On February 2, 2007 the IRS Large and Midsize Business Division ("LMSB") issued an Industry Directive and audit guidelines addressing issues arising under section 482 and section 367(d) in connection with transfers of the operations of former section 936 possessions corporations to controlled foreign corporations ("CFCs"). This directive is targeted primarily at pharmaceutical and other healthcare companies that transferred the operations of former section 936 subsidiaries to CFCs upon or in anticipation of the expiration of the section 936 possessions tax credit, and provides insight into evolving IRS thinking regarding a much broader set of intangible migration transactions. Accordingly, the Industry Directive may have far-reaching impact on future IRS audits of intangible migration transactions.
Highlights of the Industry Directive
As a result of the 2005 expiration of the possessions tax credit, most companies that had operated under section 936 transferred the operations of those corporations to CFCs sometime between 1999 and 2006. Conversion transactions have typically involved:
- the transfer of physical assets located in Puerto Rico to the CFC under section 351,
- a license or other migration of intangible property to the CFC, and
- a non-recognition transfer to the CFC of "foreign goodwill and going concern value" in a transaction intended to be exempt from the rules of section 367(d).
The IRS clearly believes that these transactions raise serious enforcement issues relating to the compensation paid by the CFC in connection with the outbound migration of intangible property and has issued the Industry Directive to coordinate its response.
The Industry Directive mandates nationwide coordination of the audit of transfer pricing and other intangible transfer issues arising in the context of section 936 conversions. This coordination extends to the year of the conversion and to any subsequent year in which the former section 936 operations are conducted in CFC form. Thus, ongoing license arrangements, ongoing use by the CFC of intangibles arguably transferred under section 367(d), and ongoing service transactions involving the CFC come within the scope of the Industry Directive. The new Industry Directive:
- establishes a national IRS Issue Management Team to monitor and control all audits of transactions related to section 936 conversions;
- mandates the audit of section 936 conversion issues in all audits scheduled to conclude in 2008 or thereafter;
- requires the application of specified audit guidelines to all section 936 conversion audits;
- requires local audit teams to seek review and approval by the Issue Management Team of all Form 5701 proposed adjustments relating to section 936 conversions; and
- requires the Issue Management Team to review and approve all final resolutions of section 936 conversion issues at the field audit level.
The Industry Directive specifically identifies three sets of issues likely to arise in the context of a section 936 conversion that must be carefully reviewed by field examiners in IRS audits. These are: (i) the arm’s length nature of the royalty paid with respect to any licensed intangible property; (ii) the arm’s length nature of compensation paid for services provided between the CFC successor to a section 936 possessions corporation and its US parent; and (iii) the tax treatment of any transfer of intangible property under section 367(d), specifically any taxpayer claim that valuable "foreign goodwill and going concern value" has been transferred to the CFC on a tax-free basis.
Audit Guideline Highlights
The most interesting elements of the Industry Directive are contained in the audit guidelines. Application of these guidelines by IRS examiners is mandated in section 936 company conversion audits. These audit guidelines reflect IRS positions on a variety of common transfer pricing and section 367(d) questions and direct IRS field examiners as to how to approach these issues. Because these issues can also arise in a variety of contexts that go far beyond the context of possessions corporation conversions, the audit guidelines are likely to have a broad impact on many future IRS transfer pricing audits.
Key issues identified and discussed in the audit guidelines include the following:
Workforce in Place - The audit guidelines expressly take the position that an assembled workforce constitutes an intangible asset within the meaning of the definition in section 936(h)(3)(B), and also states that a transferred workforce does not constitute part of the foreign goodwill and going concern value of the business. Although the proposed cost sharing regulations suggest that an assembled workforce is a valuable asset that must be separately paid for in a cost sharing context, this Industry Directive represents the first formal IRS statement that, as a general matter, an assembled workforce is an intangible asset for purposes of applying transfer pricing and section 367(d) rules. This position is certain to be highly controversial. It is inconsistent with earlier IRS pronouncements and appears to be inconsistent with the statutory requirement that an intangible have "substantial value independent of the services of any individual." The audit guidelines do not suggest how one determines an arm’s length price for a valuable workforce intangible.
Comparable Profit Split Method - The audit guidelines express strong reservations regarding the application of the comparable profit split method ("CPSM") on two grounds. First, the audit guidelines suggest that IRS field examiners should be very reluctant to accept taxpayer assertions of comparability, particularly where the purported comparable profit split is derived from a license agreement that does not guarantee the parties a specified share of profits. Second, the IRS suggests that examiners considering profit split methodologies should be less comfortable with analyses based on a split of total profits than on an analysis reflecting a split of residual profits, after compensation for routine functions. This may indicate an IRS predilection to deny the licensee any significant return for its use of licensed rights, suggesting instead that most residual profit should go to the licensor of valuable intangibles.
Rule of Thumb - The Industry Directive specifically states that IRS field examiners should treat royalties justified on the basis of an industry standard or a rule of thumb as suspect.
Analysis of Functions in Isolation - The Industry Directive strongly suggests that a transfer pricing analysis that isolates particular transactions (distribution services, management services, contract R&D) may be problematic. The IRS believes this is particularly true when the taxpayer’s transfer pricing analysis suggests that the parent company’s appropriate arm’s length return is equal to the sum of the limited risk returns to such services. It goes on to say that corporate synergies may make it inappropriate to analyze transfer pricing arrangements one service at a time, and that it is a likely sign of transfer pricing problems if one party to the transaction conducts a majority of the functional activities of running the business (marketing, sales, R&D, distribution, management) while and yet the other party retains a large share of the total profits of the business.
Risk Based Returns - The audit guidelines suggest that field examiners should be wary of taxpayer claims that the CFC’s assumption of risk entitles it to a large share of the profits, and that taxpayers often overstate the degree to which the assumption of inventory risk, product liability risk, or market risk will entitle an entity with limited functions to high returns. The guidelines mandate a review of the taxpayer’s actual loss experience in evaluating such claims. Moreover, the audit guidelines underscore the importance of questioning whether the taxpayer’s conduct over time is consistent with assertions that the CFC assumed substantial risk (e.g. if the CFC assumed product liability risk, did it in fact bear the economic cost of all product liability claims; if the CFC allegedly bears insured risks, was it the party that negotiated and paid the insurance premiums). The guidelines also suggest that examining agents investigate the role of the CFC in managing and controlling the risks it is alleged to have assumed, and that the field examiners consider the degree to which the CFC had the economic wherewithal to bear large risks, particularly after distributions of current earnings to other group members.
The Industry Directive reflects a continuing IRS focus on questions involving the migration of intangible assets. It suggests that the IRS is sharpening its analytical skills and its focus on key operational and risk-oriented issues. It undoubtedly portends more detailed, skillful, and thorough examination of transfer pricing and section 367(d) issues related to intangible migration transactions in the future.
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