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Individuals Submit Comments on Procedures for Requesting, Obtaining APAs

JAN. 3, 2022

Individuals Submit Comments on Procedures for Requesting, Obtaining APAs

DATED JAN. 3, 2022
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January 3, 2022

Andres Garcia
Internal Revenue Service
Room 6526
1111 Constitution Avenue NW
Washington, DC 20224

Subject: Comments on Revenue Procedure 2015-41

Dear Mr. Garcia:

Pursuant to a request made by the IRS in the Federal Register, Volume 86, No. 215 on November 10, 2021, the undersigned are providing comments concerning Revenue Procedure 2015-41.

One of the undersigned, who has been retired for most of the last two decades, worked for over 32 years in international taxation for several of the major accounting firms both in the U.S. and abroad, giving tax advice to multinational corporations (MNCs) headquartered in the U.S. and other developed countries. In addition to preparing numerous submissions to Treasury, Congress, and the IRS and writing articles over the past decade on international taxation,1 he has taught international taxation within the University of Washington School of Law Tax LLM program as an adjunct professor. The other undersigned is a transfer pricing practitioner, with approximately twenty-five years of experience, including serving for sixteen years in two major accounting firms. He has also written several academic and practitioner papers on transfer pricing, including several addressing cost sharing regulations and in particular the periodic adjustment regulations of Reg. Section 1.482-7(i)(6).2 The experiences and writings of both of the undersigned are directly relevant to the subject of this revenue procedure.

This revenue procedure provides guidance on the process of requesting and obtaining advance pricing agreements (“APAs") from the Advance Pricing and Mutual Agreement program (“APMA”). As such, it is broadly drafted to cover many sorts of intercompany transactions for which taxpayers may appropriately request APAs.

In this letter, we include first comments and recommendations specifically focused on cost sharing arrangements (“CSAs”). We then provide some additional comments and recommendations on a broader scope that we believe would make the revenue procedure more effective. Finally, we include an Appendix with some additional background and discussion. A table of contents for this submission is found on the following page.

We wish it to be clear upfront that we are not paid advisors to any multinationals. We have no agenda to help multinationals secure beneficial APAs. Rather, our individual studies of specific multinationals and their profit-shifting structures have revealed to us the artificiality of too many such structures. They are achieving results that the law has never intended. Often, they are using (really abusing) transfer pricing rules as a key component of these artificial structures. In so many cases, it is clear that critical functions for a multinational's seamless worldwide unitary business are conducted within the United States, but the bulk of the profits of that business for sales or services to most foreign customers/clients/users are simply reported within a tax haven or otherwise low-taxed foreign group member. Sometimes this happens as well even for sales to U.S. customers/clients/users. In some cases, APAs have been granted that further such profit-shifting structures. And the terms of those APAs may prevent the application of the “commensurate with income” (CWI) standard, which was added to section 482 by the Tax Reform Act of 1986. In short, our objective, our “agenda” if you will, is to provide ideas and approaches that will help the APMA both draft a better and more effective reissuance of Revenue Procedure 2015-41 and make better decisions in the future on the APAs they will approve and those they will reject.


Contents of Submission

Cost Sharing Arrangements

Introduction — A Little Helpful History

Enter the CSA

CSAs Are an Enabler of Profit-Shifting Structures

The “Frankenstein Regulation” — And the Mechanism that Can Reverse Its Effect

Common Features of CSA-Based Structures: Partnership Status and Effectively Connected Income

CSA-Related Recommendations

Eliminate APAs for Cost Sharing Arrangements

Re-Introduction of “Individual Exploitation”

Re-Introduction of “Participant” Requirements

Elimination of Periodic Adjustment Exemptions from APAs

Include in Terms of APA Detail Necessary to Apply Future CSA Periodic Adjustments

Include as a Term of any CSA APA the Requirement for Taxpayer Annual Preparation of Reg. section 1.482-7(i)(6) Trigger Calculation

Other Recommendations Concerning Revenue Procedure 2015-41

Elimination of Periodic Adjustment Exemptions from APAs

Include in Terms of APA Detail Necessary to Apply Future Periodic Adjustments

Extension of BEPS CCA Guidance to Licensing, Business Restructurings, and Intangible Development

Arrangements other than CSAs

ECI Taxation and Partnership Status

Schedule UTP Disclosures

Effect of OECD BEPS Pillars One and Two

Potential for Joint Audits

Reflection of TCJA Update to Section 482

Protection from Certain Penalties

APPENDIX — Additional Background and Discussion

Section 6.03 Authorization of exemption from periodic adjustments overrides CWI standard

The Reg. section 1.482-7 regulations are difficult to enforce without a periodic adjustment

Has profit shifting been material in amount?

CSAs — Out of control

Taxpayers gaming the system

Critical need for removal of Section 6.03 periodic adjustment exemption


Cost Sharing Arrangements

Introduction — A Little Helpful History3

When U.S. businesses began expanding internationally after World War II, the business environments and communication technologies of the time generally required that overseas manufacturing and other operations be conducted on a stand-alone basis, with each operating subsidiary having its own management team locally directing sales, operations, finance, and other functions. That team of course took guidance from group management back in the United States, operated under group standards, and made use of U.S.-owned intangibles. However, these subsidiaries were still very much independently operated businesses. There would typically be license agreements under which these subsidiaries would pay royalties to the U.S. group member owning the relevant intangibles. Also, unless there were local equity participation requirements, those subsidiaries were normally wholly owned.

Starting in the mid-1980s, some U.S. MNCs began moving portions of their domestic manufacturing to Asia and, in particular, to China, a country that at the time severely restricted levels of foreign ownership and mandated the legal form that investments must take. That trend accelerated in the 1990s and especially after the turn of the century. Legal and practical difficulties in China often prevented U.S. MNCs from owning and controlling manufacturing operations on the mainland. The competitive need for China's low-cost production forced U.S. MNCs to accept zero or minority ownership positions in the manufacturing operations that produced their goods. This use of uncontrolled contract manufacturers grew, and many U.S. MNCs became comfortable with these arrangements.4

That comfort level, along with advances in information technology, communications technology, and shortened logistical timelines, resulted in centrally managed supply chains and other new business model structures that were markedly different from the previous stand-alone independently operated subsidiaries. Using these new business models as a basis, U.S. MNCs placed intangible rights, which had been developed in the United States, and all commercial risks into entrepreneur subsidiaries, which were often located in tax havens or other low-tax jurisdictions. Operating subsidiaries, whether involved in production or in product distribution and whether located within or outside of the United States, were established on a limited risk and limited profit basis, thereby placing the bulk of the profits in the zero- or low-taxed entrepreneur subsidiary.5 U.S. group members that conducted not only the central management of the group, but also the day-to-day decision-making and running of the supply chain and often day-to-day sales functions as well, were generally treated from the perspective of the entrepreneur subsidiary as mere independent contractors. And these U.S. group member “independent contractors” were often compensated on a cost-plus basis, which resulted in service fees far less than the real value their activities in fact generated.6

Separate from the above developments concerning tangible product supply chains, over the past several decades, new internet-based business models grew, becoming in some cases major U.S. MNCs. They adopted similar business models with zero and low-taxed entrepreneur subsidiaries holding relevant intangible rights and contracting directly with users and other customers (importantly including advertisers for some of the most successful U.S. MNCs) for various cloud and other services. As with the above-described conduct by U.S. group members of operational management, supply chain, and sales functions in the case of tangible products, for these new internet-based models, the bulk if not all of the DEMPE functions (that is, development, enhancement, maintenance, protection, and exploitation) are conducted by U.S. group members. And similarly, these U.S. group members are compensated at far less than their real value.7 These DEMPE functions include not only the bulk of research and development efforts, but the actual day-to-day management and operations of the digital platforms through which digital cloud and other services are provided and delivered to users, customers, and advertisers worldwide. U.S. group members are not only providing the advertising and other services directly to the foreign “entrepreneur” subsidiary's paying customers, but through the platform the U.S. group members are approving and processing the entrepreneur subsidiary's contracts with its advertisers and other customers. There is zero participation in this process of any foreign entrepreneur personnel. Under the physical operational format of many of these U.S. MNCs, the business functions of personnel outside the United States (often within disregarded entity subsidiaries wholly owned by the entrepreneur subsidiary) are generally limited to routine sales and marketing, logistics, and other support functions, none of which will be directly involved in providing cloud and other services.8

As explained above, U.S. MNCs after World War II set up independently-run subsidiaries with their own separate managements and operations. However, with the technological and communication developments of the past three or four decades, foreign operations could be centrally managed and controlled from the U.S. As a result, full cadres of local management personnel were no longer needed. In its place, U.S. MNCs restructured and instituted the centrally-managed, U.S.-based supply-chain and internet-based business models that are so ubiquitous today. As a result, over the past several decades, independently run foreign subsidiaries have almost disappeared. In their place, we find production and sales operations in various locations that do not operate as independent businesses with their own independent managements. Rather, they operate as mere cogs in one centrally-managed worldwide business structure.

Enter the CSA

It was noted above that the independently-run foreign subsidiaries of U.S. MNCs would often secure needed group technology through license agreements that required the payment of royalties. With such royalties normally being subject to withholding taxes on the gross amount of royalties paid, this was a matter of concern, especially where a U.S. MNC was in an excess foreign tax credit position. As a result, many U.S. MNCs were interested in any planning or mechanism that might reduce the level of foreign withholding taxes on royalties.

