Report on the Application

and Administration of Section 482

Office of the Assistant Commissioner (International)

Office of the Assistant Commissioner (Research & Statistics of Income)

Office of the Associate Chief Counsel (International)

April 21, 1999

Table Of Contents

INTRODUCTION AND EXECUTIVE SUMMARY............................................. i - v

CHAPTER 1: ESTIMATES OF THE SECTION 482 GROSS INCOME TAX GAP.

I. Summary......................................................................................... 1-1

II. Introduction................................................................................... 1-1

III. Data ................................................................................................ 1-4

IV. Methodology ................................................................................. 1-5

V. Caveats.......................................................................................... 1-6

VI. Findings ........................................................................................ 1-9

CHAPTER 2: LEGAL AND ADMINISTRATIVE DEVELOPMENTS .................................

I. Introduction.........................................................................................

A. Issues In Brief . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-1

B. History of Section 482....................................................... 2-1

C. Administrative Problems .................................................. 2-3

1. No contemporaneous evaluation of

transfer prices ................................. 2-3

2. Priority of transfer pricing methods. 2-3

3. Limited access to necessary

information ...................................... 2-4

4. Protracted disputes ........................... 2-4

D. Five-Part Strategy to Improve Administration of Section

482............................................................... 2-4

E. Other Important Compliance Provisions ......................... 2-5

1. Sections 6038A and 6038C ............... 2-5

2. Section 982......................................... 2-6

3. Section 6501(c)(8) .............................. 2-6

4. Section 6503(j) ................................... 2-6

5. Section 1059A .................................... 2-6

II. Guidance on Application of Arm’s Length Standard................. 2-6

A. Section 482 Transfer Pricing Regulations....................... 2-6

1. Functional analysis and comparability2-7

2. Best method rule................................... 2-7

3. Range of arm’s length results.............. 2-8

4. Transfers of tangible property............. 2-8

5. Transfer of intangible property.......... 2-11

6. Loans, services, and leases............... 2-12

7. Inexact comparables .......................... 2-12

B. Section 482 Cost Sharing Regulations.......................... 2-12
C. Guidance for Specialized Industries and New Technologies

1. Proposed regulations on global dealing........................ 2-14

2. Electronic commerce....................................................... 2-15

D.Conforming Accounts to Reflect Section 482 Adjustments2-16

E. Potential Application of Section 482 to Lease Stripping

Abuse ....................................................... 2-17

III. Guidance on Upfront Compliance with the Arm’s Length

Standard ..........................................................................................

A. Statutory Framework....................................................... 2-17

B. Section 6662(e) and (h) Regulations.............................. 2-18

C. Oversight of Transfer Pricing Penalty Assessment ..... 2-20

CHAPTER 3: FIELD DEVELOPMENTS...........................................................................

I. Examination.................................................................................... 3-1

II. International Field Assistance Specialization Program (IFASP)3-2

III. Coordination with the United States Customs Service ............ 3-3

CHAPTER 4: APPEALS DEVELOPMENTS.....................................................................

I. Simultaneous Appeals/Competent Authority Procedure ........... 4-1

II. Alternative Dispute Resolution Initiatives .................................. 4-2

CHAPTER 5: COMPETENT AUTHORITY DEVELOPMENTS.........................................

I. Intergovernmental Programs ........................................................ 5-1

II. Tax Treaty Program ...................................................................... 5-1

III. Updated Competent Authority Procedure ................................. 5-2

IV. Treaty Exchange of Information.................................................. 5-3

A. Specific Request for Information Program...................... 5-3

B. Industry-Wide Exchange of Information Program .......... 5-3

C. Simultaneous Examination Program ............................... 5-4

D. Other Programs ................................................................. 5-4

CHAPTER 6: ADVANCE PRICING AGREEMENT PROGRAM .......................................

I. Introduction.................................................................................... 6-1

II. Current Status of the APA Process ............................................. 6-2

III. Purpose and Objectives of the Process .................................... 6-2

IV. Administrative Details of the APA Process............................... 6-3

V. Key Concepts ............................................................................... 6-3

A. Standard to be Applied ..................................................... 6-3

B. Comparables...................................................................... 6-4

C. Public Disclosure ............................................................. 6-5

VI. Conclusion...................................................................................... 6-5
CHAPTER 7: TAX LITIGATION .......................................................................................

I. Validity of New Enforcement Measures Sustained..................... 7-1

A. Confirmation of Section 6038A Authority.......................... 7-1

B. Penalties Applied under Section 6662(e) and (h) ........... 7-3

II. Litigation Remains a Necessary Means of Section 482

Administration............................................................................ 7-3

III. Changes in Managing Transfer Pricing Issues Since 1992 ......... 7-5

A. Strategies ................................................................................

B. Limits on Ability to Manage Transfer Pricing Litigation 7-7

C. Section 482 Management and Related Issues ................ 7-6

CHAPTER 8: RECOMMENDATIONS AND CONCLUSIONS...................................... 8-1

APPENDICES ...................................................................................................................

APPENDIX AEstimated Section 482 Gross Tax Gap .......................A1-2

APPENDIX BAnalysis of Compliance Trends......................................B1

APPENDIX CAppeals Sustention Rate in Section 482 Cases ............C1

APPENDIX DCompetent Authority - Income Tax Treaties and TIEAsD1

APPENDIX ECompetent Authority Statistics ...................................E1-3

APPENDIX FAPA Statistics ................................................................... F1

APPENDIX GAPA Significant Developments -- 1992 To Present... G1-2

APPENDIX HSignificant Section 482 Docketed Cases ................... H1-5

APPENDIX ICosts of Section 482 Litigation ......................................... I1

APPENDIX JAPA Costs – FY 1997 Costing Study............................... J1

APPENDIX KLarge Case Procedures ............................................. K1-13

INTRODUCTION AND EXECUTIVE SUMMARY

This report responds to the Congressional direction made in the

Conference Report to H.R. 4328, Omnibus Consolidated and Emergency

Supplemental Appropriations Bill Act, 1999, Pub. L. 105-277, 105th Cong.,2d

Sess. 1486 (1998). The mandate provided as follows:

TRANSFER PRICING

The Conferees are concerned about the Nation’s loss of revenue as a

result of foreign corporations employing transfer pricing. Transfer pricing,

utilized by State Trading Enterprises, reallocates items of income and

deduction among entities under common control. Reallocation of the

income and deduction results in minimizing the U.S. tax of foreign

corporations’ U.S. affiliates. Since the foreign parent corporations do not

normally do business in the United States, their income is completely free

from U.S. tax.

To ensure the Internal Revenue Service is vigorously administering

section 482 of the Internal Revenue Code, which empowers the Secretary

of the Treasury to distribute, apportion, and allocate items of gross

income and deduction between the parent corporations and their U.S.

affiliates, the conferees direct the Internal Revenue Service to review and

report to Congress, no later than six months after enactment of this Act,

on the following issues: IRS’s loss of revenue as a result of transfer

pricing; detailed information on IRS’s administration of section 482 to

distribute, apportion, and allocate items of gross income and deduction;

and recommendations on how to improve the collection of revenue from

trading enterprises.

To address the foregoing three issues, this report provides estimates of

the section 482 gross income tax gap (Chapter 1), describes legal and

administrative developments in promoting compliance under section 482

(Chapters 2 through 7), and offers recommendations and conclusions (Chapter

8). The report reviews developments since the previous report on similar subject
ii

matter made at the direction of the Congress pursuant to section 11316 of the

Omnibus Reconciliation Act of 1990. Report on the Application and

Administration of Section 482 (April 1992) (1992 report).1

 1

For a prior corporate income tax gap estimate, see Estimates of the Income Tax

Gap Among Foreign-Controlled Domestic Corporations, Department of the Treasury,

Internal Revenue Service Compliance Research Division (June 8, 1994).

Section 482 authorizes the IRS to adjust the income, deductions, credits,

or allowances of commonly controlled taxpayers in order to prevent evasion of

taxes or clearly to reflect their income. Application of section 482 to

multinational operations may involve a wide range of technical and factual

issues. For example, if a domestic distribution subsidiary buys goods from its

foreign parent for resale to unrelated parties, what markup should it earn? Or, if

an offshore subsidiary uses patents and manufacturing know-how belonging to

its U.S. parent, what rate of royalty should the parent earn for permitting the

subsidiary to use its intangible assets? In general terms, section 482 asks

whether prices charged by one affiliate to another in an intercompany

transaction involving the transfer of goods, services, or intangibles yield results

for the transaction that are consistent with the results that would have been

realized if uncontrolled taxpayers had engaged in the same transaction under

the same circumstances. This standard of a taxpayer dealing at arm’s length

with an uncontrolled taxpayer, known as the arm’s length standard, has been

incorporated in regulations under section 482 or its predecessors for over 60

years.

The IRS’s goal in administering section 482 is to ensure that each

controlled taxpayer reflects its true taxable income from intercompany

transactions as determined under the arm’s length standard. For example, if the

IRS determines that a foreign related party overcharged its U.S. affiliate for

goods or services, IRS may adjust the transfer price downward, thereby

increasing the U.S. party’s taxable income. If the foreign country in question

agrees that the transfer prices were too high, it may agree to make a correlative

adjustment decreasing the income of the foreign affiliate. However, if the foreign

country disputes the validity of the adjustment, and declines to make a

correlative adjustment, some portion of the income will be subject to double

taxation, once in the foreign country and once in the United States. The

common adoption of the arm’s length principle in all 50 of our current income tax

treaties (with the one exception of that with the former U.S.S.R.) and in the
iii

guidelines of the Organization for Economic Cooperation and Development

(OECD) minimizes the potential for double taxation and provides a basis to

resolve double tax cases by mutual agreement through the competent authority

process under the treaties.

A principal obstacle to past administration of section 482 was the lack of

contemporaneous attention given by taxpayers to complying, and documenting

compliance, with the arm’s length standard in transfer pricing. Typically

taxpayers did not take the arm’s length standard into account for purposes of

reporting their taxable income from intercompany transactions. When IRS

examiners audited the returns, they generally found that no analysis or

documentation existed to explain the appropriateness of transfer prices. Indeed,

taxpayers only began their attention to the transfer pricing issue during the audit

process, several years after the period in which the transactions took place. 

With hindsight, taxpayers and examiners often had the incentive to adopt

positions that arguably supported extreme results and led to protracted disputes.

 This report sets forth the statutory, regulatory, and administrative initiatives that

have been adopted to address these problems. The overall aim has been to

shift the focus from after-the-fact audit and litigation of transfer pricing

controversies to encouragement of upfront taxpayer compliance and advance

resolution of transfer pricing issues.

Chapter 1 presents the Internal Revenue Service’s estimates of the gross

income tax gap related to section 482 of the Internal Revenue Code. It includes

estimates for both foreign-controlled corporations (FCCs) and for U.S.-controlled

domestic corporations (non-FCCs). Chapter 1 also provides an analysis of the

available compliance data in an effort to detect compliance trends associated

with important legal developments effective in 1994. The tax gap estimates are

based on audit adjustments to income from IRS International Examiner

operational examinations of Form 1120 tax returns completed during fiscal years

1996 through 1998. The report also describes some potential limitations in the

data and in the analysis that could result in the estimates’ understating or

overstating the “true” tax gap. Subject to these important limitations, the

average annual section 482 gross income tax gap is estimated to amount to $2.8

billion. This includes a $2.0 billion gap attributable to FCCs and a $0.8 billion

gap attributable to non-FCCs. These numbers are smaller than some of the

estimates of the section 482 tax gap made by others. These other estimates,

however, are based on estimation methodologies quite different from the auditadjustment approach used in this report.

Chapter 2 summarizes the guidance the IRS has promulgated on the

application of the arm’s length standard. Principal in this category are the final

section 482 regulations issued in 1994. In addition to this substantive guidance,
iv

the IRS, with the strong backing of Congress, has moved to ensure that

taxpayers apply the arm’s length standard as provided for in the transfer pricing

regulations at the time they file their original return and that taxpayers have

contemporaneous documentation establishing such compliance. This

contemporaneous documentation is provided for in section 6662(e), as amended

in 1993. The IRS issued temporary regulations in 1994 and final regulations in

1996 implementing this provision. The incentive for taxpayers to undertake

these compliance responsibilities are the penalties that are otherwise applicable

under section 6662(a) and (h) in the event a taxpayer’s transfer pricing is

adjusted by the IRS.

Chapters 3 through 5 focus on administrative developments in

Examination, Appeals, and Competent Authority relating to the resolution of

transfer pricing issues. Significant examination resources are committed to

transfer pricing audits. There are approximately 650 international examiners

(IEs) who devote about half their time to examining transfer pricing issues. The

Office of the Assistant Commissioner (International) instituted the International

Field Assistance Specialization Program (IFASP) in 1991. IFASP includes a

team of four senior specialists who travel nationwide to provide transfer pricing

expertise and assistance to IEs, IE managers, CEP managers, and economists

on particular transfer pricing cases. As for other tax issues, the IRS makes a

conscientious effort to settle section 482 cases in examination. Most cases

involving proposed section 482 adjustments, however, are settled by Appeals. 

Appeals is always striving to develop innovative dispute resolution mechanisms.

 In recognition of the potential double tax dimension of many transfer pricing

cases, a simultaneous procedure has been inaugurated for early joint

consideration of these matters by Appeals in conjunction with the U.S.

competent authority. The procedures for requesting assistance from the U.S.

competent authority were generally revised and updated in 1996. The

competent authority process continues to achieve substantial relief for taxpayers

from double taxation by both the United States and its treaty partners. Treasury

and the IRS have joined treaty partners in the OECD to build a worldwide

consensus on the application of the arm’s length principle and on the taxpayer’s

responsibility to contemporaneously document compliance. The product of this

collaborative effort were the 1995 OECD Transfer Pricing Guidelines. Major

U.S. trading partners have subsequently adopted legislation and other guidance

 implementing the approach of the Guidelines. The United States continues to

actively contribute to the ongoing work on these guidelines.

Chapter 6 addresses the Advanced Pricing Agreement (APA) program

which IRS encourages taxpayers to use to provide certainty and advanced

resolution of potential transfer pricing disputes. An APA is a cost effective

approach to protect both against section 482 adjustments and section 6662(e)
v

penalties. APAs may be unilateral or bilateral. A unilateral APA is an

agreement for a prospective period of time between the taxpayer and the IRS on

the appropriate transfer pricing method (TPM) for the transactions at issue. With

this approach, there is no guarantee that the foreign country’s taxing authority

will agree that the TPM is correct. A bilateral APA that combines an agreement

between the taxpayer and the IRS on a particular TPM, with an agreement

(pursuant to the competent authority process under income tax treaties) between

the United States and foreign taxing authority regarding the propriety of the

TPM, may also avoid the potential double tax problems. As of the fiscal period

ended September 30, 1998, 164 APAs have been concluded with another 186

under negotiation. These APAs span a wide range of industries and involve

numerous cross-border transactions including sales of tangible property and

transfers of intellectual property. Roughly half of the APAs completed to date

have been bilateral. Both unilateral and bilateral APAs may also provide that the

agreed-upon TPM be “rolled back” to resolve similar issues for past years under

audit.

Chapter 7 discusses developments in the litigation of section 482 cases

since 1992. A sustained commitment to the successful litigation of section 482

cases is an integral part of the IRS tax compliance effort. Since 1992, the IRS

has expanded programs to ensure earlier identification of compliance issues in

cross-border cases generally, better development of the cases, and more

efficient allocation of limited litigation resources. These strategies have borne

fruit in the form of successful litigation of novel issues related to section 482,

including precedent upholding enforcement tools enacted to assist in the

examination of cross-border related party transactions. In the first case

interpreting section 6038A(e), the Tax Court in ASAT, Inc. v. Commissioner, 108

T.C. 147 (1997), upheld the IRS penalty determination of claimed related party

deductions as the result of the taxpayer’s noncompliance with section 6038A. 

In DHL Inc., and Subsidiaries v. Commissioner, T.C. Memo. 1998-461, 76

T.C.M. (CCH) 1122, the Tax Court determined that petitioner understated its

royalty income and misstated its gains from sale of petitioner’s trademark in

1992, without reasonable cause, resulting in application of accuracy related

penalties under section 6662, including a penalty of 40% of the deficiency

attributable to the gross valuation misstatement of the trademark value. DHL,

Inc., and other recent cases illustrate the difficulties faced by the IRS in

determining an appropriate reallocation and the necessity to continue to defend

such reallocations when information is not forthcoming without litigation. 

Although the reallocations sustained by the Court were greatly reduced from that

initially determined by the IRS, substantial adjustments to the position taken on

the return were sustained nevertheless. Finally, knowledge gained in litigation

has informed the development of related intercompany issues in the context of

the possessions and the withholding at source regimes and helped shape
.2

regulatory guidance.

Chapter 8 concludes the IRS intends to continue to pursue its five-part

strategy to improve the administration of section 482. Thus, the IRS plans a

combination of section 482 guidance, promotion of upfront compliance with the

arm’s length standard, strengthening the international consensus on transfer

pricing guidance and compliance, advanced resolution of transfer pricing issues

in the APA Program, and strategic management of section 482 issues in

litigation. Chapter 8 also recommends that the IRS consider improving its

section 482 tax gap and section 482 compliance trend measures and offers two

strategies for such a program. With regard to the Field, Appeals, Competent

Authority, and the Advanced Pricing Agreement program described in Chapters

3 through 7, the IRS Restructuring and Reform Act of 1998 has prompted the

most significant reorganization of the IRS in 40 years. This modernization effort

at this time is a work in process and the available information must be

considered preliminary. As a consequence, it is difficult to develop

recommendations with regard to the IRS organization and section 482. The

reorganization is expected to alter the existing structure in many significant

ways. The preliminary indications are that the reorganization will take

appropriate account of the particular functions of the International Examiners,

Appeals, Competent Authority, and the Advance Pricing Agreement program. 

The IRS’s focus on section 482 compliance will not be lost and should, in fact,

benefit from the new organization.

CHAPTER 1: ESTIMATES OF THE SECTION 482 GROSS INCOME TAX GAP

I. Summary

This report presents the Internal Revenue Service’s estimates of the

gross income tax gap related to section 482 of the Internal Revenue Code. It

includes estimates for both foreign-controlled corporations (FCCs) and for U.S.-

controlled domestic corporations (non-FCCs). This report also provides an
.3

analysis of the available compliance data in an effort to detect compliance trends

associated with two important legal developments effective in 1994. The tax gap

estimates are based on audit adjustments to income from IRS International

Examiner (IE) operational examinations of Form 1120 tax returns completed

during fiscal years 1996 through 1998. The report describes some potential

limitations in the data and in the analysis that could result in the estimates’

understating or overstating the “true” tax gap. Subject to these important

limitations, the average annual section 482 gross income tax gap is estimated to

amount to $2.8 billion. This includes a $2.0 billion gap attributable to FCCs and

a $0.8 billion gap attributable to non-FCCs. These numbers are not a measure

of the revenue loss associated with section 482 noncompliance for several

reasons including the fact that most (61%) of the noncompliance identified in this

analysis has been picked up on audit. In addition, the audit-adjustment

methodology used in this report is not necessarily reflective of the relative

compliance of FCCs as compared to non-FCCs. The tax gap numbers are

smaller than some of the estimates of the section 482 tax gap made by others. 

These other estimates, however, are based on estimation methodologies quite

different from the audit-adjustment approach used in this report.

II. Introduction

 This report presents the Internal Revenue Service’s estimates of the

gross income tax gap attributable to corporations (both foreign-controlled and

U.S.-controlled) engaged in international transactions covered under section 482

of the Internal Revenue Code. The gross income tax gap is defined as the

amount of tax that is not paid voluntarily and timely. The gross gap is divided

into the following three components, which reflect the basic nature of the

noncompliance: (1) the underreporting gap, (2) the nonfiling gap, and (3) the

underpayment gap. The underreporting gap is the amount of tax liability that is

not reported voluntarily by taxpayers who voluntarily and timely file returns. The

nonfiling gap is the tax owed by taxpayers who do not voluntarily file returns. 

The underpayment gap is the amount of tax liability that taxpayers voluntarily

report but do not pay voluntarily and timely.2

This report does not directly measure the “IRS’s loss of revenue as a

result of transfer pricing,” as requested by the Conference Report. This “loss of

revenue” is sometimes termed the “net” tax gap. The $2.8 billion tax gap

reported in this study is the “gross” tax gap, that is, it is an estimate of both the

noncompliance identified on audit and the noncompliance that would have been

identified if the IRS had audited every corporate tax return with a potential

 2

See IRS Publication 1415 (Rev. 4-96), Federal Tax Compliance Research: 

Individual Income Tax Gap Estimates for 1985, 1988, and 1992, p. 2.
.4

section 482 issue. The $2.8 billion gross tax gap includes approximately $1.7

billion identified on audit by the IEs and $1.1 billion that would have identified if

all tax returns were examined by IEs.

This report attempts to estimate the “gross” tax gap and not the “net” tax

gap. Among the more important reasons is that the available data on section

482 compliance are derived from operational audits and do not include any

information on assessments or collection. A second reason is that, from a tax

administration perspective, noncompliance that is identified on audit is in many

ways as significant as noncompliance that goes undetected. Both types of

noncompliance are indicative of taxpayers who through mistake, neglect, or

intention have erred on their returns. Both types of noncompliance are of

concern to the IRS.

It is important to note that neither the $1.7 billion identified on audit nor

the $1.1 billion that could have been identified represent tax dollars actually

collected or dollars potentially collected. This is because under the

methodology of the report, as discussed below under the heading “caveats”, the

tax gap figure represents only proposed adjustments. Its does not take into

account possible settlements that may have occurred at Appeals or in litigation,

nor any ultimate disposition of a litigated dispute. In addition, the tax gap figure

assumes an effective tax rate of 34% and thus does not take into account

possible lower effective tax rates due to net operating loss carryovers, tax

credits, and other factors. Finally, the figure assumes 100% collection, although

this may be a plausible assumption for the international businesses under study.

The effort to develop comprehensive and reliable section 482 tax gap

estimates is made difficult by the absence of comprehensive data. Prior IRS tax

gap estimates, especially of the individual income tax gap, generally have been

based on data from special examinations conducted under the Taxpayer

Compliance Measurement Program (TCMP), supplemented by information from

other special compliance studies. In developing the estimates in this report, we

made limited use of the results of the most recent TCMP corporation

examinations, which were restricted to tax year 1987 returns of small

corporations. However, the estimates in this report were

primarily developed using a methodology that relies heavily on data from

operational examinations (that is, examinations not conducted under TCMP).3

 3

The Taxpayer Compliance Measurement Program (TCMP) has been IRS’s

primary source of information on taxpayer compliance. Tax returns examined under

this program are randomly selected and subject to line-by-line review by IRS

examiners. The information collected as a result of these examinations provides

detailed line-by-line data on amounts taxpayers reported on their returns and on what
.5

Since these data provide information only on the income not reported voluntarily

by filers of returns, the estimates in this report necessarily reflect only the

underreporting gap.4

This report’s tax gap estimates are based on data from International

Examiner operational examinations of Forms 1120, “U.S. Corporation Income

Tax Return.” These Forms 1120 include returns filed by FCCs and returns filed

by non-FCCs. If a foreign corporation conducts business in the U.S. through a

U.S. subsidiary corporation, then the subsidiary files a Form 1120 and indicates

the extent of its foreign ownership on its Form 1120. FCCs are defined to be

corporations with at least 25 percent foreign ownership.

 

IRS examiners believed they should have reported. The random selection readily

enables the development of estimates of noncompliance for the population of returns

from which the TCMP sample was drawn. The line-by-line review provides a

comprehensive picture of noncompliance. 

