the commensurate with income standard really has much to say about this. But it's definitely a big issue in its own. So, I think just because of the importance of the issue and allowing other cases to go forward, I think it's a very eagerly anticipated opinion.

0:35:45.9 MF: I agree. I mean, it’s, of all the cases pending still, I think it's the most, it could be the most important case on a number of levels. And it's really interesting because the IRS just lost, not only in First Security Bank of Utah, but in Proctor & Gamble and a couple other cases, it lost this issue. And in 1994, as Ryan says, it came out with these regulations, which to many observers just struck someone as defiant. And it set these requirements that the IRS will consider foreign legal restrictions. Doesn't say how they will consider them, but they will consider foreign legal restrictions if you jump through various hoops, which, as a practical matter, no one can jump through. And so you've got these adverse court decisions, including a Supreme Court decision, and then subsequent legislative action

0:36:49.0 MF: that seems, as I say, almost in defiance of the Supreme Court and other court of appeals decisions, and the validity of those regulations are now under challenge — which, of course, now that's a trend — challenging regulations. You see that everywhere now. And that was the case in Altera, too. But the 3M decision, how it comes down on that question I think is going to have major ramifications for at least the... It will express the Tax Court's view about all these reg challenges. And it will also, I think, address some fundamental questions about [section] 482 and the arms-length standard, whether the regulations are upheld or not. So, it's going to generate a number of conferences and seminars and such, talking about the 3M decision, whenever it comes down.

0:37:56.0 RF: If I could just add one thing, I would say how defiant those regs are depends on what you think First Security Bank really says and whether you think the statutory amendment in the meantime bears on the question. And I think it would probably be a minority view to say that the commensurate with income amendment in 1986 changes much. But I do think it's pretty reasonable to argue from First Security Bank itself that that case was decided on the basis of old regulations. So, whether Treasury and the IRS are defying something or not depends on what you think sort of the original edict was, and I think there's some dispute over that.

0:38:49.9 MF: That's absolutely true. First Security Bank of Utah sort of had multiple bases for holdings, the tax parity basis. And I mean, I'll won’t get into Utah, there's a tax parity basis. And then there was an absence of distortion, absence of controlled-party distortion basis. And there may have been a third basis as well. So, discerning its true meaning is [chuckle] . . . it's like examining the Torah in that you can spend a lot of hours trying to figure it out. And maybe 3M will address that or not, but it's a fascinating case.

0:39:24.5 MR: Yeah, there's . . . It's a little bit of interesting policy overlay in too, right? I think that the heart of these regulations is, "Should the United States be ceding taxing rights to a foreign country that has transfer pricing rules that don't follow the norms of the rest of the world?" Basically, if you accept the premise that many countries follow OECD transfer pricing guidelines, and result is not. So, it interesting too. Well, it might have made it interesting to see if that factor isn't it at all or if that was just deemed to be irrelevant and the case was decided on the legal words in front of it, but it's . . . I feel like these policy questions are coming up a lot these days in the broader international tax world.

0:40:06.5 CG: Well, so you brought up the international tax implications. Is [the base erosion and profit-shifting project] going to have any impact on U.S. transfer pricing litigation?

0:40:19.1 MR: I do think it'll have an impact on the transactions that may or might not ultimately bubble up to litigation. And if you looked at a lot of these cases — I'll take Amazon just 'cause I'm familiar with the facts. You had a transfer from a relatively high-tax country to a relatively low-tax country. Pretty big tax arbitrage, especially before TCJA. I think these days, the tax arbitrage is much smaller, right? The U.S. tax rate has gone down. Committees can't really be kind of storing [intellectual property] in tax havens anymore. The laws have changed. Many companies aren't storing their IP. If pillar 2 comes into effect broadly, there will be this 15 percent minimum tax rate that will roughly apply everywhere and using different mechanisms. So, it takes away a lot of the incentive to engage in aggressive transfer pricing just because no one wants to be in court if they don't have to be. On the other hand, there still many countries that have tax rates above 15 percent, and so there is an opportunity for tax arbitrage, if the transaction is big enough, it'll still be there. So,I suspect the pressure will be taken off, but it's hard to say whether it'll be cut off completely. I'd be curious whether you have to say on that point.