One such approach was the cost sharing arrangement. The concept was simple: Replace a royalty with a payment that could be characterized as a direct expense for research and development. With withholding taxes being applied only to royalties and not to such R&D expenses, the taxes were avoided. For any U.S. MNC with excess foreign tax credits, this was in a sense pure profit.

The economics of a royalty and a CSA are of course different. Under a CSA, the foreign subsidiary gains an interest in the cost-shared intangibles. However, unless there are other outside factors, since all parties are within the same U.S. MNC group, the only real economic difference from the perspective of the MNC as a whole is the benefit of paying less withholding taxes.9

While we have made no specific study of the use of CSAs in the 1980s and prior, it is our understanding that a principal motivation for the use of CSAs in these early years was the reduction of foreign withholding tax. Later, though, with the expansion of the U.S. tax treaty network that included many treaties providing for zero source country royalty withholding tax, the need for such CSAs fell. However, the advent of the above-described new business models and intra-group tax-motivated structures that involved tax haven-located entrepreneur subsidiaries gave CSAs new life. Why? Because in any such tax-motivated structure, you had to move necessary intangibles into the entrepreneur subsidiary. And the CSA was a perfect vehicle for this.

CSAs Are an Enabler of Profit-Shifting Structures

Say that a U.S. MNC has two group members in identifiably separate businesses, with each member having its own management and operational personnel such that it conducts its own business separately from that of the other member. However, they both use in their respective business the same intangible. For example, say that one group member manufactures and sells mechanized hand-sized gardening equipment while the other manufactures and sells electric hand tools for woodworking. A particular electric motor is used both in one of the gardening products and in one of the hand tools. In such a case, it would make sense for the two group members to share any costs involved in the development and enhancement of this electric motor.

In contrast to this example, the bulk of CSAs today are used in MNC profit-shifting structures. The goal is not a sharing of costs by two group members, each of which desires to improve the intangibles used within its separate business. Rather, the goal is to provide a contractual basis for a zero or low-taxed group member, the entrepreneur subsidiary, to contract with and record revenues from third parties for products or services that are physically provided by other group members, which are most commonly U.S. group members.

The articles referenced in footnote 2 provide concrete examples of this.

  • Facebook, Inc. and Google Inc. — Personnel and assets in the United States manage and operate the internet platforms through which (i) users worldwide access the platform and its services, and (ii) advertisers and other customers access platform users and their data. Despite this, the CSA mechanism has allowed these groups' controlled foreign corporations (CFCs) as entrepreneurs to contract with, and record 100% of revenues from, advertisers and other customers located within the CFCs' defined market territories.

    To indicate how it is solely the CSA mechanism that has enabled this, consider that at the time of execution of their respective CSA arrangements, each group's foreign CSA participant was only a newly formed company (Google in 2003 and Facebook in 2010) with minimal personnel outside the United States (none of whom were “providing” the digital services10). Under the CSA mechanism, these companies' respective CFC entrepreneurs were able to immediately contract with and begin collecting all revenues from advertisers and other customers within their territories. Prior to that execution, the revenues were recorded by U.S. group members.

  • Apple Inc. — Personnel in the United States control, manage, and conduct on a day-to-day basis the group's supply chain, which produces products that are sold by both Apple U.S. group members into its Americas territory and Apple's CFC entrepreneur (Apple Operations International (AOI), an Irish subsidiary, which includes for federal tax purposes its disregarded entity subsidiaries) into its “rest-of-world” territory. Further, U.S.-based personnel are involved in negotiating and concluding AOI's sales to important foreign cellular carriers and major resellers of Apple products. In addition, U.S.-based personnel operate and maintain the internet-based stores through which customers worldwide purchase Apple and other third-party products. AOI personnel in Ireland and elsewhere outside the United States are not involved to any material extent in either these internet-based sales or in operating Apple's supply chain. Regarding the supply chain, U.S.-based personnel negotiate and conclude two sets of contracts with raw material suppliers, component vendors, and contract manufacturers.

    One set is in the name of one or more U.S. group members for sales into the Americas territory. The other set is in AOI's name and provides the contractual basis for AOI's “production” of inventory property, which then sold by AOI into its rest-of-world territory. (The Apple group also earns significant revenues from advertising and other cloud services in a manner similar to that described above for Google and Facebook. It is understood that AOI records the revenues from advertisers and customers located within its territory despite these services being provided primarily by personnel within the United States who operate and maintain the internet-based platforms.)

In the absence of the CSAs (or another form of intangible transfer11) for these three U.S. MNCs, the U.S. group members that are performing these revenue-generating functions (i.e., provision of advertising and other cloud services, operation of the supply chain, and selling products) would be directly contracting with third-party advertisers/customers/users and recognizing the related revenues. These U.S. group members would be paying service fees to their CFCs for the mostly if not wholly routine sales and marketing services, customer support, logistics, and other functions the CFCs factually perform. Overall, without the CSA, the bulk of the profits would have been recorded by U.S. group members.

It is recognized that these three U.S. MNC groups, even under their CSAs, would be subject to transfer pricing adjustments under transfer pricing regulations other than Reg. section 1.482-7 for other transfer pricing transgressions. For example, Reg. section 1.482-9 is clearly applicable given that the referenced articles point out the blatant under-valuation of the “services” that are provided by each group's U.S. members in support of their respective CFC entrepreneur's business. However, it is clear from the levels of foreign profits reported by these three high-profile groups over periods lasting multiple decades that transfer pricing enforcement under other transfer pricing regulations has not worked to reverse this profit shifting.

From the above, it is clear that the CSA mechanism itself has been an enabler of profit-shifting structures that has cost the U.S. Treasury hundreds of billions of dollars . . . and probably more considering the number of MNCs that have used these structures over what is now multiple decades. This CSA enabler status reflects:

  • The ease of executing the CSA mechanism to create a CFC entrepreneur often with little or no substance in a zero or other low-tax country;

  • The effective shifting of which group entity (i.e., the CFC entrepreneur instead of a U.S. group member) contracts with third-party customers, suppliers, vendors, contract manufacturers, etc., thereby shifting all gross profit from U.S. group members to their group CFC entrepreneur with only inadequate service fees being paid back to the U.S. group members that conduct the bulk, if not all, of the revenue generating functions; and

  • The evident fact that application of CSAs has effectively masked other transfer pricing transgressions, which is reflected by how the IRS has attempted to deal with CSA structures that they have chosen to target on examination.

The “Frankenstein Regulation” — And the Mechanism that Can Reverse Its Effect

Reflecting how CSAs have been such an effective enabler of profit shifting, two of the referenced articles labeled the CSA regulation as “a Frankenstein regulation.” The article focused on Apple, after some extensive discussion, concluded by saying:

The situation at Apple highlights the many unintended consequences of the reg. section 1.482-7 cost-sharing regulations — a beast of a regulation whose flawed design produces exactly the opposite of its intended effects in a way that perfectly personifies a Frankenstein regulation.12

The IRS has attacked a number of profit-shifting structures that have used CSAs. However, these attacks have primarily focused on the value of the buy-in payment under Reg. section 1.482-7A(g) (from January 1, 1996, through January 4, 2009) or the amount of the PCT Payment under Reg. section 1.482-7(g) (from January 5, 2009). This focus on the amount of the buy-in or the PCT Payment assumes that the CSA structure itself is legitimate. As a result, even if the IRS sustains its adjustment and collects some additional tax, the CSA and the profit-shifting structure that it enables remain viable for all future years, during which time significant profits will be shifted each and every year under the structure out of the U.S. and into the tax haven or other low-tax country.13

Once a CSA-enabled structure has been effectively legitimized (whether through IRS inaction or through an IRS attack on the amount of the buy-in or PCT Payment) and recognizing the relatively few transfer pricing adjustments for the above-noted “other transgressions,” the only transfer pricing mechanism available to truly reverse the bulk of the shifted profits is the “periodic adjustment” mechanisms as found in Reg. sections 1.482-4(f)(2) and 1.482-7(i)(6). To date, we are unaware of any instance in which the IRS has asserted a periodic adjustment under either of these sections. We can only hope that periodic adjustments will become a commonly used mechanism in the future.14

In brief, what does the periodic adjustment do economically? Focusing on Reg. section 1.482-7(i)(6), which applies specifically to CSAs, it's a two-step process. The following several paragraphs assume that a CFC, which is a participant in a CSA with its U.S. parent, has recorded high profits and is the focus of this periodic adjustment calculation.

The first step is a trigger calculation15 to determine if the periodic adjustment rules will apply at all. This trigger calculation looks at historical information and determines the actual rate of return that a CSA participant (i.e., the CFC) has realized on its investment in the CSA. This rate of return, termed the “actually experienced return ratio” (AERR), will either be within or outside a range, termed the “periodic return ratio range” (PRRR), which is defined in the regulation. If, for example, the AERR is above the PRRR, then the economic implication is that too much profit has been recorded within the CFC, meaning that the “commensurate with income” standard may have been violated.

The second step is the calculation of the periodic adjustment,16 which is the amount that will be treated as a transfer pricing adjustment, effectively moving taxable profits from the CFC to the U.S. parent CSA participant.17 This calculation is only applied to a CSA participant that has earned too much profit under the trigger calculation.