The random selection and line-by-line review features of the TCMP

examinations are two important differences between TCMP and regular operational

examinations. Returns selected for examination under operational programs are

selected based on return characteristics that suggest a potential for a tax change. 

Operational examinations also are much narrower in focus than TCMP examinations,

generally focusing on issues identified during classification of the returns and/or initial

review by the examiners. These characteristics of operational examinations make it

difficult to develop tax gap estimates from operational examinations. Our methods for

doing so are discussed later in the report, as are several caveats concerning the

limitations of the data and the methodology.

4

In our prior estimates of the income tax gap associated with all corporations, the

underreporting gap has accounted for nearly all of the gross income tax gap.
.6

A number of simplifying assumptions had to be incorporated into the

estimation methodology in order to work with the available data. Because of

various limitations involving the data and methodology, the estimates are subject

to a number of potentially serious biases. For example, to the extent that

examinations do not detect all noncompliance, our examination-based approach

may tend to underestimate the magnitude of the tax gap. Conversely, because

our tax gap estimates are not based on actual tax assessment data, but are

instead generated by applying marginal tax rates to income adjustment data, our

approach may tend to overestimate the magnitude of the tax gap. Important

caveats regarding the estimates are discussed in more detail below. Given the

assumptions that had to be employed in generating these estimates, the

estimated tax gap values presented here should be used with considerable

caution.

Finally, in a separate analysis of the same type of data used to develop

the tax gap numbers, this report presents an analysis of proposed section 482

adjustments for the two taxable-year periods ending before and on or after

December 31, 1994. This analysis seeks to identify compliance trends that may

relate to two of the more significant legal developments described in Chapter 2,

i.e., the enactment of the contemporaneous record keeping requirements under

section 6662(e) in 1993 and the promulgation of the final section 482 regulations

in 1994. Unfortunately, the analysis is inconclusive.

III. Data

 As noted above, the estimates presented in this report are based on

data obtained from operational examinations. Our section 482 tax gap estimates

were generated from a database comprising results of all Form 1120

International Examiner examinations completed during fiscal years (FY) 1996,

1997, and 1998. 

The database used to estimate the section 482 tax gap included results

for International Examiner examinations of 8,210 Form 1120 returns completed

during FY96-98. However, the returns in this database did not comprise a

random sample of all corporations. Instead, they were returns that were

selected for audit on the basis of tax change potential after being referred to

International because they had international characteristics. Of the 8,210 Form

1120 examinations, 2,233 were completed in FY 96, 2,368 in FY97, and 3,609 in

FY 98. The examinations completed in FY96 produced 7,794 income

adjustments, while those completed in FY97 produced 7,193 adjustments, and

those completed in FY98 produced 9,659 adjustments. Not all of these

adjustments to income were section 482 adjustments, however. Section 482
.7

adjustments came to 2,077 for FY96, 1,825 for FY97, and 2,135 for FY98. Data

from the three years of examinations in the database were pooled to produce

“average annual” section 482 tax gap estimates for FY96-98. This helped to

moderate the effect on the estimates of year-to-year fluctuations in examination

results.

A slightly expanded database of International examinations was used to

measure section 482 compliance trends for taxable years ending pre-and postDecember 31, 1994, the effective date of the new section 6662(e) penalty which

promotes contemporaneous documentation. To the database described in the

preceding paragraph, additional examinations were included from FY99 through

March 8, 1999.5

 In addition, the data were organized by tax return and not

adjustment. For purposes of this compliance analysis, the database included

3,033 tax returns with section 482 adjustments. Of these, 1,624 returns were for

taxable years ending prior to December 31, 1994 and 1,409 returns were for

taxable years ending December 31, 1994 and later.

IV. Methodology

Our basic approach to estimating the section 482 income tax gap involved

expanding the operational examination results in our database to the entire

Form 1120 population and converting the resulting estimated income adjustment

amounts to tax gap estimates. Specifically, our estimation methodology

involved four steps. In Step 1, database income adjustment amounts were

summed (separately for each of the three fiscal years of data in the database) by

industry group, asset size class, and type of corporation (FCCs vs. non-FCCs). 

In Step 2, these database income adjustment sums were expanded to the total

population using separate expansion ratios for each of the three sizes of

corporations.6 These expansion ratios were necessary because the completed

International Examiner operational examinations comprising our database did

not include the entire Form 1120 population. In Step 3, the expanded income

adjustment amounts were converted to tax gap estimates by applying an

average marginal corporation income tax rate of 34 percent. Finally, in Step 4,

the overall tax gap estimates for each of the FYs 1996-1998 were averaged

together to produce average annual section 482 tax gap estimates for FY96-98.

 5

In addition, the data included some non-corporate tax returns; however, these

non-corporate returns represent only 2% of the 3,033 returns.

6

The expansion ratio for small corporations was 9.16, for mid-size corporations

4.58, and for large corporations 1.00.
.8

In the next section, we discuss several biases in the tax gap estimates. 

These biases are quite severe. The estimates should be regarded as tentative

and subject to substantial revision when better data are available. 

Nevertheless, it is conceivable that, even though the level of the transfer pricing

tax gap is very uncertain, changes in transfer pricing compliance could be

discerned by using the same type of data and the same methodology with

returns for groups of taxable years. To learn whether that is possible, we

analyzed data for certain taxable years ending before December 31, 1994 and

those ending December 31, 1994 and later in an effort to determine whether the

enactment of the contemporaneous record keeping requirements under section

6662(e) and the final section 482 regulations issued in 1994 have affected the

results of IE examinations. Even if we find significant changes, interpreting

them would be difficult since a myriad of possible differences–in IRS’s

examination program, in economic conditions, and in the sources of bias–would

have to be accounted for before the changes in examination results could be

confidently attributed to changes in taxpayer behavior. In spite of these

problems, we are presenting the results of preliminary analysis of these data to

provide additional information on this issue.

To test whether examination results have been affected, we studied two

groups of IE examinations. The first group is examinations of tax returns for

taxable years ending December 31, 1992 to November 30, 1994 that closed

during the twelve month period ending February 1, 1997. The second group is

examinations of tax returns for taxable years ending December 31, 1994 to

November 30, 1996 that closed in the twelve month period ending February 1,

1999. The twelve month period ending February 1, 1999 was selected because

it contains the latest available data. The twelve month period ending February

1, 1997 is the comparable period for the examinations of the earlier set of

taxable years. The results of this analysis are presented in Appendix B. For

convenience, the first group described above is identified as the “tax period

grouping 1992 and 1993;” the second group is identified as the “tax period

grouping 1994 and 1995.” The Appendix also contains information on the total

and average number of hours devoted by IEs to the returns in each group. 

These hours relate to all issues worked by the IEs, not just section 482.

The two groups were chosen because they represent examinations of

returns from taxable years immediately before and after the significant legal

changes and that closed during comparable periods in the audit stream. This

methodology attempts to control for factors that may distinguish examinations of

differing taxable years that close during a particular fiscal year. It is possible, for

example, that simpler cases with relatively smaller adjustments close relatively

earlier. It is important, therefore, to compare the results of closed examinations
.9

of post-1993 returns with the results of examinations of pre-1994 returns that

closed at the same stage of the examination cycle.

V. Caveats

Due to limitations involving the data and the methodology that were used

in their development, the IRS estimates of the section 482 tax gap in this report

are subject to potential biases and should not be regarded as definitive. The

most important of these potential biases, and their likely directions, are indicated

below. These potential biases should be kept in mind while interpreting the

estimates.

First, the estimates are probably biased downward because they are

ultimately based on data from operational examinations, and evidence suggests

that operational examinations do not uncover all noncompliance. As explained

above, this is because operational examinations are typically not comprehensive

examinations of all potential items on a tax return; instead, examiners tend to

focus on a limited number of pre-identified issues.7 Furthermore, due to lack of

information, time constraints, etc., examiners may not necessarily identify all the

noncompliance associated with the items they do examine.8

 Our examinationbased approach, therefore, may tend to understate the true magnitude of the

section 482 tax gap. This could be a significant source of bias in our analysis. 

 7

See footnote 3, supra. 8

Some IRS tax gap estimates, especially those based on TCMP data, have dealt

with this bias by applying “multiplier” factors to certain unreported income (see IRS

Publication 7285 (3-88), Income Tax Compliance Research: Gross Tax Gap Estimates

and Projections for 1973-1992, pp. 13-14). Lack of appropriate data precluded such an

approach here.
.10

Another major source of uncertainty in the estimates is our Step 2

methodology for expanding the database results to the entire population. We

did this by using separate coverage expansion factors for each of the three

corporation size classes, 9.16 for small corporations, 4.58 for mid-size

corporations, and 1.00 for large corporations. In the case of large corporations,

we assumed that the entire population is examined, and hence no coverage

expansion factor was used for large corporations. Our assumption of 100

percent examination coverage is probably a slight overstatement, however,

biasing the estimates downward for large corporations. In the case of small

corporations, only a small proportion of the entire population of returns is

examined, and the returns that are examined are not representative of the entire

population of small corporations. We controlled for this fact in calculating our

small corporation expansion factor by comparing TCMP compliance estimates

for the entire population of small corporations to IRS operational audit results for

small corporations that were examined.9

 Due to the imprecision involved in

comparing tax year TCMP data to fiscal year operational data, our judgment is

that this probably resulted in a slight upward bias for small corporations.10 In the

case of mid-size corporations, for which we had no TCMP results, we assumed a

coverage expansion factor exactly half as large as that for small corporations. 

This is consistent with the fact that examination coverage among mid-size

corporations is considerably greater than among their small counterparts, but

nevertheless our mid-size corporation factor is inherently much more uncertain

than our factor for small corporations.

A third caveat relates to the relevance of the analysis below the level of

the totals. In particular, the report finds that $2,013 million ($2.0 billion) of the

tax gap is attributable to FCCs out of a total tax gap of approximately $2.8

billion. Of this FCC subtotal, $858 million ($0.9 billion) is attributable to large

corporations and was all identified on audit of these large FCCs. With respect to

 9

The numerator of our expansion ratio is the TY87 TCMP estimate of total tax

understatement (plus penalties) by all small corporations. The denominator is the

average annual amount of proposed deficiencies (including penalties) on all small

corporation examinations closed in fiscal years 1989 and 1990; it is an estimate of the

amount of tax deficiencies and penalties proposed in operational examinations for

small corporations for TY87. The coverage expansion factor for small corporations of

9.16 means that, for tax year 1987, the TCMP study estimated that small corporations

owed an aggregate amount of additional taxes and penalties that was approximately

nine times as large as the amount identified in operational examinations.

10Another potential source of bias has to do with the fact that our expansion ratio

is based on all small corporation noncompliance, not just section 482 noncompliance. 

However, we have no a priori basis for judging the direction in which this would bias our

estimates.
.11

the remaining $1,155 million ($1.2 billion) which is attributable to small and midsize FCCs, the magnitude of this amount is to a considerable degree a

consequence of the heavy focus on FCCs among small and mid-size taxpayers

by IEs. Since 1992, in response to Congressional concerns that effective tax

rates of FCCs were lower than U.S.-controlled domestic corporations, the IRS

has focused significant audit resources on small and mid-size FCCs. This focus

is demonstrated in the following table which shows that the IRS during the period

FY95 to FY98 devoted between 44.2% and 60.1% of its IE Direct Examination

Staff Years (DESYS)11 dedicated to taxpayers not in the Coordinated

Examination Program (CEP) for large taxpayers, i.e., non-CEP taxpayers, to the

audit of FCCs.12

International Exam Resources Dedicated to Non-CEP FCC Exams

Fiscal

Year

DESYS in Annual

Business Plan 

Dedicated to nonCEP FCC Exams

% of Total nonCEP DESYS

Dedicated to FCC

Exams in Annual

Business Plan

Actual DESYS

Dedicated to

non-CEP FCC

Exams

% of Actual

Total DESYS

Dedicated to

non-CEP FCC

Exams

1995 81 40.6% 119.81 60.1%

1996 81 40.9% 107.82 54.3%

1997 81 45.9% 98.97 46.5%

1998 81 45.6% 87.25 44.2%

 11Direct Examination Staff Years (DESYS) are hours spent on examinations and

do not include training, leave, and administrative time.

12The Coordinated Examination Program covers approximately 1,500 of the

largest corporate taxpayers. All CEP taxpayers are audited annually.

As a result of this focus, approximately 54% of all non-CEP returns (including

those with no section 482 issue identified) closed during the period covered by

this report were non-CEP FCCs. This percentage may be compared to the fact

that FCCs generally constitute between 2 and 3% of all corporate income tax

returns filed. As noted above, the methodology of this report is based on

operational audits. To the extent that section 482 adjustments for FCCs are

over represented in the data, the tax gap totals will overstate the proportion of

the “true” tax gap that is attributable to FCCs. In addition, to the extent that
.12

average noncompliance by FCCs is higher or lower as compared to average

compliance by non-FCCs, the overall tax gap will be over or understated as a

result of this audit emphasis.

Our tax gap estimates are probably biased upward because we derived

them by applying an average marginal corporation tax rate (34%) to income

adjustments proposed by examiners. Thus, our estimates do not take into

account the fact that tax assessments ultimately agreed to by taxpayers after all

appeals and litigation have been completed are, on average, lower than the tax

deficiencies proposed by examiners. Generally speaking, the true tax liability

may be regarded as likely to lie within the range encompassed by the proposed

and assessed liabilities.13 Also, our estimates do not take into account the fact

that if a corporation has current or prior year losses, an audit adjustment that

results in an increase in income does not necessarily result in increased tax

liability for the current year. In an examination of a deficit return, adjustments to

income that do not exceed the reported deficit produce no adjustments to the tax

liability. For deficit returns, therefore, the effective tax rate on the total

adjustment to income will be lower than the nominal tax rate.

Finally, our analysis of IE examination results for pre- and postDecember 31, 1994 taxable years does not correct for a number of factors that

may distinguish operational audits conducted during different time periods. For

example, the data may be affected by such factors as management emphasis on

closing cases more quickly or by a focus on particular issues, industries, or

groups of taxpayers during one audit time period as compared to another. 

These factors are difficult to correct for without conducting audits in a way

designed to detect compliance trends over time, or by gathering more extensive

data from our operational examination program. These non-taxpayer related

factors can mask, and appear to have masked in this study, taxpayer compliance

trends and render such analysis inconclusive.

VI. Findings

Appendix A presents our average annual gross section 482 income tax

gap estimates for fiscal years 1996-1998. Estimates are provided for both FCCs

and

 13For a more complete discussion of the advantages and disadvantages of these

two types of estimates, see IRS Publication 1415 (4-90), Income Tax Compliance

Research: Net Tax Gap and Remittance Gap Estimates, pp. 13-15.
.13

for non-FCCs. Estimates are shown for five industry groups and for small, midsize, and large corporations.14

As shown in Appendix A, the total section 482 income tax gap is

estimated to amount to $2.8 billion. This includes a $2.0 billion gap attributable

to FCCs and a $0.8 billion gap attributable to U.S. controlled domestic

corporations.

The industry group comprising the largest share of the Appendix A

section 482 tax gap is manufacturing, accounting for approximately $1.4 billion

of estimated tax gap, or about half of the total. Next largest is wholesale and

retail trade, accounting for another $0.9 billion. The estimated tax gap

attributable to finance, insurance, and real estate is slightly more than $0.2

billion, while services account for less than $0.2 billion of estimated tax gap. 

The estimated tax gap attributable to all other industries is $0.1 billion. These

relative size rankings among industry groups also hold true if one looks at FCCs

alone. In the case of non-FCCs, however, the “other industries” group, which

accounts for an estimated $0.1 billion of the gap, is more important than finance,

insurance, and real estate ($0.09 billion) or the services group ($0.02 billion).

On the whole, large corporations account for the major portion of our

estimated total section 482 tax gap—an estimated $1.5 billion. Mid-size

corporations account for another $1.0 billion, and small corporations $0.4 billion.

 In the case of FCCs, however, mid-size corporations account for more of the

estimated tax gap ($1.0 billion) than do large corporations ($0.8 billion). In the

case non-FCCs, small corporations are a more important component ($0.1

billion) of the gap than are mid-size corporations ($0.05 billion).

In Chapter 2, we describe the significant administrative developments

including the contemporaneous recordkeeping requirements under section

6662(e) and the final section 482 regulations published in 1994. Both of these

developments are expected to improve compliance. Even though our estimates

of the aggregate amount of noncompliance are very uncertain, we compared the

available data from certain returns for taxable years ending December 31, 1994

and later with certain returns ending before that date in an effort to determine

whether these significant legal changes have changed IE examination results in

a way that suggests improved compliance. These results for the selected tax

 14Small corporations are defined here as those having assets of less than $10

million, mid-size corporations as those having from $10 million to $250 million in

assets, and large corporations as those having assets of $250 million or more.
.14

returns are set forth in Appendix B. The overall results are analyzed further for

CEP taxpayers and non-CEP taxpayers.

The analysis is inconclusive. For all selected returns, there is some

reduction in the average proposed adjustment per return between the 1992 and

1993 tax grouping and the 1994 and 1995 tax grouping ($1,654,902 vs.

$826,294); on its face, this appears to indicate improved compliance. However,

this change is not statistically significant, and, therefore, no conclusions

concerning compliance may be drawn. Perhaps more importantly, the average

proposed adjustment increased between these periods for CEP taxpayers (from

$3,133,119 to $3,794,829) where the legal changes would be expected to have

the greatest effect; this change is not statistically significant. The comparability

of these examinations is doubtful given the noticeably smaller number of CEP

cases that closed in the earlier period compared to the number closed in the

later period (51 vs. 100). There is a statistically significant reduction in the

average proposed adjustment between the periods for non-CEP taxpayers. 

However, the dramatic change in the number of returns closed during the two

periods, (151 vs. 602) suggests that other factors could account for the

decrease (from $1,155,636 to $333,182). For example, IRS has been working

with taxpayers in recent years to bring audit cycles more current. This may

account for the large increase in tax return closures for both CEP and non-CEP

taxpayers and render simple comparisons of average adjustments between the

two periods unproductive. 

From this analysis, it is clear that the available data will not support any

conclusion about the impact on compliance of the major legal changes that took

effect for the 1994 taxable year. Given the significant number of returns in this

analysis and the apparent presence of factors unrelated to the legal changes,

i.e., reduced elapsed time of IE examinations, that are affecting the data, it is

possible that accumulation of additional data as more post-1993 cases close

will not provide a definitive answer as to whether the section 6662(e) penalties

and the 1994 final section 482 regulations have affected examination results.
.2

CHAPTER 2: LEGAL AND ADMINISTRATIVE DEVELOPMENTS

I. Introduction

A. Issues In Brief

Section 482 authorizes the IRS to adjust the income, deductions, credits,

or allowances of commonly controlled taxpayers in order to prevent evasion of

taxes or clearly to reflect their income. Application of section 482 to

multinational operations may involve a wide range of technical and factual

issues. For example, if a domestic distribution subsidiary buys goods from its

foreign parent for resale to unrelated parties, what markup should it earn? Or, if

an offshore subsidiary uses patents and manufacturing know-how belonging to

its U.S. parent, what rate of royalty should the parent earn for permitting the

subsidiary to use its intangible assets? In general terms, section 482 asks

whether prices charged by one affiliate to another in an intercompany

transaction involving the transfer of goods, services, or intangibles yield results

for the transaction that are consistent with the results that would have been

realized if uncontrolled taxpayers had engaged in the same transaction under

the same circumstances. This standard of a taxpayer dealing at arm’s length

with an uncontrolled taxpayer, known as the arm’s length standard, has been

incorporated in regulations under section 482 or its predecessors for over 60

years.

The IRS’s goal in administering section 482 is to ensure that each

controlled taxpayer reflects its true taxable income from intercompany

transactions as determined under the arm’s length standard. For example, if the

IRS determines that a foreign related party overcharged its U.S. affiliate for

goods or services, IRS may adjust the transfer price downward, thereby

increasing the U.S. party’s taxable income. If the foreign country in question

agrees that the transfer prices were too high, it may agree to make a correlative
.3

adjustment decreasing the income of the foreign affiliate. However, if the foreign

country disputes the validity of the adjustment, and declines to make a

correlative adjustment, some portion of the income will be subject to double

taxation, once in the foreign country and once in the United States. The

common adoption of the arm’s length principle in all 50 of our current income tax

treaties (with the one exception of that with the former U.S.S.R.) and in the

guidelines of the Organization for Economic Cooperation and Development

(OECD) minimizes the potential for double taxation and provides a basis to

resolve double tax cases by mutual agreement under the treaties.

B. History of Section 482

As early as 1917, the IRS was authorized to allocate income and

deductions among affiliated corporations, and to require affiliated corporations to

file consolidated returns. The predecessors of current section 482 date to 1921

and 1928. The provision added as section 45 of the 1928 Internal Revenue Act

authorized the Commissioner to make adjustments to accounts of related parties

to the extent necessary to prevent tax avoidance and to ensure the clear

reflection of income. The legislative history clarified that the latter authority

permitted the Commissioner to determine the “true taxable income” of related

parties. H.R. Rep. No. 2, 70th Cong., 1st Sess. 16-17 (1928).

 Since 1935, the regulations (then under section 45) have utilized the

"arm's length" standard as the means to effectuate the provision. Transfer

pricing regulations issued in 1968 provided further guidance on the application

of the arm’s length standard, including specified pricing methods and additional

rules for particular types of intercompany transactions.

 In 1986, Congress added a second sentence to section 482 which

required related party transfers of intangible property to yield income

"commensurate with the income attributable to the intangible." In addition to a

basic concern that high-profit intangibles were being transferred outside the U.S.

tax jurisdiction without adequate consideration, the legislative history of this

provision reflected dissatisfaction with the comparability analysis in some judicial

decisions:

Certain judicial interpretations of section 482 have suggested that

pricing arrangements between unrelated parties for items of the same

apparent general category as those involved in the related party

transfer may in some circumstances be considered a 'safe harbor' for

related party pricing arrangements, even though there are significant

differences in the volume and risks involved, or in other factors. See,

e.g., United States Steel Corporation v. Commissioner, 617 F.2d 942
.4

(2d Cir. 1980). While Congress was concerned that such decisions

may unduly emphasize the concept of comparables even in situations

involving highly standardized commodities or services, it believed that

such an approach is sufficiently troublesome where transfers of

intangibles are concerned that a statutory modification to the

intercompany pricing rules regarding transfers of intangibles was

necessary.

Staff of Joint Committee on Taxation, General Explanation of the Tax Reform Act of

1986, 100th Cong., 1st Sess. 1014-15 (1987).

In 1990, Congress in section 6662(a), (e), and (h)(2)(A) enacted 20% and

40% accuracy-related penalties for substantial and gross valuation misstatements. 

In 1993 these provisions were amended to specifically focus on whether the

taxpayer generates contemporaneous documentation and analysis of its transfer

pricing decisions, and provides such documentation promptly in response to a

request from the IRS.

 After the White Paper (A Study of Intercompany Pricing Under Section 482

of the Code, 1988-2 C.B. 458) in 1988, proposed regulations in 1992, and

temporary regulations in 1993, the IRS issued final regulations under section 482 in

July 1994. The IRS also issued temporary regulations under section 6662(e) in July

1994 and then final regulations in 1996. These regulations are discussed in

Sections II and III below.

 The United States has helped build a international consensus in favor of 

the arm’s length standard. All of our 50 current income tax treaties (with the one

exception of that with the former U.S.S.R.) contain articles requiring mutual

application of the arm’s length principle to resolve transfer pricing disputes. The

OECD similarly adopted the arm’s length principle as the foundation first of its 1979

report (Transfer Pricing and Multinational Enterprises) and then of its 1995 Transfer

Pricing Guidelines (Transfer Pricing Guidelines for Multinational Enterprises and

Tax Administrations). Since 1995, many major U.S. trading partners have amended

their domestic laws governing transfer pricing to incorporate the arm’s length

principle, and put into effect transfer pricing documentation requirements, consistent

with the OECD Transfer Pricing Guidelines.

