Topic: Arms Length

Eaton A.P.A. cancellations were an abuse of I.R.S. discretion

This article appears in Insights vol. 4, Issue 9.  Insights is the Tax Journal of Ruchelman PLLC.

As the transfer pricing travails of Eaton Corporation (“Eaton”) continue, a recent Tax Court decision affirmed that I.R.S. administrative procedure set down in Revenue Procedures and relied upon by the I.R.S. and a taxpayer cannot be arbitrarily circumvented, and that the I.R.S. must reasonably exercise its discretion.

At issue was the cancellation of two advance pricing agreements (A.P.A.’s) and the consequent I.R.S. income adjustments made as a result of applying a new transfer pricing method.  Eaton’s position was that the A.P.A.’s were binding contracts, and that these contracts were cancelled for reasons other than those named as cause for termination in the respective A.P.A. agreements.  Though the Tax Court did not agree with Eaton that an A.P.A. agreement should be interpreted under contract law, the Tax Court carefully reviewed the circumstances of the cancellation against the I.R.S. Revenue Procedures Rev. Proc. 96-53 and Rev. Proc. 2004-40 that governed the drafting and administration if the A.P.A. agreements in the relevant tax years.

An A.P.A. is an alternative to the traditional adversarial model between a taxpayer and one or more tax authorities.  Its purpose is to reach an agreement concerning the transfer pricing method to be used for a number of tax years in one or more controlled transactions.  A.P.A.’s take a long time to negotiate, owing both to the fact-intensive nature of transfer pricing matters and the considerable due diligence both sides must undertake.  Both sides must be prepared to compromise their technical positions somewhat in order to obtain practical transfer pricing certainty.  Once concluded, an A.P.A. agreement is signed and a program of annual reviews undertaken to ensure that the terms of the A.P.A. are being followed.  For transfer pricing positions that influence a large share of a tax provision, or a significant transfer pricing position that is complex or unique, generally accepted convention holds that is it better to spend the time and fees for two years negotiating an A.P.A. than to spend an even greater amount to produce I.R.C. § 6662 documentation, manage examinations, Appeals, Competent Authority and litigation.  Currently, the administrative procedures for requesting and administering an A.P.A. are set out in Rev. Proc. 2015-41.

As with any agreement, the hallmarks of a successful A.P.A. are negotiation in good faith, disclosure of all material or relevant facts or documents, disclosure of true facts or documents, and the adherence to the terms of the agreement over the duration of the agreement’s lifespan.  The I.R.S. alleged “failure of a critical assumption, misrepresentation, mistake as to a material fact, failure to state a material fact, failure to file a timely annual report, or lack of good faith compliance with the terms and conditions of the A.P.A.”[1] as among the “numerous reasons” for the cancellation of the Eaton A.P.A.’s.  The Tax Court weighed each claim, finding in favor of Eaton in the case of all stated reasons for cancellation.

The origin of the dispute was a series of inadvertent accounting errors committed by Eaton accounting and tax personnel, and discovered only after a new transfer pricing manager joined the company and looked de novo at the calculations and underlying information used to comply with the terms of the A.P.A.’s.  Many of these errors did not result in a favorable tax outcome for Eaton, though in net terms the transfer prices were higher as a result by approximately 5% in each of the 2005 and 2006 tax years.  Eaton alerted the I.R.S. to these discrepancies, filed Forms 1120X to report the additional income, and prepared to update its annual A.P.A. reports to explain the effect of the errors.

In response, the I.R.S. changed its view concerning the transfer pricing method in negotiations of a third A.P.A., advised Eaton not to file updated A.P.A. reports, and issued a letter cancelling the A.P.A.’s covering tax years 2001-2009.

The extensive information gathering and questioning that occurred during the first and second A.P.A. negotiations, as well Eaton’s responsiveness and cooperation, proved to be a large part of the undoing of the I.R.S. case.  Many items of information that were alleged to have been omitted or neglected by Eaton in an act of bad faith bargaining were found to have been disclosed during A.P.A. negotiations, or alternatively could have been discovered by the I.R.S. during its many series of questions or meetings.

In the end, the conditions for the cancellation of an A.P.A. set out in the Revenue Procedures were not met, as the Tax Court found in its analysis that concentrated inter alia on the interpretation of the terms “material fact”, “critical assumption” and “misrepresentation” in the context of the Eaton facts.  It was noted that either side could have walked away during either of the two A.P.A. negotiations if viewpoints concerning the best transfer pricing method differed significantly enough, and that the I.R.S. signing of two largely similar A.P.A. agreements limited its ability to argue in retrospect for a different transfer pricing method.

The Eaton case outcome highlights the complexities of implementing a transfer pricing method once the “transfer pricing study” is complete, especially when accounting and enterprise information systems are used to store information and generate reports to be used in tax calculations.

The 202 page Tax Court memo explains in considerable detail the data warehousing procedures used by Eaton to store report templates and files, the ledgers and “mirror ledgers” used to record transfer prices for accounting purposes and eliminate intercompany transactions on consolidation, and the sources of information used to calculate ratios and cost variance factors critical to the compliance with the A.P.A. terms.  It was the fact that many data sources had to connect across group companies using the intervention of controllers and tax personnel that informed the finding of “human error” or “computational error” rather than deliberate misrepresentation or deceit.  Even with an audit opinion on the non-consolidated financial statements of the Eaton entities relevant to the A.P.A.’s, the calculation errors slipped by the taxpayer and the I.R.S. at successive annual reporting checkpoints.