Economically, this calculation establishes: (i) how much CFC should make from the routine functions it factually performs; and (ii) CFC's share of the total non-routine profits it has recorded. Note that the total non-routine profits CFC has recorded is equal to the total profits recorded by CFC less the routine profits calculated in (i). Note also that these calculations are made on a cumulative basis including all years after the defined CSA Start Date up through the Adjustment Year. Importantly, although the Adjustment Year must still be an open year, the cumulative feature of the calculation means that shifted profits from closed years (often going back to 2009) are recaptured, so to speak, in the Adjustment Year.18

  • Return from routine functions performed. Normal transfer pricing concepts and applicable regulations under section 482 determine the return for these functions. For example, if CFC performs, say, routine sales and marketing, customer support, and logistics functions, then an arm's length return will be determined under normal transfer pricing rules. By way of simple illustration, Example 1 in Reg. section 1.482-7(i)(6)(vii) assumes that the return for comparable functions undertaken by comparable uncontrolled companies is 8% of certain expenses.

  • CFC's share of total non-routine profits. At the initiation of the CSA, each of CFC and U.S. parent brought to the CSA certain platform and operating contributions. Based on the relative contributions of platform and operating contributions from CFC and the platform contributions from U.S. parent, an “adjusted residual profit-split method” is applied to split total non-routine profits recorded by CFC between the CFC and U.S. parent.

The periodic adjustment transferring profits from CFC to U.S. parent is equal to the CFC's total profits less its calculated routine profits and its share of total non-routine profits. Again, these computations are on a cumulative basis from the CSA Start Date up through the Adjustment Year.

In many CSAs, especially where a CSA is executed with a newly established CFC, the CFC itself will have neither any platform contributions nor any operating contributions. The only such contributions come from the U.S. parent. Where this is the case, under the adjusted residual profit-split method, CFC's share of total non-routine profits will be zero. This of course means that the only profit left within the CFC will be its arm's length return from the routine functions that it has factually performed. On the other hand, where a pre-existing CFC truly comes to the table with its own platform and/or operating contributions, then it should earn a ratable portion of the total non-routine profits.

We believe that the drafters of Reg. section 1.482-7 were right to create this approach. It gets to a sensible and economically correct result. If the CFC had no contributions that benefit the CSA activity beyond routine functions, then it should not realize any future profits from future developed cost-shared intangibles. If it has made such contributions, then it should benefit ratably.

Should the IRS Be Applying Periodic Adjustments?

We strongly believe that the IRS should be using these periodic adjustment mechanisms, especially the one found in Reg. section 1.482-7(i)(6) where it applies.19 One of the undersigned has made the case for this regulation's clear applicability and its practical application in the three referenced articles that concern Facebook, Apple, and Google. The drafters of Reg. section 1.482-7(i)(6) are to be applauded for devising in paragraph (i)(6)(v) a calculation that:

  • Is true to the 1986 Congressional mandate to use ex post profitability;20 and

  • At the same time, allows a calculation that effectively covers not only shifted profits arising solely from the CSA, but also from any existing “other transgressions.”

Common Features of CSA-Based Structures: Partnership Status and Effectively Connected Income

Before leaving this discussion of CSAs as an enabler of profit-shifting structures, it must be noted that CSAs have encouraged U.S. MNCs and their perhaps mercenary advisors to create structures in which the CFC entrepreneur is clearly subject to direct U.S. taxation on its effectively connected income (ECI). Somehow in their zeal for lower effective tax rates, U.S. MNCs and their advisors have outright ignored or discounted the IRS ability to apply the ECI rules.

The basic concept behind ECI in rough terms is that a foreign taxpayer (including a CFC) should be taxable in the same manner as any domestic taxpayer to the extent that that foreign taxpayer earns profits from the conduct of a trade or business within the United States. Given the structures used and their integrated and centrally-managed-and-conducted nature (those described in the three referenced articles are excellent examples), it is clear that a CFC entrepreneur will often be engaged in a U.S. trade or business (section 864(b)) and will earn some amount of U.S. source income that will be ECI under section 864(c)(3). Often, the integrated and centrally-conducted nature of actual operations means that the U.S. group members and the CFC entrepreneur are conducting a joint business that constitutes a separate entity for federal tax purposes, which will be classified as a partnership under the entity classification default rule in the absence of an active election to be treated as an association (Reg. sections 301.7701-1 and -3). The existence of a partnership21 makes the application of ECI taxation much easier given both section 875(1) and the fact that the relevant ECI regulations have not yet been updated for modern business models.22

In raising this ECI issue, we do not intend to cover it further within this submission. Rather, we raise it only to provide a basis for one of the recommendations made below in the “Other Recommendations” section for any future update of Revenue Procedure 2015-41.

CSA-Related Recommendations

Eliminate APAs for Cost Sharing Arrangements

Overall, we recommend that Reg. section 1.482-7 be abolished, and that CSAs no longer be allowed between related parties due to the oversized role that they have played in profit-shifting structures and the fact that true CSAs are seldom if ever found between unrelated persons.23 This is of course consistent with what some academics and transfer pricing experts have been recommending for many years.24

We of course understand that this submission concerning Revenue Procedure 2015-41 will not result in the elimination of the regulation itself. However, considering the above discussion on how CSAs have been an important enabler of profit-shifting structures, we recommend that any future reissuance of Revenue Procedure 2015-41 expressly provide for a complete elimination of the issuance of APAs for CSAs. If it is decided to continue issuing APAs for CSAs, then we recommend in the alternative that the procedure includes a clear statement that APAs will only be issued with respect to CSAs in the circumstances, which are expected to be rare, where the taxpayer is able to establish the following to the satisfaction of the APMA:

(i) That there is a legitimate business need for the CSA;

(ii) That all participants meet the “individual exploitation” requirement described below;

(iii) That all participants meet the “participant” requirement described below; and

(iv) That the use of the CSA will not result in tax avoidance over the life of the CSA.

The below two items on “re-introduction of 'individual exploitation'” and “re-Introduction of 'participant' requirements” of course assume a decision to continue issuing APAs.

Re-Introduction of “Individual Exploitation”

Reg. section 1.482-7A, which was in effect from the beginning of 1996 until immediately prior to the January 5, 2009, effective date of Temp. Reg. section 1.482-7T,25 included an “individual exploitation” requirement in paragraph (a)(1).

Reg. section 1.482-7A(a)(1) reads, in part:

A cost sharing arrangement is an agreement under which the parties agree to share the costs of development of one or more intangibles in proportion to their shares of reasonably anticipated benefits from their individual exploitation of the interests in the intangibles assigned to them under the arrangement. . . .

This “individual exploitation” requirement was not included in Temp. Reg. section 1.482-7T or in Reg. section 1.482-7, which was finalized in 2011. Despite the exclusion of this specific language from the current regulation, its relevance remains clear through the many examples throughout Reg. section 1.482-7, all of which include factual background situations that involve participants that conduct their own individual active businesses. There is no example that suggests a CSA participant that would not use the cost-shared intangibles within its own business.

Despite the elimination of this “individual exploitation” language from the current regulation, we recommend that any future reissuance of Revenue Procedure 2015-41 expressly provide that an APA will only be issued for CSAs where all participants factually exploit the cost-shared intangibles within their own individually conducted businesses. This requirement should include examples showing that this requirement will not be met where any other person, whether related or not, conducts business functions that the putative participant could not conduct itself or does not have the personnel and capacity to direct others to perform on its behalf. More specific examples could include (i) a CFC that putatively manufactures products where the production functions are performed by a related person, and (ii) a CFC that in contractual form conducts an internet-based business but where a related person actually operates the platform through which advertising and other digital cloud services are delivered to the CFC's users, customers, and advertisers.

Re-Introduction of “Participant” Requirements

An “active conduct” rule was originally included in Reg. section 1.482-7A(c) when the regulation was promulgated in T.D. 8632 in December 1995. Prior to its elimination by T.D. 8670 in May 1996, this rule read:

(c) PARTICIPANT —

(1) IN GENERAL. For purposes of this section, a participant is a controlled taxpayer that meets the requirements of this paragraph (c)(1) (controlled participant). . . . A controlled taxpayer may be a controlled participant only if it —

(i) Uses or reasonably expects to use covered intangibles in the active conduct of a trade or business, under the rules of paragraphs (c)(2) and (c)(3) of this section;

. . .

(2) ACTIVE CONDUCT OF A TRADE OR BUSINESS —

(i) TRADE OR BUSINESS. The rules of section 1.367(a)-2T(b)(2) apply in determining whether the activities of a controlled taxpayer constitute a trade or business. For this purpose, the term CONTROLLED TAXPAYER must be substituted for the term FOREIGN CORPORATION.

(ii) ACTIVE CONDUCT. In general, a controlled taxpayer actively conducts a trade or business only if it carries out substantial managerial and operational activities. For purposes only of this paragraph (c)(2), activities carried out on behalf of a controlled taxpayer by another person may be attributed to the controlled taxpayer, but only if the controlled taxpayer exercises substantial managerial and operational control over those activities.