0:41:35.3 MF: I guess I'd say two things. I don't . . . The OECD transfer pricing guidance part of BEPS, I don't think that's going to have a material impact on the course of U.S. transfer pricing litigation. In terms of the tax, the international tax reform, as Marissa says, it may have an impact to the extent it affects international tax planning. But even there, I think you can exaggerate its likely impact, I would tend to think. Well, I would point out the following: If you look at the U.S. competent authority inventory, transfer pricing inventory, three-quarters of those transfer pricing cases involve foreign adjustments, which means three-quarters of the cases involve foreign governments who think the taxpayer left too much money in the United States, which is not a taxation. My observation is that transfer pricing adjustments are not so much driven by concerns that you're parking too much money abroad; they're concerned . . . they're driven by, you're not including enough income in the U.S. regardless of the arbitrage opportunities.

0:42:51.5 MR: That's a very good point. I agree with that. Definitely, we're seeing a big uptake in the foreign tax authorities and their adjustments. So, I think that's a trend that will continue.

0:43:02.9 RF: It's interesting, though. I mean, I don't disagree with anything that either of you guys said, but just to speak for people who've said this. A lot of people saw sort of inklings of BEPS in the Coca-Cola opinion. I don't really agree with that, but people said that the whole idea of exercising control, right? The idea that you can reallocate risk based on the degree of control or lack thereof that a party exercises, which . . . Whether this is a discrepancy between the OECD guidelines and the U.S. regs is itself a matter of dispute, but it's arguably a difference. And some people thought that in the Coca-Cola case, because these foreign supply points . . . that was with the foreign subsidiaries — that they didn't exercise control over marketing activities that supposedly generated the intangibles that entitled them to the higher returns than the IRS thought they should receive — that that factored into the opinion. I don't really see that. I think that's a stretch, but I do think . . . I've seen arguments in briefs that kind of from the IRS side, that at least. . . . Oh, sorry, I have a screaming cat. [chuckle] Anyhow, lost my train of thought there, but yeah, I think that you do see it brought in as a secondary argument, and maybe on a sort of subtle level, it is factoring into some opinions now. But again, that's something I think people disagree about.

0:44:54.7 MF: I would draw a distinction there between what you're seeing at exam and what may be motivating agents. What sort of sources agents are drawing from for inspiration versus what we're seeing in the courts. I think Coca-Cola would have been written exactly the same way if BEPS never happened, if the OECD guidance never was issued. I don't think it had anything to do with the OECD. But the IRS is a big organization, and there are a lot of agents pursuing issues. And some of them are inspired by some of the BEPS-related language. And so, you do see that on exam. Again, I don't see that seeping through, and I don't think it's going to seep through into court decisions. And partly I draw that from my observations of Canadian practice, where the [Canada Revenue Agency] is heavy on sort of OECD-inspired themes, and the Canadian courts have nothing to do with it.

0:45:55.5 RF: Yeah, I want to be clear. I don't see this either, but there is, there are people who are saying this, so I'm raising it not necessarily on my own behalf, but I agree that Coca-Cola would have come out the same way regardless. And I think maybe the term "control" was referring to arguably two different things in Coca-Cola compared to the OECD guidelines. But you know, the view is there.

0:46:24.2 CG: I think it's interesting to try to figure out — and everybody is doing this in many areas — to try to figure out what BEPS is going to mean as it goes and what the OECD guidelines are across the board as they come out, and try to figure out how it all fits in. The one case we haven't spent any or enough time on is Altera 'cause we have to bring this up as a case. It was certainly a landmark decision when it came out. From your opinions, what are the implications of Altera today? And Matt, you kind of brought up the right challenges and validity and some of those issues. What does Altera mean to that?

0:47:06.3 MF: Well, Altera upheld the regs, right? So that was a win for the IRS. And I mean, it's hard to talk about Altera without talking about Xilinx and talking about . . . I mean, Altera is one of the most divisive cases in transfer pricing sort of history among advisers and taxpayers and such. People fall into one of two camps. And so, I hesitate to broach the topic when we only have 12 minutes left. I think 3M is going to supplant Altera when it comes to how the Tax Court, how transfer pricing practitioners sort of view challenges to transfer pricing regulations. I cited Altera also for affirming the IRS view that CWI is consistent with the arm's-length standard. I'm not sure what other sort of long-term lessons I would draw from that case.

