Substance Matters

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.

Treasury published final regulations (T.D. 9456) regarding the treatment of controlled services transactions under §482 of the Internal Revenue Code on August 4, 2009. This post is our second in a series discussing key points of interest in the final regulations.

Reviewing the final regulations, two key areas of clarification jumped out at us.

Services Cost Method clarification. The application of Services Cost Method (SCM) has been clarified and the regulations revised to provide that the tests for SCM are conjunctive rather than disjunctive, as some had perhaps hoped. That is, all four of the requirements must be satisfied to apply the SCM:

1. The service must be a “covered service;”
2. The service must not be an “excluded activity;”
3. The service cannot be precluded from being a “covered service” by operation of the business judgment rule; and
4. Adequate books and records must be maintained with respect to the service.

As a result, it seems likely that the scope of services to which the exception would apply will be somewhat diminished. To what extent remains to be seen. However, most taxpayer-favorable exceptions tend to be narrowly construed. We doubt this will be an exception.

Business Judgment Rule clarification. The Preamble reiterates that the Business Judgment Rule (BJR) should be determined on a controlled group basis and the final regulations clarify this by noting that, “it is determined by reference to a trade or business of the controlled group.” In applying the BJR, the Preamble to the final regulations contains a helpful clarification with regard to evidencing the BJR. The final regulations answer the question of whether an executive’s representation must be preferred to the tax director’s, by clarifying that the BJR is applied on a case-by-case basis and takes into account the taxpayer’s facts and circumstances. Therefore the rank of the representative making the representation is a secondary consideration to the basis for that representation. It appears that IRS and Treasury carefully considered the comments received from the tax community in finalizing the services regulations. Only time will tell how the regulations will apply in the real world.

The final services regulations are effective for tax years beginning on or after July 31, 2009.