Substance Matters

Welcome to 2010. This year promises to bring interesting developments on the U.S. legislative agenda, particularly with respect to international “tax reform.” Case in point, two bills – one each in the House and Senate – could have serious implications for companies with a U.S. taxable presence. Here are three issues which we believe will be significant in the next calendar year and strategies for addressing them proactively.

1. Global increase in transfer pricing audits – In 2009 the IRS hired scores of additional agents, particularly international examiners and economists, with the intention of expanding audits of large and mid-size corporate taxpayers – particularly those in the middle-market. The U.S. was not alone. Around the world, tax authorities increased their numbers of cross-border examiners in 2009 and beyond. Of the countries with the most aggressive additions of audit related personnel, key U.S.-trading partners Brazil, Mexico and China have signaled an increase in transfer pricing audits in the coming year. Multinational enterprises must anticipate that IRS initial documentation requests will include a request for transfer pricing documentation and be prepared to respond to such requests within 30 days of the request. Other countries will have similar, if not, shorter response times. Moreover, failing to respond in many cases is tantamount to being non-responsive. The days of “just-in-time” transfer pricing documentation are over.
2. Intellectual property and cost-sharing – On December 31, 2008, the U.S. Treasury released the new temporary cost-sharing regulations under Treas. Reg. §1.482-7T. The Temporary Treasury Regulations are hardly taxpayer-friendly and represent the increased scrutiny U.S. multinationals will face with respect to arrangements to share costs and the global structuring and alignment of intellectual property portfolios going-forward. In order to “grandfather” cost-sharing arrangements in place prior to the January 5, 2009 effective date, taxpayers had until July 6, 2009 to conform their existing cost-sharing arrangements to the requirements contained in the new temporary regulations with certain adaptations. The key for U.S. multinationals in 2010 is to remain vigilant with respect to existing cost-sharing arrangements and events that may trigger an arrangement – particularly important as M&A deal flow likely increases during the coming year in response to a (hopefully) reviving economy.
3. Codification of Economic Substance – The proposed bill codifying the Economic Substance Doctrine is still alive in the House and will likely find its way into law sometime in 2010 – either in the form of the ultimately enacted healthcare bill or in another piece of legislation. U.S. taxpayers must critically examine the transaction structuring and planning which has provided tax benefits and be prepared to produce documentation and other evidence showing the non-tax business purpose justifying the underlying transaction and attendant structuring.

The stakes are rising for multinational enterprises as the world is getting smaller and tax authorities are sharing information at unprecedented levels. Thus, the best defense is a well-crafted offense that is integrated contemporaneously with acquisitions, divestitures and/or restructurings. The days of operational autonomy for multinational enterprises are over.

Concerned about high blood pressure? Don’t read the tax press.

In a move sure to raise systolic and diastolic numbers everywhere, Caroline Silberzstein, head of the Transfer Pricing Unit in the OECD Centre for Tax Policy and Administration, went on the record last week at the OECD transfer pricing and treaties conference in Paris supporting the proposition that there was no need to define “intangible” for treaty purposes.

Huh? We’re confused.

In other words, if we don’t have a standard definition of an intangible asset what is to prevent different jurisdictions from asserting their own definition and wreaking havoc on transfer pricing? Nothing. That’s what. Without a definition, tax authorities could argue that a given piece of intellectual property is or is not an asset and therefore (based on the more favorable treatment for the tax authority) deny or force an arm’s length payment. Sounds like open season on taxpayers with significant cross-border transactions involving intangibles.

For example, U.S. law defines “intangible” for purposes of Section 482 – the transfer pricing statute – as “an asset that has substantial value independent of the services of any individual if it derives its value not from its physical attributes but from its intellectual content or other intangible properties.” (Treas. Reg. § 1.482-4(b)).

Other countries differ as to the definition of “intangible.” Case in point, India believes that an “intangible” asset should have human intelligence and uniqueness to be recognized. Given this construct, query then to what extent “distribution rights” would be valued in the U.S. versus India? Clearly the U.S. definition of intangible would include a distribution right as an intangible, as the right has value from its “other intangible properties,” notwithstanding that there may be no employees as yet. India, apparently, would reach an inapposite conclusion in the absence of employees. Apparently the ability to distribute vis-à-vis current employees is paramount from an Indian point of view. Given the dichotomy of views as to what constitutes an “intangible” for transfer pricing purposes, it will be difficult at best for tax authorities to agree on what an arm’s length result should be in the absence of a definitional framework as to what constitutes an “intangible” asset for treaty purposes.

This should be a clarion call for the OECD and its member states to put forth a common definition of “intangible” for treaty purposes or if not a definition, at least agree on the indicia of an “intangible” so that taxpayers and tax authorities alike will have a framework to foster negotiation. Moreover, in light of convergence of financial reporting standards there will likely be differences between what is reported for financial accounting purposes, statutory accounting purposes (the starting point for the tax return) and tax reporting in the U.S. versus non-U.S. jurisdictions. Thus leading to a further mudding of the waters as to intangibles that may or may not be reported for financial accounting purposes, but may nevertheless exist for tax purposes.

Absent a definition or at least an agreement as to the indicia of intangible asset(s) for treaty purposes, we will be left with the so-called Pornography Standard: You’ll know it when you see it. The OECD can and should do better.