(iii) EXAMPLES. The following examples illustrate this paragraph (c)(2):

Example 1. Foreign Parent (FP) enters into a cost sharing arrangement with its U.S. Subsidiary (USS) to develop a cheaper process for manufacturing widgets. USS is to receive the right to exploit the intangible to make widgets in North America, and FP is to receive the right to exploit the intangible to make widgets in the rest of the world. However, USS does not manufacture widgets; rather, USS acts as a distributor for FP's widgets in North America. Because USS is simply a distributor of FP's widgets, USS does not use or reasonably expect to use the manufacturing intangible in the active conduct of its trade or business, and thus USS is not a controlled participant.

EXAMPLE 2. The facts are the same as in EXAMPLE 1, except that USS contracts to have widgets it sells in North America made by a related manufacturer (that is not a controlled participant) using USS' cheaper manufacturing process. USS purchases all the manufacturing inputs, retains ownership of the work in process as well as the finished product, and bears the risk of loss at all times in connection with the operation. USS compensates the manufacturer for the manufacturing functions it performs and receives substantially all of the intangible value attributable to the cheaper manufacturing process. USS exercises substantial managerial and operational control over the manufacturer to ensure USS's requirements are satisfied concerning the timing, quantity, and quality of the widgets produced. USS uses the manufacturing intangible in the active conduct of its trade or business, and thus USS is a controlled participant.

(3) USE OF COVERED INTANGIBLES IN THE ACTIVE CONDUCT OF A TRADE OR BUSINESS —

(i) IN GENERAL. A covered intangible will not be considered to be used, nor will the controlled taxpayer be considered to reasonably expect to use it, in the active conduct of the controlled taxpayer's trade or business if a principal purpose for participating in the arrangement is to obtain the intangible for transfer or license to a controlled or uncontrolled taxpayer.

(ii) EXAMPLE. The following example illustrates the absence of such a principal purpose:

EXAMPLE. Controlled corporations A, B, and C enter into a qualified cost sharing arrangement for the purpose of developing a new technology. Costs are shared equally among the three controlled taxpayers. A, B, and C have the exclusive rights to manufacture and sell products based on the new technology in North America, South America, and Europe, respectively. When the new technology is developed, C expects to use it to manufacture and sell products in most of Europe. However, for sound business reasons, C expects to license to an unrelated manufacturer the right to use the new technology to manufacture and sell products within a particular European country owing to its relative remoteness and small size. In these circumstances, C has not entered into the arrangement with a principal purpose of obtaining covered intangibles for transfer or license to controlled or uncontrolled taxpayers, because the purpose of licensing the technology to the unrelated manufacturer is relatively insignificant in comparison to the overall purpose of exploiting the European market.

In October 2015, as part of the OECD/G20 BEPS process (within which the United States was an important and influential participant), new transfer pricing guidance was published with that guidance later being included in the July 2017 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the “Guidelines”).

It will be appreciated that the United States was a particularly important participant in the BEPS process. The following was reported immediately following the October 2015 issuance of the Actions 8-10 Final Report,26 which contained the guidance relevant to this discussion of “participant” requirements.

The Department of Treasury will likely not have to issue “substantial” changes to current transfer pricing regulations due to the OECD's Action Plan on Base Erosion and Profit Shifting, according to a senior official.

“To the extent that we think these rules are kind of clarifying the arm's-length standard that are already embodied in our regulations, we are not anticipating having to make substantial changes” to current regulations on Internal Revenue Code Section 482, said Robert Stack, U.S. deputy assistant Treasury secretary for international tax affairs, in an Oct. 9 Deloitte Tax LLP webcast. “It's possible that as we dig through, we may see these clarifications as something that might need to be elucidated upon.”27

The point of quoting this statement is to indicate that the below-discussed BEPS guidance is very much consistent with the above quoted regulatory language that was eliminated from Reg. section 1.482-7A in May 1996.

The new guidance is included in Chapter VIII (Cost Contribution Arrangements), section C.2. of the Guidelines. It focuses expressly on whether a controlled taxpayer could be a participant in a cost contribution arrangement.

A particular aspect of this new guidance concerning participants in a CCA (or CSA to use U.S. terminology) is that a controlled taxpayer may only be a “participant" if it meets certain criteria. These criteria include:

  • The controlled taxpayer must benefit from the objectives of the subject activity. An example provided is “exploiting its interest or rights in the intangibles.” The guidance goes on to say: “a party would not be a participant in a CCA if it is not capable of exploiting the output of the CCA in its own business in any manner.” (Para 8.14.)

  • The controlled taxpayer must exercise control over the specific risks it assumes under the CCA (Para 8.15). The guidance explains that:

    . . . a CCA participant must have (i) the capability to make decisions to take on, lay off, or decline the risk-bearing opportunity presented by participating in the CCA, and must actually perform that decision-making function and (ii) the capability to make decisions on whether and how to respond to the risks associated with the opportunity, and must actually perform that decision-making function. While it is not necessary for the party to perform day-to-day risk mitigation activities in relation to activities of the CCA, in such cases, it must have the capability to determine the objectives of those risk mitigation activities to be performed by another party, to decide to entrust that other party to provide the risk mitigation functions, to assess whether the objectives are being adequately met, and, where necessary, to decide to adapt or terminate the arrangement, and must actually perform such assessment and decision-making.

  • The controlled taxpayer must have the financial capacity to assume the risks (Para 8.15). This means that a party providing funding must have the functional capability to exercise control over the financial risk attached to its contributions to the CCA and it must actually perform these functions. The guidance explains (para 6.63):

    . . . exercising control over a specific financial risk requires the capability to make the relevant decisions related to the risk bearing opportunity, in this case the provision of the funding, together with the actual performance of these decision making functions.

    In addition, the party exercising control over the financial risk must perform the activities as indicated in paragraph 1.65 and 1.66 in relation to the day-to-day risk mitigation activities related to these risks when these are outsourced and related to any preparatory work necessary to facilitate its decision making, if it does not perform these activities itself.

In explaining the requirements for a controlled taxpayer to be a participant in a CCA, the guidance emphasizes that just providing funding is insufficient to be a participant (para 8.16). The guidance explains:

To the extent that specific contributions made by participants to a CCA are different in nature, e.g. the participants perform very different types of R&D activities or one of the parties contributes property [such as cash] and another contributes R&D activities, the guidance in paragraph 6.64 is equally applicable. This means that the higher the development risk attached to the development activities performed by the other party and the closer the risk assumed by the first party is related to this development risk, the more the first party will need to have the capability to assess the progress of the development of the intangible and the consequences of this progress for achieving its expected benefits, and the more closely this party may need to link its actual decision-making required in relation to its continued contributions to the CCA to key operational developments that may impact the specific risks it assumes under the CCA. . . .

Given the above, the revised APA guidance with respect to any transfer of intangibles in connection with a CSA must make clear that a participant may only be treated as a participant to a CSA if it factually meets these requirements. Note in particular both Robert Stack's statement about consistency of the new OECD guidance with existing U.S. transfer pricing regulations and the comment above that all examples within Reg. section 1.482-7 are consistent with participants having substance in the conduct of their own active businesses.

Similar to the recommendation above concerning re-introduction of an “individual exploitation” requirement, we recommend that these “use of covered intangibles in the active conduct of a trade or business” rules and principles within the new OECD guidance be integrated into any reissuance of Revenue Procedure 2015-41 so that they will form a part of guidance to taxpayers seeking APAs and to APMA personnel who are evaluating APA request submissions.

We also recommend that guidance make clear that a group member will not qualify as a participant if it subcontracts important elements of its exploitation process to another participant or to an independent contractor where another participant or a person under another participant's control is the party having the capability to direct and control the risks of the exploitation elements being performed by the independent contractor.

It should normally not be possible for a newly formed group member to qualify as a participant under the standards recommended above. Recognizing this, the guidance should state clearly that a newly established group member would not qualify as a participant except under unusual factual circumstances. Rather, a controlled entity would have to already be itself conducting a business that would actually use the anticipated cost-shared intangibles in order to qualify as a participant.

Elimination of Periodic Adjustment Exemptions from APAs

Section 6.03 of Revenue Procedure 2015-41 says that an APA may provide that the periodic adjustment mechanisms will not apply “during or after the APA term”.

We recommend that this exemption be specifically eliminated in the case of any CSA. (We also recommend that this be eliminated as well for non-CSA intangible transfers and cover this in the “Other Recommendations” section below.)

We noted above that the drafters of Reg. section 1.482-7(i)(6) should be applauded for devising in paragraph (i)(6)(v) a calculation that serves two explicit purposes. These are:

  • The calculation achieves the 1986 Congressional mandate to use ex post profitability to deal with intangible transfers; and

  • The calculation effectively covers not only shifted profits arising solely from a CSA, but also transfer pricing problems arising from issues unrelated to the CSA itself.

As indicated in the earlier discussion, the reference three articles in footnote 2 show that transfer pricing enforcement has been unable to reverse what appears to be blatant cases of inappropriate, if not potentially fraudulent, transfer pricing in regard to amounts charged for critical business functions performed by U.S. group members for related CFC entrepreneurs. Such transfer pricing abuse is likely endemic to hundreds of profit-shifting structures that are similar to those described in the three articles.

Given this situation, the relatively objective-to-apply formula approach set out in Reg. section 1.482-7(i)(6)(v) is a unique tool that can be applied where a taxpayer's level of CFC entrepreneur's profits exceeds the defined range so that a periodic adjustment is triggered. Whether the excess profits that cause the trigger arise strictly from the use of the CSA or partly or wholly from other transfer pricing transgressions, the formula approach gets to the right economic answer with a minimum of difficulty.