While a relief for companies with pending or in-force A.P.A.’s or Competent Authority settlements, this decision illustrates the value of proper transfer pricing policy implementation and the engagement of employees and advisors outside of the tax function to make sure the system works reliably from the start.  People entrusted with key information or process control can change jobs unexpectedly or eventually retire.  Initial engagement of all people needed to produce results representing true taxable income is critical, as is a periodic check to ensure that the system is performing as expected.

Finally, Eaton serves as a reminder of the possible unfortunate consequences of fixing mistakes, even honest mistakes, in a climate of heightened suspicion of tax avoidance among tax authorities.

[1] Eaton Corporation and Subsidiaries v. Commr. T.C. Memo 2017-147, p. 112.

TRANSFER PRICING NEWSLETTER is provided as a free service to clients and friends of Cadesky Tax. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing a tax planning arrangement or taking an uncertain tax filing position. Cadesky Tax cannot accept any liability for the tax consequences that may result from acting based on the contents hereof.

Amazon makes the CUT – an important taxpayer win, a reminder to consider transactional evidence

This article also appears in the May issue of Insights, the Tax Journal of Ruchelman PLLC

In finding for the taxpayer in a recent transfer pricing decision,[1] the U.S. Tax Court followed its own determination in Veritas[2] in valuing a buy-in payment made as compensation for the right to use pre-existing intangible property in a related-party cost-sharing arrangement (“CSA”).  This decision, like other major transfer pricing decisions, serves as a reminder of the fact-intensive nature of transfer pricing matters and of the importance of uncovering and properly analyzing transactional evidence from the controlled transaction in question and from uncontrolled transactions or dealings of the business., Inc. (“Amazon”) entered into a CSA with Luxembourg subsidiary AEHT in 2005.  The CSA covered: (i) the software and other technology underlying the Amazon European domain-name websites, fulfillment centers, and related business activities; (ii) marketing intangibles, including trademarks, tradenames, and domain names used in Amazon’s European business; and (iii) customer lists, customer data, and the Amazon tradename and mark.  The right to use the pre-existing intangible assets in these three categories was priced at $254.5 million, payable over a seven-year period corresponding with the useful life of the intangible assets.

Using the income method and the same discounted cash flow approach rejected by the court in Veritas, the IRS estimated the arm’s length value of the buy-in payment to be $3.468 billion, effectively disregarding the CSA and valuing the transfer of rights as a business that would exploit infinitely-lived intangibles in perpetuity.  The IRS also disputed the Amazon failure to classify certain technology and content expenses of as intangible development costs, thereby biasing downward the income from annual cost sharing payments received from AEHT over the term of the CSA.

The economic substance of the AEHT Luxembourg operations hub was not critical on its own.  Local language requirements, local vendor relations, and European logistics considerations and customer tastes were all factors contributing to the need to carry on a business in Luxembourg, and the change in economic position for AEHT expected to result from the CSA  In rejecting the IRS transfer pricing method, the court made clear that “AEHT was not an empty cash box.”  This determination contrasts sharply with the O.E.C.D. outcomes under the BEPS Action Plan that attack hypothetical “cash boxes” that are legal owners of rights but lack the decision-making and risk management capacity needed to allocate capital to investments with uncertain returns.  The dispute in Amazon therefore centered on (i) the transfer pricing method, (ii) the assumptions made and analyses used to value the buy-in payment, and (iii) the correct treatment of the intangible development costs within the term of the CSA

In deciding for the taxpayer, the court relied on the testimony and reports of 30 experts in computer science, marketing, economics, and transfer pricing economics.  The opinions of the computer science experts on the state and viability of the Amazon software and websites served as a stable foundation upon which the transfer pricing economics experts for the taxpayer could anchor their assumptions.  These assumptions were critical – as the technical constraints of the software system provided a reliable estimate of the lifespan of the software used to power the core operations of the Amazon websites and fulfillment business.  The marketing experts helped the court decide on a proper method to estimate key variable values used in the marketing intangibles value calculation.  They also assisted the court in determining how the intangibles allowed a team of engineers – for whom no technical challenge seemed too large – to overhaul the websites without causing them to crash during popular shopping seasons.

However, the star of the trial was a Treas. Reg. §1.482-7 transfer pricing method – the Comparable Uncontrolled Transaction method (“CUT”).  Amazon used an unspecified transfer pricing method resembling in some respects the profit-split method to calculate the original buy-in payment, while the IRS used an application of the income method.  The IRS income method calculated the present value of cash flows forecasted to result from AEHT’s European business, using cash flow and balance sheet forecasts as its only company data input.  Both approaches neglected or devalued Amazon’s outsourced web store programs, and thousands of Associates or Syndicated Stores programs that provided customer referrals to Amazon.

The website platform and referrals transactional data alone did not win the case for Amazon.  Considerable expert testimony was required to establish reliable assumptions of discount rates, value decay rates, useful asset life, and trademark ownership.  The company’s own information, however, was a crucial element in winning the case.  CUT’s that involve transactions between the taxpayer and independent businesses (sometimes called internal CUT’s), are highly persuasive given these fit well within the framework of the comparability requirements of Treas. Reg. §1.482(c)(1), which is critical to selecting a best method.  CUT’s are not abstract agreements between third parties.  They must bear some resemblance to one of the controlled parties and its business.

