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Transfer Pricing Under the TCJA

David Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Worldwide Tax Daily. This week, transfer pricing and the TCJA. We're diving into one of the less-explored areas of the Tax Cuts and Jobs Act, specifically section 482 of the Internal Revenue Code. Now, section 482 deals with transfer pricing or transactions between related parties. Under the system of transfer pricing, companies are required to price related-party transactions as if they were done by unrelated parties using various valuation methods. Now, while this system may seem simple, it meets a harsh reality when you're trying to price difficult-to-value items like intangible assets.

As part of the Tax Cuts and Jobs Act, Congress amended section 482 to authorize the IRS to make transfer pricing adjustments using certain valuation methods for intangible transfers. It also amended the definition of intangible property under section 936. I'm joined this week by Worldwide Tax Daily legal reporter Ryan Finley to talk about what these changes mean for the future of transfer pricing.  

Ryan, welcome to the podcast.

Ryan Finley: Thank you.

David Stewart: Before we begin, can you explain what changes were made?

Ryan Finley: So, the TCJA added a new sentence to the end of section 482 that says transfers of intangibles shall be valued in the aggregate or on the basis of realistic alternatives if the secretary determines that doing so provides the most reliable result.

So the sentence essentially takes the aggregation and realistic alternatives concepts that are already in the 482 regulations and incorporates them into the statute, at least for intangibles. The TCJA also amended the definition of intangible property under section 936(h)(3)(B) to explicitly include goodwill, going-concern value, and workforce-in-place. And this is important for transfer pricing purposes because the new sentence added to section 482 and the commensurate-with-income principle, adopted in 1986, apply only to transfers of property that fall within that definition.

David Stewart: Alright it's no secret that the IRS has been, let's say, less than successful with transfer pricing disputes brought to the Tax Court. How did these changes effect those major cases?

Ryan Finley: So the concepts addressed by the amendments — aggregation, the realistic alternatives principle, and the definition of intangible property — were all at the center of the disputes with Amazon and Medtronic. In Amazon, which was a cost-sharing case, the Tax Court held that the IRS couldn't use aggregation or the realistic alternatives principle to support its use of a discounted cashflow valuation because the resulting value included goodwill, going-concern value, and workforce-in-place, which are the same items that Congress just added to the definition of intangibles. In Amazon, the court said that the preexisting intangibles contributed to the cost sharing arrangement had to be priced using the comparable uncontrolled transaction — or CUT — method, which uses arm’s-length licenses of comparable intangibles. In Medtronic, which was a non-cost-sharing case involving a lot of the same issues, the court similarly held that the CUT method was the most reliable method. So the amendment appears to single out the issues litigated in Amazon and Medtronic and to explicitly authorize the IRS to do what the Tax Court said it couldn't do under prior law.

David Stewart: Does this mean that those cases would have been decided differently under this law?

Ryan Finley: Well, based on the TCJA conference report and the text of the amendments, that certainly seems to have been the intent. But that was arguably what Congress had tried to do back in 1986 when it amended section 482 to require that the compensation for an intangible be commensurate with the income of the intangible. To find out what practitioners expect, I spoke to Guy Sanschagrin of WTP Advisors by phone.

Guy Sanschagrin: Potentially. I mean, it's hard to put ourselves in the judges’ shoes and how they're interpreting the facts and the law as it existed or exists at the time of the transaction. If the judge is taking a look at the new law, I could certainly view this as having a significant impact on how the case would be analyzed.

Ryan Finley: None of the TCJA's transfer-pricing-related amendments say anything explicit about selection of transfer pricing method. But they do arguably remove some of the obstacles that the IRS has faced in defending its use of profit-based intangible valuation methods. According to Sanschagrin, the CUT method should remain a viable transfer pricing method in appropriate circumstances.

Guy Sanschagrin: So, when we look at that method and we're looking at a specific technology, I don't think it erodes the ability to use the CUT method to analyze a transaction involving specific IP. Now that said, if we're taking a look and identifying additional intangibles that are being relocated or moved, then potentially there's a need to do further analyses to do separate valuations for the other intangibles that are being moved. So in that case, you would still use, potentially, the CUT method if it's a reliable CUT, if it's truly a comparable transaction. And then you would supplement that with additional analyses to value the other intangibles that are being relocated.