As one example to alleviate any doubt, consider that in 2006 an APA was granted to Google Inc. for a CSA that the taxpayer exploited to avoid as much as $50 billion in U.S. corporate income taxes over the sixteen-year life of the CSA (2003 through 2019). During this long period, there has been no indication of (i) any IRS detection or enforcement of either the validity and status of the CSA itself from the January 5, 2009, effective date of Temp. Reg. section 1.482-7; or (ii) the apparent blatant mispricing of certain inter-company transactions. These inter-company transactions importantly include Google U.S. group members conducting core business functions so that these U.S. group members, rather than Google Ireland itself, were actually providing advertising and other cloud services directly to Google Ireland's advertisers and other paying customers.28

A second example involves Apple Inc. Although it is unknown whether Apple ever secured an APA for its CSAs over the past forty years, it is clear that this taxpayer's use of its CSA since January 5, 2009, has allowed the group to avoid around $85 billion in taxes through 2020. As set out in the referenced article, this is something which the IRS must address.29 These two examples demonstrate how important it is that the allowed exemption from future Reg. section 1.482-7(i)(6) periodic adjustments, presently found in Section 6.03 of Revenue Procedure 2015-41, must be eliminated in any future reissuance of this revenue procedure.

Congress was clear in its directions.30 Periodic adjustments should be based on ex post information. The Joint Committee on Taxation's blue book summarizes well this congressional guidance:

Congress did not intend, however, that the inquiry as to the appropriate compensation for the intangible be limited to the question of whether it was appropriate considering only the facts in existence at the time of the transfer. Congress intended that consideration also be given to the actual profit experience realized as a consequence of the transfer. Thus, Congress intended to require that the payments made for the intangible be adjusted over time to reflect changes in the income attributable to the intangible . . . it will not be sufficient to consider only the evidence of value at the time of the transfer.

Adjustments will be required when there are major variations in the annual amounts of revenue attributable to the intangible. In requiring that payments be commensurate with the income stream . . . the profit or income stream generated by or associated with intangible property is to be given primary weight.31 [Emphasis added.]

To allow the inclusion in an APA of an exemption from any future application of a Reg. section 1.482-7(i)(6) periodic adjustment simply flies in the face of this clear and unambiguous Congressional guidance.

Include in Terms of APA Detail Necessary to Apply Future CSA Periodic Adjustments

Whether or not our recommendation to eliminate the potential exemption from periodic adjustments discussed above is accepted, we recommend that any reissuance of Revenue Procedure 2015-41 includes a clear statement that the terms of any APA will include the basis on which the Reg. section 1.482-7(i)(6) periodic adjustment rule will be applied in future years. Such upfront agreement should prevent significant future disagreements and potential litigation.

Under the required use of the adjusted residual profit-split method, it is necessary to identify and establish values for the relative platform and operating contributions of each participant to a CSA.32 We recommend that the APA include as express terms the identified contributions and either specific values for the contributions from each participant or, if the CSA has not yet been executed, the specific methodology for the valuing each contribution.

We recommend also that the reissuance should make clear that in the case where a participant conducts solely routine functions and makes no platform or operating contributions at the time of the CSA's execution that any future application of the Reg. section 1.482-7(i)(6) periodic adjustment rule will attribute all non-routine profits to the PCT Payee. In the event that any newly established group member is determined to qualify as a participant, the guidance should make clear that such a participant will be treated as having made zero platform and operating contributions.

In this regard, we recommend that the reissuance and internal APMA policies and practices take into account some of the examples included in Temp. Reg. section 1.482-1T(f)(2)(i)(E).33 For example, Example 6 in this temporary regulation concerns a newly established foreign subsidiary (S1) of U.S. parent P. At formation, P contributes certain intangibles to S1, treating the contribution as a transfer described in section 351 that is subject to section 367. At a later date within the same year, P and S1 execute a CSA with S1 treating its recently received intangibles as its platform contribution. As a result of having made this platform contribution, in the event that there is later a periodic adjustment calculation, this S1 platform contribution would provide a basis for S1 to claim a share of total non-routine profits under the required adjusted residual profit-split method.

In a situation such as this, we recommend that the guidance for taxpayers and APMA personnel be clear that in such a situation S1 will be treated as having made no platform contribution at the execution of the CSA.

Include as a Term of any CSA APA the Requirement for Taxpayer Annual Preparation of Reg. section 1.482-7(i)(6) Trigger Calculation

We recommend that when an APA involves a CSA that the APA as issued must include an express requirement that the taxpayer will compute and submit to the APMA annually a Reg. section 1.482-7(i)(6) trigger calculation. The taxpayer would also be required to submit this calculation at the commencement of any regular IRS examination to the IRS examining team.

Such a requirement to include this calculation within an APA is fully justified considering that any taxpayer desiring a CSA knows upfront that all of the conditions and requirements included in Reg. section 1.482-7 will apply to the CSA and the taxpayer. The Reg. section 1.482-7(i)(6) trigger calculation is an integral part of the full CSA regulation.

Other Recommendations Concerning Revenue Procedure 2015-41

Elimination of Periodic Adjustment Exemptions from APAs

Section 6.03 of Revenue Procedure 2015-41 says that an APA may provide that the periodic adjustment mechanisms will not apply “during or after the APA term.” Specifically, the procedure reads:

. . . If a covered issue is the transfer of intangible property (which does not constitute a platform contribution transaction as defined in Treas. Reg. §1.482-7(b)(1)(ii)) within the meaning of Treas. Reg. §1.482-4, the APA may provide that such transfer will not be subject to periodic adjustments, during or after the APA term, under Treas. Reg. §1.482-4(f)(2) or (6). . . .

For the same reasons articulated above under “CSA-Related Recommendations”, we recommend that this exemption be specifically eliminated in the case of any transfer of intangible property that does not constitute a PCT in connection with a CSA.

Include in Terms of APA Detail Necessary to Apply Future Periodic Adjustments

Whether or not our above recommendation to eliminate the potential exemption from periodic adjustments is accepted, we recommend that any reissuance of Revenue Procedure 2015-41 included a clear statement that the terms of any APA will include the basis on which the Reg. section 1.482-4(f)(2) periodic adjustment rule will be applied in future years. Such upfront agreement should prevent significant future disagreements and potential litigation. This is particularly relevant given the present relatively vague guidance included in Reg. section 1.482-4(f)(2).

We recommend also that the reissuance should make clear that in the case where the transferee of any intangibles conducts solely routine functions and holds itself no non-routine intangibles at the time of the transfer that any future application of the Reg. section 1.482-4(f)(2) periodic adjustment rule will attribute all non-routine profits to the transferor.

Extension of BEPS CCA Guidance to Licensing, Business Restructurings, and Intangible Development Arrangements other than CSAs

In “Re-Introduction of “Participant” Requirements” in the above CSA-related recommendations, we made certain recommendations regarding the qualification for a group member to be a participant. In that discussion, we explained certain guidance from the OECD BEPS project on “cost contribution arrangements.” We believe that certain of that guidance is relevant to other intangible transfers.

For example, say intangibles are licensed from one U.S. group member to a foreign group member. The licensee foreign group member must be the party that will exploit the licensed intangibles. Important elements of the exploitation process cannot be subcontracted back to the licensor or to an independent contractor where the licensor or some other person under the licensor's control and not the licensee is the party having the capability to direct and control the risks of the activities being performed by the independent contractor.

We recommend that guidance to this effect be integrated into any reissuance of Revenue Procedure 2015-41 so that it will be available to taxpayers seeking APAs and to APMA personnel who are evaluating APA request submissions.

ECI Taxation and Partnership Status

It would be beneficial to both taxpayers and the APMA for the future Revenue Procedure 2015-41 update to include explicit language saying that any APA application must consider and include factual background on worldwide group or divisional operations including, for example, the nature of any group unitary businesses, the conduct of any joint business functions that benefit two or more group members, where and by whom critical business functions are conducted for transactions being recorded by any foreign group member, and the use of service agreements or similar contractual arrangements that cover core business functions (in contrast to internal staff functions).

This information is not just needed; it is critical. First, of course, the APMA team should be aware if any requested APA appears to be merely a component of a profit-shifting or other tax avoidance structure. Secondly, both the taxpayer requesting an APA and the APMA team evaluating that request must be aware if transactions and business operations contemplated in connection with the requested APA cause:

  • Joint business activities of two or more group members to create a separate entity for federal tax purposes under Reg. section 301.7701-1(a)(2) that will be treated as a partnership under the default rule of Reg. section 301.7701-3(b) if an active election is not made to treat the entity as an association taxable as a corporation; and/or

  • Applicable foreign group members to become subject to direct U.S. taxation under the effectively connected income rules of section 864(c).