One small levity allowed in the 207-page decision was that “one does not need a Ph.D. in economics to appreciate the essential similarity between the DCF methodology that Dr. Hatch employed in Veritas and the DCF methodology that Dr. Frisch employed here.”  Similarly, a Ph.D. is not required to present a well-selected and adjusted CUT to the IRS or a Tax Court judge.  It seems unlikely in the case of Amazon’s CSA that the IRS would have paid any attention to a CUT at the examination level, given the strong motivation within the IRS to re-litigate Veritas.  Nonetheless, CUT’s remain a valuable commodity to be mined and stockpiled for use in appropriate circumstances.

Not only was Amazon’s transactional data important in building its case in favor of the buy-in payment value, its Code §41 credit cost detail proved useful in substantiating the company’s claim that a significant class of expenses should not be classified as intangible development costs and shared with other CSA participants.  This is another good example of seeking the data required within the company’s records before reinventing the wheel.

An open question in the case is the treatment of employee stock option costs in a CSA.  This question will have to wait for the outcome of the IRS appeal in Altera.[3]

Pending a successful outcome in Altera, two theories used by the IRS to attack a technology company CSA could be blunted.  To the extent that IRS estimates regarding the size of the tax gap rely on large income windfalls from litigating CSA positions of high-tech companies, Amazon could prove to be an early indication that these estimates require a downward adjustment.

[1], Inc. & Subsidiaries v. Commr., T.C., 148 T.C. No. 8 Docket No. 31197-12.

[2] Veritas Software Corp. v. Commr., T.C., 133 T.C. 297 (2009).

[3] Altera Corp. v. Commr., T.C. 145 T.C. No. 3 (2015).

TRANSFER PRICING NEWSLETTER is provided as a free service to clients and friends of Cadesky Tax. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing a tax planning arrangement or taking an uncertain tax filing position. Cadesky Tax cannot accept any liability for the tax consequences that may result from acting based on the contents hereof.

Is the CRA skipping dinner in the hope of getting its deserts? Digesting the “new” Canadian transfer pricing documentation standard

The CRA was recently asked “Will the CRA’s expectations of the “reasonable efforts” that a taxpayer must make to determine and use arm’s length transfer prices include the preparation of transfer pricing documentation that is consistent with the recommendations from the OECD in Action 13 of the BEPS initiative (i.e. Master File and Local File transfer pricing documentation)?

This is a reasonable question to ask in view of the years of work of the Canadian government delegates to the OECD Base Erosion and Profit Shifting Project (BEPS), and the endorsement of the final BEPS Project Action 13 Report by the Government of Canada in the latest federal budget.  Perhaps some were expecting harmonization with the new international norm, or more precise guidance on how to avoid penalties than can be found in the current six bullet points in paragraph 247(4)(a) of the Income Tax Act and a smattering of guidance.  The response suggests something different altogether.

Answer: “The CRA considers that BEPS Action Item 13 has been dealt with by the introduction of proposed section 233.8 of the Act relating to Country-by-Country Reporting. The “reasonable efforts” requirement is based on the legislation contained in section 247 of the Act, in particular the requirement to produce “contemporaneous documentation” in accordance with subsection 247(4). Proposed section 233.8 has no direct relation to section 247 and does not include a specific requirement to produce a “local file” or “master file”. As such, the CRA has not altered its criteria regarding whether a taxpayer has made reasonable efforts to determine and use arm’s length transfer prices.

Like a quietly disappointed restaurant patron wishing to be left alone to finish her mediocre dish, the CRA was in effect asked how it was enjoying its meal of the OECD’s new transfer pricing documentation guidelines.  Its response suggests local file and master file requirements were too much of an acquired taste, and the CRA has now sent those items back to the kitchen.  The diner’s overall response of “Fine…” derives only from the great pleasure the Agency may expect from a dessert of Country-by-Country reports, and from being able to claim the OECD confection has been adopted and was a good choice for Canada.

The prospect of the empty calories from the Country-by-Country data tables must be too thrilling to risk filling the stomach with the main course, as many other tax authorities are learning to do.  (CbC reports, like desserts, contain relatively little nutritional value, and are only intended to look at for risk assessment purposes, not to make a meal of for easy reassessment calculations.)  A feast of taxpayer data and a maintained state of uncertainty keeps the playing field tilted in favour of the CRA.

Many foreign tax authorities have adopted the Action 13 report as a whole as well as other new transfer pricing principles, in line with the intentions of their finance ministers.  Many tax administrations have also taken on board the updated OECD Transfer Pricing Guidelines.  These tax authorities will require the master file from foreign subsidiaries of Canadian-parented companies as part of their documentation requirement.  It will be burdensome for Canadian taxpayers to have to produce more documentation than is ostensibly needed (and risk creating more than one set of facts when double tax cases arise).  An opportunity to mitigate the median taxpayer’s burden has clearly been passed up.  The “new” documentation burden will fall disproportionately on Canadian companies with worldwide net sales under $ 1 billion (approximately €750M at today’s exchange rate) that do not have to file a CbC report, but also do not have extensive tax departments.  These mid-sized and smaller companies must now contend with the compliance cost of the CRA double standard.

