If you’re conducting business overseas, it’s important to understand how the IRS approaches international tax issues. Fortunately, the Large Business and International (LB&I) division of the IRS publishes international practice units (IPUs)—slide decks that serve as job aids and training materials for IRS staff on various international tax issues.
Although IPUs can’t be used, cited, or relied upon as official directives or pronouncements of law, they’re nevertheless a great tool for taxpayers—and their advisors—to gain insight into the IRS’s audit approach regarding various international tax issues.
LB&I began publishing IPUs in December 2014. To date, they cover a wide range of international tax issues—from general overviews of major topics to detailed explanations of specific technical areas.
This article focuses on two of the most recent IPUs (“Three Requirements of IRC 482” and “Taxpayer’s Affirmative Use of IRC 482”) that serve as useful reminders to taxpayers of some very basic tenets of US transfer pricing rules under Internal Revenue Code (IRC) Section 482.
Three Requirements of IRC 482
IRC Section 482 allows the IRS to make allocations to ensure taxpayers clearly reflect income attributable to controlled transactions and to prevent the evasion of taxes. The IPU entitled “Three Requirements of IRC 482,” released April 6, 2016, goes over three basic prerequisites found in the statutory language of IRC Section 482. For the IRS to apply the US transfer pricing rules:
- There must be two or more organizations, trades, or businesses. This rule applies regardless of whether they’re incorporated or organized in the United States, or part of an affiliated group. For these purposes, the term organization, trade, or business is defined very broadly. An “organization” is one of any kind—including sole proprietorships, partnerships, trusts, estates, associations, or corporations; even tax-exempt organizations are included in the definition. A “trade or business” means a trade or business activity of any kind—regardless of place of operation, whether or where it’s organized, and whether it’s owned individually or otherwise.
- There must be common ownership or control, either direct or indirect. The US transfer pricing rules include a very broad definition of what constitutes control. For these purposes, control includes any kind of control—direct or indirect, legally enforceable or not, and however exercisable or exercised. It includes control resulting from the actions of two or more taxpayers acting in concert or with a common goal or purpose. It’s the reality of the control that is decisive, not its form or the mode of its exercise. In other words, it’s actual, practical control rather than any particular percentage of stock ownership. A presumption of control arises if income or deductions have been arbitrarily shifted.
- The allocation must be necessary to prevent evasion of taxes or clearly reflect income. The IRS has the power to allocate, distribute, or apportion items of gross income, deductions, credits, or allowances between or among two or more controlled organizations, trades, or businesses if it determines such allocation is necessary. Reasons such action could be necessary include preventing tax evasion or clearly reflecting the income of any of the controlled organizations, trades, or businesses. Numerous court cases have decided an IRS allocation will be upheld unless the taxpayer can prove the agency’s determinations were arbitrary and capricious. The IRS’s analysis should consider whether the income, deductions, credits, or allowances are appropriate given the functions performed by the parties.
This IPU also points out that IRC Section 482 applies not only to international transactions, but also to those between two US organizations, trades, or businesses. It’s interesting to note that this IPU didn’t address the rule that income with respect to any transfer—or license—of intangible property must be commensurate with income attributable to the intangible, as stated in the second sentence in IRC Section 482. That rule, commonly known as the commensurate with income standard, was separately addressed in “License of Intangible Property from U.S. Parent to a Foreign Subsidiary,” an IPU released November 4, 2015.
Taxpayer’s Affirmative Use of IRC Section 482
In general, IRC Section 482 can be used only by the IRS. However, taxpayers are allowed to invoke IRC Section 482 in certain scenarios, as outlined in the IPU titled “Taxpayer’s Affirmative Use of IRC 482,” released on May 12, 2016. These scenarios include:
- A timely filed return. While working on the tax return for the prior year, it’s common for a taxpayer to determine that a transfer pricing adjustment is needed because the prices charged during the year on one or more controlled transactions didn’t produce an arm’s-length result. In such circumstances, taxpayers may make an adjustment on a timely filed return—including extension—to correct the transfer prices. The adjustment may either increase or decrease the taxpayer’s taxable income. Corresponding adjustments (known in the regulations as correlative allocations) would also be made to any of the taxpayer’s affiliates affected by the adjustment.
Although not explicitly stated in this IPU, taxpayers should also make an entry to their books so their accounts reflect the impact of the transfer pricing adjustment. In general, those so-called “conforming adjustments” to the taxpayer’s accounts would aim to treat the allocated amount as a dividend or a capital contribution, as appropriate. As outlined in another IPU titled “Revenue Procedure 99-32 Inbound Guidance,” the taxpayer is able—in certain situations—to treat the allocated amount as an account receivable or an account payable.
- An amended return. In appropriate circumstances, taxpayers may be allowed to file an amended return to increase the taxable income resulting from controlled transactions. The IPU emphasizes, however, that taxpayers aren’t allowed to file an untimely or amended return that decreases their taxable income based on allocations or other adjustments with respect to controlled transactions.
- A setoff adjustment. When the IRS proposes a transfer pricing adjustment under IRC Section 482, the taxpayer may claim a “setoff adjustment” to take into account the effect of any other non-arm’s-length transactions. Setoff adjustments are permitted, however, only if the adjustment is made to a non-arm’s-length transaction in the same taxable year between the same parties. In addition, the taxpayer must also satisfy various procedural requirements, including notifying the IRS within 30 days after either the notice of proposed adjustment or the statutory notice of deficiency—whichever is earlier.
Although this particular IPU focuses on the taxpayer’s use of IRC Section 482 on inbound transactions, it also emphasizes that the types of adjustments listed above can be applied to both inbound and outbound transactions.
It’s also important to note that the types of taxpayer-initiated adjustments discussed above could give rise to double taxation. For example, if a US taxpayer self-adjusts its transfer pricing to increase its taxable income, there would be no guarantee the foreign government would allow a reduction to the taxable income of the foreign related party involved in the controlled transaction. This IPU points out that relief from double taxation in such a situation could be available through the mutual agreement process, assuming there’s an applicable income tax treaty.
This IPU also reminds the IRS agent to check to see if the taxpayer made corrections to its US customs declarations (Forms 7501) to reflect any taxpayer-initiated transfer pricing adjustments made for income tax purposes. That’s because IRC Section 1059A effectively prevents US taxpayers from claiming a price on imported goods purchased from a related party for income tax purposes that is higher than the price declared for customs purposes. It’s important for taxpayers to always keep customs issues in mind—from both sides of the controlled transaction—when dealing with transfer pricing issues.
International businesses should keep up with the IRS’s approach to transfer pricing and other international tax issues by continually monitoring the IPUs released by the IRS. All of the IPUs released to date can be found on the IRS’s Web site. If you have any transfer pricing or other international business–related questions, contact your Moss Adams tax professional or e-mail firstname.lastname@example.org.