C. Administrative Problems

The significant factors that have hindered effective administration of section

482 in the past are reviewed briefly below. 

1. No contemporaneous evaluation of transfer prices
.5

Typically taxpayers did not take the arm’s length standard into account for

purposes of reporting their taxable income from intercompany transactions. When

IRS examiners audited the returns, they generally found that no analysis or

documentation existed to explain the appropriateness of transfer prices. Indeed,

taxpayers only began their attention to the transfer pricing issue during the audit

process, several years after the period in which the transactions took place. With

hindsight, taxpayers often had the incentive to adopt positions that arguably

supported extreme results.

2. Priority of transfer pricing methods

The 1968 regulations set forth a hierarchy of methods to be used to

determine transfer prices. Where the taxpayer or the IRS argued for application of

a lower priority method, the hierarchy in effect created a threshold burden to

disprove the applicability of the higher priority method or methods not selected. 

3. Limited access to necessary information

International examiners (IEs) who conducted audits of multinational

enterprises often needed access to company records that were located outside the

United States. Inability to obtain such information, or long delays between the

original request and the receipt of information, were prevalent in the case of foreignowned groups. These problems were especially difficult in the case of entities

located in tax haven countries with which the United States had no provision for

sharing of tax related information. In some cases, delays on the part of the taxpayer

in providing information required IEs to close transfer pricing audits with no

adjustment. Where the cases went forward, the difficulty in obtaining relevant

information from the taxpayer significantly contributed to the long delays in resolving

these matters.

4. Protracted disputes

When the IRS made adjustments under section 482, the positions of the IRS

and the taxpayer were generally far apart, both in terms of pricing methodology and

dollar amount of the adjustment. In the absence of any contemporaneous

documentation, the development of the facts necessary to the fact-intensive

evaluation under the arm’s length standard effectively began only years after the

fact. The taxpayer enjoyed the advantage of starting with a better command of the

facts relevant to its business. Matters not resolved by Appeals went on to become

matters on the docket of the Tax Court, as the magnitude of the section 482
.6

adjustments and the resulting deficiencies in tax generally prevented taxpayers from

paying the tax first and seeking refunds in District or Claims Court. At the litigation

stage, polarized positions and taxpayer delays in furnishing information to IRS

further contributed to contentious and protracted disputes. See discussion of tax

litigation in Chapter 7.

D. Five-Part Strategy to Improve Administration of Section 482

Since the April 1992 report, the IRS has followed a five-part strategy to

improve the administration of section 482. The overall aim has been to shift the

focus from after-the-fact audit and litigation of transfer pricing controversies to

encouragement of upfront taxpayer compliance and advance resolution of transfer

pricing issues.

· First, the IRS has promulgated guidance on the application of the arm’s

length standard. Principal in this category are the final section 482 transfer

pricing regulations issued in 1994.

· Second, the IRS, with the strong backing of Congress, has moved to ensure

that taxpayers apply the arm’s length standard as provided for in the transfer

pricing regulations at the time they file their original return and that taxpayers

have contemporaneous documentation establishing such compliance.

· This contemporaneous documentation is provided for in section

6662(e), as amended in 1993. The IRS issued temporary regulations

in 1994 and final regulations in 1996 implementing this provision.

· The incentive for taxpayers to undertake these compliance

responsibilities are the penalties that are otherwise applicable under

section 6662(a) and (h) in the event a taxpayer’s transfer pricing is

adjusted by the IRS.

· Third, the Treasury and the IRS have worked to build a worldwide consensus

on the application of the arm’s length principle to particular facts and the

taxpayer’s responsibility to contemporaneously document compliance. The

OECD reflected that consensus in guidance on the arm’s length principle and

taxpayer responsibility in its 1995 Transfer Pricing Guidelines. Major U.S.

trading partners have subsequently adopted legislation and other guidance

implementing the approach taken by the 1995 OECD Guidelines. The

international consensus on the arm’s length principle is the basis for

resolution of double tax cases in the competent authority process under

income tax treaties discussed in Chapter 5.

· Fourth, the IRS has encouraged taxpayers to use the Advance Pricing

Agreement (APA) program to provide certainty and advanced resolution of
.7

potential transfer pricing disputes. An APA may protect both against section

482 adjustments and section 6662(e) penalties. The APA program is

discussed in Chapter 6 of this report.

· Fifth, Chief Counsel has developed procedures to coordinate the necessary

technical and litigation support in litigation involving cross-border

transactions.

E. Other Important Compliance Provisions

In addition to sections 482 and 6662(e), there are other important provisions

that are relevant to transfer pricing cases:

1. Sections 6038A and 6038C

Section 6038A imposes reporting, recordkeeping, and document production

obligations, and provides the IRS with summons authority with respect to the related

party transactions of foreign-based groups and their 25% or greater U.S. affiliates. 

Section 6038C imposes similar requirements on foreign corporations engaged in a

trade or business in the United States without regard to the percentage of foreign

ownership. There are penalties for noncompliance. Congress amended section

6038A, and enacted section 6038C, in response to the above-described problems

IRS experienced in obtaining foreign-based information relevant to transfer pricing

determinations.

2. Section 982

Section 982 authorizes the IRS to issue to taxpayers formal document

requests for foreign-based documentation. If the taxpayer fails to comply with a

formal document request without reasonable cause, this provision bars the taxpayer

from subsequently introducing the documentation in subsequent civil tax litigation.

3. Section 6501(c)(8)

Section 6501(c)(8) extends the statute of limitations for three years after the

date on which the IRS obtains information required to be reported under section

6038, 6038A, 6038B, 6046, 6046A, or 6048. This provision serves as a backup to

Forms 5471 and 5472, which inform the IRS of relevant related party transactions

that may require examination for compliance with the arm’s length standard.

4. Section 6503(j)

Section 6503(j), formerly section 6503(k), authorizes the IRS to issue a single
.8

designated summons per income tax return. This designated summons prevents

expiration of the statute of limitations pending judicial enforcement of the summons,

as well as any related summonses issued within 30 days of the original summons.

5. Section 1059A

Section 1059A caps the section 482 cost of certain dutiable imported

merchandise at the amount taken into account in computing customs value for duty

purposes. The purpose is to prevent a potential whipsaw which would result if

affiliated taxpayers in inbound transactions could claim one value for customs

purposes, while reporting higher transfer prices on the same items in computing

taxable income.

II. Guidance on Application of Arm’s Length Standard

This section summarizes the substantive guidance issued since the 1992

report on the application of the arm’s length standard.

A. Section 482 Transfer Pricing Regulations

The central guidance for taxpayers and IRS examiners on the application of

the arm’s length standard is set forth in the final regulations under section 482

issued in July 1994. T. D. 8552, 1994-2 C.B. 93.15 These regulations were

developed at the same time as, and are fully consistent with, the 1995 OECD

Transfer Pricing Guidelines. The salient provisions of the regulations are discussed

below.

1. Functional analysis and comparability

Fundamentally the arm’s length standard calls for an evaluation of the

functions performed, assets used, and risks assumed by commonly controlled

taxpayers in their intercompany transactions as measured against those elements of

“comparable” uncontrolled transactions entered into by uncontrolled taxpayers. The

regulations elaborate upon the factors for determining comparability, including the

functions, contractual terms, risks, economic conditions, and nature of the property

or services involved in the controlled and uncontrolled transactions. In addition to

the general guidance on comparability, guidance is also provided on the significant

comparability considerations under particular transfer pricing methods.

The regulations flexibly recognize that comparability need not be exact, but

 15The final regulations had been preceded by temporary and proposed

regulations issued in January 1993. T.D. 8470, 1993-1 C.B. 90.
.9

the uncontrolled transaction either must be, or must be adjusted to be, sufficiently

similar to provide a reliable measure of an arm’s length result. Generally,

adjustments based on commercial practices, economic principles, or statistical

analyses must be made for material differences between the controlled and

uncontrolled transactions, if the reliability of the measure is improved. If

adjustments for material differences cannot be made, the uncontrolled transaction

may be used as a measure of an arm’s length result, but the reliability of the

analysis is reduced. The extent and reliability of any adjustments affects the

relative reliability of the analysis under the best method rule.

2. Best method rule

Under the regulations, the arm’s length result of a controlled transaction must

be determined under the method that, under the facts and circumstances, provides

the most reliable measure of an arm’s length result. Neither the IRS nor the

taxpayer is held to the former hierarchy of methods, but if another method is

subsequently shown to produce a more reliable measure of an arm’s length result,

such other method prevails. 

In the selection of the best method, the two primary factors to take into

account are the degree of comparability between the controlled and uncontrolled

transactions and the quality of the data and assumptions used in the analysis. If the

best method rule does not clearly indicate which method should be selected, an

additional factor that may be taken into account is whether any of the competing

methods produce results that are consistent with the results obtained from the

appropriate application of another method.

3. Range of arm’s length results

The regulations recognize that generally there will not merely be a single, but

a range of possible arm’s length results of a controlled transaction (arm’s length

range). The results reported by the taxpayer for a controlled transaction will not be

subject to an IRS adjustment if the results fall within the arm’s length range.

The arm’s length range is derived only from those uncontrolled transactions

that have, or through adjustments can be brought to, a similar level of comparability

and reliability. Those uncontrolled comparables that have a significantly lower level

of comparability and reliability may not be used in establishing the arm’s length

range.

The regulations provide rules for defining the range, including rules for

increasing the reliability of the analysis where inexact comparables are used. The

regulations also provide rules for the IRS adjustments that may be made where the
.10

results of a controlled transaction fall outside the arm’s length range.

4. Transfers of tangible property

Subject to the best method rule, the regulations permit the arm’s length

results of controlled transactions involving the transfer of tangible property, e.g., the

intercompany sale of goods, to be determined under any of five specified methods

or under an unspecified method. The five specified methods are the comparable

uncontrolled price (CUP) method, the resale price method, the cost plus method,

the comparable profits method, and the profit split method.

Under the CUP method, the transfer price in a controlled transfer of tangible

property is evaluated by reference to the price in a comparable uncontrolled

transaction. The regulations provide guidance on the comparability considerations

and adjustments (e.g., for volume, level of the market, geographic market, or

trademark). In particular, similarity of products generally will have the greatest

effect on comparability under this method. The results derived from the CUP

method generally will be the most direct and reliable measure of an arm’s length

result, if either there are no differences between the controlled and uncontrolled

transactions, or there are only minor differences with definite and reasonably

ascertainable effects on price for which appropriate adjustments are made. If such

an exact comparable is not available, the CUP method may still be used based on

an inexact comparable, but the reliability of the analysis as a measure of arm’s

length results will be reduced.

The resale price method evaluates the gross profit margin earned in the

controlled transaction by reference to the gross profit margin realized in comparable

uncontrolled transactions. The regulations provide guidance on comparability

considerations and adjustments, including on the need for consistency as between

the controlled and uncontrolled transactions in cost accounting practices that

materially affect the gross profit margin. The resale price method focuses on the

value of the reselling functions, so while similarity in functions, risks, and

contractual terms is significant, comparability under this method is less dependent

on similarity in the physical products being distributed. The resale price method is

not ordinarily used where the controlled taxpayer uses its intangible property, e.g.,

trademarks, to add substantial value to the goods resold.

The cost plus method evaluates the gross profit markup earned in the

controlled transaction by reference to the gross profit markup realized in

comparable uncontrolled transactions. The regulations provide guidance on

comparability considerations and adjustments, including on the need for

consistency as between the controlled and uncontrolled transactions in cost

accounting practices that materially affect the gross profit markup. The cost plus
.11

method focuses on the value of the production functions, so while similarity in

functions, risks, and contractual terms is significant, comparability under this

method is less dependent on similarity in the physical products being produced.

The comparable profits method evaluates the operating profit earned in the

controlled transactions (relevant business activity) by reference to the operating

profit that would have been earned if performance in the relevant business activity

were equal to the profit level indicator in comparable uncontrolled transactions. 

The relevant business activity encompasses the most narrowly identifiable business

activity for which data incorporating the results of the controlled transactions is

available. In this analysis, the tested party, i.e., the controlled taxpayer whose

relevant business activity is being evaluated, generally is the least complex the

affiliated taxpayers and does not utilize valuable intangible property or unique

assets in the controlled transactions to a degree that is distinguishable from the

uncontrolled transactions. The regulations provide for a variety of profit level

indicators, such as the ratios of operating profit to operating assets, operating profit

to sales, and gross profit to operating expenses. Generally, the analysis must be

made over at least a three-year period comprising the taxable year under review

and the preceding two taxable years, since use of data from multiple years may

increase reliability by avoiding the distorting effects on operating profit of business

cycles or life cycles of the product or intangible being examined. The regulations

provide guidance on comparability considerations and adjustments, including on the

need for consistency as between the controlled and uncontrolled transactions in

cost accounting practices that materially affect operating profit, and on the need to

allocate costs, income, and assets between the relevant business activity and other

activities of the tested party and the uncontrolled comparable. The comparable

profit method focuses on the return on investment of resources and assumption of

risk in the relevant business activity, so similarity in resources employed and risks

assumed is significant. Comparability under this method is less dependent on

similarity in physical products and, moreover, generally tolerates a greater degree

of functional differences than other methods since taxpayers performing different

functions may have very different gross profit margins, but earn similar levels of

operating profit. On the other hand, comparability under this method may be more

sensitive to other factors, e.g., management efficiency, that may affect the reliability

of the analysis.

The profit split method is applied using one of two alternative approaches. 

Under the comparable profit split, the combined operating profit or loss earned by

the controlled taxpayers in the controlled transactions (relevant business activity) is

allocated between them by reference to the allocation between uncontrolled

taxpayers of the combined operating profit or loss in comparable uncontrolled

transactions. Under the residual profit split, a two step process is used to allocate

the combined operating profit or loss from the relevant business activity between
.12

the controlled taxpayers. The first step allocates operating income to each party to

provide a market return to its routine contributions of tangible property, services,

and intangibles to the relevant business activity. Such market returns may be

determined under any of the other provisions of the regulations (e.g., the

comparable profits method). The second step allocates the residual profit or loss

between the parties based on the relative value of their contributions of unique

intangible property to the relevant business activity, as measured by external or

internal gauges. The regulations provide guidance on comparability considerations

and adjustments, including on the need for consistency as between the controlled

and uncontrolled transactions in cost accounting practices that materially affect

operating profit, and on the need to allocate costs, income, and assets between the

relevant business activity and other activities of the parties. The reliability of the

analysis under the comparable profit split and the first step of the residual profit split

depends on similar considerations as apply for the external market benchmarks

used under other provisions of the regulations. To the extent the allocation of profit

or loss in the second step of the residual profit split is not based on external market

benchmarks, the reliability of the analysis is decreased. The reliability of both profit

split approaches may be enhanced by their two-sided evaluation of the contributions

of both parties to the controlled transactions, as distinguished from the one-sided

analysis under other methods, provided data and assumptions with respect to both

parties are similarly reliable.

The regulations also permit the use of unspecified methods, subject to the

best method rule. Consistent with the specified methods, an unspecified method

should take into account the general principle that uncontrolled taxpayers evaluate

the realistic commercial or business alternatives prior to entering into a transaction.

 Thus, an unspecified method should provide information on the prices or returns

available under realistic alternatives to the controlled transaction.16

5. Transfer of intangible property

Subject to the best method rule, the regulations permit the arm’s length

results of controlled transactions involving the transfer of intangible property, e.g.,

the intercompany license of patents, to be determined under any of three specified

methods or under an unspecified method. The three specified methods are the

comparable uncontrolled transaction (CUT) method, the comparable profits method,

and the profit split method. The comparable profits, profit split, and unspecified

methods are discussed above.

 16 The 1994 final regulations deleted the procedural provision, which had been

contained in the 1993 temporary regulations, requiring disclosure on the tax return of

the use of an unspecified transfer pricing methodology.
.13

Under the CUT method, the transfer price in a controlled transfer of

intangible property is evaluated by reference to the price in a comparable

uncontrolled transaction. The regulations provide guidance on the comparability

considerations and adjustments (e.g., exclusive or nonexclusive rights, stage of

development of the intangible, and duration of license). In particular, application of

this method requires that the controlled and uncontrolled transactions involve either

the same or comparable intangible property. To be comparable for this purpose,

both intangibles must be used in connection with similar products or processes

within the same general industry or market and have similar profit potential. The

need to reliably measure profit potential increases in relation to both the total

amount of potential profits and the potential rate of return on investment necessary

to exploit the intangible. The results derived from the CUT method generally will be

the most direct and reliable measure of an arm’s length result, if either there are at

most only minor differences between the controlled and uncontrolled transactions

with definite and reasonably ascertainable effects on price for which appropriate

adjustments are made. If such an exact comparable is not available, the CUT

method may still be used based on an inexact comparable, but the reliability of the

analysis as a measure of arm’s length results will be reduced. 

The regulations implement the commensurate with income principle of the

second sentence of section 482 with respect to transfer of intangible property. The

regulations authorize the IRS to adjust the consideration charged for the transfer in

subsequent years, even if the charges in earlier years are determined to be arm's

length (periodic adjustments). The regulations provide for exceptions to the

periodic adjustments rule. Among the exceptions are cases in which the

consideration charged for the transfer is based on an exact comparable or, where

an inexact comparable is used, the actual results do not diverge (except due to

extraordinary events beyond the taxpayer’s control that could not reasonably have

been anticipated) from projected results by more than 20% (among other

conditions).

6. Loans, services, and leases

The regulations continue provisions from the 1968 regulations governing

application of the arm’s length standard to intercompany loans, services, and

leases.

7. Inexact comparables

The regulations authorize the use of inexact comparables under all transfer

pricing methods. Use of such comparables is subject to an evaluation of the relative

reliability of their results under the best method rule. Use of inexact comparables

may also require adjustment of the arm's length range as a means of increasing
.14

reliability.

B. Section 482 Cost Sharing Regulations

In 1996, the IRS issued final regulations relating to qualified cost sharing

arrangements under section 482. T.D. 8632, 1996-1 C.B. 85, as amended by T.D.

8670, 1996-1 C.B. 99.

In enacting the commensurate with income principle with respect to the

transfer of intangible property, Congress indicated that it did not intend to curtail the

use of bona fide research and development agreements by related parties. H.R.

Rep. No. 281, 99th Cong., 2d Sess. at II-638 (1986). The cost sharing regulations

set forth the rules under which affiliates may share ownership of intangibles by

sharing the development costs, thereby obviating the need to apply the transfer of

intangible property rules to determine an arm’s length royalty.

A cost sharing arrangement is defined as an agreement to share the costs of

development of one or more intangibles in proportion to the shares of reasonably

anticipated benefits from the parties’ individual exploitation of their assigned

interests in the intangibles. A taxpayer must also satisfy formal requirements in

order to claim the treatment provided under the regulations for a qualified cost

sharing arrangement. In particular, there must be contemporaneous documentation

of the arrangement, the methodology, the research to be undertaken, and each

participant’s interest in any intangible property that is developed. The IRS may

apply the treatment under the regulations to what in substance constitutes a cost

sharing arrangement, notwithstanding a failure to meet a formal requirement for a

qualified cost sharing arrangement. The regulations clarify that a cost sharing

arrangement will not be treated as a partnership, and will not of itself cause

effectively connected trade or business (or permanent establishment) status for a

foreign participant.

IRS adjustments with regard to a qualified cost sharing arrangement are

limited to bringing cost shares into equivalence with benefits shares. However, if a

controlled taxpayer acquires an interest in intangible property from another

controlled taxpayer (other than in consideration for bearing a share of the costs of

the intangible’s development), then the IRS may make adjustments under the

general rules governing transfers of intangible property.

The participation rules generally require that a participant in a qualified cost

sharing arrangement must reasonably anticipate benefits from the use of intangibles

that are developed as the result of research undertaken pursuant to the

arrangement (covered intangibles). In addition, to qualify for participation certain

formal requirements must be satisfied related to accounting, documentation, and
.15

reporting.

The regulations flexibly permit the taxpayer to define the scope of research

and development to be covered (intangible development area). Thus, the intangible

development area includes research and development actually undertaken under

the cost sharing arrangement. Covered intangibles include any intangible that

actually results from the research and development under the cost sharing

arrangement.

The intangible development costs to be shared under a cost sharing

arrangement include all costs related to the intangible development area (i.e.,

operating expenses, other than depreciation or amortization, plus a charge for the

use of tangible property), plus cost sharing payments made, and minus cost sharing

payments received. Separate consideration (the buy-in) is required for pre-existing

intangible property made available to the arrangement, as determined under the

general rules governing transfer of intangible property.

Whether a controlled participant is bearing an appropriate cost share is

determined by comparing its share of the total intangible costs of all controlled

participants to its share of the total reasonably anticipated benefits of all controlled

participants. For this purpose, anticipated benefits are the additional income

generated or the costs saved by the use of covered intangibles. A controlled

participant’s share of reasonably anticipated benefits must be determined using the

most reliable estimate of reasonably anticipated benefits.

The reliability of a benefits estimate depends in particular on the reliability of

the basis used for measuring benefits and the reliability of projections used to

estimate benefits. Measures of benefits can be direct (i.e., of additional income to

be generated or costs saved from the use of covered intangibles) or indirect. 

Indirect measures may include units used, produced or sold, sales, operating profit,

or other bases, to the extent that there is expected to be a reasonably identifiable

relationship between the basis used and benefits attributable to the use of covered

intangibles. The regulations indicate which indirect measure is likely to be most

reliable under given circumstances.

Projections whose reliability must be evaluated include projections of the time

period before benefits are to be received, the time period over which benefits will be

received, and the benefits anticipated for each year. Current benefit shares may be

the most reliable projection of anticipated benefit shares if the arrangement is a

long-term arrangement, if it covers a wide variety of intangibles, if the composition

of intangibles is unlikely to change, if the intangibles are unlikely to generate

unusual profits, and if each participant's share of the market is stable. A significant

divergence between projected and actual benefit shares may indicate that the
.16

projections were not reliable, but a divergence of 20% or less for every controlled

participant will not be considered unreliable, and IRS will not make an allocation

based on a divergence that is due to an extraordinary event beyond the taxpayers’

control and reasonable anticipation.

The general rules for transfer of intangible property will continue to govern

new entry, exit, and other changes in interest among the participants in a cost

sharing arrangement. Moreover, if, after any cost allocations, a controlled

participant bears costs that over a period of years are consistently and materially

greater or lesser than its share of reasonably anticipated benefits, IRS may allocate

income under the general rules consistent with the course of conduct.

C. Guidance for Specialized Industries and New Technologies

1. Proposed regulations on global dealing

In 1998, the IRS issued proposed regulations which addressed the allocation

and sourcing of income from a global dealing operation. 63 Fed. Reg. 11,177

(March 6, 1998).17 Global dealing refers to execution by financial institutions of

customer transactions in a financial product or line of financial products, in multiple

tax jurisdictions and/or through multiple participants.

 17At the same time as the proposed regulations were being developed, the

Treasury and the IRS had been actively participating in the work of the OECD in this

area. OECD, The Taxation of Global Trading of Financial Instruments (1998) (updated

discussion draft revising earlier version of February 14, 1997). In addition, the U.K.

Inland Revenue recently issued relevant guidance. U.K. Inland Revenue, Tax Bulletin,

paragraphs 61-62 (December 1998).