David Stewart: Okay, so now the law would seem to be on the side of the IRS in any future Amazon or Medtronic cases. Does this solve the IRS's problems with these intangible transfers?

Ryan Finley: Well, according to the IRS's appellate brief in Amazon, the amendments are a complete vindication of its longstanding approach and the rebuke of decades of Tax Court case law. But according to Jeffery Kadet, who teaches at the University of Washington School of Law and is a contributor to the BEPS Monitoring Group, the new statute may inadvertently legitimize arrangements that have no purpose other than to artificially shift profit. I spoke to him by phone.

Jeffery Kadet: I think Congress is only legitimizing these structures that so many multinationals are using. Now certainly on a positive note, I very much agree that having a more realistic valuation or approach to valuing something that cannot realistically be valued by comparables simply because there are no close comparables to these kinds of unique intangibles, and having something that hopefully the courts will respect this time, in having this amendment to section 482 to force the courts to give some credibility to the approaches that the IRS has tried to use — I think that, of course, is a positive thing. But again, I think that focusing on just one part of the bigger scheme rather than on the whole scheme itself, and how profits are allocated, where they're earned, how existing tax laws should be applied to those things, I think those are the bigger questions that both the IRS and Congress going forward should be looking at.

Ryan Finley: Sanschagrin was more optimistic.

Guy Sanschagrin: And one of the challenges I think that both sides are facing in these highly contentious cases is taking an extreme approach on either end of the spectrum. Whereas, as you know, in transfer pricing and valuation, usually there's a range of reasonableness that can be determined. And it seems like in these high-dollar cases, that the sides are really fighting to get on both sides of the extreme, rather than trying to define a reasonable point somewhere in the middle. Which I would suggest that both sides would be more successful at settling the case if there was an effort to try to meet somewhere in the middle.

Ryan Finley: So time will tell how the new section 482 will fare, but transfer pricing will probably remain a contentious issue.

David Stewart: Well, we'll have to have you back when we find out how this actually plays out. Ryan, where can listeners find you online?

Ryan Finley: I'm on Twitter @ryanmfinley, that's F-I-N-L-E-Y.

David Stewart: Thank you for being here.

Ryan Finley: Thank you.

David Stewart: And now, Coming Attractions. Each week we preview commentary that will be appearing in the next issue of the Tax Notes magazines. Filling in for Jasper Smith this week, is Acquisitions Editor Lindsay Graham. Lindsay, what will you have for us?

Lindsay Graham: This week in Tax Notes, Professor Dennis Ventry of UC Davis School of Law argues that codifying the IRS Free File program would mask violations of free file provider companies. We also have Yuval Ruppin of Alvarez & Marsal Taxand considering the tax consequences when an applicable high-yield discount obligation is refinanced at a premium, focusing on whether that premium is deductible.

In State Tax Notes, Mark Sommer and Ryan Gallagher of Frost Brown Todd discuss the unitary filing method in Kentucky, including its statutory origins and how things stand following the unitary doctrine's resurrection. We also have Paul Bogdanski and Dan Hunt of Grant Thornton examine state sales tax rulings on e-learning transactions, noting that the few states that have weighed in have chosen not to tax traditional student-teacher interactions.

In Tax Notes International, we have Lawrence Hill and Tiffany Pan of Winston & Strawn examine a new set of model rules from the OECD that seek to prevent common reporting standard avoidance arrangements and the use of opaque offshore structures by imposing reporting obligations on intermediaries. We also have KPMG Nigeria discussing the reasons why countries should use tax incentives to support small and medium-size enterprises and reviewing existing tax regimes in Nigeria and elsewhere before presenting several recommendations for tax initiatives that they believe will help Nigeria's SMEs prosper.

David Stewart: You can read all that and a lot more in the July 16th editions of Tax Notes, State Tax Notes, and Tax Notes International. That's it for this week. You can follow me on Twitter @TaxStew, that's S-T-E-W. If you have any comments, questions, or suggestions for a future episode, you can email us at podcast@taxanalysts.org. Be sure to subscribe to us on iTunes or Google Play to make sure you get the next episode of Tax Notes Talk.

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