0:48:21.0 MF: Well, I mean it does raise a fundamental question about what the focus of the arm's-length standard is. And what Altera basically said was the focus of the arm's length, of transfer pricing is the reasonableness of the result — the arm's-length nature of the result, not the methods by which you get to the result, and the role of comparables in a proper transfer pricing analysis. And that has lots of important implications. But I don't think I'm going to start down that path in this session. Marissa, maybe you can make. . . .

0:48:58.6 MR: No, I agree. And the part of Altera that's always fascinated me the most is this kind of question about what it means for the arm's-length standard. And I think for many, many, many transfer pricing fact patterns, maybe it won't be all that relevant. But I think where it is the most relevant is you have these transfers of what the IRS would call the crown jewel IP that's relatively unique. It's really the kind of the core IP of a company that a company might transfer to a related party but it would never transfer to a competitor, for example. It wouldn’t make sense. And so those are the transactions that are particularly hard for both practitioners and the IRS to value, because there's a question of whether there really are any comparables for those types of transactions.

0:49:45.2 MR: And I think the way that the Tax Court interpreted the arm's-length standard is kind of focusing on how uncontrolled parties would behave. When you take a transaction and kind of morph it a little bit so that it looks like transactions that controlled parties do enter into, it’s a lot easier to find comparables. But if you take the IRS view where they say its really more about economics than the price, and you price the transaction as it was structured, even if there was one that controlled parties wouldn't enter into, it's a different analysis. I think that's a pretty fundamental question that will come up frequently I think with these types of unique IP transfer cases, and sort of the day-to-day transfer pricing, maybe much less so. But I do think there's a fundamental question of what the arm's-length standard means that Altera took on and, I think answered in a way that was agreeing with the IRS's position. So, I do think that will have an impact on how the arm's-length standard is interpreted.

0:50:43.3 RF: There was also sort of an interesting — I don't want to say minor issue, but it didn't get as much sort of attention as this broader comparables-versus-economics-based approach. It was whether cost-sharing arrangements, or specifically the cost-sharing payments that are made over time under a cost-sharing arrangement, are subject to the commensurate with income standard at all. Because Altera, one of the sort of secondary arguments, was that even if the commensurate with income standard would affect the result here, they are saying the IP which we transferred to the cost-sharing arrangement, okay that was an IP transfer. But these cost-sharing payments that happen over time — the payments that either should have or should not have included the value of stock-based compensation, depending on your position —

0:51:37.7 RF: those are generating new intangibles, so that doesn't relate to any intangible transfer. Personally, I didn't find that argument especially persuasive, but there were a lot of amici briefs filed on this exact issue, and it seemed to be important to a lot of tech companies. And the Ninth Circuit said no. Of course, it's just one appeals court, but it's the court where all of our tech companies are. And they held that cost-sharing arrangements, including cost-sharing payments to take place over time, are subject to the commensurate with income standard, which by its terms only applies to intangible transfers of licenses. So, I think that that's important as well.

0:52:26.8 MR: It is an interesting point. Back to the earlier point of what does CWI mean. Does this refer to periodic adjustments or something broader? Yeah, I think the reason that there is may be some hesitation in applying the periodic adjustment rules is that there is this question of can you apply them to a transaction that involves IP and something else? It might be very rare these days to see a pure IP transfer as opposed to a transfer of IP combined with maybe a service transaction. And there's a question that I think out there as to whether this kind of service income standard applies more broadly or could have applied to a mixed transaction. And so, it's an interesting question. I think it'll be interesting to see kind of where that goes and if there's any more clarity on that issue in the broader context.

0:53:14.3 CG: We've thrown out a bunch of cases, a bunch of topics. What does this all mean for taxpayers? And how should taxpayers be responding? How are taxpayers responding? You know, is there a trend, is there not? What are your takeaways for taxpayers?

0:53:31.7 MR: Yeah, I think what we're saying is that, especially after Coca-Cola came out, because it was such a shock to a lot of people to have such a big case in the IRS's favor. A lot of companies I think are just reevaluating their own positions. Whether it requires a change or not, they're just taking a hard look at the transfer pricing policies, taking a hard look at their contracts, and really just seeing that their contracts line up with their policies. Are they undertaking any transactions that might be inconsistent with those transactions? I think a big question that came up in the Coca-Cola case, there was this closing agreement that was not technically applicable to the years at issue other than for penalty purposes. And there was a big debate over how much weight that carried.