There are three main parts of the proposed regulations. The first part adapts

the general guidance under the section 482 regulations to the particular context of a

global dealing operation in which two or more affiliates participate. The regulations

provide guidance on the conditions and comparability considerations for application

of four specified methods (comparable uncontrolled financial transaction method,

gross margin method, gross markup method, and profit split method) and

unspecified methods. The regulations take into account comparability factors

unique to the financial services industry and are designed generally to

accommodate the range of business structures that are utilized in global dealing
.17

operations by adopting the “best method” rule for selection of the correct transfer

pricing method for each global dealing activity.

The second part of the proposed regulations provides guidance on the

sourcing of the income from a global dealing operation conducted in multiple

locations by a single taxpayer. The proposed regulations generally adopt the

approach that sources an amount of income to each location as would have been

allocated to that location under the special section 482 guidance if the various

locations were separate affiliates participating in the global dealing operation. The

regulations take into account, however, the economic differences between acting

through a single legal entity and through separate legal entities. In particular, the

regulations effectively provide that compensation for risk bearing should be sourced

by reference to where capital of the entire entity is employed in the global dealing

operation by traders, marketers and salespeople, rather than by reference to the

residence of the capital provider.

The third part of the proposed regulations provides guidance on coordination

of the different timing rules, based on mark-to-market accounting, applicable to the

global dealing “desk” within a single financial services entity, as distinguished from

its lending or other desks.

These regulations recognize that risk may be transferred among separate

operating units of an affiliated group or multiple locations of a single taxpayer, and

that the transfer can be respected for tax purposes by virtue of the separately

identifiable accounting treatment and risk management activities performed by the

respective units in the ordinary course of their business.

Although the regulations provide transfer pricing guidance with respect to

related party transactions entered into by a global dealing operation, the proposed

rules are limited to transactions in securities and foreign currency. The regulations

do not extend to transactions in commodities or to proprietary trading operations

that include related-party transactions in securities. 

2. Electronic commerce

Treasury and the IRS have been studying the implications of the internet and

related technologies for income tax administration including section 482 issues.18

Conceptually, electronic commerce does not present any different transfer pricing

issues than for more longstanding modes of doing business. The task remains to

evaluate the arm’s length results of functions performed, resources employed, and

 18See Selected Tax Policy Implications of Electronic Commerce (November

1996); A Framework for Global Electronic Commerce (July 1997).
.18

risks assumed in domestic and foreign tax jurisdictions, and to minimize any

potential for double taxation. The Treasury and IRS are actively involved in the

OECD consideration of these issues.19

D. Conforming Accounts to Reflect Section 482 Adjustments

The process for conforming the accounts of affiliates to reflect primary

section 482 adjustments by the IRS is currently set forth in Rev. Proc. 65-17, 1965-1

C.B. 833.20 Consider, for example, the case of a U.S. parent that undercharges its

foreign subsidiary in an intercompany transaction. If the IRS makes a primary

adjustment increasing the income of the parent, there is a need to conform the

accounts of the parent and subsidiary to reflect that the subsidiary did not actually

pay the parent the additional cash necessary to make up for the undercharge. 

Without more, the conforming adjustment would be to reflect the additional amount

as a capital contribution to the subsidiary. Rev. Proc. 65-17 sets forth procedures

by which taxpayers may adopt either of two alternative means to conform their

accounts. Under one alternative, taxpayers may offset the primary adjustment to

the extent of the amount of a dividend paid in the same year (dividend offset).21

 19From October 7 to 9, 1998, the United States joined with other OECD member

states in a ministerial level conference in Ottawa regarding taxation of electronic

commerce in the global marketplace, entitled: “A Borderless World: Realizing the

Potential of Global Electronic Commerce.” In a declaration at the end of the

conference, the ministers recognized certain common principles regarding electronic

commerce, including agreement in principle that no taxes specific to internet commerce

should be enacted. Working groups were established to carry forward the

consideration of taxation issues related to electronic commerce. See OECD, Electronic

Commerce: Taxation Framework Conditions.

20See also Rev. Rul. 82-80, 1982-1 C.B. 89, extending Rev. 65-17 to inbound

cases.

21See also Rev. Proc. 70-23, 1970-2 C.B. 505 and Rev. Proc. 71-35, 1971-2 C.B.
.19

Under the other alternative, taxpayers may set up interest bearing accounts payable

and receivable in the amount of the primary adjustment, pay the accounts, and take

into income the interest for the period beginning with the end of the year of the

primary adjustment up through the date of payment.

 

573, clarifying the application of the dividend offset in various situations.

The IRS has proposed revisions to Rev. Proc. 65-17 in Announcement 99-1,

1999-2 I.R.B. 41. Four main changes are proposed. While availability of the

alternative treatments under Rev. Proc. 65-17 is premised on absence of a tax

avoidance motive, under the proposed Revenue Procedure alternative treatment

would be available provided that the taxpayer is not subject to a penalty under

section 6662(e)(1)(B) or (h) by reason of the primary section 482 adjustment. 

Dividend offset treatment would be eliminated, so that the only alternative treatment

would be the establishment of interest bearing accounts payable and receivable. A

procedure is proposed by which taxpayers could establish cash repatriation

accounts themselves in situations in which they make taxpayer-initiated primary

adjustments (i.e., in connection with their own upfront compliance with the arm’s

length standard). In addition, the proposed revenue procedure would clarify that,

generally, a foreign tax credit is available for foreign withholding tax with respect to

the repayment of the principal or interest on a cash repatriation account, subject to

the limitations under the foreign tax credit rules.

E. Potential Application of Section 482 to Lease Stripping Abuse

Lease stripping refers generally to a class of transactions in which the parties

(which may or may not have overlapping ownership) apportion income from an

asset to one party (exempt from the U.S.’s taxing jurisdiction), and deductions

associated with the asset to another party (which is subject to the U.S.’s taxing

jurisdiction). In Notice 95-53, 1995-2 C.B. 334, the IRS stated that section 482 was

one of several Code provisions which might be used to combat abuse in this area,

because the participants acted pursuant to a common design to shift income and

deductions arbitrarily in an effort to distort the taxable income of one of the parties

(i.e., the entity subject to the U.S.’s taxing jurisdiction) . Under the authority of

section 482, the Commissioner might reallocate expenses or deductions to a

specific party in accordance with the economic substance of the transaction in order

to prevent tax evasion or obtain a clear reflection of income.

III. Guidance on Upfront Compliance with the Arm’s Length Standard

 A. Statutory Framework

The Revenue Reconciliation Act of 1990 amended section 6662 to make the
.20

penalty applicable to substantial and gross valuation misstatements, and

specifically, through subsections (e)(1)(B), (e)(3), and (h)(2)(A), to section 482

adjustments. The penalty is 20% of the portion of any underpayment of tax

attributable to a substantial valuation misstatement and 40% of any underpayment

of tax attributable to a gross valuation misstatement.

Prior to the 1993 amendment below, a substantial valuation misstatement

resulted by reason of a net section 482 transfer price adjustment exceeding $10

million, and a gross valuation misstatement resulted by reason of a net section 482

transfer price adjustment exceeding $20 million (net adjustment penalty). For

purposes of determining whether the thresholds for application of the net adjustment

penalty were met, there was excluded any portion of what would otherwise have

been the net section 482 transfer pricing adjustment to the extent the taxpayer were

shown to have had reasonable cause for its determination and the taxpayer acted in

good faith. In addition, a substantial valuation misstatement resulted by reason of a

transfer price claimed on the taxpayer’s return being 200% or more (or 50% or less)

than the amount determined under section 482, and a gross valuation misstatement

resulted by reason of a transfer price claimed on the taxpayer’s return being 400%

or more (or 25% or less) than the amount determined under section 482

(transactional penalty). No penalty is imposed with respect to a portion of an

underpayment to the extent it may be shown that the taxpayer had reasonable

cause for such portion and acted in good faith.

The Revenue Reconciliation Act of 1993 amended the penalty provisions

applicable to section 482 adjustments. The 1993 amendment reduced the net

adjustment penalty threshold for a substantial valuation misstatement from $10

million to the lesser of $5 million or 10% of gross receipts, and for a gross valuation

misstatement from $20 million to the lesser of $20 million or 20% of gross receipts. 

The transactional penalty thresholds were not changed.

Importantly, in lieu of the threshold consideration of reasonable cause and

good faith of the taxpayer, the 1993 amendment made the net adjustment penalty

applicable only where the taxpayer has failed to undertake an upfront effort to

comply with the arm’s length standard, to contemporaneously document that

compliance, and to provide that documentation to the IRS within 30 days of

request.22

B. Section 6662(e) and (h) Regulations

 22 The regulations similarly provide an excuse from the imposition of the transactional

penalty where the taxpayer undertakes these compliance obligations.
.21

The IRS issued final regulations under section 6662(e) and (h) in 1996.23

The purpose of the guidance had been stated in the preamble to the temporary

regulations that the IRS had previously issued in 1994:

 23 T.D. 8656, 1996-1 C.B. 329. Proposed regulations construing the statute prior to the

1993 amendment had been issued in January 1993. 58 Fed. Reg. 5304. Temporary

regulations implementing the 1993 amendment had been issued in February and July

1994. T.D. 8519, 1994-1 C.B. 298; 59 Fed. Reg. 35030.
.22

The experience of the IRS has been that the majority of taxpayers do

not provide an explanation of how their intercompany pricing was

established. In many cases examiners’ access to a corporation’s

transfer pricing information is delayed or denied. Moreover, many

taxpayers do not rely upon any form of comparables or

contemporaneous information either in planning or in defending

intercompany transactions. . . . The failure by taxpayers to analyze

their intercompany pricing prior to audit increases controversy between

taxpayers and the IRS, as both seek to develop post hoc analyses of

the arm’s length character of the transactions. Thus, the failure to

apply the arm’s length standard in setting prices for controlled

transactions (and the lack of contemporaneous documentation

explaining that application) increases the time spent and expense

incurred by both the taxpayer and the IRS in determining whether that

result was consistent with the arm’s length standard. Accordingly,

these regulations are designed to encourage taxpayers to make a

serious effort to comply with the arm’s length standard, report an arm’s

length result on their income tax return, document their transfer pricing

analyses, and provide that documentation to the IRS upon request.24

The regulations provide guidance on how taxpayers may satisfy their

compliance obligations regarding analysis, documentation, and production, and so

avoid imposition of the section 482 related penalties. The required compliance

depends on whether the taxpayer applies a specified or an unspecified method

under the section 482 regulations.

For specified methods, the taxpayer must select and apply a specified

method in a reasonable manner. The taxpayer must reasonably conclude that

under the facts and circumstances the method and its application provide the most

reliable measure of an arm’s length result pursuant to the best method rule. For

purposes of this analysis, the taxpayer must perform a reasonably thorough search

for relevant data and evaluate the potential applicability of the other specified

methods. 

The taxpayer must maintain documentation of its compliance. The

regulations divide the required documentation into two categories, principal

documents and background documents. Principal documents (as further subdivided

into ten parts) include the basic documentation explaining the business,

organization, application of the section 482 regulations, additional relevant data

obtained after the end of the tax year prior to filing the tax return, and a general

index of the principal and background documents along with a description of the

 24 T.D. 8519, 1994-1 C.B. at 299.
.23

system of cataloguing and accessing these documents. Background documents

generally include the relevant backup for the principal documents. All the principal

and background documentation must be in existence when the return is filed, with

the exception of the summary of post-year end relevant data and the general index

and recordkeeping system description.

The taxpayer must provide the documentation to the IRS within 30 days of a

request. The IRS may excuse a minor or inadvertent failure to produce

documentation, if the taxpayer made a good faith effort to comply and promptly

remedies the failure. Background documents need not be produced in response to

a request for principal documents, and the IRS may, in its discretion, extend the

period for producing background documentation.

For unspecified methods, the taxpayer must reasonably conclude that under

the facts and circumstances none of the specified methods was likely to provide a

reliable measure of an arm’s length result, and that the method selected is applied

in a way that would likely provide a reliable measure of an arm’s length result. For

purposes of this analysis, the taxpayer must evaluate the potential applicability of

the specified methods in light of the best method rule. If the intercompany

transaction being analyzed is of a type for which no methods are specified under

the section 482 regulations, the taxpayer must conclude that the method and its

application provide the most reliable measure of an arm’s length result under the

best method rule. The documentation and production requirements are essentially

the same for unspecified methods as for specified methods.

The requirements to contemporaneously document compliance with the arm’s

length standard, and promptly provide that documentation to the IRS upon request,

play an important role in ameliorating problems previously experienced in the

administration of section 482. Shortly after an examination begins, the IRS will now

have available documentation (and an index) with respect to the taxpayer’s products

or services, organization, and mode of operation, as well as the taxpayer’s own

evaluation of its transfer prices under the section 482 regulations. Moreover, the

requirement that the taxpayer’s analysis be contemporaneous tends to lessen the

opportunity to adopt extreme positions that the benefits of hindsight encouraged in

the past. Thus, the IRS now has a well-defined starting point for section 482 issues.

 The IRS no longer has to generate a transfer pricing analysis in a vacuum, but can

focus on the analysis contemporaneously prepared by the taxpayer. This focus is

salutary for resolution of issues in examination, as well as for resolution of those

issues that must go forward to the Appeals or litigation process.

C. Oversight of Transfer Pricing Penalty Assessment

To help promote consistency and uniformity among individual IRS district

offices, a Penalty Oversight Committee has been established to review proposed
.2

imposition of section 6662 penalties.25 The committee has representatives from the

Assistant Commissioner International, Examinations, Appeals, and Associate Chief

Counsel (International).

 25 Announcement 96-16, 1996-13 I.R.B. 22 (March 25, 1996).

CHAPTER 3: FIELD DEVELOPMENTS

Administration of transfer pricing rules in the international context is the

responsibility of the Office of the Assistant Commissioner (International) (ACT), in

conjunction with the Offices of the Assistant Commissioner (Examination) and the

Associate Chief Counsel (International). ACT’s administration of transfer pricing

consists of three major functions: examinations of taxpayers, participation in

intergovernmental programs, and implementation of the U.S. tax treaty network. 

The latter two functions are addressed in Chapter 5. This chapter reviews

developments in the examination of transfer pricing issues since the 1992 report.

I. Examination

Transfer pricing issues require substantial factual development. In order to

determine whether the results of controlled transactions are consistent with the

arm’s length standard, the IRS must identify the related entities and the nature of

their inter-relationships, understand the underlying transactions, and then evaluate

potentially comparable uncontrolled transactions. The IRS must assemble and

analyze the data concerning the functions performed, assets used, and risks

assumed in the controlled and uncontrolled transactions. Transfer pricing

examinations are resource intensive. They typically are tackled by a team of

experienced personnel with special training, including, as needed, international

examiners (IEs), attorneys, economists, industry specialists, and outside experts. 

There are approximately 650 IEs throughout the country devoting about half

their time to examining transfer pricing issues. They assist in all Coordinated

Examination Program (CEP) examinations that involve international issues. The

CEP consists of tax examinations of the 1,500 largest companies in the United
.3

States, and their domestic and foreign subsidiaries. Although the headquarters of a

corporate taxpayer may be in one location, agents from other parts of the country

may examine portions of the taxpayer’s operations in other locations. In some

cases, a CEP audit team may also examine operations located in foreign

jurisdictions.

As for other tax issues, the IRS makes a conscientious effort to settle section

482 cases in examination. Most cases involving proposed section 482 adjustments,

however, are settled by Appeals, as discussed in Chapter 4.

Section 482 cases that are not settled in Examination or Appeals proceed to

litigation, usually in the United States Tax Court. When a Tax Court case is

docketed, primary control for the matter passes to the Office of Chief Counsel. 

Section 482 litigation is discussed further in Chapter 7.

II. International Field Assistance Specialization Program (IFASP)

ACT instituted the International Field Assistance Specialization Program

(IFASP) in 1991. IFASP specialists provide IEs with practical assistance regarding

technical issue identification and case development in the international area. 

IFASP includes a team of four senior specialists who travel nationwide to provide

transfer pricing expertise and assistance to IEs, IE managers, CEP managers, and

economists on particular cases. The IFASP team promotes coordination and

consistency for transfer pricing examinations. IFASP coordinates issues and

proposed actions as necessary with the Office of the Associate Chief Counsel

(International) and with Appeals. IFASP transfer pricing specialists are also

frequently assigned to APA teams as advisors.

The IFASP transfer pricing specialists work closely with the IEs. They assist

in identifying issues, suggest audit techniques, help search out and evaluate

comparables data, and put audit teams with similar issues or industries into contact

with one another. IFASP efforts have fostered more efficient audits, betterdeveloped issues, and the identification of trends in section 482 compliance. IFASP

plays a central role in IRS training and outreach on transfer pricing topics for both

internal and external audiences.

IFASP works on developing coordinated approaches to transfer pricing

examinations for particular industries. Specific industry focused projects on which

IFASP specialists provided input in recent years include the following:

· Far East and European Automobile Industry

· Camera Industry (foreign-controlled corporations)

· Computer Industry (foreign-controlled corporations)
.4

· Electronic Distributors (foreign-controlled corporations)

· Mexican Produce Growers (imports into the United States)

· Data Processing Industry (consistency in comparable data)

· Forestry/Fishing Industries (cooperative efforts of the U.S. and Canada

regarding pricing studies)

· Entertainment Industry (offshore transfer of film intangibles)

IFASP transfer pricing specialists participate in reviewing Code provisions

and regulations in need of clarification or revision. IFASP input concerning the

need for contemporaneous documentation of taxpayer efforts to comply with the

arm’s length standard was a significant impetus to the 1993 amendment to section

6662(e). IFASP specialists also contributed to the development of the new

regulatory guidance under sections 482 and section 6662(e).

III. Coordination with the United States Customs Service

In 1992 the IRS/Customs Policy board was established. The IRS has been

working closely with the United States Customs Service to better coordinate transfer

pricing compliance through the IRS/Customs Policy Board and Working Groups:

· Customs provides IRS import data in conjunction with specific examinations

and soon IEs will have direct access via intranet to the Customs database.

· Both agencies recognize the need to assess compliance by industry,

identifying patterns of noncompliance, and developing examination

techniques. For that purpose, Customs provided IRS with its FY99 Audit and

Compliance Plans in an effort to help identify industries of common interest. 

Both agencies are sharing lists of industry and issue specialists in an effort to

increase communication.

· Customs is sharing developments in software used to analyze imports,

including demonstrations at IRS locations. This software is expected to save

IRS research time and help economize on the use of Computer Audit

Specialist support.

· Customs recently agreed to provide IRS information pertaining to freight

forwarders to assist in the development of examination issues in that

industry.

· Customs executives meet every six months with the Southwest Border

District Directors to address Mexican border issues.

· National Office Research and Analysis and Southwest District Office

Research and Analysis have Customs data pertaining to imports from Mexico

and are analyzing that data in conjunction with other compliance initiatives.
.2

For dutiable goods imported in controlled transactions, section 1059A

generally limits the cost basis that may be taken into account for income tax

purposes to the amount taken into account in computing customs value. Thus,

cooperation between IRS and the Customs Service facilitates section 1059A

compliance. In addition, the IRS uses customs data as a more general resource in

its transfer pricing compliance efforts, with due regard to the limitations of the

customs data in that context. For example, there are no customs data for imported

or exported services and intangibles, areas of significant transfer pricing

controversies.

Section 6103 generally prevents the IRS from releasing tax-return

information, even to other Federal agencies pursuant to valid law enforcement

purposes. An exception is provided pursuant to section 522 of the North American

Free Trade Agreement (NAFTA) Implementation Act, Public Law 102-182, 107 Stat.

2057, codified as section 6103(l)(14), enacted on December 8, 1993. Under this

provision, the IRS may release to Customs certain information necessary for

Customs officials to determine on audit (or in other actions for collection of

revenue), whether entries were correctly reported. This provision and the

regulations thereunder prohibit any re-use of the taxpayer information by Customs

for any other purpose. See T.D. 8527 (August 1994) (temporary regulations); T.D.

8694 (December 1996) (final regulations).

CHAPTER 4: APPEALS DEVELOPMENTS

This chapter summarizes recent developments in the Appeals process which

are relevant to the administration of section 482. Appendix C sets forth sustention

rate results for section 482 cases in Appeals.

I. Simultaneous Appeals/Competent Authority Procedure

A new simultaneous Appeals/Competent Authority procedure, described in

Rev. Proc. 96-13, 1996-1 C.B. 616, encourages the taxpayer to request joint

competent authority assistance and Appeals consideration for double tax issues. 

This procedure is particularly suited to transfer pricing matters, given the competent

authority dimensions typical in such cases. The goal of the new procedure is to

expedite resolution of competent authority issues by enabling Appeals to participate

actively in the competent authority process.

The revenue procedure sets forth specific circumstances under which the

simultaneous Appeals/Competent Authority consideration may be requested and

describes the role of Appeals. Taxpayer requests should be made as early in the

process as possible after Examination’s proposal of a section 482 adjustment, e.g.,
.3

before a protest is filed or immediately after the first Appeals conference. A

taxpayer may also request the simultaneous procedure after competent authority

has begun to consider a case, generally until the U.S. competent authority has

communicated its position to the foreign competent authority. The U.S. competent

authority may also request on its own initiative that Appeals become involved in a

case.

As discussed in Chapter 6, in certain cases, the specific transfer pricing

methodology developed for prospective application in a bilateral APA may also be

used to resolve section 482 issues in prior open tax years, a procedure referred to

as a rollback. Rev. Proc. 96-53, 1996-2 C.B. 375, describes the procedures for

obtaining a rollback of an APA. The Revenue Procedure provides rules for

coordination of APA rollback requests with accelerated competent authority

resolution or with simultaneous Appeals/Competent Authority consideration. Small

business taxpayers that seek APAs under the newly streamlined procedures (Notice

98-65, 1998-52 I.R.B 10) may also utilize the simultaneous Appeals/Competent

Authority procedures.

The simultaneous procedure coordinates Appeals and competent authority

consideration in a manner that recognizes the interest of taxpayers in access to

Appeals while avoiding the past potential for abuse and inefficiency through

iterative resort to both processes. Thus, for example, a taxpayer that received

consideration by Appeals without achieving a settlement and that subsequently

requests competent authority assistance, may be denied access to the

simultaneous procedure. Similarly, a taxpayer that has already received

substantial Appeals consideration does not obtain a right to a reconsideration of

Appeals’ position merely by invoking the simultaneous procedure. Rather, in such

cases, the IRS will rely on the previous consideration by Appeals when it considers

the case under the simultaneous procedure. If, prior to pursuing competent

authority assistance, the taxpayer has already reached a settlement of the transfer

pricing issue with Appeals, and that settlement was reduced to writing, the U.S.

competent authority will only endeavor to obtain a correlative adjustment from the

treaty partner, but will not undertake any action that might undermine Appeals’

settlement agreement. 

If the competent authorities fail to agree, or if the taxpayer does not accept

the mutual agreement reached by the competent authorities, the taxpayer may refer

the transfer pricing issue to Appeals for further consideration.

Fifteen simultaneous Appeals/Competent Authority cases have been

completed to date and fifteen additional cases are in process. These cases

principally involve proposed adjustments under section 482.
.4

II. Alternative Dispute Resolution Initiatives

Section 3465 of the Restructuring and Reform Act of 1998 (RRA 1998)

enacted new Code section 7123, which codifies Appeals alternative dispute

resolution (ADR) procedures. In addition, the Administrative Dispute Resolution Act

of 1996 encouraged federal agencies to use all available ADR techniques in the

federal administrative process. In response to growing taxpayer interest, Appeals

has developed several new procedures intended to resolve tax disputes, including

section 482 controversies, more effectively and efficiently.26 These procedures are

primarily designed to address discrete issues which, if resolved at an early stage,

may allow the underlying case to be resolved expeditiously:

· Early Referral. Early referral procedures allow a taxpayer whose return is

under examination to request transfer to Appeals of a developed but

unresolved issue, while other issues remain in Examination for further

development. Early referral and resolution of a key issue may encourage the

taxpayer and the IRS to reach agreement on other outstanding issues in the

case. Early referral may also save time by enabling Appeals and

Examination to work simultaneously on distinct portions of the same case. 

