Secondary transfer-pricing adjustments

By Sean Foley, J.D., LL.M., and Saurabh Dhanuka, CPA, Silicon Valley, Calif.

Editor: Mary Van Leuven, J.D., LL.M.

Taxpayers facing transfer-pricing adjustments should be aware of rules requiring secondary adjustments. The purpose of these adjustments is to resolve discrepancies that arise from primary and corresponding adjustments. A primary adjustment occurs when a tax authority or a taxpayer adjusts taxable profits as a result of applying the arm's-length principle to transactions between related parties. A corresponding adjustment is the offsetting income reduction in the counterparty jurisdiction. Typically, getting a corresponding reduction to be recognized by the tax authority of the second tax jurisdiction affected requires a mutual agreement procedure (MAP) case under an income tax treaty.

A secondary adjustment reflects an inferred secondary transaction that resolves the discrepancy caused by the primary adjustment and the corresponding adjustment between the taxpayer's cash accounts and tax accounts. More specifically, the inferred secondary transaction is deemed to have taken place to produce the result that, if the primary transaction had been conducted at arm's length, the outcome in the cash accounts would be identical to the actual profit allocation between the related parties.

Secondary transfer-pricing adjustment rules vary among tax jurisdictions, and in fact, most jurisdictions do not impose secondary adjustments. For example, the United States, Canada, Germany, and India have secondary adjustment rules, but the United Kingdom, Japan, and Australia do not. This item focuses on the United States and rules promulgated under Regs. Sec. 1.482-1(g)(3) and Rev. Proc. 99-32. A global survey of secondary adjustment rules is provided by Foley, Taheri, and Sullivan, "Country-by-Country Survey of Global Secondary Adjustment Rules," 103 Tax Notes International 29 (July 5, 2021).

As discussed below, an inferred secondary transaction may be in the form of a deemed dividend, a deemed capital contribution, or a deemed loan.

Deemed dividend

For example, suppose a primary transfer-pricing adjustment increases the taxable income of a U.S. company. If the related party that recorded the excess income prior to the primary adjustment owns stock directly or indirectly in the U.S. company (e.g., a foreign parent company), then a deemed transaction that results in an identical outcome in the cash accounts would be a dividend distribution from the U.S. company to its related party. (See the diagram "Resolve Discrepancy Between Tax Accounts and Cash Accounts Through Secondary Adjustment," below.) The deemed distribution may have tax consequences. Under Sec. 881, the related party would be subject to a 30% tax liability on the distribution, and under Sec. 1442, the U.S. company would be a withholding agent required to withhold the tax.


Deemed capital contribution

In contrast, if the U.S. company directly or indirectly owned stock in the foreign related party, then a deemed transaction that results in an identical outcome in the cash accounts would be a capital contribution from the U.S. company to its related party. The deemed contribution increases the U.S. company's basis in the related company's stock and can have an impact on subsequent distributions and capital gains income recognizable and reportable by the U.S. company.

If the U.S. company and the foreign related party are not related by direct or indirect stock ownership (e.g., "sibling companies" with a common stockholder or parent company), then a deemed transaction that results in an identical outcome in the cash accounts would involve both a distribution and a subsequent capital contribution. This would entail the direct and indirect tax consequences associated with the same. (In some jurisdictions, however, a distribution or contribution may be deemed directly between the parties regardless of the ownership structure; see Foley, Taheri, and Sullivan for further details.)

Deemed loan

An alternative characterization of a secondary transfer-pricing adjustment is a deemed loan. The taxpayer may treat the entity in the jurisdiction in which taxable income is increased by the primary transfer-pricing adjustment as having made a loan to the related party. The repayment of the loan to the entity with the increased income matches the cash and tax accounts. Importantly, as the repayment of a loan does not create income or a deduction, this deemed loan transaction together with the actual repayment eliminates most tax consequences of the secondary adjustment, particularly any withholding tax associated with a deemed dividend. In the United States, this characterization may be allowed under certain conditions in accordance with Rev. Proc. 99-32. The deemed loan must be repaid within a certain period, typically 90 days from the primary adjustment, and interest must be recognized over the deemed period of the loan, i.e., from the last day of the year to which the primary adjustment relates.

Direct and indirect tax consequences of secondary transfer-pricing adjustments may be different depending on the jurisdiction of the related party, any applicable income tax treaties, or mutual agreements. The introduction of the U.S. participation exemption system as part of the law known as the Tax Cuts and Jobs Act, P.L. 115-97, may in certain cases mitigate adverse effects of secondary transfer-pricing adjustments. For instance, Sec. 245A may allow U.S. corporations to deduct 100% of dividends received from 10%-owned foreign corporations other than passive foreign investment companies. As a result, when the participation exemption applies, U.S. taxpayers may be able to avoid income tax on the inbound deemed dividend or a subsequent repatriation of the outbound deemed capital contribution.

Secondary adjustments are a highly technical and nonintuitive area of transfer pricing. In the United States, transfer-pricing adjustments typically create secondary adjustments. Taxpayers need to know about these secondary adjustments, understand the tax consequences, and consider possible planning opportunities, including those involving repatriation under Rev. Proc. 99-32. (See the diagram "Resolve Discrepancy Between Tax Accounts and Cash Accounts Through Cash Repatriation," below.)



Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.

For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or

Contributors are members of or associated with KPMG LLP.

The information in these articles is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of Section 10.37(a)(2) of Treasury Department Circular 230 because the content is issued for general informational purposes only. The information is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. The articles represent the views of the author or authors only, and do not necessarily represent the views or professional advice of KPMG LLP.

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