0:54:16.6 MR: I think the court's rejection of that is making a lot of companies think who may have relied on the old closing agreements or [memoranda of understanding], or just past audit history, or [advance pricing agreements] that might have lapsed and taken some comfort in those, I think it's making them maybe just draw a question of, is that really a source of comfort, or should they really be just be kicking things around a little bit and making sure their documentation is still strong and not overly relying on those past agreements. Yeah, I think day-to-day, I don't know if these necessarily are affecting many companies’ actual transactions. But just the broader idea that maybe there's a little bit more risk and that there's a little bit more risk that examiners might be less willing to settle in the same terms is something that companies should be aware of and are prepared for, I think.

0:55:07.8 MF: I guess my thought is there’s a consistency or constancy in transfer pricing litigation: Don’t put any weight on trends or try to predict what's next. The major issues 10, 20, 30 years ago are still the major issues now. The best practices from 30 years ago are still the best practices now. Be prepared. Keep your eye on the reasonableness of the result. Every transfer pricing case affirms that what they're evaluating is not the method, but the result. And so no matter what method you put forward as your primary transfer pricing method, you have to keep an eye, as courts do too, on the reasonableness of the results. So, if you go back, actually, if you look back 40, 50 years, all the transfer pricing cases that have been litigated, the vast majority of them always have an eye on distribution of profit between the parties.

0:56:09.8 MF: So Eli Lilly in the mid-1980s said, "Profit split is the most commonly used transfer pricing method in courts." And if you look back through the cases — even the cases that purport to use comparable and controlled prices or uncomparable and uncontrolled transactions as the primary method — they have one eye on the distribution of profit and whether they think that distribution is reasonable. So, I would tell taxpayers, keep your eye on that. You want to be able to show that to the court — not only that you turned square corners and you followed the methods, but that your destination is a destination the court should be confident of. And if you do that, if you make the court think that that is the right result and that you've gotten to it in a reasonable way, that position is your best for success.

0:57:15.2 CG: That seems like incredibly wise advice. And when you look at some of these cases and that sort of consider myself a layperson in the transfer pricing space — that makes absolutely 100 percent sense. One question, in the two minutes that we have remaining, that came in from our viewers was whether COVID has had any impact on transfer pricing formulas and adjustments, given supply chain issues. Out of curiosity, I just wonder if you've seen anything that seems awfully recent and that there may not be felt for a few years to come. But I'm interested in your opinions on that.

0:57:53.7 MF: Obviously not in litigation. We'll see it in litigation eight, 10, 15 years from now.

0:57:55.7 MR: Yeah. Yeah. Absolutely.

0:58:00.6 MF: At exam. Yeah. It has not had that much of an impact on the work of the IRS, but in terms of the sort of results that are being reported by companies in certain industries, obviously, it does have an impact. And if you had to sort of discern a theme, it’s that the IRS will be patient, but they want to see a return. That they will, at least, for example, in the APA program, they’ll want to see you work your way out of that shock and over a multiyear period go back to sort of normal returns. At exam, it's a little bit more difficult because the exam teams are focusing on a single year or two, but those exams, frankly, are just kicking off now.

0:58:52.7 CG: Yeah.

0:58:54.8 MR: Yeah. I think there are some structures that might have been structured to put profits in a low-tax jurisdiction, and they're now putting losses in a low-tax jurisdiction because of COVID. And I think that raises a lot of different issues that I think ultimately comes down to the actual arrangement itself as to how that comes out. But I can see those types of transactions being scrutinized, or the companies try to flip and kind of put the profits back in the higher-tax jurisdiction likely being scrutinized. But it’ll be interesting to see how that plays out.

0:59:23.7 CG: Yeah, I guess it'll be interesting to see if it's a blip on the radar. Then it may not have as much of an impact if the trend sort of continues, and it'll be fun to watch. Well, I want to thank you guys. This is very interesting. It was very informative. I enjoyed it thoroughly. I thank you for sharing your time and your insights. And to our viewers, thank you for watching. And we look forward to the next one. Have a great day.

0:59:47.8 MR: Thank you.