See Rev. Proc. 96-9,1996-1 C.B. 575, containing the procedures for an early

referral request.

 26See IRS Initiatives to Resolve Disputes Over Tax Liabilities, GAO Report to the

Chairman, Subcommittee on Oversight, Committee on Ways and Means, House of

Representatives, GAO/GGD-97-71 (May 1997).

· Mediation. A taxpayer whose case is in the administrative Appeals process

but not yet docketed in court may pursue mediation. Mediation consists of a

negotiation, assisted by an objective and neutral third-party mediator who

does not have authority to impose a decision. Mediation may be invoked

only after good faith negotiations in Appeals have proven unsuccessful. 

Mediators may come from Appeals or from outside the IRS. Appeals and the

taxpayer generally share the expense of a mediator, but Appeals assumes all

the expenses if a member of its staff serves as the mediator.

· Arbitration. Section 7123(b)(2) of the Code requires the Secretary to

establish a pilot program whereby a taxpayer and Appeals may jointly

request binding arbitration on an issue that remains unresolved at the

conclusion of Appeals procedures (or after an unsuccessful attempt to enter

into a closing agreement under section 7121 or a compromise under section

7122).
.6

The new ADR procedures have not had significant application in section 482

cases, because these cases frequently require competent authority assistance and

thus are appropriately handled under the simultaneous Appeals/competent authority

provisions discussed above.

CHAPTER 5: COMPETENT AUTHORITY DEVELOPMENTS

This chapter summarizes developments in the income tax treaty program

since the 1992 report.

I. Intergovernmental Programs
.3

IRS representatives regularly participate in intergovernmental forums for the

improvement of international tax administration. Transfer pricing issues frequently

receive considerable attention in these meetings. For example, IRS joined its treaty

partners in the OECD in the common elaboration of the arm’s length principle

reflected in the 1995 Transfer Pricing Guidelines and contributes to OECD’s

ongoing work on those Guidelines. Other forums for these discussions include the

Pacific Association of Tax Administrators (consisting of the United States, Canada,

Japan, and Australia), the Group of Four (the United States, Germany, France, and

the United Kingdom), and the Central Inter-American Center of Tax Administrations

(a group of Western-Hemisphere tax administrators).

II. Tax Treaty Program

The United States is a party to 50 income tax treaties and 13 tax information

exchange agreements or TIEAs (see Appendix D). ACT functions as the United

States competent authority, with responsibility for administering these agreements,

issuing technical interpretations and resolving double taxation problems. The

Associate Chief Counsel (International) determines the Government’s legal

interpretation of treaty provisions.

The treaty competent authority process is important to resolution of transfer

pricing issues in many cases, because transfer pricing adjustments for U.S.

taxpayers often have correlative effects on foreign affiliates, or double tax effect on

the taxpayer. The mutual assistance article in the tax treaties provides a

mechanism to effectuate relief from international double taxation. In 1996, Rev.

Proc. 96-13, 1996-1 C.B. 616, revised the procedure for requesting competent

authority assistance (see below).

Under Article 9 of all its income tax treaties (except that with the former

U.S.S.R.), the United States and its treaty partners are mutually obligated to apply

the arm’s length principle to evaluate the controlled transactions of associated

enterprises. Further, under Article 25 of most treaties, the United States and its

treaty partners must attempt to resolve double taxation issues. Pursuant to Article

26 of most treaties, as well as the provisions of TIEAs, the United States and its

counterparts undertake programs to exchange information for income tax

compliance purposes, including the resolution of transfer pricing issues. Appendix

E sets forth statistics of the recent year results of the competent authority process.

III. Updated Competent Authority Procedure

Article 25 of United States income tax treaties provides for a procedure that

affords an opportunity for relief to a taxpayer who believes that an action of the tax

authority of one of the treaty countries is contrary to the intent of the treaty. 
.1

Transfer pricing cases, including in the bilateral APA context, account for

approximately half of the inventory of the U.S. competent authority under this

process.

If the U.S. competent authority believes the taxpayer’s request has merit, it

opens a dialogue with the treaty partner's competent authority and attempts to

resolve the matter. Rev. Proc. 96-13 establishes procedures for making a request

to ACT, the United States competent authority for treaty purposes. ACT is entitled

to consider all the facts and circumstances of the case, as well as the policies

underlying the treaty, in deciding whether to accept a case for consideration.

Rev. Proc. 96-13, issued in January 1996, revised the procedures for

requesting assistance from the U.S. competent authority. Rev. Proc. 96-13 took into

account several internal IRS studies and comments submitted by an ad hoc industry

task force. These sources identified difficulties experienced with the mutual

agreement procedure. The updated revenue procedure demonstrates a renewed

commitment by the United States to the competent authority process. 

Important elements of Rev. Proc. 96-13 regarding transfer pricing cases

include:

· The U.S. competent authority will be guided by the arm’s length principle in

seeking to arrive at an agreement with the treaty partner.

· The coordination of competent authority proceedings and Appeals has been

revised to prevent procedural abuses, while still giving taxpayers ample

opportunity to exercise appropriate administrative appeal rights. The

Simultaneous Appeals/Competent Authority procedure allows a taxpayer or

the U.S. competent authority to request simultaneous competent authority

and Appeals consideration of an issue (see Chapter 4).

· The coordination of competent authority assistance and litigation is clarified.

· Taxpayers must take affirmative protective measures (both in the U.S. and

the treaty country) to minimize procedural barriers to implementing any

eventual competent authority settlement.

· A new, small case provision encourages competent authority assistance

requests when the amounts in issue are relatively small.

· Section 7 of Rev. Proc. 96-53 addresses the coordination of the APA and

competent authority procedures in the context of bilateral APAs. If an APA

request involves a treaty country, taxpayers are encouraged to seek
.1

competent authority agreement with respect to matters that are the subject of

the APA.

· Taxpayer may now request an accelerated competent authority procedure to

resolve continuing transfer pricing issues for subsequent taxable periods

ending prior to the date of the request for assistance.

· Rev. Proc. 96-14, 1996-1 C.B. 626 addresses the coordination of conforming

adjustments to reflect primary section 482 adjustments and competent

authority assistance. If a taxpayer intends to request competent authority

assistance, then any request for treatment under Rev. Proc. 65-17 should be

made in conjunction with the request for competent authority assistance. In

other treaty cases, a closing agreement under Rev. Proc. 65-17 requires

ACT’s concurrence.

IV. Treaty Exchange of Information

Pursuant to tax treaties and TIEAs, the IRS conducts exchanges of taxrelated information with United States treaty partners, and coordinates simultaneous

examinations of specific taxpayers. These programs materially assist the IRS in

promoting compliance with the arm’s length standard as well as in enforcing other

domestic and international tax provisions. The discussion below focuses on the use

of these programs in connection with transfer pricing issues.

A. Specific Request for Information Program

The IRS may obtain information from treaty partner tax authorities related to 

transfer pricing issues for particular taxpayers under audit in the United States. The

subject matter of a specific request could include, for example, information

concerning foreign persons, their relationship to the U.S. taxpayer, their

transactions with the U.S. taxpayer and any comparable transactions with third

parties, and similar facts relevant to whether a transfer pricing adjustment is

appropriate. Generally, the IRS requests information from the treaty partner only

when equivalent information cannot be obtained domestically.

B. Industry-Wide Exchange of Information Program

The industry-wide exchange of information program allows treaty partners to

share their cumulative experience regarding a particular industry, as a means of

enhancing subsequent examinations of specific taxpayers in that industry. The

program, which is closely aligned with the overall Industry Specialization Program,

seeks to advance the knowledge of IRS and our treaty partners concerning

business operations and transfer pricing practices in specific industries. These
.2

industry-wide exchanges of information may reveal the need for an examination of

tax issues, and that may lead the treaty partners to simultaneous examinations of

specific taxpayers.

In recent years, the IRS has placed increased emphasis on industry-wide

exchanges of information with treaty partners relating to transfer pricing practices. 

To date, successful industry-wide exchanges of information in the transfer pricing

area have involved the following industries: pharmaceuticals, oil, grain, data

processing, heavy construction, and electronics.

C. Simultaneous Examination Program

In a simultaneous examination, IRS personnel meet face-to-face with the

audit team of the treaty partner to exchange factual information regarding specific

taxpayers that may have transfer pricing audits in the respective jurisdictions under

their respective laws. Simultaneous examinations facilitate flexible and efficient

information exchanges. Simultaneous examinations are not a vehicle for

negotiation of potential differences which are the subject of the competent authority

process.

 

Simultaneous examinations are undertaken pursuant to working

arrangements between the IRS and the treaty partner tax authorities. At present,

the United States has twelve such working arrangements, with the following

countries: Australia, Canada, France, Germany, Italy, Japan, Korea, Mexico,

Norway, the Philippines, Sweden, and the United Kingdom.

D. Other Programs

The IRS also participates in spontaneous and routine exchanges of

information with treaty partners. Routine exchange relates to ongoing sharing of

information that identifies recipients of passive or investment income, such as

dividends, interest, rents, and royalties. Spontaneous exchange relates primarily to

the sharing of information discovered in the course of audit that may indicate

noncompliance with the tax laws of a treaty partner.
.3

CHAPTER 6: ADVANCE PRICING AGREEMENT PROGRAM

I. Introduction

Under a traditional adversarial approach, the data gathering, development,

and analysis of a transfer pricing issue is a complex, time-consuming process which

often results in an administrative appeal and litigation. A significant transfer pricing

issue can typically take eight or more years to resolve. Developed in 1991 as an

alternative to the traditional adversarial process, the Advance Pricing Agreement

(APA) Program attempts to resolve transfer pricing disputes in a principled and

cooperative manner.

During the 1980s and prior to the creation of the APA Program, the

government as well as taxpayers with transfer pricing issues began to explore some

sort of an advance pricing agreement mechanism. A 1985 study by a U.S.

professional group on how to improve the large case program recommended

advance rulings in the transfer pricing area. In 1986, an agenda topic at a meeting

of U.S. and foreign tax officials on how to reduce controversies discussed an

advance resolution process for transfer pricing. Then, in 1987, Japan developed

transfer pricing legislation and subsequently initiated a preconfirmation process on

transfer pricing issues. Finally, in 1989, several taxpayers and groups approached

the IRS to consider alternative approaches to transfer pricing compliance, viewing

the existing means of dealing with transfer pricing issues as being too adversarial

as well as unproductive. 

The IRS considered new techniques whereby all parties could “buy-in” and

share the responsibility for enhancing compliance in the transfer pricing area. 

Derived from the “Compliance 2000" initiatives, this concept of shared responsibility

is also consistent with the current mission statement of the IRS to work with

taxpayers “to help them understand and meet their tax responsibilities.” In April of

1989, the IRS announced at a meeting with the Tax Executives Institute that it was

considering an advance ruling procedure for transfer pricing issues. The IRS

entered into pilot projects with several taxpayers to negotiate and execute what

were initially called Advance Determination Rulings but later became known as

Advance Pricing Agreements (APAs). In June of 1990, a draft IRS Revenue

Procedure for Advance Determination Rulings was publicly disseminated and the

first APA was concluded in January of 1991. With the publication of Rev. Proc. 91-

22, 1991-1 C.B. 526, the IRS formally initiated the APA Program in March of 1991,

and by the end of that year, 15 new negotiations had started. The current revised

procedures for APAs are set forth in Rev. Proc. 96-53, 1996-2 C.B. 375.
.3

The APA Program is a cost-effective means of bringing participating

taxpayers into section 482 compliance. See Appendix J, setting forth the results of

a recent APA costing study and showing that APAs have an average cost of less

than $72,000.

II. Current Status of the APA Process

Since 1992, the APA Program’s caseload and staffing have steadily grown. 

Appendix G provides a chronological history of the APA Program through the

present. In 1997, the IRS instituted an Early Referral program by which, in

appropriate cases, audit teams suggest that taxpayers pursue APAs before

substantial time is spent auditing transfer pricing issues. In 1998, the IRS published

more streamlined procedures for APAs involving Small Business Taxpayers in an

effort to attract smaller taxpayers who may lack the resources to do the

sophisticated studies normally included in APA requests. By the end of the 1998

fiscal period, the IRS had concluded four APAs under these streamlined

procedures.

The APA Program currently has a Director, two branch chiefs, three

economists, and fifteen team leaders, who are either attorneys or accountants. As

of the fiscal period ended September 30, 1998, 164 APAs have been concluded

with another 186 under negotiation. As outlined in Appendix F, these APAs span a

wide range of industries and involve numerous cross-border transactions including

sales of tangible property and transfers of intellectual property.

As the United States has become more comfortable with the APA process so

has the world. Today, APAs are receiving increased acceptance by many of our

treaty partners, including Japan, Canada, Australia, and the United Kingdom. In

fact, of the 164 closed APAs, 75 involve our treaty partners through the bilateral

process (the bilateral process is discussed below). Currently, the OECD is

finalizing guidelines for bilateral APAs, which will likely lead to an even broader

acceptance of the APA process by the international community.

III. Purpose and Objectives of the Process

The APA process is designed to enable taxpayers and the IRS to agree on

the proper treatment of transfer pricing, including cost sharing arrangements. An

APA need not cover all of a taxpayer’s pricing arrangements and instead may be

restricted to specified years, specified affiliates, and specified intercompany

transactions.
.4

APAs may be “unilateral” or “bilateral.” A unilateral APA is an agreement for

a prospective period of time between the taxpayer and the IRS on the appropriate

transfer pricing method (TPM) for the transactions at issue. With this approach,

there is no guarantee that the foreign country’s taxing authority will agree that the

TPM is correct. A bilateral APA combines an agreement between the taxpayer and

the IRS on a particular TPM with an agreement between the United States and

foreign taxing authority regarding the propriety of the TPM, pursuant to the mutual

agreement process promulgated in Article 25 of our income tax treaties. As outlined

in Appendix F, roughly half of the APAs completed to date have been bilateral. 

Both unilateral and bilateral APAs may also provide that the agreed-upon TPM be

“rolled back” to resolve similar issues for past years under audit.

The APA process focuses on identifying an appropriate TPM, not a desired

tax result. The ultimate goal of the APA process is to arrive at an agreement on

three basic points: (1) the description of the intercompany transactions to which the

APA applies; (2) the TPM to be applied to those transactions; and (3) the arm’s

length range of results that is expected after applying the agreed-upon TPM to the

covered transactions.

IV. Administrative Details of the APA Process

Within the IRS, the APA Program is located in the Office of the Associate

Chief Counsel (International), which is part of the Office of Chief Counsel. This

placement reflects the fact that concluding an APA requires negotiating skills, legal

analysis, and legal drafting (APAs are essentially contracts between the taxpayer

and the IRS). In addition to demanding a variety of skills from the individual

members of the APA Program, the APA process also draws on expertise from other

offices within the IRS. The APA team typically includes:

· the APA team leader from the APA Program;

· the International Examiner responsible for auditing the taxpayer

on transfer pricing issues, and often that IE’s manager and/or

the case manager (the manager with overall responsibility for

the taxpayer in question);

· an economist, either one assigned to the APA Program or a

field economist assigned to assist the Examination team;

· an attorney from the District Counsel office that provides legal

advice to the Examination team;
.5

· on bilateral cases, an analyst from the Tax Treaty Division,

which is part of the Office of the Assistant Commissioner

(International).

V. Key Concepts

A. Standard to be Applied

Section 482 of the Internal Revenue Code permits the IRS to allocate items

of income, deductions, credits, or allowances between controlled groups or

organizations, “to prevent evasion of taxes, or clearly to reflect the income of any of

such organization . . .” or, in the case of transfers of intangible property, to allocate

income with respect to the transfer in a manner that is “commensurate with the

income attributable to the intangible.” 

In determining whether an allocation under section 482 is necessary clearly

to reflect a controlled taxpayer’s income, the IRS employs the “arm’s length”

standard, a principle which is defined in the attendant Treasury regulations. A

controlled transaction meets the arm’s length standard if the results of the

transaction are consistent with the results that would have been realized if

uncontrolled taxpayers had engaged in the same transaction under the same

circumstances. Under current Treasury regulations, the IRS is willing to consider

many different approaches to establish the taxpayer’s appropriate intercompany

transfer pricing methodology or cost sharing practices, provided these approaches

satisfy the arm’s length principle. Any reasonable methodology may be accepted if

it clearly reflects income, is supported by available and reliable data, and can be

efficiently administered.

This arm’s length approach is also applied for bilateral and multilateral APAs.

 The OECD Model Tax Convention provides:

where conditions are made or imposed between the two enterprises in

their commercial or financial relations which differ from those which

would be made between independent enterprises, then any profits

which would, but for those conditions, have accrued to one of the

enterprises, but, by reason of those conditions, have not so accrued,

may be included in the profits of that enterprise and taxed accordingly.

Under the OECD approach, the arm’s length range contemplates “a range of

figures that are acceptable for establishing whether the conditions of a controlled

transaction are arm’s length and that are derived either from applying the same

transfer pricing method to multiple comparable data or from applying different

transfer pricing methods.” Comparable language outlining the arm’s length principle
.6

is included -- generally in Article 9 -- in most income tax treaties to which the United

States is a party.

B. Comparables

The Treasury regulations under section 482 rely on comparable uncontrolled

transactions to arrive at an intercompany price that “clearly reflects income” or in

the case of intangibles that is “commensurate with the income attributable to the

intangible.” Some of the factors that are considered in evaluating comparable

transactions include the line of business, accounting and functional differences,

volume differences, market level of operation, product maturity, terms of sale, and

the capitalization of the tested parties.

C. Public Disclosure

The APA process proceeds from a voluntary disclosure of information by

taxpayers to the IRS in an effort to resolve specific transfer pricing issues proposed

by the taxpayer. Thus, the confidentiality of the submitted information is an

important concern to both the private sector and the government. Because

substantial pricing information may be submitted and because transfer pricing

issues are unique to each taxpayer, the IRS historically treated an APA request as

tax return information exempt from public disclosure under section 6103 of the

Internal Revenue Code. However, as a result of a lawsuit filed by the Bureau of

National Affairs (BNA), the IRS recently conceded that APAs are the type of written

determinations that fall within the scope of section 6110(a). The IRS still maintains

that disclosure of APAs is subject to the inherent disclosure limitations contained in

Section 6110 as well as subject to the nondisclosure requirements of tax treaties

and conventions to which the United States is a party.

VI. Conclusion

The APA process enhances taxpayer compliance by providing an alternative

forum to resolve transfer pricing disputes. The success of the APA process is due

in part to the coordination and cooperation from all aspects of the APA team

including the Examination function. The success of the APA program in resolving

transfer pricing issues is evidenced by the increasing acceptance of APAs in the

international community. Nevertheless, the IRS continues to identify ways to

improve the APA process, as evidenced by the recent small business taxpayer

initiative. 

Since the enactment in1994 of the final section 482 regulations as well as the

additional disclosure and penalty provisions, the APA Program has enjoyed greater

success in identifying important transfer pricing issues while at the same time
.2

providing greater uniformity with respect to the treatment of those issues. 

Notwithstanding this increased uniformity, the APA process remains sufficiently

flexible to accommodate the unique circumstances of each taxpayer. 

The Program’s goals originally enunciated in 1991 – principled negotiations

and enhanced tax administration – continue to guide the process. In addition to

these goals, the direction that the APA Program will follow in the future can be

found in the language of the current IRS Mission Statement – to help taxpayers

understand and meet their tax responsibilities by applying [transfer pricing

concepts] with integrity and fairness.

CHAPTER 7: TAX LITIGATION

This chapter discusses developments in the litigation of section 482 cases

since the 1992 report. A sustained commitment to the successful litigation of

section 482 cases is an integral part of the IRS tax compliance effort. From a tax

administration perspective, litigating such cases serves two purposes: First, it

provides guidance in those cases where the outcome establishes legal precedents

of general applicability and second, it encourages early voluntary compliance by

confirming a willingness to enforce the transfer pricing rules vigorously, when

necessary. To achieve those ends, the IRS has expanded programs to ensure

earlier identification of compliance issues in cross-border cases generally, better

development of the cases, and more efficient allocation of limited litigation

resources. These strategies have borne fruit in the form of successful litigation of

novel issues related to section 482, better use of resources generally, and

enhanced development of related intercompany issues in the context of the

possessions tax credit under section 936 et seq. and the withholding at source

regime. A list of significant court opinions issued since 1992 in cases in which an

adjustment under section 482 was a major issue is provided at Appendix H.

I. Validity of New Enforcement Measures Sustained

The IRS has successfully established precedent upholding enforcement tools

in sections 6038A and 6662 to assist in examination of cross-border related party

transactions. Section 6038A imposes recordkeeping, reporting, and documentation

production obligations, backed up by penalties for noncompliance, intended to

assist the IRS in obtaining information from foreign related parties to cross-border
.3

transactions. Section 6662 provides for 20% and 40% penalties for underpayments

of tax attributable to substantial and gross valuation misstatements. Pursuant to

section 6662(e), such penalties attributable to transfer pricing adjustments may be

avoided provided the taxpayer undertakes upfront compliance with the arm’s length

standard as specified in the statute and regulations.

A. Confirmation of Section 6038A Authority

In evaluating controlled transactions to which a foreign person that controls a

domestic corporation is a party, key information relating to the function and risk

analysis, potential comparables, and other facts may be in the possession of the

foreign affiliate, not the controlled domestic corporation. Section 6038A addresses

this situation by imposing reporting, recordkeeping, and documentation production

obligations, and providing the IRS with summons authority with respect to the

related party transactions of foreign-based groups and their 25% or greater U.S.

affiliates. In the event that the foreign related party does not authorize the domestic

corporation to act as its agent for receipt of such summonses, or fails to

substantially and timely comply with a proper summons, section 6038A(e)(3)

provides for a noncompliance penalty whereby the IRS in its sole discretion based

upon information in its possession determines the domestic corporation’s

deductions and costs in the related party transaction.

In the first case interpreting section 6038A(e), the Tax Court in ASAT, Inc. v.

Commissioner, 108 T.C. 147 (1997), upheld the IRS penalty determination of

claimed related party costs and deductions as the result of the taxpayer’s

noncompliance with section 6038A. In this case, the taxpayer, a U.S. subsidiary of

a foreign corporation, failed to furnish an examining agent authorization from its

foreign parent for service of summonses, as required pursuant to section

6038A(e)(1), or documents in the possession of the foreign parent in support of

positions taken on the return. Using its discretion under section 6038A(e)(3), the

IRS issued a notice of deficiency applying a noncompliance penalty adjustment

determining that the taxpayer’s cost of goods sold would be decreased and that a

net operating loss carryforward that originated from the taxpayer’s transactions with

its foreign parent would be eliminated, and, in the alternative, relied on section 482

for the adjustments. Because resolution of the section 6038A issue had the

potential “to negate the need for a trial of issues involving section 482,” a separate

trial of the section 6038A issue was held. Id. at 148. In sustaining the deficiencies

and penalties, the Court held that the IRS determination must be sustained unless

the taxpayer could “show by clear and convincing evidence and without reference to

information not in respondent’s possession or knowledge when the determination

was made, that respondent’s determination was made with an improper motive or is

clearly erroneous in light of all reasonably credible interpretations or assumptions of

facts.” Id. at 167.
.4

In deciding that the IRS had not abused its discretion, the ASAT, Inc. Court

relied on the language of the statute, which provides that the adjustment “shall be

the amount determined by the Secretary in the Secretary’s sole discretion from the

Secretary’s own knowledge or from such information as the Secretary may obtain

through testimony or otherwise,” Id. at 166 (quoting section 6038A(e)(3), emphasis

added by the Court). The Court determined that the limited information used by

the IRS to make the adjustments to the return was sufficient. In rejecting the

taxpayer argument that the merits of the adjustment must be determined on the

basis of all evidence available, the Court noted that such a redetermination would

be contrary to the purpose of the statute, and stated in pertinent part:

Petitioner’s attack on respondent’s results . . . ignores the purpose of

the statute. Section 6038A was enacted to insure that the IRS would

have either timely access to the information necessary to make a

complete analysis of costs between related parties or the right to make

an

adjustment based solely on the information that it did have. Whether the taxpayer

can later justify a cost is irrelevant.