If the CRA can ignore adding parts of the BEPS Project transfer pricing reports  to Canadian transfer pricing rules (despite those additions being endorsed by the most recent federal budget), one might ask what will be ignored next.  The CRA has stated publicly that it already takes similar positions to those set out in writing in the various BEPS transfer pricing final reports, making it seem the international guidance is of diminished value in Canadian transfer pricing matters.  Will the CRA adopt the OECD Guidelines as updated by the BEPS project, or stick with the 2010 version it finally recognized in October 2012?  The historical approach suggests it is appropriate to avoid setting down the CRA position in writing for some time.  Perhaps the CRA is waiting for the U.S. Department of the Treasury to walk away from the BEPS Project consensus after Donald Trump enters office, is hedging its bets in anticipation of several Tax Court decisions, or is really more interested in penalties and reassessments than encouraging compliance.

Taxpayers that have wondered “How good is good enough?” when it comes to interpreting the Canadian documentation requirement will continue to be offered a diet of junk food by the CRA and asked to keep guessing.  Unfortunately for taxpayers, the real rules are off the menu and appear only when requested directly by professional tax advisors.  Taxpayers owe the Canadian Tax Foundation a debt of gratitude for this revelation.

Canadians are known the world over for many great traits, but in taxation are increasingly known for picking the luke-warm bowl of porridge.  The made-in-Canada approach (or compromise) is also a favourite.  Companies will need to carefully consider how to approach this particular tepid bowl of Canadian porridge.

TRANSFER PRICING NEWSLETTER is provided as a free service to clients and friends of Cadesky Tax. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing a tax planning arrangement or taking an uncertain tax filing position. Cadesky Tax cannot accept any liability for the tax consequences that may result from acting based on the contents hereof.

A new way to do the splits: BEPS draft guidance falls short of enabling global formulary apportionment

This article also appears in INSIGHTS vol 3 no 7 published by Ruchelman PLLC (

It takes considerable training and the right physical conditioning to successfully do the splits and avoid injury or embarrassment.  For those who view transfer pricing as a gymnastics sub-discipline, applying a profit split method is often an approach of last resort and is arguably as difficult to accomplish in a graceful manner as the gymnastic feat.  Since the BEPS (Base Erosion and Profit Shifting) Project began in 2013, a key focus the revision of the OECD guidance that multinational companies and tax authorities use to apportion income resulting from the joint commercialization of intangible assets within a multinational group.  The unwelcome, and potentially widespread, ex-post use of profit split methods as proxy for global formulary apportionment was viewed by corporate taxpayers and commentators with the same sense of dread as a surprise gymnastics skills test.

However, it would appear that companies can relax somewhat after the July 4 publication of the OECD Revised Guidance on Profit Splits discussion draft.  The discussion draft links other transfer pricing developments in the BEPS Project[1] to the guidance on the application of the transactional profit split method, but it does not propose to place an over-broad profit apportionment tool in the hands of tax authorities.

Like a gymnastic maneuver, successful application of the transactional profit split method requires a full understanding of risk – in this case economically significant risk incurred by the participants in the relevant business opportunity.  The transactional profit split method is one of five transfer pricing methodologies set out in Chapter II of the OECD Guidelines.  In cases where controlled taxpayers participate in highly integrated operations and contribute valuable intangible assets in respect of a joint business opportunity, the profit split method is used to split the profits or losses from the combined activity on an economically valid basis to approximate an arm’s length return to the respective contributors.

Not unlike the provisions of Treas. Reg. §1.482-6, the transactional profit split may be applied using either the more direct contribution analysis or the more indirect residual analysis (i.e., routine profits to the associated enterprises are determined first, and then deducted from the actual pooled profit to determine the residual profit to split).  The transactional profit split method can also be used in conjunction with a valuation method to estimate the value of an intangible asset transferred from one controlled taxpayer to another.

In contrast to the Treas. Reg. §1.482-6 method, the OECD Guidelines allow for the splitting of either anticipated or actual profit.  The discussion draft adapts the OECD Guidelines profit split by incorporating the changes to Section D.2.6.2 of Chapter VI that discuss how to reliably estimate anticipated profit from an intangible asset.  The draft properly points out that appropriate use of the transactional profit split method uses a profit split metric determined in advance of the knowledge of the actual profit to be divided between the two parties.  This serves as a reminder to companies of the evidentiary value of intercompany agreements – used in this instance to demonstrate taxpayer intent and to clearly set out the way in which a split of unanticipated profit will be calculated in the future.  The fact that an agreement is required to manage the uncertain outcome of a business activity where risk is shared, in and of itself, reinforces the appropriateness of a profit split method.

The use of the transactional profit split method based on the combined actual profits of the contributing parties is linked to the control exercised by those parties over the economically significant risks associated with the combined business.  The transactional profit split method may, therefore, not be appropriate in circumstances where the risks of the combined business are not separately or collectively controlled by the participants, or where each party does not have the financial capacity to assume its proportional share of the risk.  The evaluation of control over risk should be carried out annually, as actual profits are intended to be split each taxation year under the transactional profit split method.

This limiting control condition arises from the work completed by the BEPS Project, to date, on transfer pricing issues relating to intangible assets.  Interestingly, this new limitation on attribution of profit from intangible assets to only those entities exercising control over risk and possessing sufficient financial resources to mitigate risk circumscribes the authority of tax administrations to use the transactional profit split method in a formulary way, as was feared by many BEPS Project observers.

Some useful guidance appears in the discussion draft to differentiate a reliable profit split from a less graceful version.  Parties must “share the same economically significant risks”[2] associated with the combined business activity or “separately assume closely related risks”[3] associated with the same activity.

