Transfer-Pricing Arm’s-Length Standard and Transfers of Foreign Goodwill Clarified

The IRS issued temporary and proposed regulations Monday to clarify the coordination of the arm’s-length standard and the best method rule for transfer-pricing purposes (T.D. 9738; REG-139483-13). The temporary regulations require consistent valuation of controlled transactions for all Code purposes and are effective Sept. 14, 2015. The proposed rules narrow the scope of transfers of foreign goodwill or going concern value that are eligible for nonrecognition of gain or income.

Sec. 482 governs transfer pricing and is designed to ensure that taxpayers properly reflect income attributable to controlled transactions and to prevent the avoidance of taxes for such transactions. The standard applied under Sec. 482 is a taxpayer dealing at arm’s length with an uncontrolled taxpayer. A controlled transaction will meet the arm’s-length standard if its results are consistent with the results that would have occurred if uncontrolled taxpayers had engaged in the same transaction under the same circumstances. Sec. 482 authorizes the IRS to adjust the results of controlled transactions to clearly reflect the income of commonly controlled taxpayers in accordance with the arm’s-length standard and, in the case of the transfer of intangible property, so as to be commensurate with the income attributable to the intangible.

While the determination of arm’s-length prices for controlled transactions is governed by Sec. 482, other Code sections and regulations also apply to controlled transactions. Monday’s temporary regulations clarify the coordination of Sec. 482 and those other rules.

In the preamble to the temporary regulations, the IRS says that, based on taxpayer positions it has encountered in examinations, it is concerned that taxpayers are employing an inappropriately narrow analysis of the scope of the transfer-pricing rules in some cases. In particular, the IRS is concerned about situations in which controlled groups evaluate economically integrated transactions on a separate basis in a manner that results in a misapplication of the best method rule and fails to reflect an arm’s-length result.  

For example, taxpayers may assert that, for purposes of Sec. 482, separately evaluating interrelated transactions is appropriate simply because different statutes or regulations apply to the transactions. These positions are often combined with what the IRS considers to be inappropriately narrow interpretations of Regs. Sec. 1.482-4(b)(6), which provides guidance on when an item is considered similar to the other items identified as constituting intangibles for purposes of Sec. 482. The interpretations purport to have the effect, contrary to the arm’s-length standard, of requiring no compensation for certain value provided in controlled transactions despite the fact that compensation would be paid if the same value were provided in uncontrolled transactions.

To avoid these results, the temporary regulations require consistent valuation of controlled transactions for all Code purposes. They also clarify the coordination of the application of Sec. 482 and other provisions in determining the proper tax treatment of controlled transactions. The specific areas covered include:

• Compensation;
• Aggregate or separate analysis, depending on economic interrelatedness of controlled transactions; and
• Aggregation and allocation for purposes of coordinated analysis under multiple Code or regulatory provisions.

The temporary regulations apply to tax years ending on or after Sept. 14, 2015.

Proposed regulations

Monday’s related proposed regulations are designed to prevent taxpayers from avoiding the recognition of gain or income attributable to high-value intangible property by asserting that an inappropriately large share of the value of the property transferred is foreign goodwill or going concern value that is eligible for favorable treatment under Sec. 367.

The IRS says in the proposed regulations’ preamble that it is concerned about transactions in which taxpayers value property transferred in a manner that it considers contrary to Sec. 482 in order to minimize the value of the transferred property that the taxpayers identify as Sec. 936(h)(3)(B) intangible property for which a deemed income inclusion is required under Sec. 367(d) and to maximize the value of the transferred property that they identify as exempt from current tax.

The IRS is also concerned that some taxpayers are asserting too broad an interpretation of foreign goodwill and going concern value for purposes of Sec. 367.

To rectify this situation, the IRS is proposing to eliminate the foreign goodwill exception under Temp. Regs. Sec. 1.367(d)-1T and to limit the scope of property that is eligible for the exception for property transferred to a foreign corporation for use in its active conduct of a trade or business generally to certain tangible property and financial assets. Accordingly, under the proposed regulations, upon an outbound transfer of foreign goodwill or going concern value, a U.S. transferor will be subject to either current gain recognition under Sec. 367(a)(1) or the tax treatment provided under Sec. 367(d).

The proposed rules will generally apply to transfers occurring on or after Sept. 14, 2015, and to transfers occurring before this date resulting from entity classification elections made under Regs. Sec. 301.7701-3 that are filed on or after this date.

 —Alistair M. Nevius (anevius@aicpa.org) is The Tax Adviser’s editor-in-chief.