Id. at 171 (citing H. Conf. Rept. 101-386, at 594 (1989)). Based on its resolution of

the section 6038A issues, the Court did not reach the section 482 alternative theory.

B. Penalties Applied under Section 6662(e) and (h)

The requirements pursuant to the 1993 amendment and section 6662(e)

regulations for taxpayers to contemporaneously document compliance with the

arm’s length standard, and to promptly provide that documentation to IRS upon

request, will mean such documentation should be available at an early stage of an

examination. That in turn should promote more frequent resolution of disputes

without the need to resort to litigation, or at least a better state of the record at the

beginning of litigation. Where such information is not forthcoming, the IRS has

demonstrated its willingness to press for its production and assert all available

remedies.

In DHL Inc., and Subsidiaries v. Commissioner, T.C. Memo. 1998-461, 76

T.C.M. (CCH) 1122, the Tax Court determined that petitioner substantially

understated its royalty income and grossly misstated its gains from sale of

petitioner’s trademark in 1992, without reasonable cause. As a result, accuracy

related penalties were sustained at a rate of 20% of the deficiency attributable to

the royalty income misstatements, and at a rate of 40% of the deficiency attributable

to the gross valuation misstatement of the trademark value. Although the penalty

statute applied was that as in effect prior to the 1993 amendment that incorporated
.5

the contemporaneous documentation requirements, the Court’s analysis of the

factors considered in its determination of whether the taxpayer was negligent or had

reasonable cause and good faith is helpful in determining how to apply the

documentation requirements. DHL argued that it relied in good faith on a

contemporaneous appraisal of the trademarks whose transfer was a principal

subject of IRS’s section 482 adjustments. The Court held the reliance was not

reasonable, noting that the appraisal was not requested until after negotiations had

established the transfer price that the parties wished to justify, and the parties had

informed the appraiser of that goal. 76 T.C.M. (CCH) at 1169. The Court

suggested the matter may have been different had the valuation project been

assigned to an independent valuation entity before any values were placed on the

trademark, or had the parties not advised the evaluator of a value. Id.

II. Litigation Remains a Necessary Means of Section 482 Administration

Because these cases typically revolve around complex factual valuation

issues, they require the devotion of an enormous amount of resources on the part of

the IRS, the courts, and the taxpayers. See Appendix I, detailing costs incurred by

the IRS in litigating two recent section 482 cases. Nevertheless, the cost of

litigation cannot be a controlling factor when deciding whether to litigate. 

Otherwise, tactical delay in producing information until a case has reached the

Court would yield enormous advantage to uncooperative taxpayers. Several recent

cases illustrate the difficulty faced by the IRS in determining an appropriate

reallocation and defending such reallocation when information is not forthcoming

until after a controversy reaches court. Although the reallocations sustained by the

Court were greatly reduced from those initially determined by the IRS, substantial

adjustments to the position taken on the return were sustained nevertheless. 

In DHL, the taxpayer’s dilatory conduct in responding to IRS requests for

information contributed to IRS’s inability to provide the taxpayer with any notice or

report of the proposed adjustments before issuance of the notices of deficiency and

to IRS’s need to reduce its proposed adjustments in light of information acquired

only after issuance of the notices of deficiency. 76 T.C.M. (CCH) at 1142-45. The

Court was inconvenienced as well, and noted that procedural accommodations were

necessitated as the result of the taxpayer’s dilatory compliance and untimely

production of information to the IRS, “which continued into the middle portion of a

lengthy trial.” Id. at 1166 n.28. As discussed above, the misstatements of transfer

prices were ultimately established by the IRS to the Court’s satisfaction. The

availability of, and willingness to commit, sufficient resources to support the trial

team’s continued effort to secure and analyze the necessary information were

critical to that outcome. 
.6

In Seagate Tech., Inc., & Consol. Subs. v. Commissioner, 102 T.C. 149, 171

(1994), the IRS made numerous concessions in light of information not obtained

until preparation for trial. Seagate was a leading manufacturer of hard disk drives

for personal computers, and IRS reallocated $285,396,000 from Seagate Singapore

to taxpayer pursuant to section 482. Although the Tax Court held that the IRS’s

reallocation was arbitrary, capricious, and unreasonable, the court nevertheless

determined that a reallocation of a lesser amount was necessary. In doing so, it 

held that the royalty rate in the property transfer agreement, the transfer prices for

the component parts and complete disk drives, and the taxpayer’s allocation of

research and development costs were not arm's length. The estimated income

allocation sustained by the court was over $40 million.

In Medieval Attractions N.V. v. Commissioner, T.C. Memo 1996-455, 72

T.C.M. 924, 929 (1996), the Tax Court agreed with the IRS’s arguments that

numerous transactions were devoid of economic substance and necessitated

reallocations to clearly reflect income. Spanish investors formed various

Netherlands Antilles, Netherlands and United Kingdom companies to hold their

interests in a Spanish corporation. The Antilles corporations formed various U.S.

corporations, first in Florida and later in California and New Jersey, to develop and

operate medieval dinner theaters in the United States. The U.S. entities paid

"franchise fees", "royalty" payments for use of the intangibles and marks, and

various "management fees" to these Netherlands Antilles entities, which, in turn,

paid "interest" and "guarantee fees" ultimately to the Spanish investors. The Tax

Court denied deductions for interest on various promissory notes paid by a group of

U.S. corporations that operated the entertainment facilities because no genuine

indebtedness existed. Royalty payments lacked economic substance and were

shams undertaken solely for tax-avoidance purposes. Certain franchise and royalty

expenses paid by the U.S. entities represented income to nonresident alien

individuals or foreign corporations, and distribution, apportionment, or allocation of

those amounts was necessary in order to prevent evasion of taxes and to clearly

reflect income. The Court applied the negligence, substantial understatement and

increased interest penalties. 

The “Aramco Advantage” cases were also decided since the April 1992

report. Accepting the taxpayers' position in Exxon Corp. v. Commissioner, T.C.

Memo. 1993-616, aff'd sub nom. Texaco Inc. v. Commissioner, 93 F.3d 825 (5th Cir.

1996), cert. denied 520 U.S. 1185 (1997), the Tax Court held that a Saudi Arabian

pricing restriction was the "substantial equivalent of foreign law" that can preclude a

section 482 adjustment. The pricing restriction in dispute was a price ceiling on

sales of Saudi crude by the U.S. corporations who purchased the oil from the

government controlled oil company, ARAMCO. The restriction was imposed by a

letter from the Saudi Arabian Oil Minister (the so-called "Yamani Edict"). However,

taxpayers' foreign affiliates were not subject to the Yamani Edict, and reaped the
.7

Aramco Advantage by processing the low-cost Saudi crude and selling the resulting

products at world market prices. Viewing the the Saudi-imposed price restriction as

a condition of sale imposed in the context of a commercial relationship, rather than

a legal restriction, the IRS determined that an arm’s length price for Exxon’s and

Texaco’s sales of Saudi crude oil to their related refiners exceeded the price

purportedly permitted, and reallocated the Aramco Advantage income from the

foreign affiliates to the taxpayers. The Tax Court held that the price restriction was

a legal restriction sufficient to preclude a section 482 reallocation, applying the

principles of Commissioner v. First Security Bank, 405 U.S. 394 (1972) as

interpreted in Procter & Gamble v. Commissioner, 95 T.C. 323 (1990). aff’d 961 F.

2d 1255 (6th Cir. 1992). In the IRS's appeal of Texaco, the Fifth Circuit affirmed. 

The section 482 regulations that became final in 1994 now provide that a foreign

legal restriction, whether temporary or permanent, will be given effect only to the

extent that it affects the results of transactions at arm’s length. Treas. Reg. § 1.482-

1(h)(2). The IRS believes that, had this regulation been applicable to the years

before the Tax Court in Texaco, the Court would have reached a different result

without violating the principles enunciated in Commissioner v. First Security Bank,

supra.

III. Changes in Managing Transfer Pricing Issues Since 1992

A. Strategies

As part of an IRS wide effort to frontload technical expertise in cases to either

mitigate the need for litigation or better develop those cases that result in litigation,

since 1992, the Office of Associate Chief Counsel (International) (ACCI) has refined

and expanded its program to manage case development, information gathering

abroad, and coordination of technical issues within International and with other

functions of Chief Counsel, the Assistant Commissioner (International), Treasury

and Justice. Staff with both substantive tax expertise and litigation experience

serve as a link between the technical branches and field personnel in Counsel,

Appeals and Examination as well as IFASP, to provide advice on tax controversies

at all stages. Together with branch personnel they coordinate and review Tax

Court, refund and summons enforcement litigation at the trial and appellate levels. 

Concomitant with that coordination and Counsel-wide procedures, all newly

docketed cases with a disputed amount of tax over $1 million and an international

issue are screened upon receipt. Cases with potential tax administration

significance, issues with industry wide significance, or particularly complex or large

dollar adjustments are identified through this process and selected for the closer

coordination under the Large Case Procedures. A copy of the Chief Counsel

Directives outlining those procedures is attached as Appendix K.
.8

This screening process, together with frequent informal assistance to IFASP

specialists, has a practical effect of providing early review of almost all cases

arising under section 482. If a case is included in that program, ACCI participates

in the development and review of workplans, technical positions and litigation

strategy. Attorneys from ACCI will review, and in some instances prepare, trial

briefs and other significant filings, and coordinate appellate litigation. On several

occasions, attorneys from ACCI have been members of trial teams. Regardless of

whether a case is handled under the Large Case Procedures, the goal is to provide

effective legal services to the field, while preserving consistency in the nationwide

enforcement of the Code with respect to international matters. The success of the

Large Case Procedures in international section 482 litigation is evidenced by the

fact that both ASAT and DHL fell within the program.

B. Limits on Ability to Manage Transfer Pricing Litigation

Several extrinsic factors constrain the ability of the IRS to maximize the

effectiveness of its transfer pricing litigation. Overall, IRS strategy has been to

encourage settlement of section 482 cases that reach the courts and to litigate only

those cases that present broad compliance issues, such as ASAT and DHL. 

However, regardless of the willingness of the IRS to settle a case rather than

consume resources on inherently factual issues of little or no administrative

significance, any such settlement must be grounded in facts and law and is subject

to the acceptance of the other party. If that party is determined to go to trial, the

IRS may have little choice but to proceed to litigation. Second, the discretion of a

judge in case management, derived from Fed. Rule Civ. Proc. 16, is extremely

broad, with the result that special orders may be entered that set unanticipated

limits on discovery schedules and trial times or impose special filing requirements. 

Because the various judges differ in the extent to which they solicit the parties’

views in determining pretrial schedules, the impact of a case assignment can not

always be predicted. Finally, the Tax Court’s limits on discovery continue to have

an impact in section 482 cases because it remains the only prepayment forum

available to taxpayers and its rules significantly limit the use of depositions for

discovery purposes, in Rules 74 and 75 of the Tax Court Rules of Practice and

Procedure. 

C. Section 482 Management and Related Issues

Lessons learned in strategically managing the transfer pricing cases have

had a beneficial effect in developing the cases arising under provisions other than

section 482, but requiring intensive factual development of intercompany practices,

as in the case of corporations claiming the possessions credit. For instance, the

Tax Court held that prices charged to Altama Delta by its Puerto Rican subsidiary

were not arm's length, adjusting the subsidiary's gross profit margin based on the
.9

court’s "best estimate" of appropriate transfer prices. In doing so, the Court held

that the Puerto Rican subsidiary’s gross profit margin for 1985-87 should be equal

to the 19.2% gross profit margin the parent company averaged for 1986-87. The

court also found that the subsidiary owed a cost sharing payment under section

936(h)(5)(C)(i)(III)(a). Altama Delta Corp. v. Commissioner, 104 T.C. 424 (1996)

Enforcement of section 482 reallocations includes the use of the “withholding

at the source regime” to collect the resulting tax deficiency from the U.S. party to the

transaction. Although the precise issue of whether a section 482 allocation of U.S.

source income to a foreign entity is subject to section 1442 withholding has not

been addressed by a court, there is case law to support such an approach. The

IRS strategy is to ultimately confirm the point in an appropriate case. In an

unpublished opinion, interest imputed to a foreign related entity under section 7872

was held to be subject to withholding. Climaco and Nakamura v. Internal Revenue

Service, 96-1 USTC ¶ 50,153 (E.D.N.Y. 1996) (unpublished opinion, Jan. 24, 1996).

The government’s position in Climaco was based on Casa de la Jolla Park,

Inc. v. Commissioner, 94 T.C. 384 (1990) and Central de Gas de Chihuahua v.

Commissioner, 102 T.C. 515 (1994). In Casa de la Jolla Park, Inc., a US

corporation was held liable for withholding tax on interest constructively received by

its sole shareholder on the corporation’s promissory note as a result of the

authorized remittance of corporate sales proceeds to a foreign creditor of the

shareholder. In so holding, the Tax Court rejected arguments that withholding

obligations require actual payment and receipt, and invoked the constructive receipt

doctrine. In Central Gas de Chihuahua, the Court rejected an analogous taxpayer

argument that an actual payment, rather than a reallocation under section 482, is

required for imposition of tax under section 881 on the deemed recipient of income.

 Because that case involved the foreign recipient, rather than the deemed payor, the

Court did not address the withholding obligation of the payor under section 1441.

Recently issued final regulations under section 1441 (Treas. Reg. § 1.1441-

2(e)(2)) specifically provide that an allocation of income subject to withholding under

section 482, as well as income arising as a result of a secondary adjustment made

in conjunction with a reallocation of income from a foreign person to a related U.S.

person, is subject to withholding under section 1441. While this regulation is not yet

effective, we view the new regulation as consistent with currently applicable law on

this point. It is also worth noting that the IRS enforcement of section 482 in the

imputed interest context is often met with a taxpayer disavowal of the form of its

intercompany transactions to avoid the section 482 allocation. To date, the IRS has

relied on the principles of Commissioner v. National Alfalfa Dehydrating and Milling

Co., 417 U.S. 134 (1974) to hold the taxpayer to its chosen form. See also, Taiyo

Hawaii, Ltd., v. Commissioner, 108 T.C. 570, 601-603 (1997) (imposition of excess

interest tax pursuant to section 884).
.2

CHAPTER 8: RECOMMENDATIONS AND CONCLUSIONS

The IRS intends to continue to pursue its five-part strategy to improve the

administration of section 482. Thus, the IRS plans a combination of section 482

guidance, promotion of upfront compliance with the arm’s length standard,

strengthening the international consensus on transfer pricing guidance and

compliance, advanced resolution of transfer pricing issues in the APA Program, and

strategic management of section 482 issues in litigation.

With respect to compliance measurement, Chapter 1 concludes that the

annual gross tax gap due to noncompliance with section 482 is $2.8 billion. 

Chapter 1, however, calls attention to a number of possible biases in this number --

both upward and downward. Many of these biases arise from the fact that this study

relies upon operational audit data to measure the tax gap. Operational audits, while
.3

accurately reporting the results of IE activity, have important limitations when used

to extrapolate compliance or non-compliance to the entire universe of taxpayers. 

Chapter 1 also concludes that the available data from the operational audits is

inconclusive as to whether the section 6662(e) penalties and the 1994 final section

482 regulations have improved compliance. This inconclusiveness is in substantial

part due to the fact that operational audit results are subject to a variety of factors

that make compliance trends difficult to detect using this data. It seems clear that if

the IRS is to more accurately measure the section 482 tax gap or to measure trends

in section 482 compliance, alternative methodologies should be considered.

There are at least two alternatives that could be considered, depending on

the desired result. If measuring the absolute value of the section 482 tax gap is the

desired end, there are a number of improvements that could be made to the

methodology adopted in this report. In particular, the operational audit data could

be supplemented with information regarding the broader class of taxpayers with

potential transfer pricing issues. For example, information from Schedule M of Form

5471 “Transactions Between Controlled Foreign Corporations and Shareholders or

Other Related Persons,” Form 5472 “Information Return of a 25% Foreign-Owned

U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business,”

and once it is finalized, Schedule H of the proposed Form 8865 “Transactions

Between Controlled Foreign Partnership and Partners or Other Related Entities”

could be used to supplement the operational audit data available on transactions

between commonly controlled taxpayers. In addition, there are certain advanced

econometric methods that might be applicable to mitigate the lack of randomness

inherent in the selection of taxpayers for operational audits. Extending the tax gap

methodology to include these data and techniques could require a substantial

commitment of time and resources. It is likely, however, that such an extended

methodology would provide a better measure of the section 482 tax gap.

While the extended tax gap methodology described in the preceding

paragraph could improve the measurement of the gross section 482 tax gap, there

is some doubt whether even this better measure of the tax gap could demonstrate

whether section 482 compliance is improving, getting worse, or remaining constant.

 This is because in order to spot compliance trends, a high level of precision is

required in the measurement. Particularly with respect to measuring changes in

compliance over time, it is vital that a compliance measurement methodology

control for extraneous issues that can affect the results of audits conducted at

different time periods. In order to obtain the relatively high precision required to

measure compliance trends, it is possible that the IRS would have to undertake

special audits designed to investigate taxpayer compliance with section 482. 

Obviously such an effort would be a major undertaking. However, the continuing
.4

importance of section 482 compliance to tax administration may militate in favor of

such research.

With respect to improving the section 482 guidance described in Chapter 2,

the IRS contemplates several regulations projects on transfer pricing issues. The

regulations on global dealing are to be finalized in the near future and consideration

is being given to whether a similar approach may be adapted for other interbranch

issues. Attention may be addressed to clarifying the application of the detailed

principles enunciated in the 1994 section 482 regulations to interaffiliate services as

well as to further elucidating the treatment of intangibles, including marketing

intangibles. The IRS will also complete its revision of the revenue procedure on

conforming accounts to reflect section 482 adjustments.

The shift to upfront compliance with the arm’s length standard should reduce

transfer pricing controversies or provide a desirable focus for those that do arise. 

The IRS will continue its initiatives to resolve transfer pricing cases in Examination

and Appeals, to avoid double taxation via the competent authority process, and to

vigorously litigate unresolved cases, as appropriate. The IRS will similarly continue

its involvement in the ongoing work of the OECD on the Transfer Pricing Guidelines,

as well as its participation in other multinational forums, to help ensure international

consistency and uniformity in the application of the arm’s length principle.

The IRS will further its emphasis on the APA Program as a means of

advance resolution of transfer pricing issues that provides protection against

domestic and foreign adjustments and penalties. Moreover, as it was with respect

to global dealing, the APA Program will be a laboratory to identify and formulate

appropriate approaches to particular transfer pricing issues which then can be

incorporated into guidance.

With regard to the Field, Appeals, Competent Authority, and the Advance

Pricing Agreement program described in Chapters 3 through 7, the IRS

Restructuring and Reform Act of 1998 has prompted the most significant

reorganization of the IRS in 40 years. This modernization effort at this time is a

work in process and the available information must be considered preliminary. As a

consequence, it is difficult to develop recommendations with regard to the IRS

organization and section 482. The reorganization is expected to alter the existing

structure in many significant ways. The preliminary indications are that the

reorganization will take appropriate account of the particular functions of the

International Examiners, Appeals, Competent Authority, and the Advance Pricing

Agreement program. The IRS’s focus on section 482 compliance will not be lost

and should, in fact, benefit from the new organization.
.5

APPENDICES
1

APPENDIX A

Estimated Section 482 Gross Tax Gap

Average Annual Estimated Section 482 Gross Tax Gap (In $ millions),

By industry Group, Size Class and Type of Corporation, FY96 - FY98

Industry

Group

Asset Size

Class

FCC’s Non-FCC’s Total

Manufacturing Total

Small

Mid-size

Large

976

81

334

561

448

46

(33)

436

1,424

126

301

996

Wholesale and

Retail Trade

Total

Small

Mid-size

Large

746

81

479

186

144

72

51

21

890

153

530

207

Finance,

Insurance and

Real Estate

Total

Small

Mid-size

Large

139

21

67

50

88

1

18

69

227

22

85

120

Services Total

Small

Mid-size

Large

139

37

82

20

21

1

9

11

160

38

91

31

Other Industries Total

Small

 Mid-size

Large

14

15

(5)

3

117

0

4

113

130

15

(1)

116

Total Total

Small

Mid-size

Large

2,013

235

957

821

818

120

49

649

2,831

355

1,005

1,471
2

Portion of Section 482 Tax Gap Identified in Audits

Asset Size Class Gross Tax Gap Portion of Gross

Tax Gap Identified

in Audits

Portion of Gross

Tax Gap Not

Identified In Audits

$M $M Percent $M Percent

Small

Mid-size

Large

355

1,005

1,471

39 11%

220 22%

1,471 100%

316 89%

786 78%

0 0%

Total 2,831 1,729 61% 1,102 39%
1

APPENDIX B

Analysis of Compliance Trends

Tax Period

Group

ings

Closing Period Returns

Closed

Adjustments

Proposed

$’s per return

Avg. Proposed

$’s per

return

Standard

Deviation

- adj

Hours

Expended

Avg. Hrs

Per return

All Returns

92 and 93 97 total 202 334,290,128 1,654,902 6,253,902

std error

440,023

29,302 145

94 and 95 99 Total 702 580,058,258 826,294 4,202,696

Std. Error

158,621

74,699 106

Difference 828,608 Std. Error

467,740

t-statistic 1.77

CEP

92 and 93 97 total 51 159,789,089 3,133,119 11,527,437

Std error

1,614,164

13,102 257

94 and 95 99 Total 100 379,482,939 3,794,829 9,334,961

Std. Error

933,496

21,024 210

Difference (661,710) Std. Error

1,864,656

t-statistic (0.35)

Non-CEP

92 and 93 97 total 151 174,501,039 1,155,636 2,668,579

Std. Error

217,166

16,200 107

94 and 95 99 Total 602 200,576,319 333,182 2,130,090

Std. Error

86,816

53,674 89

Difference 822,454 Std. Error

233,876

t-statistic 3.52
1

APPENDIX C

Appeals Sustention Rate in Section 482 Cases

The sustention rate in Appeals is defined as the percentage of adjustment

dollars proposed by Examination that is actually agreed to in Appeals. For

example, if the Field proposed an adjustment of $100x and Appeals approved a

settlement for $20x, the sustention rate is 20%.

In practice, the sustention rate may be affected by the disposition of issues

outside Appeals’ jurisdiction. For example, if Appeals fails to obtain settlement with

respect to a particular issue and sends that issue forward to Counsel for trial

preparation, the issue does not factor into the sustention rate. In such cases,

although the issue was not conceded by Appeals, neither was it actually settled or

agreed. Moreover, in computing the sustention rate, any amount conceded by

Appeals due to a judicial decision for an earlier audit cycle for the same taxpayer

that also affects the audit cycle before Appeals, is also taken into account. 

Similarly, the results of a Simultaneous Appeals/Competent Authority agreement on

an issue under Appeals’ jurisdiction is included in computing the sustention rate. 