The term “economically significant risks” is explained in the revised Chapter I of the OECD Guidelines[4] as being those factors that cause the anticipated objectives or outcomes of the business activities for the contributing parties to vary to the greatest degree.  Strategic risks, marketplace risks, infrastructure risks, operational risks, financial risks, transactional risks, and hazard risks are suggested as the principal (though not the only) types of risk to consider.

There is, therefore, a less reliable profit split where

  • the economically significant risks have not been specified,
  • the nature of the contributions of the parties has not been accurately determined,
  • an evaluation of how those contributions influence profit outcomes has not been made,
  • the profits to be split have not been reliably identified, and
  • the basis for splitting the profits has not been reliably determined.

In certain cases, tax authorities (and sometimes companies) choose to skip the difficult work of comparability analysis or comparability adjustments, and apply the profit split method.  The discussion draft acknowledges a shortage of comparables may exist in practice, but it warns that a lack of comparables alone does not justify the use of the transactional profit split method.  Rather than stretching to apply the transactional profit split method, the discussion draft suggests that the use of a different method (inexact comparables) and well-supported comparability adjustments may result in a pricing outcome that better approximates an arm’s length result.

Similarly, the discussion draft sets out limitations, concerning integrated operations, unique and valuable contributions of intangible assets, and group synergies to the use of the transactional profit split method, in order to promote the responsible use of this transfer pricing method.  The mere appearance of integrated operations is stated as an insufficient condition for the application of the profit split method.  A careful functional analysis and an understanding of the company’s value chain is required to establish whether it is truly the case that the functions of company participants are so integrated that an intercompany transaction cannot be reliably delineated and perhaps priced using a more reliable methodology.

Finally, the discussion draft clarifies that treatment accorded to profits resulting from group synergies should differ from the treatment of profit resulting from the commercialization of intangible assets.  The benefits or cost savings connected with group synergies are termed “marginal system profits,” which should not be included in the “total system profits” to be divided using the transactional profit split method.

Room for disagreement exists with regard to the definition of a unique or valuable intangible asset, the degree to which a risk is economically significant, the importance of location savings, and the way market characteristics figure into a profit split analysis between a company based in a country with a developed economy and a related party with operations in a country with an emerging economy.  Nonetheless, the focus of the OECD guidance on intangible assets has been sharpened significantly, thereby reducing uncertainty for all.

[1] See, e.g., OECD, Aligning Transfer Pricing Outcomes with Value Creation, Actions 8-10 Final Reports, (OECD Publishing, Paris: 2015) (the “OECD Guidelines”).

[2] OECD, Public discussion draft, BEPS Actions 8 – 10, Revised Guidance on Profit Splits, (OECD Publishing, Paris: 2016), para. 16.

[3] Id.

[4] Supra note 1, Section D., pp. 25-28.

TRANSFER PRICING NEWSLETTER is provided as a free service to clients and friends of Cadesky Tax. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing a tax planning arrangement or taking an uncertain tax filing position. Cadesky Tax cannot accept any liability for the tax consequences that may result from acting based on the contents hereof.

Mind the $2 billion gap – Medtronic decision for the taxpayer favors pricing transactions over profit split

The U.S. Tax Court recently decided for the taxpayer in a $2 billion transfer pricing adjustment imposed by the IRS [Medtronic, Inc. v. Commissioner, T.C., No. 6944-11, T.C. Memo No. 2016-112].  At issue was the pricing of two licenses – one in respect of medical device technology, and one covering the Medtronic names and marks – and which transfer pricing method is the best method to apply under Treasury Regulations § 1.482-4.

Medtronic took the approach of looking to uncontrolled licensing transactions for support in applying the Comparable Uncontrolled Transaction (CUT) method, while the IRS used the Residual Profit Split Method (PSM).  Broadly speaking, the CUT prices the transaction directly in a manner that follows how most third parties make IP deals.  The PSM, on the other hand, splits the system or joint profit left over after allocating a basic return to the contributions of the transaction participants.  The art in the PSM is deciding how most reliably to split the profit that’s left over – a value that can be large where valuable intangible assets are used in a business at scale.  Reasonable people can disagree over works of art.

The difference between the outcomes of two approaches was colossal (no, that 59% royalty rate was not a typo), even after the dispute had been through the IRS audit process for some time.  To an experienced transfer pricing economist, a large difference in the results obtained from more than one transfer pricing method means only one thing.  An error or errors, a questionable assumption, a data problem, or incomplete information.  In this instance, the experts for the petitioner and the respondent were not of much help to the judge in exposing the reasons for the gap between the two positions.  The judge was left to go back to the complex facts and make her own decision – as has been the case in other transfer pricing trials.

Without spending considerable time determining whether the taxpayer’s approach was reasonable, the decision dismantles the IRS PSM analysis thoroughly, relying on the facts rather than the assumed consequences of company characterization clichés –  “contract manufacturer”, “limited risk”, “routine intangibles”, etc.

The decision sounds a warning for those currently parroting the undefined OECD term “value creation” as a determinant of the location of company profit.  The court found the IRS “value chain” analysis to have no standing as a transfer pricing method, and relied on a misinterpretation the business facts to fit the theory of the PSM approach.  Alternatively, the decision evaluates what attributes made Medtronic’s products worth purchasing and paying for (and also less worth purchasing and paying for) to its physician and patient customers.  A causal connection was found between market share and market pricing, product quality outcomes, and the companies, departments and employees that contributed to an effective and safe product, final assembly and product sterilization, final quality checks.  The decision also carefully identified which companies incurred losses when implanted products failed or were recalled, and used this information in its comparability analysis.