As a first example of why this additional information is needed, say that a U.S. MNC from its U.S. headquarters conducts for its worldwide product sales the bulk of all production functions (including those functions listed in Reg. section 1.954-3(a)(4)(iv)(b)) except for the physical manufacturing of the products. Physical manufacturing is performed by unrelated contract manufacturers. The centrally-managed group has a number of foreign group members in various countries around the world that conduct routine sales and marketing services, customer and logistics support, etc. The U.S. MNC has requested an APA due to its planned execution of a CSA between itself and a newly formed CFC (CFC), which is the holding company for the foreign group members, all of which are disregarded entity subsidiaries. Under the terms of the CSA, CFC will hold the rights to manufacture, or have manufactured, products for sale into its territory, which is the rest-of-world outside the United States. By contracting directly with suppliers, vendors, and contract manufacturers, CFC (including its disregarded entity subsidiaries) will source its manufactured products using intangibles transferred in connection with the CSA (including as well cost-shared intangibles to be developed in the future under the CSA) and will then sell those manufactured products to unrelated customers within its rest-of-world territory.

The principal reasons for the requested APA are to establish the overall terms of the CSA as well as identify the platform contributions made by U.S. MNC and agree the amount of a PCT Payment that CFC must pay to U.S. MNC for these platform contributions (Reg. sections 1.482-7(b)(1)(ii) and (g)). Say that in reviewing the factual background of U.S. MNC's worldwide operations and how those operations would be conducted following the execution of the CSA, the APMA determines that U.S. MNC headquarters' personnel will continue to perform substantially all production functions and make all production decisions including, for example, decisions on production and inventory levels to be maintained worldwide. CFC will have few or no production personnel and will conduct little or no other product sourcing functions. As such, the relevant U.S. MNC headquarters' personnel will conduct joint production operations, i.e. for itself in connection with products to be sold into United States and for CFC for products that CFC will sell into its rest-of-world territory. Under a service agreement, CFC would pay U.S. MNC a service fee on a cost-plus basis for these production activities . . . and that service agreement would include a clause stating that U.S. MNC is an independent contractor and not an agent, joint venturer, or partner of CFC.

In contractual form, CFC is independently manufacturing the products that it will sell into its rest-of-world territory. Contracts with suppliers, component vendors, and contract manufacturers would be signed in CFC's name and CFC would invoice the sales to customers in its territory.

Despite this contractual form, U.S. MNC and CFC's operations are integrally related along both management and operational lines. CFC would not have the personnel or practical ability to manufacture or otherwise source the products it sells. It could not operate as an independent unit. Following the execution of the CSA, the functions that it performs through its disregarded entity subsidiaries will still be routine functions concerning sales and marketing and customer and logistics support.

The application of U.S. tax law and regulations involves first understanding a taxpayer's factual situation, which includes its organizational form, the legal relations it has created through contracts, and the physical activities that each entity's employees and agents perform. When there is a serious divergence between legal form and the conduct of the parties, the IRS may use judicially based doctrines (e.g. substance vs form, assignment of income, etc.) to recharacterize a taxpayer's chosen form into something else. In this discussion of U.S. MNC and CFC, it is assumed that the APMA in its analysis would accept the entity and contractual form that the taxpayer created.

Without going into detail, in applying U.S. tax rules to the taxpayer's chosen structure, the APMA could notice the joint production activities. Just these joint production activities are enough to cause an entity to exist for federal tax purposes under the entity classification rules (section 761(a) and Reg. section 301.7701-1(a)(2)). Additional factors that likely exist such as centralized management and U.S. MNC's participation in the negotiation and conclusion of CFC's more major sales contracts only cements this “entity for federal tax purposes” finding. In the absence of an active election for association status, the default rule in Reg. section 301.7701-3(b) treats such an entity as a partnership that is conducting the joint business of the partners.34

Partnership status can, of course, have a number of possible implications. The most significant for purposes of Revenue Procedure 2015-41 from an overall perspective is that if the joint business activities, which include the CSA Activity, are all within the partnership, then there can be no CSA. This is because there is only one taxpayer: the partnership. The putative CSA participants (the U.S. parent and one or more of its CFCs) are now partners in a partnership that is conducting the joint business. With no CSA, there is no ability to even request an APA, and of course no ability for the APMA to issue one.

A particularly important result of partnership status is that the application of the effectively connected income rules to CFC are much easier and more straight-forward to apply.35 The various rules to calculate effectively connected income are applied at the partnership level. The foreign partner's share of that income is then subject to taxation under section 882.

Even in the absence of the finding of a partnership, the APMA would see that U.S. MNC through its management and conduct of the entire production process is making day-to-day business decisions on behalf of CFC and is, in fact, conducting a major portion of CFC's business as its de facto agent. This causes CFC to be engaged in a trade or business within the United States. A further factual finding that U.S. MNC participates in the negotiation and conclusion of not only CFC's contracts with suppliers, vendors, and contract manufacturers, but also with CFC's more major sales contracts would only further cement this de facto agent status.

With a finding that CFC is engaged in a U.S. trade or business and the TCJA's focus on location of production (amended section 863(b)), there would be some amount of U.S. source income that would be treated as ECI under section 864(c)(3).36

This sort of analysis will help the APMA decision-making process on whether to issue an APA, and if they decide to issue one, what its terms and restrictions might be. This analysis will also help taxpayers decide if they wish to continue with a planned structure, and if they do, how they might scale back or eliminate any tax-motivated aspects so that they focus on only the business and commercial benefits to be derived.

Where the execution of a planned CSA would result in shifted profits and/or that execution raises concerns about the existence of a partnership and/or ECI taxation, a narrowly focused APA that considers only the terms of the CSA and the amount of PCT Payment would not further either taxpayer certainty or good tax administration. Rather, if the APA application process can identify partnership and ECI taxation issues that will accompany a taxpayer group's planned CSA structure (often indications of the planned structure being primarily for inappropriate profit shifting), then the taxpayer group may choose to reconsider its plans and perhaps avoid executing a risky structure.

In brief, a second example is a U.S. MNC engaged in an internet-based business that earns primarily advertising revenues. Substantially all personnel and equipment that maintain and operate the worldwide internet platform through which users access the platform and advertisers reach users are located within the United States. U.S. MNC plans to establish a CFC, which through a CSA or license agreement will hold the rights to contract with foreign advertisers. Following the establishment of CFC, there will be no change in operations so that the same U.S. personnel and equipment will continue to provide the advertising services to users and advertisers worldwide. CFC and U.S. MNC enter into a service or similar agreement under which U.S. MNC will directly provide the advertising services to CFC's advertisers on CFC's behalf.

As with the first example, it is assumed that the APMA accepts the entity and contractual form that the taxpayers created. Without going into detail, the same partnership and ECI results arise from this structure. There is one centrally managed and operated worldwide business with U.S. MNC personnel and assets conducting CFC's business. This is joint business activities that will cause an “entity for federal tax purposes” that will be treated as a partnership under the entity classification rules. There will be a U.S. trade or business (section 875(1)), income will be U.S. source under Reg. section 1.861-4,37 and there will be ECI under section 864(c). And of course, with the finding of a partnership, there will be only one taxpayer: the partnership. As such, with only one taxpayer, there can be neither a CSA nor a license.

Schedule UTP Disclosures

We recommend that any Mandatory Pre-Filing Memorandum must include information on whether Schedule UTP (Form 1120) disclosure has been, is, or is expected to be required for any aspect of the transactions or businesses for which an APA is being sought. Doing so will alert APMA personnel to areas and issues requiring closer attention.

Effect of OECD BEPS Pillars One and Two

We recommend that consideration be given to including in any Mandatory Pre-Filing Memorandum information on how the taxpayer expects that Pillars One and Two of the OECD Inclusive Framework BEPS project might affect the transactions or businesses for which an APA is being sought. Doing so would allow anticipation and the development of approaches for the resolution of potential future issues.

Potential for Joint Audits

We recommend that the updated Revenue Procedure 2015-41 include notice that the APMA may recommend through appropriate IRS channels that the IRS and relevant tax authorities from other countries should consider the conduct of a joint audit of applicable transactions and/or businesses of the taxpayer that are the subject of an APA. This of course makes obvious sense for any bilateral or multilateral APA. But we believe that such a notice within an updated Revenue Procedure 2015-41 should apply as well to unilateral requests. Such a notice would discourage taxpayer planning to present differing factual information and differing transaction characterizations to two or more tax administrations.

While we are not aware of the current state of jointly conducted audits of MNCs, we have seen in prior years that such audits should become more common in the future. As a prime example of why such joint audits are needed, the referenced article noted in footnote 2 on Apple highlights the differing factual information that Apple has presented to the European Commission and the United States in regard to its structure and its CSA.

We of course understand that the APMA has certain restrictions to provide taxpayer comfort with the APA process (e.g. Section 6.05 of Revenue Procedure 2015-41). And there are also limits on future examinations that cover the subject transactions of an APA (e.g. Section 7.03 of Revenue Procedure 2015-41). We do not believe that this recommended notice of potential future joint audits should violate these aspects of the APA process.

Reflection of TCJA Update to Section 482

We expect that the planned future update to Revenue Procedure 2015-41 will include guidance to implement the additional sentence that was added to section 482 by the TCJA. This sentence reads:

For purposes of this section, the Secretary shall require the valuation of transfers of intangible property (including intangible property transferred with other property or services) on an aggregate basis or the valuation of such a transfer on the basis of the realistic alternatives to such a transfer, if the Secretary determines that such basis is the most reliable means of valuation of such transfers.

We encourage the inclusion of clear guidance on this. Since this additional sentence is principally focused on valuations as of the time of intangible transfer, we believe that this coordinates well with the periodic adjustment rules, which focus on actual achieved results in the years subsequent to the intangible transfer.

