CALIFORNIA TAX BOARD SAYS TRANSFER-PRICING REGS PROVIDE INSUFFICIENT GUIDANCE.

Coffill and Sommers criticize the basic assumption in the regulations that comparables exist for all cases. They further criticize the lack of guidance on how the comparable profit method should be applied in cases where the profit level indicators of the uncontrolled parties do not converge and the reliability of the uncontrolled data is relatively equal. Because of the significant gaps in the application of the arm's-length standard, Coffill and Sommers contend that safe-harbor rules are essential for the administration of the regulations. According to the authors, the safe-harbor methodology need not be specifically delineated in the regulations; the regs could simply permit a taxpayer to use a formulary profit split when comparables cannot be identified.

The following comments are submitted as to certain aspects of the proposed intercompany transfer pricing and cost sharing regulations under Section 482. Because comments relating to the cost sharing provisions overlap with those relating to the other provisions, this letter is being sent in duplicate to both INTL-0372- 88 and INTL-0401-88.

These comments are submitted from an unusual perspective because under state law, California Franchise Tax Board will be enforcing the regulations in a role similar to that of the Service.

As a matter of background, where a California corporate taxpayer is engaged in an integrated business enterprise operating in more than one state or in foreign countries, the approach utilized by California for the allocation and apportionment of taxable income to California, for purposes of imposing its corporate franchise/income tax, is the unitary business principle. Under the "worldwide" unitary method, California includes the foreign operations of a taxpayer's unitary business in the calculations which determine the amount of income derived from or attributable to California for tax purposes. ¹ However, in 1986, California enacted legislation which allows certain taxpayers engaged in a worldwide unitary business to make for income years beginning on or after January 1, 1988, a "water's-edge" election as an alternative to the worldwide unitary method. ² Subject to minor exceptions, a corporate taxpayer making a water's- edge election only accounts for the income and apportionment factors of the following related entities in calculating its California franchise/income tax: corporations incorporated in the United States; any corporation, wherever incorporated, if the average of its apportionment factors within the United States is 20 percent or more; affiliated corporations which are eligible to be included in a federal consolidated return; domestic international sales corporations and foreign sales corporations; any corporation not mentioned above but only to the extent of income derived from or attributed to sources within the United States; and any affiliated corporation which is a controlled foreign corporation and has Subpart F income as defined in the Internal Revenue Code. ³

In administering the water's-edge law, in the case of two or more organizations, trades or businesses owned or controlled directly or indirectly by the same interests, California Franchise Tax Board is authorized by statute to distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among these organizations, trades, or businesses, if it determines that such action is necessary in order to prevent evasion of taxes or clearly to reflect income. ⁴ In making these distributions, apportionments, and allocations, California Franchise Tax Board is required by statute to "generally follow the rules, regulations, and procedures of the Internal Revenue Service in making audits under Section 482 of the Internal Revenue Code." ⁵

Accordingly, the practicality of the proposed regulations is of great concern to California Franchise Tax Board which must administer them as part of its water's-edge international audit program. The following comments are submitted with those concerns in mind.

GENERAL COMMENTS

1. The proposed regulations are unreasonably dependent upon the assumption that comparables exist for all cases -- an assumption which will not prove valid, especially in situations involving unique, high-profit intangibles. If uncontrolled parties performing similar functions to those performed by the controlled parties cannot be located, inadequate guidance is provided as to how the arm's- length standard is to be applied.

2. Assuming comparables can be found, no guidance is provided as to how the comparable profit method is to be applied if the profit level indicators of the uncontrolled parties do not converge as required by proposed section 1.482-2(f)(7) and the reliability of the uncontrolled data is relatively equal.

For these reasons, there are significant gaps in the proposed regulations for applying the arm's-length standard. While it is acknowledged the Service is reluctant to provide safe harbor rules in the context of section 482, we believe "last resort" safe harbor rules are ESSENTIAL in order for the regulations to be administrable. Theoretical difficulties exist with any safe harbor scheme, but it is submitted that the inclusion of a less than perfect safe harbor in the proposed regulations is far preferable to the uncertainty which will arise under the proposed regulations in attempting to apply the arm's-length standard.

The safe harbor methodology need not be specifically delineated in the regulations, which could simply provide that if it is impossible to identify any comparables (or impossible to quantify material differences between near comparables with any reasonable degree of accuracy), it is permissible for a taxpayer to use a formulary profit split, so long as it is reasonable under the facts and circumstances of the situation. It is believed that formulary apportionment profit splits have been used in certain Advanced Pricing Agreement cases, and there is no good reason they cannot be used in a regulatory safe-harbor provision as well.

If specific guidance is desired, a more detailed formula approach could be articulated in the regulations. For example, the formula profit split approach in the Uniform Division of Income for Tax Purposes Act ("UDITPA") ⁶ which is used by many states, including California, is one possible approach. This methodology is attractive because it looks to taxpayer specific data, as opposed to industry averages. Recognizing that the factor or factors used in an apportionment formula should reflect "a reasonable sense of how income is generated", the UDITPA formula has been recognized as "something of a benchmark against which other apportionment formulas are judged." ⁷ Alternatively, a formulary approach, such as that set forth in Regulation section 1.863-3T(b)(2) involving income from the sale of personal property derived partly from within and partly from without the United States, should be considered.