Underlining the importance of good intercompany agreements, the decision relied on the intercompany contracts the parties had concluded to explain their responsibilities and the division of liability in the event of a quality problem.  The contracts could be relied on, as the contractual terms matched the actions of the parties.

This taxpayer win, which may yet be appealed, is instructive for companies that must perform a best method analysis under US tax law, encouraging to companies now experiencing an unexplained IRS breach of an agreement on the method of determining true taxable income, and foreshadows the release of controversial OECD guidance on the application of profit split transfer pricing methods.

TRANSFER PRICING NEWSLETTER is provided as a free service to clients and friends of Cadesky Tax. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing a tax planning arrangement or taking an uncertain tax filing position. Cadesky Tax cannot accept any liability for the tax consequences that may result from acting based on the contents hereof.

Canadian transfer pricing rules – scattered from far and wide

The recent March 22 budget announced an update of the transfer pricing guidance used by the CRA.  The main change was the adoption of the revised OECD Transfer Pricing Guidelines, last amended in October 2015 as a result of the OECD/G20 BEPS Project.  While this guidance does not have the force of law, it is used by the CRA in transfer pricing audits as well as selectively by Canadian courts.

This announcement itself is noteworthy only in its timing, given CRA has deviated somewhat from the international consensus on the implementation of the BEPS Project results.  More notable is that Canadian transfer pricing guidance is now scattered across 22 documents – add a few more for large companies required to file a Country-by-Country report.  This count does not include the law or transfer pricing decisions from the courts, which are critical to consider.

The result will be awkward and time-consuming reading until the OECD Guidelines are properly reissued in the next few years after the conclusion of further work.

In the long-run, taxpayers and their advisors should ideally be able to reference two or three documents, in addition to relevant jurisprudence.  We’ll update you once we get there.

TRANSFER PRICING NEWSLETTER is provided as a free service to clients and friends of Cadesky Tax. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing a tax planning arrangement or taking an uncertain tax filing position. Cadesky Tax cannot accept any liability for the tax consequences that may result from acting based on the contents hereof.

Is the CUP half empty?

In its recent decision in Marzen Artistic Aluminum Ltd. [2016 FCA 34], the Federal Court of Appeal upheld the Tax Court’s use of a contract between two independent parties as a Comparable Uncontrolled Price.[1]  One of those independent parties was a participant in the related-party transaction whose pricing was at issue, and the other was a management company.  Is Marzen Aluminum the new exception in the rationale for the use of the CUP method, or the new rule (in Canada, at least)?

Suppose Canadian corporation A is related to non-resident corporation B, and A contracts with B to perform a single type of service.  B then contracts with C, an independent non-resident individual or corporation to provide substantially all the same types of services that B is obligated to provide to A.  B can meet its obligation to A by hiring no further resources other than C.

Should the price charged by C be used to set the transfer price charged by B?  Though both the Tax Court and the Federal Court suggest this approach makes sense, the facts of Marzen Aluminum were unique, meaning this approach might not always apply.  Comparability standards set out in the OECD Transfer Pricing Guidelines require that the correct answer to this question should address both the facts of the transaction and the economic circumstances of the transacting parties.

The utility of the Marzen Aluminum decisions is limited for two main reasons.  First, as different services were rendered by B and C involving fundamentally different risks, any comparability analysis is arguably of limited future value.  Second, the ranking of transfer pricing methodologies that once held the CUP method to be the most reliable has been replaced by the more objective ‘most appropriate method’ approach introduced in the 2010 version of the OECD Guidelines.  The standard of comparability required to use the CUP reliably has increased between 1995 and 2010.

Marzen Aluminum may suggest that pricing a related-party transaction using the CUP method now leads to greater uncertainty, or that the CRA can now successfully rely on a bygone standard.  If accepted comparability standards and analytical rigour are employed, the CUP will remain half-full.  Using another transfer pricing method?  It may runneth over the CUP.

[1] CUP – one of the five transfer pricing methods accepted by the Canada Revenue Agency and other tax authorities

TRANSFER PRICING NEWSLETTER is provided as a free service to clients and friends of Cadesky Tax. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing a tax planning arrangement or taking an uncertain tax filing position. Cadesky Tax cannot accept any liability for the tax consequences that may result from acting based on the contents hereof.

New transfer pricing guidance from the OECD – A Hitchhiker’s Transfer Pricing Guidelines to the Galaxy

The October 5, 2015 releases from the controversial OECD/G20 BEPS Project are finally here.  While there is still work to do on a number of the transfer pricing matters, companies now know what will be considered by tax authorities in modernizing country transfer pricing rules and guidelines.

The outcomes of the BEPS project, on one hand, mean nothing quite yet.  The OECD has issued tax policy and guidelines.  For these guidelines to be meaningful there must be formal adoption under the law.  The G20 members and other BEPS Project participants are committed to proceeding from policy to implementation.  An appropriate reaction might follow Ford Prefect’s mantra: “Don’t panic”. 