One additional matter should be raised in the context of the TCJA amendment to section 482, which applies to transfers in tax years beginning after December 31, 2017, in that Revenue Procedure 2015-41, Section 7.07 states:

If controlling U.S. case law, statutes, regulations, or treaties change the federal income tax treatment of any matter covered by the APA, the new case law, statute, regulation, or treaty provision supersedes any inconsistent terms and conditions of the APA.

We recommend that for any already issued APA that involved a transfer of intangible property where the year of the transfer is still open and the transfer occurred in a tax year beginning after December 31, 2017, the APMA may at its discretion enter into discussion with the taxpayer to revise the APA in accordance with section 7.05 so as to be in accordance with the TCJA amendment to §482. If an agreement to revise cannot be reached with the taxpayer, the APMA may revoke or cancel the APA in accordance with section 7.06.

Protection from Certain Penalties

The conclusion of an APA, especially one that includes one or more rollback years, may cause additional taxes to become payable. Section 7.01(1) refers to this and states, in part:

. . . for such an APA year, the taxpayer will not be subject to the failure to pay penalties under sections 6651 and 6655 of the Code, or the failure to make timely deposit of taxes penalty under section 6656 of the Code, by reason of the APA primary adjustment and any related adjustments.

We recommend that this protection from certain penalties should be conditioned on the taxpayer's having not already been under audit with respect to the transfer pricing used in any applicable year.

* * * *

We hope that this submission is useful to you. We would be pleased to respond by email or phone to any questions or comments concerning the above discussion and recommendations.

Very truly yours,

Jeffery M. Kadet
Seattle, Washington

Stephen L. Curtis
Denver, Colorado

Enclosures:
Stephen L. Curtis, “Facebook, the IRS, and the Commensurate With Income Standard,” 169 Tax Notes Federal 1921 (December 21, 2020), soft copy available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3800344

Stephen L. Curtis and David Glenn Chamberlain, “Apple's CSA: Frankenstein's Monster,” 172 Tax Notes Federal 1049, August 16, 2021 (Part 1), and 172 Tax Notes Federal 1217, August 23, 2021 (Part 2), soft copy available at SSRN: https://ssrn.com/abstract=3931424

Stephen L. Curtis, “Google's Cost Sharing Arrangement: Bride of Frankenstein” Tax Notes Federal, Vol. 173, p. 1623 (December 20, 2021)

FOOTNOTES

1For Jeffery M. Kadet, his articles and other documents, including various governmental submissions, are available at http://ssrn.com/author=1782073.

2Stephen L. Curtis, “Forensic Approaches to Transfer Pricing Compliance and Enforcement,” 8 J. Forensic & Investigative Acct. 359 (2016), available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2786779; Curtis and Yaron Lahav, “Forensic Approaches to Transfer Pricing Enforcement Could Restore Billions in Lost U.S. Federal and State Tax Losses: A Case Study Approach,” 12 J. Forensic & Investigative Acct. 285 (2020), available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3528318; Stephen L. Curtis, “Facebook, the IRS, and the Commensurate With Income Standard,” 169 Tax Notes Federal 1921 (December 21, 2020), available at SSRN:https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3800344; Stephen L. Curtis and David Glenn Chamberlain, “Apple's CSA: Frankenstein's Monster,” 172 Tax Notes Federal 1049, August 16, 2021 (Part 1), and 172 Tax Notes Federal 1217, August 23, 2021 (Part 2), available at SSRN: https://ssrn.com/abstract=3931424; Stephen L. Curtis, “Google's Cost Sharing Arrangement: Bride of Frankenstein” Tax Notes Federal, Vol. 173, p. 1623 (December 20, 2021), available at: https://www.taxnotes.com/tax-notes-federal/transfer-pricing/googles-cost-sharing-arrangement-bride-frankenstein/2021/12/20/7cnth.

3The following paragraphs on history were taken with some additions from Jeffery M. Kadet, “BEPS Primer: Past, Present, And Future, Part 1”, 168 Tax Notes Federal 45, July 6, 2020, at 50. Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3669899.

4After China joined the WTO in late 2001, it became possible to have wholly-foreign-owned Chinese subsidiaries. However, by this time, many U.S. MNCs had already integrated unrelated Chinese contract manufacturers into their business models and had become comfortable with these arrangements.

5A documented detailed example of this can be found in the Majority Staff Report issued in connection with the Senate Permanent Subcommittee on Investigations hearings on Impact of the U.S. Tax Code on the Market for Corporate Control and Jobs (S. Hrg. 114-88, July 30, 2015). Available at https://www.hsgac.senate.gov/imo/media/doc/S.%20Hrg.%20114-88%20PSI%20July%2030,%202015%20Final%20Hearing.pdf. See in particular the discussion of Valeant Pharmaceuticals (now Bausch Health) beginning on page 12 of the Majority Staff Report (page 93 of the full hearing document).

6See, for example, the Caterpillar inter-company service agreement, which shows a cost-plus 5% service fee. This agreement was disclosed in connection with the 2014 Senate Permanent Subcommittee on Investigations hearings into Caterpillar's Swiss Tax Strategy (Exhibit #52 (Fifth Amended and Restated Services Agreement, Schedule 3), Exhibits Part 2 of 2, Caterpillar's Offshore Tax Strategy, April 1, 2014. Available at https://www.hsgac.senate.gov/imo/media/doc/EXHIBITS-Part%202%20of%202%20(4-1-14%20Caterpillar%20Hrg).pdf.)

7Supra note 2, Curtis (2020), Curtis and Chamberlain (2021), and Curtis (2021). These articles deal respectively with Facebook, Inc. (now Meta Platforms, Inc.), Apple Inc., and Google Inc. (now Alphabet Inc.). Each represents an example of serious under-compensation of U.S. group members that are conducting services and other functions that often represent the actual conduct of critical portions of the foreign subsidiary's business. Throughout this submission, despite their name changes, Facebook and Google are referred to by their original names.

8Once the check-the-box rules became available in 1997 and allowed the easy creation of disregarded entity subsidiaries, these non-U.S. personnel employed by these disregarded entities could be within the same foreign taxpayer entity for U.S. tax purposes. This was something that helped enable minimizing foreign taxes in countries where these mostly routine functions were performed, thereby maximizing profit in the tax haven or other low-taxed country of the entrepreneur.

9Ignoring the issue of whether there should be a buy-in payment at the initiation of a CSA, it's fair to say that paying a portion of group R&D expenses should be significantly smaller in amount than what the royalty would have been. This was likely an attractive factor that motivated some number of countries to accept CSAs and accept the loss of withholding taxes. The lower R&D payments, of course, also meant higher local taxable profits.

10Over time, each of these MNCs has increased the number of its foreign-based personnel. These personnel, however, are primarily engaged in routine sales and marketing, customer support, administration, and other functions that are ancillary in nature to the high value, centralized exploitation, which is conducted by the relevant U.S.-based personnel and assets. It will be noted that the principles of Reg. section 1.861-4(b) focus on where services are performed and not, for example, on the location of sales and marketing personnel. See also Reg. section 1.937-3(e), Example 5, which involves an application service provider and which relies on Reg. section 1.861-4 to determine the taxpayer's source of income. See also Jeffery M. Kadet, “Sourcing Cloud Transactions Economically — the Right Way”, 171 Tax Notes Federal 1555, June 7, 2021, available at https://ssrn.com/abstract=3880006.

11Of course, Google, Facebook, and Apple, as an alternative to a CSA, could have alternatively chosen to license or otherwise transfer relevant intangibles to their respective CFCs. Had they done so, it seems likely that the low-value-add of the CFCs to their own profitability in comparison to the high-value-add of the intangibles and the actual business functions performed by the U.S. group members on behalf of the CFCs would have been much more visible. Likely, this would have attracted more IRS attention. Using the CSA structures, Apple and Google's situations appear to have gone mostly if not wholly unnoticed, in contrast to the Facebook situation which did attract IRS attention. Note that Google terminated its cost sharing arrangement at the end of 2019, and subsequently reported an almost instantaneous doubling of its U.S. pretax income and halving of its foreign pretax income in 2020 (an estimated profit shift of around $20 billion), with no material change in its business operations or in the ratios of U.S. versus foreign revenues, assets, or personnel. That these profits can be shifted so easily without any material change in functions illustrates the artificiality of these arrangements.

12Supra, note 2, Curtis and Chamberlain (Part 1), page 1062.

13It will of course be appreciated that any shifted profits will be included in GILTI. However, even if that GILTI is fully subject to U.S. tax (despite the cross-crediting of foreign tax credits that is available within the section 904(d) GILTI basket), that U.S tax is normally at just half the normal U.S. corporate rate due to the section 250 GILTI deduction. As a result of this, the GILTI regime continues the high motivation for profit shifting that existed in previous years under the pre-2018 deferral system.

14We are greatly encouraged by the mention of “periodic adjustments” in the 2021-2022 Priority Guidance Plan released on September 9, 2021 (International section E.4.).

15The trigger calculation and its components are found in Reg. section 1.482-7(i)(6)(i), (ii), and (iii).

16This calculation is found in Reg. section 1.482-7(i)(6)(v). Examples of its application are found in Reg. section 1.482-7(i)(6)(vii).