A safe harbor based only upon a rate of return on assets method, as suggested in the Summary of Proposed Regulations ("Safe Harbor"), would not provide reasonable results. There are numerous, legitimate reasons for a controlled taxpayer's return on assets to be above or below country-wide or industry averages. ⁸ Nor can these problems be cured by making adjustments to such averages, for quantifying these differences is practically impossible and unworkable from an administrative standpoint. Furthermore, as noted in the White Paper, industry averages generally do not reflect arm's-length prices for highly profitable intangibles. In sum, a formulary profit split methodology is a more viable approach than the use of industry averages, and should be incorporated into the regulations.

COMMENTS ON SELECT SPECIFIC PROVISIONS

1. SECTION 1.482-2(d)(5)(iv) EXCEPTIONS

This provision provides that where the comparable profit method applies, the district director may make an adjustment that results in a level of operating income for the transferee at the most appropriate point within the comparable profit interval if the consideration paid by the transferee in connection with the controlled transfer was "substantially disproportionate" to the value of the intangible. Clarification is needed, either by way of definition or examples, regarding what will be considered "substantial."

2. SECTION 482-2(f)(1) COMPARABLE PROFIT INTERVAL IN GENERAL

This provision provides that while in many cases a sequential six step analysis is used to derive the comparable profit level, "the steps are interdependent and certain steps may have to be reapplied to take into account results derived in succeeding steps." Clarification is needed, either by way of definition or examples, regarding the meaning and intended application of this language.

3. SECTION 1.482-2(f)(2) DATA FROM MULTIPLE YEARS

This provision sets forth a general rule that a comparable profit interval is to be determined by reference to the three-year period that includes the taxable year under review, the preceding year and the following year. While the use of multiple year data is proper and recommended, use of subsequent year data in that determination is disfavored from a compliance perspective. It is suggested that the interval be based upon data from the current year and the two preceding years, as is done in the cost sharing rules set forth in paragraph (g) ("Cost/income ratio") of the proposed regulations.

4. SECTION 1.482-2(f)(5)(iii) APPLICABLE BUSINESS CLASSIFICATION

This provision states that in establishing the applicable business classification, where it is not possible to obtain reliable data regarding uncontrolled taxpayers that perform functions with respect to products that closely correspond to the products related to the tested operations, then the scope of the classification "is broadened to include the functions performed by the tested party and as broad a category of products as is necessary to obtain reliable data." This approach appears badly flawed in that as the business category becomes more broadly defined, the uncontrolled data becomes less comparable. It is suggested that this forced broadening of the business classification, which effectively results in the use of industry averages, amply illustrates the need for the regulations to include a safe harbor formulary profit split methodology.

5. SECTION 1.482-2(f)(6)(iii)(B) ASSETS

This provision requires appropriate adjustments to asset values where there are distortive differences between the book value of the assets of the controlled and uncontrolled taxpayer. Presumably, such an adjustment would be required in situations where significant differences are created as a result of differences in the Generally Accepted Accounting Principles between the countries of the controlled and uncontrolled taxpayer. For example, GAAP in certain countries "writes-up" or "writes-down" book value of assets to reflect changes in fair market value.

It is suggested that this provision, either by text or example, provide guidance regarding how to adjust for such differences. For instance, are GAAP differences to be ignored? If either the controlled or uncontrolled taxpayer is a U.S. taxpayer, it is appropriate to adjust asset book values to reflect U.S. GAAP? If both the tested party and the uncontrolled taxpayer are foreign incorporated, but in different countries, and there are significant GAAP differences between the accounting standards for the two foreign countries, what are the appropriate means of adjusting asset values to account for those differences?

6. SECTION 1.482-2(g)(4)(iv)(D) EXAMPLES

Example #2 demonstrates a buy-in situation where in year ten a fifth controlled taxpayer joins the cost sharing group. The example states the fair market value of the intangible property within the cost share arrangement is $45 million and the new member is therefore required to pay one-fifth of the $45 million to the prior participants. However, the example assumes that the fair market value of the intangible is ascertainable at the time of the buy-in. How is the buy-in issue to be resolved in situations where it may prove impossible to determine the fair market value of the intangible (such as situations involving unique, high profit intangibles)?

If you have any questions, please do not hesitate to contact Eric J. Coffill at (916) 369-3323 or Kathryn S. Sommers at (916) 369- 4169.

Sincerely,

² 1986 Cal. Stat. 660; Cal. Rev. & Tax. Code sections 25110- 25115.

³ Cal. Rev. & Tax. Code section 25110, subd. (a).

⁴ Cal. Rev. & Tax. Code section 25114, subd. (b).

⁵ Cal. Rev. & Tax. Code section 25114, subd. (b)(2).

⁶ UDITPA uses an equally weighted three factor formula consisting of payroll, property, and sales. See Pierce, The Uniform Division of Income for State Tax Purposes, Taxes, Oct. 1957, p. 747; Keesling and Warren, California's Uniform Division of Income for Tax Purposes Act, Parts I and II, 15 U.C.L.A. L. REV. 156 (1967), 15 U.C.L.A. L. REV. 655 (1968)

⁷ Container Corp., supra, 463 U.S. at 169-170.

⁸ For example, a start-up business, a business striving for increased market share, and unusually poorly or well managed businesses would deviate from "average" returns.