Thus, although the sustention rate in part reflects the percentage of Examination’s

proposed adjustment that is upheld in Appeals, the rate is also affected by the

foregoing extrinsic factors.

In settling disputed issues such as transfer pricing adjustments, Appeals

considers the hazards of litigation in an effort to reach a resolution that is fair to

both the taxpayer and the Government. Hazards of litigation center around

disagreements regarding the facts and the law. Appeals must consider the facts

and the law in arriving at an answer that a court would be likely to reach. In most

cases, both factors are in dispute, or are not fully developed. In a fact intensive,

heavily litigated area such as transfer pricing, assessing the hazards of litigation is

a case specific inquiry. The assessment takes into account the facts of the case

and the likely application of the law, including relevant judicial decisions. Given the

difficulty of developing these cases, particularly the cases currently before Appeals

which predate the new regulations governing contemporaneous documentation of

compliance with the arm’s length standard, and the difficulty of litigating these

issues to conclusion, the hazards are generally significant.

Appeals tracks the five largest issues in the CEP cases that it considers. 

Although this issue tracking system is not complete, it monitors disposition of the

most significant issues in the largest cases before Appeals. Based on data from

this system, since October 1, 1994, the sustention rate on section 482 issues in

Appeals was 27% ($8,127,494,906 proposed by Examination, of which

$2,207,444,606 was agreed in Appeals). For calendar year 1998, the sustention
2

rate was 34.22% ($3,754,558,544 proposed by Examination, of which

$1,284,730,936 agreed in Appeals).

APPENDIX D

Competent Authority - Income Tax Treaties and TIEAs

The United States is a party to fifty income tax treaties in force,27 with the

following countries:

Australia Egypt Israel New Zealand South Africa

Austria Finland Italy Netherlands

Antilles28

Spain

Barbados France Jamaica Norway Sweden

Belgium Germany Japan Pakistan Switzerland

Bermuda29 Greece Kazakhstan Philippines Thailand

Canada Hungary Korea Poland Trinidad/Tobago

China Iceland Luxembourg30 Portugal Tunisia

 27 The Senate has approved the Ukraine income tax treaty, but instruments of

ratification have not been exchanged due to concerns about Ukraine’s bank secrecy

laws.

28The treaty is terminated to the extent provided in the protocol effective December 30,

1996.

29 The income tax treaty with Bermuda relates only to taxation of insurance enterprises

and mutual assistance in tax matters.
2

Cyprus India Mexico Romania Turkey

Czech

Republic

Indonesia Morocco Russia USSR31

Denmark Ireland Netherlands Slovak

Republic

United Kingdom

 30The Senate has approved a new Luxembourg income tax treaty, but instruments of

ratification will not be exchanged until instruments of ratification for a treaty for mutual

legal assistance in criminal matters are also exchanged at the same time.

31 The US-USSR income tax treaty applies to the countries of Armenia, Belarus,

Georgia, Kyrgyzstan, Moldova, Tajikistan, Turkmenistan, Ukraine and Uzbekistan. The

status of Azerbaijan is not clear.

The United States has entered into a total of thirteen TIEAs, with the

following countries:

Barbados Dominica Guyana Marshall

islands

St. Lucia

Bermuda Dominican

Republic

Honduras Mexico

Costa Rica Grenada Jamaica Peru
1

APPENDIX E

Competent Authority Statistics

1. Volume

The number of requests for U.S. competent authority assistance tends to

fluctuate from year to year, but has generally increased over the past several years,

as the following chart indicates. However, over the same period, the number of

APAs has more than doubled from 54 at the end of FY 1994 to 123 by the end of FY

1998:

 NonAllocation Allocation APA Total

FY 1995

Inventory 10/94 177 115 54 346

Receipts 92 84 33 209

Closure 79 70 9 158

Inventory 9/95 190 129 78 397 

 

FY 96

Inventory 10/95 190 129 78 397

Receipts 99 61 59 219

Closure 55 85 20 160

Inventory 9/96 234 105 117 456 

FY 97

Inventory 10/96 234 105 117 456

Receipts 124 55 39 218

Closure 104 51 35 190

Inventory 9/97 254 109 121 484 

FY 98

Inventory 10/97 254 109 121 484

Receipts 83 62 33 178

Closure 125 58 31 214

Inventory 9/98 212 113 123 448 

Allocation Cases: cases involving transfer pricing issues

Non-Allocation Cases: cases involving other issues, such as withholding tax
2

APA: Advance Pricing Agreement

2. Relief Effected

The relief percentages are computed based on dollars amounts.

Consequently, one very large case could conceivably affect the smaller categories,

such as Partial and No Relief. The following statistics show the degree to which

taxpayers were relieved from double taxation on all cases:

 1995 1996 1997 1998

FULL RELIEF

 Correlative Adjustment 49.12% 50.30% 52.87% 41.09%

 Adjustment Withdrawn 41.90% 38.22% 46.17% 45.96%

PARTIAL RELIEF 0.41% 0.00% 0.19% 8.20%

NO RELIEF 8.58% 11.48% 0.78% 4.45%

“Full Relief” has two components:

1) Correlative Adjustment - the U.S. or the treaty partner allows a corresponding

adjustment.

2) Adjustment Withdrawn - the initiating country withdraws the adjustment.

“Partial Relief” means that the taxpayer received a foreign tax credit because no

agreement was reached (treaty partners unable to agree or relief barred by statute

of limitations).

“No Relief” means the taxpayer does not receive relief that the competent authority

process ordered (e.g., taxpayer withdraws and seeks a settlement outside of

competent authority, treaty partners unable to agree, statute of limitations bars

adjustment and tax not creditable).

Note these statistics are for Allocation and Non-Allocation cases only and do

not include APA cases.
3

3. Processing time

The program ordinarily comes close to its goal of 730 days to resolve the

average case:

 Open Cases Closed Cases

Cases Days Cases Days

FY 95

U.S. – Init. 156 458 64 656

Foreign-Init. 163 453 85 597

Combined 319 455 149 622

FY 96

U.S. – Init. 174 624 48 533

Foreign-Init. 165 492 92 555

Combined 339 560 140 547

FY 97

U.S. – Init. 195 518 74 933

Foreign-Init. 168 552 81 670

Combined 363 538 155 807

FY 98

U.S. – Init. 149 627 103 726

Foreign-Init. 176 534 80 806

Combined 325 577 183 761

Note these statistics are for Allocation and Non-Allocation cases only and do

not include APA cases.
1

APPENDIX F

APA Statistics

Participants in the APA program span a wide spectrum of industries. For the 164

APA cases closed as of September 30, 1998, the industries that have been

represented include:

-Financial products (22)

-Computers (16)

-Consumer Products - Retail (27)

-Consumer Electronics (11)

-Petroleum\Chemical (10)

-Automotive (14)

-Manufacturing\Industrial (24)

-Biotech\Pharmaceuticals (8)

-Oil Gas (4)

-Aluminum\Steel (2)

-Aerospace (5)

-Publishing (2)

-Food (7)

-Shipping (1)

-Telecommunications (5)

-Software (1)

-Construction (4)

-Entertainment (1)

The following chart summarizes the number of new APA cases that have been filed

and completed over the past eight years. Included in this chart for completed cases

is information identifying whether the APA was bilateral or unilateral and the region

where the APA originated. 

Year New Cases Completed Cases / (Unilateral / Bilateral) / By Region

Total (U/B) Northeast Midstates Southeast West 

1991 15 1 (1 U) 1

1992 21 5 (2U / 3B) 5

1993 34 10 (8U / 2B) 5 1 2 2

1994 41 3 (3U) 3

1995 58 21 (14U / 7 B) 11 4 1 5

1996 60 32 (16U / 16B) 18 6 4 4

1997 65 41 (27U / 14B) 19 10 5 7

1998 63 51 (18U / 33B) 35 7 5 4
1

APPENDIX G

APA Significant Developments -- 1992 To Present

September, 1992 By fiscal year end, the APA Program had completed 6

APAs.

September, 1993 APA Task Force Report issued: “Implementation Issues for

a More Effective APA Program.” This report addressed the

issue of whether the APA Program should stay as part of the

Office of Chief Counsel or should instead be placed under the

Assistant Commissioner (International). The APA Program

remained within the Office of Chief Counsel, but with a

recognition that the APA Program’s multifunctional nature

requires close coordination with the Office of the Assistant

Commissioner (International).

September, 1993 By fiscal year end, the APA Program had completed 16

APAs.

February, 1994 Proposed and temporary transfer pricing penalty regulations

published. These regulations provided additional incentive for

taxpayers to request APAs, to avoid possible substantial

penalties if substantial transfer pricing adjustments were

sustained. (Revised proposed and temporary regulations

issued July, 1994; final regulations issued February, 1996.)

April, 1994 Notice 94-40 (1994-1 C.B. 351) issued, titled Global Trading

Advance Pricing Agreements. This Notice gave guidance to

financial institutions that conduct round-the-clock trading,

passing their book of investments from (for example) New York

to London to Tokyo over a 24-hour period.

September, 1995 By fiscal year end, the APA Program had completed 40

APAs.

September, 1996 By fiscal year end, the APA Program had completed 72

APAs.

November, 1996 IRS Chief Counsel Directives Manual part (42)(10) issued,

setting out internal procedures for processing APA cases.

December, 1996 Rev. Proc. 96-53 (1996-2 C.B. 375) issued, providing

revised procedures for APAs.

August, 1997 Early Referral Program instituted, effective October 1, 1997,

by which districts selectively refer appropriate taxpayers with
2

transfer pricing issues to apply for an APA before the issue

receives substantial audit attention.

September, 1997 By fiscal year end, the APA Program had completed 113

APAs.

February, 1998 Notice 98-10 (1998-6 I.R.B. 9) issued, providing draft

procedures for Small Business Taxpayer APAs. (Small

businesses, defined generally as having under $100 million

worldwide sales, were previously eligible for APAs; however,

the draft procedures were designed to encourage smaller

corporations to participate in the APA program by making the

process more streamlined and less expensive.)

September, 1998 By fiscal year end, the APA Program had completed 164

APAs, including its first four APAs under the Small Business

Taxpayer procedures.

December, 1998 Notice 98-65 (1998-52 I.R.B. 10) issued, providing final

procedures for Small Business Taxpayer APAs. (Small

business redefined as generally under $200 million worldwide

sales.)
1

APPENDIX H

Significant Section 482 Docketed Cases

This appendix provides information on sixteen significant court opinions

published after 1992 in cases in which an adjustment under section 482 was a

major issue. The opinions are listed both by year of publication and by alphabetical

order. The alphabetical list includes synopses of those cases not discussed in the

text of the report. 

Annual List:

1993:

· Perkin-Elmer Corp. v. Commissioner, T.C. Memo. 1993-414, 66 T.C.M.

(CCH) 634

· Apple Computer Inc. v. Commissioner, T.C. Docket No. 21780-90

· Exxon Corp. v. Commissioner, T.C. Memo. 1993-616, 66 T.C.M. (CCH) 1707,

aff’d sub. nom. Texaco Inc. v. Commissioner, 98 F.3d 825 (5th Cir. 1996),

cert. denied 520 U.S. 1185 (1997)

1994:

· Central de Gas de Chihuahua v. Commissioner, 102 T.C. 515 (1994)

· Seagate Tech., Inc., & Consol. Subs. v. Commissioner, 102 T.C. 149 (1994)

· National Semiconductor Corp. v. Commissioner, T.C. Memo. 1994-195, 67

T.C.M. (CCH) 2849

1995:

· W.L. Gore Inc. v. Commissioner, T.C. Memo. 1995-96.

1996:

· InverWorld v. Commissioner, T.C. Memo. 1996-301, 71 T.C.M. (CCH) 3231

· Medieval Attractions N.V. v. Commissioner, T.C. Memo. 1996-455, 72 T.C.M.

(CCH) 924
2

1997:

· Gibbs International, Inc. v. Internal Revenue Service, 1997 U.S. App. LEXIS

30504 (4th Cir. Nov. 7, 1997), cert. denied, 118 S.Ct. 1512 (1998)

· Pikeville Coal Co. v. United States, 37 Fed. Cl. 304, 97-1 U.S.T.C. ¶ 50,256

(1997)

· Kaps Warehouse, Inc. v. Commissioner, T.C. Memo 1997-309; 74 T.C.M.

(CCH) 18

· ASAT v. Commissioner, 108 T.C. 147 (1997)

1998:

· Podd, et al. v. Commissioner, T.C. Memo 1998-231; 75 T.C.M. (CCH) 2575

· Kenco Restaurants, Inc. v. Commissioner, T.C. Memo. 1998-342, 76 T.C.M.

(CCH) 512; appeal to the 6th Circuit docketed. 

· DHL Corp. v. Commissioner, T.C. Memo. 1998-461, 76 T.C.M. (CCH) 1122

1999 (through March 31, 1999):

None

Alphabetical List of Opinions:

Apple Computer Inc. v. Commissioner, T.C. Docket No. 21780-90

In September of 1993, Judge Jacobs announced that an arbitration panel

accepted the Service's transfer pricing figures for the three years at issue in binding

"baseball" arbitration. Transfer Pricing Report, September 22, 1993, and October

20, 1993.

ASAT v. Commissioner, 108 T.C. 147 (1997)

Central de Gas de Chihuahua v. Commissioner, 102 T.C. 515 (1994)

DHL Corp v. Commissioner, T.C. Memo. 1998-461, 76 T.C.M. (CCH) 1122

Exxon Corp. v. Commissioner, T.C. Memo 1993-616, aff'd sub nom. Texaco Inc. v.

Commissioner, 93 F. 3d 825 (5th Cir. 1996), cert. denied 65 U.S.L.W. 3711 (1997)

Gibbs International, Inc. v. Internal Revenue Service, 1997 U.S. App. LEXIS 30504

(4th Cir. Nov. 7, 1997), cert. denied, 118 S.Ct. 1512 (1998)
3

The Fourth Circuit affirmed a decision of the U.S. District Court for the District

of South Carolina that the Service was not required to disclose under FOIA a letter

that the Service wrote to German tax officials suggesting that they participate in a

simultaneous tax examination of the taxpayer and its German subsidiary.

InverWorld v. Commissioner, T.C. Memo 1996-301, supplemented by T.C. Memo

1997-226

The Tax Court found that INC was LTD’s dependent agent in the United

States and that LTD was engaged in a U.S. trade or business through an office or

fixed place of business by virtue of INC’s U.S. activities. Additionally, the Tax Court

found that LTD could not avail itself the securities trading safe harbors set out in

Code section 864(b)(2). Consequently, income derived by LTD’s U.S. trade or

business was taxable and LTD was required to file U.S. returns. The Court also

found that LTD was not entitled to deduct expenses or to a correlative adjustment

for income allocated to INC as a result of the Tax Court’s transfer pricing analysis

because LTD had failed to file U.S. returns. InverWorld is one of the few cases

discussing when the activities of an agent conducted through that agent’s U.S.

office or fixed place of business will constitute a U.S. trade or business of the

foreign principal. InverWorld is the first case that discusses the securities trading

safe harbor set out in 864(b)(2)(i), as applied to dealers and one of the few cases

that discusses the securities trading safe harbor set out in 864(b)(2)(ii), as applied

to trading for the taxpayer’s own account. Petitioners’ appeals are pending in both

the 5th Circuit (Docket No. 98-60376) and in the D.C. Circuit (Docket Nos. 98-

1257 and 98-1258).

Kaps Warehouse, Inc. v. Commissioner, T.C. Memo 1997-309

The taxpayer sold automotive parts and supplies to both related and

unrelated customers at the same price, but gave "rebates" at year end to its related

customers. The Tax Court found that, by granting the rebates, the taxpayer

essentially sold merchandise at non-arm's-length prices and arbitrarily shifted

income to related entities. As a result, the Service's reallocation of income to the

taxpayer under section 482 was proper.

Kenco Restaurants, Inc. v. Commissioner, T.C. Memo 1998-342, appeal docketed in

6th Cir.

The taxpayers were related corporations, each of which owned or operated

one or more Taco Bell restaurants. Each also paid fees to a related corporation,

BKK Management, Inc. (BKK), for management and administrative support services.

 The Service reallocated the BKK fees based on gross sales of the restaurants, with

certain adjustments. At trial, the Service offered the testimony of an expert witness

who arrived at an allocation which differed from that of the statutory notice. The

Service explicitly stated, however, that it had not abandoned the notice. The

taxpayers focused their attention at trial and on brief to attacking the allocation

advanced by the Service's expert. The court found that the taxpayers had failed to
4

carry their burden of proving that the Service had abused its discretion, i.e., that the

allocations in the statutory notice were arbitrary, capricious or unreasonable.

Medieval Attractions N.V. v. Commissioner, T.C. Memo. 1996-455

National Semiconductor Corp. v. Commissioner, T.C. Memo 1994-195

The case involved round trip transfers of silicon chips and technology to

further process them between a U.S. company and its S.E. Asian subs, with the U.S.

distributor claiming losses on the resale of the imported items. The Tax Court

upheld approximately 50% of the section 482 adjustments taken to trial, relying on

the Service’s expert (with modifications).

Perkin-Elmer Corp. v. Commissioner, T.C. Memo 1993-414

The case involved section 482 adjustments concerning transfers of tangible

and intangible property between the taxpayer and its § 936 subsidiary. The Tax

Court rejected taxpayer's application of the resale price method, but sustained other

features of its computation to arrive at a result that was about equally favorable to

both parties.

Pikeville Coal Co. v. United States, 37 Fed. Cl. 304 (1997)

Taxpayer is a wholly-owned, second-tier U.S. subsidiary of a Canadian

corporation and owns and operates a coal producing property in Kentucky. The

Service examined the price at which the taxpayer sold coal to its parent, and under

the authority of section 482, allocated income from the taxpayer to its parent,

reducing taxpayer's taxable income. Taxpayer filed a claim, and later a suit for

refund, seeking a greater he reduction in its sale price than that allowed by the

Service. The IRS moved to dismiss the complaint for failure to state a claim on

which relief may be granted, arguing that in effect taxpayer sought an order

requiring the Service to apply section 482. With an exception not applicable here,

section 482 has traditionally been available to taxpayers for a defensive use only,

not, as in this case, offensively. The Court of Federal Claims denied the

government's motion to dismiss.

Podd et al. v. Commissioner, T.C. Memo 1998-231 (1998), on reconsideration, T.C.

Memo. 1998-418.

Powertex, a U.S. corporation, is closely held by three Canadian citizens, a

father and his two sons. Powertex manufactures bulk shipping container liners

pursuant to patents held by the individual shareholders. The Service disallowed

royalty payments to the individuals on the basis that (1) the patents were worthless,

(2) Powertex either owned the patents or held "shop rights" to the patents as a

result of paying the expenses of development and registration and furnishing space

and equipment to the shareholders who were officers of the corporation and (3)
5

under all circumstances, the amount of royalties being paid was overstated and not

arm’s length within the meaning of section 482. The Service conceded the first

argument that the patents were worthless and the Court completely ignored the

second argument that Powertex either owned the patents or held "shop rights". The

Court then held under section 482 that the royalties were excessive to the extent

that they exceeded 9%.

With respect to other subsidiary issues, the court held that the excessive

royalty payments were dividends to the shareholders, that payments to a third party

were kickbacks and therefore not ordinary and necessary business expenses, that

amounts paid to a Canadian corporation wholly owned by Powertex’s shareholders

were paid for management services and did not constitute dividends to the

individuals, that one of the sons was a U.S. resident for tax purposes and that none

of the deficiencies were subject to penalties because the taxpayers had relied on a

tax professional.

Seagate Technology, Inc. v. Commissioner, 102 T.C. 149 (1994)

W.L. Gore Inc. v. Commissioner, T.C. Memo. 1995-96.

The Tax Court rejected the taxpayer’s motion for summary judgment

attacking the Service’s application of section 482 to shareholder with less than a

majority interest. The taxpayer contended that the Service is precluded from

treating the intercompany transfers between petitioner and JGT as “controlled”

transactions because petitioner directly owned only 50% interest in JGT, and its

indirect ownership of the balance of JGT could not be attributed to petitioner

because the attribution rules under section 318 were not expressly made applicable

to section 482. The Court held that the question of common control was an issue of

fact requiring examination of all relevant indicia of control, including ownership, both

direct and indirect, regardless of the applicability of the attribution rules of

ownership under section 318
1

APPENDIX I

Costs of Section 482 Litigation

Tables 1 and 2 show actual costs incurred by the Office of Chief Counsel in

preparing and litigating two recent section 482 cases. 

Table 1 – Large Case A

TOTAL LABOR $2,365,854

NON-LABOR DIRECT COSTS

 Expert Witness Fees $2,103,800

 Other Non-Labor Direct costs32 154,707

TOTAL DIRECT

NON-LABOR COSTS $2,258,507

TOTAL COSTS33 $4,624,361

Table 2 – Large Case B

TOTAL LABOR $1,335,475

NON-LABOR DIRECT COSTS

 Expert Witness Fees $ 674,000

 Other Non-Labor Direct costs34 $ 87,329

TOTAL DIRECT

NON-LABOR COSTS $ 761,329

TOTAL COSTS35 $2,096,804

 32Includes transcript fees, automated legal research and travel.

33Does not include indirect costs such as rent, equipment, services, data

processing, or telecommunications, which were estimated to total $549,209.

34Includes transcript fees, automated legal research and travel

35Does not include indirect costs such as rent, equipment, services, data

processing, or telecommunications, which were estimated to total $310,017.
1

APPENDIX J

APA Costs – FY 1997 Costing Study

Category Average Cost

Original Requests from Companies Over $1B $72,268

Renewal Requests from Companies Over $1B $24,172

Original Requests from Companies Between

$100M and $1B

$49,745

Original Requests from Companies Under $100M $69,957

Small Transaction Request from Company Under

$100M

$2,452

Source: 1997 Costing Study

The APA costing study was performed to determine the actual costs incurred to the

government of each of the 28 APA cases that closed in FY 1997. The current APA

pricing structure contains 12 fee areas; cases which closed in 1997 fell under only

five of the 12.

The basis of the costing formula is time. Hours spent on each case are sorted by

professional categories. Each category has an average hourly rate which covers

salary and benefits for those employees. Multiplying hours by salary rate provides

the professional salary and benefits costs associated with each case. Hours are

also used to apportion support and management costs, as well as non-labor costs

such as rent and computer equipment.
1

APPENDIX K

Large Case Procedures

Internal Revenue Manual, Part XXXV, Chief Counsel Directives Manual

Chapter (35)300, Coordination

Section (35)3(19)0, Large Case Coordination Procedures

Sub-Section (35)3(19)1, Background and Overview

 Date document last amended: 7-13-1995.

Background and Overview

(1) Introduction. The large case program is an aspect of tax administration of

critical importance to the Internal Revenue Service. In support of this program, the

Office of Chief Counsel plays an essential role in assisting in the proper

development and disposition of large cases prior to litigation, as well as in litigating

these cases before the Tax Court. In recognition of the unique challenges of this

program, it is the policy of the Office of Chief Counsel to utilize a coordinated

approach to deal with the most significant large case matters, and in appropriate

cases, to utilize litigation teams composed of Field and National Office attorneys.

This approach is designed to ensure that the best resources of the Office as a

whole will be available to deal with those cases that have the greatest importance to

tax administration.

(2) Essential Elements of Large Case Litigation. Certain aspects of the

coordinated and team approach to large case litigation have been used successfully

on an ad hoc basis in specific cases over the years. Extrapolating from this

experience, the procedures in this section focus on two elements that are essential

to successful large case litigation:

(a) First, there must be an active working partnership between the National

Office and the Field Offices. This partnership must span the entire process of

large case litigation from initial case planning and development through pretrial

practice, trial preparation, trial of the case, and submission of briefs. Every person

and every office involved in the case must be encouraged to contribute to the

entire process.