Companies can be fairly certain that the new guidance will be followed reasonably closely by G20 member states and others.  It’s therefore good to be prepared like Arthur Dent (who always knows where his towel is) for an eventual meeting with the Vogons of the world’s tax administrations under the amended OECD Transfer Pricing Guidelines.  After all, a number of countries have already started enacting BEPS-inspired legislation, and adopting BEPS-like administrative positions.  Here is what the future looks like, in brief, and from a high altitude:

  • A related party transaction will be priced given what it is (or can be proven to be) in fact, not what it says it is on paper. Contracts will be respected if their terms are the same as actual expectations or outcomes.  Well drafted contracts are now essential, not optional.
  • Risk connected with a related-party transaction can be moved or reassigned by tax authorities between related companies where an entity does not demonstrate control over risk. This will mean having appropriate people making investment decisions and managing and controlling the resulting risk over the lifespan of the investment.
  • Capital at risk without control over risk occurring in the entity that invests the capital, with only limited exceptions, will attract only a risk-adjusted return.
  • Intangible assets are now defined more broadly. Location savings and market characteristics, argued by China and India to be intangible assets, are now important comparability factors to consider as determinants of price or profit.  One-sided approaches that give all intangible returns to one or few group companies will have to be reviewed under the new guidance.
  • Valuations of intangible assets and contributions of intangible assets to cost sharing arrangements will receive considerably more scrutiny, and will be revised in certain circumstances after the transaction has occurred if forecasts and actuals differ by more than 20%.
  • The arm’s length principle will continue to apply. However, more work is being done on profit split techniques at the OECD.  Companies will have to present more robust transfer pricing analyses using an OECD method to convince a tax authority that the profit split is not the most appropriate method to apply.
  • Transfer pricing documentation requirements will become more onerous and detailed in most countries, and a ‘master file’ describing the worldwide business will need to be produced and kept up to date and on file.
  • Country-by-country reporting requirements begin to take effect in 2016 for large corporations with global revenues exceeding €750 million. Tax authorities will have more data to use in assessing transfer pricing and other risk, and will have to guarantee data security and responsible use.
  • Different countries will read and interpret the 186 pages of guidance and examples issued on October 5 differently. Just as transfer pricing disputes between tax authorities and taxpayers is expected to increase, so too will the resulting number of double taxation cases to be resolved between countries.  Tax authorities are generally not well prepared to handle the expected significant increase in cases.  Expect double tax to persist for a longer period of time.  The OECD continues work on dispute resolution procedures and tools.

In the real Hitchhiker’s, a computer called Deep Thought is designed to calculate the “Answer to the Ultimate Question of Life, The Universe, and Everything”.  After 7.5 milion years, the answer that resulted was 42 (it should have been 54).  The OECD took 2 years to answer a slightly less difficult question about international tax.  Don’t panic.

TRANSFER PRICING NEWSLETTER is provided as a free service to clients and friends of Cadesky Tax. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing a tax planning arrangement or taking an uncertain tax filing position. Cadesky Tax cannot accept any liability for the tax consequences that may result from acting based on the contents hereof.

Making popcorn from a kernel of truth – Does the U.S. Tax Court decision in Altera have broader consequences?

The U.S. Tax Court’s recent decision in Altera v. Comr. affirmed that that the arm’s length standard controls over another specific regulatory provision, in this case the commensurate-with-income standard of Treas. Reg. 367(d).  The decision in Altera found that stock-based compensation is not an expense that should be pooled and shared under a qualifying cost sharing arrangement.

Altera’s support for its position was largely empirical, and stood on the shoulders of the case built in Xilinx for exclusion of stock-based compensation from a cost pool in a cost sharing arrangement.  This empirical evidence consisted of a number of joint venture and other collaboration agreements submitted by commentators to the 2003 proposed cost sharing regulations.  The Tax Court was persuaded that not only is stock-based compensation not shared between cooperating independent parties; it held that stock-option expense should not be considered as an element of the comprehensive set of costs considered by Treasury to be “relevant costs” in a qualifying cost sharing arrangement.

These agreements included certain elements of labor compensation that parties to the agreements consented to share, but did not include stock-based compensation among those expenses.  Agreements from the software industry, comparable to the industry in which Altera operated during the years at issue were produced and viewed as sufficiently comparable to the Altera arrangement at issue. These agreements proved persuasive in Altera, and served to amplify the effect of the failure of Treasury to consider the submissions from commentators to the 2003 proposed cost sharing regulations.

Neither Treasury, as part of its finalization of the 2003 regulations, nor the IRS in Altera produced evidence of an agreement between third parties that included stock option cost.  Proof of arm’s length behaviour with respect to stock option expense was therefore delivered in the form of a negative empirical result.

To rebut the arguments advanced by the taxpayer, the IRS relied on the commensurate-with-income standard, and did not present any expert opinion that supported its position that stock-based compensation must be included in the cost pool of a qualifying cost sharing arrangement to achieve an arm’s-length result.

If the U.S. Tax Court can strike down regulations that are not consistent with the arm’s length standard, one might think about the prospects for other aspects of Treasury Regs. Section 482 that are not based entirely on empirically supported independent corporate conduct, or consistent with the definition of the arm’s length standard in Section 482-1(b)(1).  Some areas to consider might be:

  • The empirical support for the factor of 1.3 used in Section 482-2(a)(2)(iii)(B)(1) to set arm’s length interest rates based on the AFR, or the use of the AFR more generally
  • The relevance of the lists of specified covered services, excluded activities, or the concept of low-margin covered services in the Section 482-9 services regulations when compared with documented business practices concerning the price of certain services types
  • Joint venture arrangements or other transaction evidence used as comparables for intangible assets transactions that do not depend on a valuation technique akin to the income method


Oddly, this self-criticism may be good for the U.S. Treasury Department at a time of threat to the arm’s length standard from the G20/OECD BEPS project, which is due to report finally on October 5, 2015.  The Treasury Department has consistently debated the proposed use of a ‘special measure’ resembling the commensurate-with-income standard to effect post-transaction value adjustments in the case of “hard-to-value” intangible assets.  Temporary 482-1 Regulations issued September 14 however attempt to reconcile intangible asset expatriation transactions under Section 482 and Section 367.