17Note that the regulation in Reg. section 1.482-7(i)(6)(i) allows the Commissioner the discretion to impose a periodic adjustment or to not impose an adjustment as calculated under the regulation. The guidance is: “In determining whether to make such adjustments, the Commissioner may consider whether the outcome as adjusted more reliably reflects an arm's length result under all the relevant facts and circumstances, including any information known as of the Determination Date.”

18The calculated periodic adjustment will be recognized as income by U.S. parent in the Adjustment Year, which is whichever open year of U.S. parent to which the IRS chooses to apply the adjustment. Thus, for example, in the three articles referenced in supra, note 2, that involve Facebook, Apple, and Google, the calculated periodic adjustment is applied to 2017 as the Adjustment Year. This is because 2017 is still open for each of these three MNCs and because 2017 is the last pre-TCJA year, meaning that the 35% tax rate still applies. Since all cumulative shifted profits in 2017 and earlier years will have given a 35% benefit to the taxpayer, it makes sense to make 2017 the Adjustment Year so that the recapture through the periodic adjustment is taxed at the same 35% rate. The periodic adjustment regulation includes rules for applying the adjustment to each year subsequent to the Adjustment Year. As a result, for example, the article on Apple calculates periodic adjustments to be recognized in 2017, 2018, 2019, and 2020. The 2017 year periodic adjustment would be taxed at the 35% rate while the following three years would be taxed at the TCJA rate applicable to each year.

19The Reg. section 1.482-4(f)(2) periodic adjustment mechanism, which applies to any intangible transfer and not just CSAs, was written in relatively vague terms. As such, it seems that it could be difficult to apply in practice. We are hopeful that mention of “periodic adjustments” in the 2021-2022 Priority Guidance Plan means that the Reg. section 1.482-4(f)(2) periodic adjustment mechanism will be appropriately amended to allow it to be a viable tool for the IRS to apply.

20It is worth noting that the legislative history for the 1986 Tax Reform Act addition to section 482 of the “commensurate with income” language was clear and unambiguous. The impossibility of valuing transferred intangibles on an ex ante basis fully warranted the ex post use of actual profits earned. Further, it is also worth noting that the legislative history provides no basis for the discussion of exceptions in the 1988 White Paper, the regulatory exceptions to periodic adjustments included in Reg. sections 1.482-4(f)(2)(ii) and 1.482-7(i)(6)(vi), or the provision in Revenue Procedure 2015-41, section 6.03, that an APA may provide that the periodic adjustment mechanisms will not apply “during or after the APA term.”

21See note 35 below for explanation of what any active election of association status would be extremely unlikely.

22One of the undersigned has had a series of articles over the past seven years focused on the application of ECI taxation to profit-shifting structures. He has also submitted to the Treasury and the IRS detailed recommendations for regulatory and other modernizations and updates that would make the application of ECI taxation more directly relevant to modern business structures, more understandable to taxpayers, and easier for the IRS to examine. Those interested in considering ECI taxation further are encouraged to access the submission and the articles.

1. Jeffery M. Kadet, Submission re Notice 2021-28, 2021-2022 Priority Guidance Plan (May 11, 2021), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3844971.

2. Jeffery M. Kadet, “Attacking Profit Shifting: The Approach Everyone Forgets”, 148 Tax Notes 193 (July 13, 2015), available at http://ssrn.com/abstract=2636073.

3. Thomas J. Kelley, David L. Koontz, and Jeffery Kadet, "Profit Shifting: Effectively Connected Income and Financial Statement Risks”, 221(2) Journal of Accountancy 48 (February 2016), available at http://ssrn.com/abstract=2728157.

4. Jeffery M. Kadet and David L. Koontz, “Profit-Shifting Structures and Unexpected Partnership Status”, 151 Tax Notes 335 (April 18, 2016), available at http://ssrn.com/abstract=2773574.

5. Jeffery M. Kadet and David L. Koontz, “Profit-Shifting Structures: Making Ethical Judgments Objectively,” Part 1 at 151 Tax Notes 1831 (June 27, 2016) and Part 2 at 152 Tax Notes 85 (July 4, 2016), available at http://ssrn.com/abstract=2811267 and http://ssrn.com/abstract=2811280.

6. Jeffery M. Kadet and David L. Koontz, “Internet Platform Companies and Base Erosion — Issue and Solution,” Tax Notes, Dec. 4, 2017, p. 1435, available at http://ssrn.com/abstract=3096925.

7. Jeffery M. Kadet and David L. Koontz, “Effects of New Sourcing Rule: ECI and Profit Shifting”, Tax Notes, May 21, 2018, p. 1119, available at http://ssrn.com/abstract=3201365.

8. Jeffery M. Kadet, “Sourcing Rule Change: Manufacturing and Competitiveness”, Tax Notes, November 5, 2018, p. 717, available at http://ssrn.com/abstract=3296763.

9. Jeffery M. Kadet and David L. Koontz, “Transitioning From GILTI to FDII? Foreign Branch Income Issues”, Tax Notes Federal, July 1, 2019, p. 57. (http://ssrn.com/abstract=3428540).

10. Jeffery M. Kadet and David L. Koontz, “A Case Study: Effectively Connected Income”, Tax Notes Federal, April 13, 2020, p. 217. (https://ssrn.com/abstract=3598733).

23Some practitioners believe that CSAs are consistent with common uncontrolled transactions (for example, see Tyler M. Johnson, John Hildy and John W. Horne, “Cost Sharing Is a Tax Shelter Now. Wait, What?” Tax Notes Federal, Sept. 18, 2020, p. 2193). However, Curtis, (2020) and Curtis and Chamberlain, (2021), supra., note 2 discuss how this is simply false, beginning on pages 1890 and 1068 respectively. The latter also discusses how cost sharing arrangements are inconsistent with the arm's length standard, beginning on page 1064. These comments are excerpted in the Appendix.

24See in particular Reuven S. Avi-Yonah, “Amazon vs. Commissioner: Has Cost Sharing Outlived Its Usefulness?” U of Michigan Law & Econ Research Paper No. 17-003 and U of Michigan Public Law Research Paper No. 551, (May 1, 2017), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2961235; and Yariv Brauner, “Cost Sharing and the Acrobatics of Arm's Length Taxation,” University of Florida Legal Studies Research Paper No. 2010-19 (2010), available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1651334.

25These regulations under § 1.482-7T were effective on January 5, 2009. See T.D. 9441, 2009-7 I.R.B. 460, and were made final effective December 16, 2011. See T.D. 9568, 2012-12 I.R.B. 499.

26OECD (2015), Aligning Transfer Pricing Outcomes with Value Creation, Actions 8-10 - 2015 Final Reports, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris, available at http://dx.doi.org/10.1787/9789264241244-en.

27Alex M. Parker, “Stack: No Big Changes to Transfer Pricing Rules From BEPS”, International Tax News (BNA) (October 13, 2015). Also,Alex M. Parker, International Tax Policy Forum (October 12, 2015), available at https://itpf.org/itpf_blog?article_id=3601. For completeness, it is worth noting that the cited article goes on to quote Mr. Stack as saying that if there is “smart cash” within a group member, then that group member should not just receive a risk-free return. He said: “We think that once you can demonstrate the ability to control the funding risk — know what to do as an investor — then you should be entitled like anyone to that full return[.]” It seems very safe to say that in the case of the three multinationals examined in the three referenced articles (supra, note 2) that personnel within the relevant CFC group members would have factually exercised no control over the funding risks that those group members assumed. Rather, all such decisions would have been made solely at group headquarters in the United States. Google is a particularly good example of this given that it executed its CSA shortly after the formation of its Irish structure at a time when there were just a handful of low-level Irish personnel and one manager who had been transferred from the United States to supervise them.

28See Curtis (2021), supra, note 2.

29See Curtis and Chamberlain, (2021), supra., note 2.

30See H.R. Rep. No. 99-426, 1986-3 C.B. Vol. 2, at 420ff.

31JCT, “General Explanation of the Tax Reform Act of 1986,” JCS-10-87, at 1016 (1987).

32See Reg. section 1.482-7(g)(7)(iii)(C).

33This temporary regulation expired in 2018. However, it still exists as a proposed regulation in REG-139483-13, Par. 14, 80 Fed Reg 55582 (September 16, 2015).

34See supra note 22. Article #4 examines how many profit-shifting structures create unexpected partnerships with relevant group members being partners and the joint business being conducted by the partnership. See also LTR 201305006.

35There is no need to discuss any detailed consequences of an active election (Reg. section 301.7701-3(c)) to threat the “entity” as an association taxable as a corporation. It is extremely unlikely that a taxpayer would ever make such an election. The “entity” includes the joint business activities conducted by U.S. MNC and CFC. If the “entity” were treated as a domestic corporation, then the portion that relates to CFC's proportionate share would be fully subject to current U.S. taxation. If the “entity” were treated as a foreign corporation, then even U.S. MNC's proportion of the joint business would be subject to ECI taxation, which is generally worse than being taxed in the normal manner. While there can be additional disadvantages, the most important would be the section 884 branch profits tax, which can significantly increase the effective tax rate above the normal section 11 U.S. corporate rate.

36See also section 865(e)(2) and Reg. section 1.865-3.

37See Reg. section 1.937-3(e), Example 5, which involves an application service provider and which relies on Reg. section 1.861-4 to determine the taxpayer's source of income.

END FOOTNOTES

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