Let’s hope that Altera has served as a useful caution to the OECD BEPS project, and shown that that country rules that depart from the arm’s length principle and that are based on the OECD transfer pricing guidelines will be subjected to litigation challenge, with the possible unwelcome result that the general OECD guidance will be undermined. 

If the arm’s length principle is to survive, as is widely expected, careful analysis and empirical support will be critical to supporting a transfer pricing position.  The beliefs of taxpayers and tax administrations about what transacting parties would or would not do, mechanical or categorical rules, and simple statements of principle may well lose out to good evidence more often in the future.

 *Portions of this article appeared in a co-authored article published in the Ruchelman PLLC August 2015 Insights newsletter.

TRANSFER PRICING NEWSLETTER is provided as a free service to clients and friends of Cadesky Tax. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing a tax planning arrangement or taking an uncertain tax filing position. Cadesky Tax cannot accept any liability for the tax consequences that may result from acting based on the contents hereof.

Rowing with only one ‘or’ in the water, as the interpretation of section 247(2) remains unclear

On June 12, the Federal Court of Appeal issued its decision on a motion brought by Cameco in an ongoing transfer pricing case.

The Federal Court of Appeal ordered the Crown to communicate to Cameco “its position as to the arm’s length price or prices at which Cameco and CEL ought to have purchased/sold uranium transacted between them during the 2003 taxation year or a formula which allows Cameco to identify this price or these prices”.  One would normally assume that in a transfer pricing dispute, the positions of CRA and the taxpayer on the price of the transaction in question would include an indication of the price each side believes is arm’s length.  The Cameco case shows that in the topsy-turvy world of Canadian transfer pricing, this cannot be assumed.

The CRA reassessed Cameco under paragraph 247(2)(a), paragraph 247(2)(b), Section 56(2), and by alleging the Cameco transaction structure was a “sham intended to conceal the fact that all income earning activities were performed in Canada”.

Section 247(2) allows the CRA to make an income or capital adjustment where paragraph (a) or paragraph (b) applies.  Paragraph (a) applies where the terms and conditions of the transaction or series are non-arm’s length.  Paragraph (b) applies where the transaction or series meets two conditions, namely: (i) the transaction or series would not have been entered into between persons dealing at arm’s length and (ii) the transaction or series “can reasonably be considered not to have been entered into primarily for bona fide purposes other than to obtain a tax benefit”

Where only paragraph (a) applies, the terms and conditions made or imposed, paragraph (c) then applies to re-price the transaction or series.  Where paragraph (b) applies, paragraph (d) then applies to replace the original transaction or series with a different transaction or series that would have been carried on between arm’s length parties, and then use the price from that different transaction or series to price the related-party transaction.

We could just describe the relationship between paragraphs (a) through (d) as follows:

If (a) implies (c) and (a) is true, then (c) is true

If (b) implies (d) and (b) is true, then (d) is true

If (b) implies (d) and both (a) and (b) are true, then (d) is true

But if a company or partnership were to follow the logic above, it may be out of step with the Tax Court of Canada in General Electric Canada and current CRA assessing practice as evidenced in a July 6 proposed reassessment of 2005 to 2010 taxation years of Silver Wheaton.  These interpretations of Section 247(2) suggest that both (a) and (b) can be true in a certain circumstance or that the distinction between them is blurred, opening what appears to be a route to replace a mispriced transaction with a different transaction as opposed to changing the price of the original transaction as follows:

If (b) implies (d), and either both (a) and (b) are true or (a) is the same as (b), then (a) implies (d)

Meeting the two-part test of paragraph 247(2)(b) is difficult, as is making the argument for an arm’s length price under 247(2)(c).  A logical bypass of paragraphs 247(2)(b) and (c) (or at least 247(2)(b)) is therefore a solution that CRA may find worthwhile to attempt.  This may be an attractive option when compared with a legislative amendment to include a rule with two ‘ors’ – (a) or (b) or ((a) and (b)) – that sets out the consequences to taxpayers of meeting these conditions.

Cameco is defending its position vigorously through uncertain territory.  In fairness, the CRA and the Tax Court are not alone in experiencing difficulty reasoning through the distinction between substituting an arm’s length price and substituting an arm’s length transaction when non-arm’s length conditions are found to have been used to determine taxable income.  This issue is the subject of the hotly debated and incomplete BEPS Actions 8, 9 and 10.

As we wait for the Cameco trial and decision, companies should treat Section 247(2) transfer pricing proposals of zero adjusted price, zero adjusted profit, and claims about what arm’s length parties would or would not do with professional skepticism, and consult a transfer pricing advisor.

THE NON-ARM’S LENGTH NEWS is provided as a free service to clients and friends of Cadesky Tax. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing a tax planning arrangement or taking an uncertain tax filing position. Cadesky Tax cannot accept any liability for the tax consequences that may result from acting based on the contents hereof.