(b) Second, senior executives in both the Field and the National Offices must

be directly engaged in all significant large cases. Executives will be expected to

participate in the development of substantive legal positions, decisions about

litigation tactics and strategy, and substantive review of significant written

pleadings, motions, and briefs. Their involvement must go well beyond traditional

notions of management review and oversight.

(3) Overview of Procedures. This section incorporates these basic principles

into specific procedures for the coordination and team litigation of large cases.
3

These procedures do not mandate a set of rules to be rigidly followed in every

case. Rather, they establish an overall framework for dealing with all large cases,

and within this framework suggest general guidelines for actions in each case.

(a) Docketed Cases. This section provides a five step process for handling

docketed cases.

1 Screening--all cases will be screened to identify the large cases that should

be subject to the procedures under the section (Notice Cases) and to determine

which of those Notice Cases should be subject to team litigation. Cases not

subject to these procedures will be handled through existing procedures.

2 Work Plan--an appropriate work plan will be developed for every Notice

Case; the precise contents of the work plan will be determined on a case-bycase basis. For example, if case processing is suspended because of the

court’s consideration of an interlocutory matter, a less detailed work plan may

be adequate and longer periods may be provided between updates and

reviews of the work plan.

3 Coordination and Litigation Teams--there will be close coordination

between the Field and the National Office in every Notice Case; formal litigation

teams will be established for the most significant Notice Cases. There will be a

lead Field attorney and a principal National Office contact attorney for every

Notice Case. If two Associate Offices share jurisdiction over an issue or an

issue within one office’s jurisdiction is intertwined with an issue within the

jurisdiction of another office, one principal National office contact will be

designated for the case. However, if two or more issues are to be coordinated

which are wholly independent and under the jurisdiction of different Associate

offices, each Associate Office will designate a principal contact for issues within

its jurisdiction. Other attorneys in the Field and National Office will participate in

each case to the extent appropriate.

4 Team Organizational Meeting. An organizational meeting, telephone

conference call, or teleconference among those assigned to the case should

take place as soon as practical after the case is designated as a Notice Case.

The purpose of holding such a meeting will be to develop the initial work plan,

define the roles of, and assign responsibilities to, the participants, and to foster

a spirit of cooperation and teamwork. Obviously, agreements as to roles, work

plans etc., reached at the meeting are subject to normal executive oversight

and approval. In determining roles and assigning tasks, emphasis should be on

a team approach.

5 Post-Review--there will be a systematic review of the performance of the

Office in every Notice Case.
4

(b) Nondocketed Cases. These procedures also cover coordination between

the Field and the National Office whenever the Field provides significant legal

advice in a nondocketed case.

Sub-Section (35)3(19)2 , Definitions

 Date document last amended: 7-13-1995.

Definitions

(1) Large Case. In general, the term “large case” means any case described

in one or more of the following categories:

(a) The case involves a Coordinated Examination Program (CEP) taxpayer;

(b) The case involves an Industry Specialization Program (ISP) issue;

(c) The case (and all related nonshelter groups of cases) involves a disputed

liability totalling $10 million or more (including additions to tax and penalties, but

not including interest); or

(d) The case involves an issue of potential significance to tax administration

(including all cases assigned to Special Trial Attorneys).

(2) Certain Large Cases Excluded From Notice Cases

(a) Bankruptcy/Insolvency Cases. Significant bankruptcy/insolvency cases are

not treated as large cases subject to the procedures in this section and will be

handled in accordance with CCDM (34)(10)30.

(b) Refund Cases. Refund cases arising in either the U.S. Court of Federal

Claims or the U.S. District Courts are not subject to these procedures; however,

the office will provide assistance and support to the Department of Justice in

these cases in accordance with established procedures.

(c) Discretion to Exclude Cases. A case that otherwise meets the definition of a

large case may be excluded from the procedures described in this section as a

result of the screening process described in (35)3(19)3:(1) below.

(3) Notice Cases. The term “Notice Case” as used in this section means those

cases that are designated by the procedures described in this section as subject

to either coordination or team litigation provisions.

(4) Team Litigation. The term “team litigation” as used in this section refers to the

process that will be employed in those Notice Cases that are determined to be so

significant as to warrant the formal establishment of trial litigation teams

composed of National Office and Field attorneys. Teamwork and appropriate
5

coordination between the National Office and the Field is, of course, expected

and encouraged in every Notice Case, including those not selected for formal

team litigation.

Sub-Section (35)3(19)3 , Cases in Docketed Status

 Date document last amended: 1-6-1997.

Cases in Docketed Status

(1) Screening of Petitions. Tax Court petitions (including amended petitions) will

be screened in both the National Office and the Field. The purpose of this

screening is to determine which petitions represent large cases as defined in

(35)3(19)2, and which of these large cases should be excluded from the

procedures of this section because the issues in the case either: (a) involve wellsettled principles of law; or (b) are not sufficiently complex or important to warrant

the special commitment of resources envisioned by this section. Any case

excluded from the procedures in this section will be handled under existing

coordination procedures.

(a) National Office Screening and Report to the Field. The National Office will

be responsible for screening all petitions with proposed deficiencies in excess of

$1,000,000, other than cases in which the deficiency is in Estate and Gift tax or

the deficiency is based upon transferee liability.

1 The Assistant Chief Counsel (Field Service) will identify and provide copies

of all such petitions to the National Office function(s) responsible for screening

and to the Special Counsel (Modernization and Strategic Planning) [“(MSP)”]

within 5 days of the date the petition is served on the National Office.

2 Petitions will be screened by each Associate Chief Counsel Office with

subject matter jurisdiction over the issues presented in the case. Petitions will

be screened by both the Field Service function and the Technical function

within each Associate Office.

a For each petition screened--the Associate Office shall determine whether

the case (a) should be classified as a Notice Case or (b) should be excluded

from the procedures in this section (either (1) because it does not meet the

definition of a large case stated in (35)3(19)2, or (2) because it is properly

excludible from the procedures in this section under the criteria stated in

(35)3(19)3:(1)) or (c) should be temporarily deferred for a period of no more

than 30 days (as provided in subparagraph d below).

b For each proposed Notice Case--the Associate Office shall designate a

principal National Office attorney for the issues under the jurisdiction of that

Associate Office (generally at grade GS/GM 15), and shall determine
6

whether the Associate believes the case should also be classified as a team

litigation case.

c Within 5 business days after a determination that a case should be

classified as a Notice Case, the Associate Office shall so notify the Field

Office to which the case is assigned, the appropriate Regional Office, the

Assistant Chief Counsel (Field Service), and the Special Counsel (MSP). See

initial communication procedures, (35)3(19)3:(1)(d).

d If the Associate Office believes that the petition cannot adequately be

screened because of an inadequate description or explanation of the issues

involved, the Associate Office will contact the Field attorney to determine

whether the Service files can provide information to determine the

significance of the issues. If the significance cannot be determined within the

initial screening period, by agreement of the Associate Office and the Field,

screening may be deferred for a period not exceeding 30 days. This period of

time may not be further extended. The case shall temporarily be classified as

“deferred” for the monthly report provided below. The case will then be

screened again in the following month, with the benefit of greater knowledge

of the significance of the issue, and a determination made whether the case

should be classified as a Notice Case.

e Within 10 days after the end of each month, each Associate Office shall

provide to the Assistant Chief Counsel (Field Service), a list of all petitions

assigned to that Associate Office for screening during the month, and the

proposed classification of each case.

3 The Assistant Chief Counsel (Field Service) will prepare a monthly report

reflecting the results of the National Office screening. This report will compile

the information provided by the respective Associate Offices with respect to the

petitions assigned to them for screening during the previous month. This report

will be distributed to the Chief Counsel and Deputy Chief Counsel, all Regional

Counsel, Deputy Regional Counsel (Tax Litigation), Assistant Regional

Counsel (Large Case), all Associate Chief Counsel, all Assistant Chief

Counsel, and the Special Counsel (MSP), no later than 15 days following the

close of the month during which the listed petitions were served on the National

Office.

(b) Field Screening and Response to National Office. To the extent not

otherwise specified in this section, screening of cases by the Field will be done in

accordance with procedures established by the Regional Counsel.

1 Every petition will be screened by the assigned District Office or Office of

Assistant Regional Counsel (Large Case). Within 5 business days after a

petition is screened, the assigned Office will notify the Regional Office of every
7

case it recommends be treated as a Notice Case or whether it recommends that

classification be deferred for a period not exceeding 30 days.

2 Within 5 business days after it determines that a case identified by an

assigned Office should be classified as a Notice Case, the Regional Office will

so notify the Assistant Chief Counsel (Field Service). At that time, the Regional

Office will also indicate whether it recommends the case be subject to team

litigation, and provide the name of the lead Field attorney for the case. The

Assistant Chief Counsel (Field Service) will provide this information to the

appropriate Associate Chief Counsel and to the Special Counsel (MSP).

3 If the Regional Office believes that the petition cannot adequately be

screened because of an inadequate description or explanation of the issues

involved, the Regional Office will contact the Associate Office. If the

significance of the issue cannot be determined within the initial screening

period, by agreement of the Associate Office and the Regional Office,

screening may be deferred for a period not exceeding 30 days. The case will

then be screened again in the following month, with the benefit of greater

knowledge of the significance of the issue, and a determination made whether

the case should be classified as a Notice Case.

4 Within 10 days after receipt of the National Office report listing the cases

screened in the National Office during the previous month, the Regional Office

will advise the Assistant Chief Counsel (Field Service) of any disagreement

with any item in the report, of any additional cases or information that should be

included in the report, and of any cases that the Field believes cannot be

properly evaluated pending receipt of the administrative file.

(c) Reconciliation of National Office and Field Classification of Cases. The

Assistant Chief Counsel (Field Service) will coordinate the responses received

from the Regional Offices with the appropriate Associate Chief Counsel, and will

circulate a monthly cumulative report of Notice Cases.

1 Final decisions as to whether a case will be treated as a Notice Case, and

whether team litigation procedures will be employed for such cases, will be

made by the Regional Counsel and the affected Associate Chief Counsel.

Absent agreement, a case will betreated as a Notice Case if either the Regional

Counsel or the Associate Chief Counsel requests such treatment. Any

disagreement as to whether a Notice Case will be subject to team litigation will

be resolved by the Chief Counsel or Deputy Chief Counsel.

2 A case that is initially excluded from the procedures of this section, or

initially determined not to require team litigation, may later be reclassified as a

Notice Case or made subject to team litigation procedures if, as the case

progresses, it is determined (in accordance with the procedures used for the

initial classification) that such reclassification is appropriate. Likewise, a case
8

initially classified as a Notice Case, or initially made subject to team litigation,

may subsequently be excluded upon agreement of the Regional Counsel and

Associate Chief Counsel.

(d) Initial Communication Following Screening. As soon as practical after a case

is identified as a proposed Notice Case, the lead Field attorney and the principal

National Office attorney should communicate with each other to discuss the

issues in the case and the proposed Answer. This initial communication should

not wait for the distribution and reconciliation of the monthly reports described in

(35)3(19)3:(1)(a)3 and (35)3(19)3:(1)(b)3, but rather should be initiated as soon

as either the lead field attorney or the principal National Office attorney is

assigned to the case. To facilitate this initial communication--

1 If the principal National Office attorney is assigned to a proposed Notice

Case before a lead Field attorney is assigned to that case, he/she should

contact the Assistant Regional Counsel (Large Case).

2 If the lead Field attorney is assigned to a proposed Notice Case before a

principal National Office attorney is assigned to that case, he/she should

contact the Assistant Chief Counsel (Field Service).

(2) Work Plan. A work plan is essential to the proper development, trial and

briefing of every Notice Case. The specific form and contents of the work plan

will be determined by the responsible executives on a case-by-case basis,

according to the nature, importance and difficulty of the legal and factual issues

presented by the case, whether the case requires team litigation, the activity or

status of the case, and the availability of resources. The following guidelines

are intended to facilitate the creation of appropriate work plans.

(a) Contents of Work Plan. A complete work plan will set forth the essential

facts, legal issues, litigation strategy, and time tables that are expected to apply

to the case. It is expected that the work plan will become more specific and fully

developed as the case progresses. The work plan will be prepared using the

FALCON Report program. Details of the format and content of the work plan are

set forth in Exhibit (35)300-13. In general, a complete work plan should:

1 Indicate whether the case is to be referred to Appeals (in whole or in part)

for consideration or retained by Counsel or returned from Appeals, if

appropriate, for factual development, pursuant to existing procedures, and

provide a schedule for monitoring the progress of the case (or part thereof)

while it is with Appeals to ensure adequate time for development of any issue

that is not resolved by agreement.

2 Describe further action needed to properly develop the legal and factual

issue(s) presented by the case. Depending on the case, the required actions
9

may include clarification of office position on legal issues, retention of expert

witnesses, determination of the need for discovery, etc.

3 Establish an overall schedule for the case, including a schedule for

completion of the actions noted in subparagraph (2)(a)2, as well as the ordinary

landmarks of litigation (e.g., stipulations of fact, trial memorandum, trial,

briefing, etc.).

4 Identify the responsibilities of each Field and National Office attorney

assigned to the case. Because the role of each participant will vary depending

on the particulars of each case, the work plan should set forth the specific tasks

and projected completion dates for each participant to avoid misunderstandings

and disagreements.

(b) Initial Preparation and Approval of Work Plan. The lead Field attorney will

be responsible for preparation of the work plan, in coordination with the principal

National Office attorney. The plan will be submitted for review to the Regional

Counsel, appropriate Associate Chief Counsel, and the Special Counsel (MSP),

within 60 days after filing the Answer. Within 30 days thereafter, the Regional

Counsel and Associate Chief Counsel will agree on an approved work plan. The

Assistant Regional Counsel (Large Case), will be the contact person regarding

processing of work plans within the region whether or not the lead Field attorney

is a Special Trial Attorney and whether or not the region has processed the work

plan in another manner. A copy of the approved work plan will be provided to the

affected Field and National Office attorneys and to the Special Counsel (MSP).

(c) Updating and Review of Work Plan. The work plan will be updated as

necessary to reflect actual and anticipated developments in the case, and will

generally be formally reviewed and approved at least semi-annually (based on

the date of the initial work plan) by the Regional Counsel and Associate Chief

Counsel(s). Copies of reviewed work plans will be provided to the Special

Counsel (MSP) and the Deputy Chief Counsel, and the original forwarded to the

Assistant Chief Counsel (Field Service) for retention. For this section, “updating”

means the modification of the work plan to reflect events and necessary

adjustments, and regularly updated work plans are used routinely by the team

and local managers as a tool in day to day development of the case. “Review” of

an updated work plan encompasses executive oversight of the work plan at the

regional and national office levels. No updating or review of a work plan is

required during the period of time that the case is submitted to a court (the Tax

Court or appellate court) and is pending a decision of that court. Upon a decision

or opinion of the court, a work plan will be required to provide for further case

processing.

(3) Litigation Teams. National Office and Field attorneys are expected to share

responsibility in all aspects of case development, trial, and briefing. The nature

and degree of responsibility assigned to individual attorneys will vary from case to
10

case, based on the nature, importance, and difficulty of the legal and factual

issues presented by the case and the availability of resources. An organizational

meeting, teleconference, or videoconference among those assigned to the case

should be held as soon as practical after the case is designated as a Notice Case

to develop the initial work plan, define roles, assign responsibilities, and

encourage teamwork. The following general guidelines will apply unless the work

plan provides otherwise:

(a) Lead Field Attorney. The Lead Field attorney will be the counsel of record,

will be responsible for overall litigation of the case, and will be responsible for

preparation of all written submissions (stipulations of fact, trial memoranda, briefs,

etc.), in consultation with the other team members.

(b) Principal National Office Attorney. The principal National Office attorney(s)

will be responsible for coordinating National Office participation in the case and

will be expected to become knowledgeable about the case as a whole. To the

extent provided in the work plan, she/he will assist in the preparation of all written

submissions, including preparation of initial drafts, and will otherwise participate

in the trial of the case.

(c) Other Attorneys. Other attorneys from the Field or National Office assigned

to a trial team will participate in the case to the extent provided in the work plan.

(4) Formal advice from National Office. Formal Field Service Advice should be

requested concerning any aspect of a Notice Case (including technical,

procedural, or litigation questions) whenever such advice may be helpful in the

development of the case. The Assistant Chief Counsel with jurisdiction over the

issue must review and approve any responsive Field Service Advice.

(5) Post-Review of Cases. There will be an analysis of the performance of the

Office of Chief Counsel in every Notice Case. This analysis is designed primarily

to facilitate sharing useful experiences, information, and innovations throughout

the Office, to identify and correct systemic problems, and to gather data that will

contribute to improved tax administration. It is not intended to focus on the

performance of the individuals involved in particular cases.

(a) Report on Notice Case Issue Results. A report, “Notice Case Issue Results”,

will be prepared in the form of Exhibit 35(300)17 within 60 days of the date of any

of the following events:

1 Settled issues: the earlier of the filing of the decision document or a

stipulation of settled issues covering the Notice issue.

2 Excluded issues (issues for which Notice Case designation is removed):

upon agreement of the responsible Regional Counsel and Associate Chief

Counsel pursuant to CCDM (35)3(19)3(1)(c)2.
11

3 Tried issues (including dispositive motions) not appealed: the conclusion of

the 90 day appeal period following entry of the Tax Court decision.

4 Appealed issues (interim report): when the national office advises that a

notice of appeal has been filed.

5 Appealed issues (final report): when the Tax Court decision becomes final.

(b) Preparation, Review and Approval. The lead trial attorney will prepare the

report on Notice Case Issue Results for events 1 to 4.

1 The report for events will be prepared by the national office attorney

assigned to the issue on appeal, except that, if the issue is remanded and not

appealed after remand, the report for event 5 will be prepared by the lead trial

attorney.

2 Reports will be reviewed and approved by the responsible Assistant

Regional Counsel (Large Case) and the Assistant Chief Counsel. Copies of

approved reports will be provided to the Deputy Chief Counsel, the Special

Counsel (M&SP), and the Assistant Chief Counsel (Field Service). Upon receipt

of an approved report for events 1, 2, 3 or 5, the Assistant Chief Counsel (Field

Service) will remove the issue from the Monthly Large Case Report.

(c) To aid in the post-review of settled Notice Cases, the Lead Field Attorney

will be responsible for submitting complete copies of the Appeals supporting

statement or the counsel settlement memorandum to both the Special Counsel

(MSP) and to the Deputy Associate Chief Counsel (Domestic Field Service)

within thirty days after the decision is entered.

Sub-Section (35)3(19)4 , Field Assistance in Nondocketed Large Cases

 Date document last amended: 7-13-1995.

Field Assistance in Nondocketed Large Cases

(1) Purpose. To ensure consistency of legal advice provided by the Office, to

promote the best possible development of large cases, and to keep the

National office apprised of emerging issues raised by large case taxpayers,

Field attorneys providing assistance to Examination or Appeals in nondocketed

large cases will coordinate all significant advice with the National Office.

(2) Definition of Significant Advice. For purposes of this procedure, legal

advice is deemed significant if it is material to the development or disposition of

any issue in the case, except as provided below.
12

(a) Legal advice generally will be deemed not significant if it is consistent with

advice previously rendered by the National Office in the same case.

(b) Legal advice may be deemed significant even if procedural in nature;

however, advice is not deemed significant if it deals with routine factual

development (such as documents that need to be obtained, problems with IDRs,

summonses, etc.).

(c) In the interest of keeping the National Office fully advised, advice should be

presumed significant unless the Field attorney is reasonably certain that it is not.

(3) Coordination Prior to Providing Significant Advice. In general, Field attorneys

should use established procedures for requesting Technical Advice, Technical

Assistance, or Field Service Advice from the National Office before providing

significant legal advice to Examination or Appeals in any nondocketed large case.

Such procedures must be used whenever the advice involves a legal issue that

cannot be resolved with a high degree of certainty by application of settled

principles of law to the particular facts of the case in which the advice is

requested.

(4) Coordination After Providing Significant Advice. Field attorneys may provide

significant legal advice to Examination or Appeals in a nondocketed large case

without prior coordination with the National Office only if: (a) the advice involves

the application of well-settled principles of law to the facts of a particular case, or

(b) the circumstances in which the advice is requested make prior National Office

coordination impractical. After providing such advice, the Field attorney must

coordinate with the National Office as described below.

(a) Information Copy Sent to National Office. A copy of the advice will be

forwarded to the Assistant Chief Counsel (Field Service) within 10 days of the

advice being rendered. If the advice is given orally, a written summary of the

advice will be prepared with copies forwarded to the Assistant Chief Counsel

(Field Service) and the regional office within such 10 day period. The Assistant

Chief Counsel (Field Service) will provide copies of all such advice to the

appropriate Associate Chief Counsel and the Special Counsel (MSP).

(b) Response of National Office to the Field. No later than 10 days after receipt

of the copy of the Field advice, the Associate Chief Counsel will respond directly

to the Field and will provide a copy of the response to the Assistant Chief

Counsel (Field Service) and to the Special Counsel (MSP). The response will

indicate whether the National Office: 1) concurs with the Field advice; 2) believes

some modification of the advice is appropriate; or 3) needs additional information

or time for analysis in order to evaluate the advice. In the event that the National

Office cannot provide a definitive response to the Field within this 10 day period,

the Associate Chief Counsel will advise the Field when a response will be

provided.
13

(c) Report of Advice Received and Responses Provided. The Assistant Chief

Counsel (Field Service) will maintain a list of all reports of advice received from

the Field and of the responses to such advice provided by the respective

Associate Chief Counsel. This list will be circulated to the Chief Counsel, Deputy

Chief Counsel, Regional Counsel, Deputy Regional Counsel (Tax Litigation),

Assistant Regional Counsel (Large Case), Associate Chief Counsel, Assistant

Chief Counsel, and the Special Counsel (MSP), no later than 15 days following

the close of the month during which the listed items were received in the National

Office.

Sub-Section (35)3(19)5 , Provisions Applicable to All Cases

 Date document last amended: 7-13-1995.

Provisions Applicable to All Cases

(1) Management Responsibility. The procedures of this section do not modify

existing management responsibility for supervision of attorneys or for determining

work priorities and scheduling. It is the responsibility of the managers of every

attorney involved in a large case to remain appropriately informed of

developments in the case.

(2) Delegation of Authority.

(a) Regional Counsel. Except as provided below, the authority of a Regional

Counsel under this section may be delegated only to a Deputy Regional Counsel

(Tax Litigation) or to an Assistant Regional Counsel (Large Case).

(b) Associate Chief Counsel. Except as provided below, the authority of an

Associate Chief Counsel under this section may be delegated only to a Deputy

Associate Chief Counsel or an Assistant Chief Counsel.

(c) Screening of Petitions. Authority to screen petitions under this section may

be delegated to employees at level GM/GS 15 or above; however, authority to

exclude a large case under the criteria specified in (35)3(19)3:(1) or to determine

that a case should be subject to team litigation, may not be so delegated.

(d) Review of Certain Work Plans. Authority to preliminarily review and approve

on behalf of the Field the work plan for any case in which the Lead Field Attorney

reports to a District Counsel may be delegated to that District Counsel. However,

all work plans will be coordinated by the regions with the Assistant Regional

Counsel (Large Case), who will be responsible as the regional contact on that

work plan.

(e) Post-Review of Advice Provided by Field. Authority to approve the National

Office response to the Field pursuant to (35)3(19)4:(4)(b) involving post-review of
14

significant legal advice provided by the Field may be delegated to those persons

in the National Office with authority to approve Technical Advice Memoranda or

Field Service Advice.

(3) Reconciliation of Disagreements. Any disagreements concerning the

application of these procedures will be resolved by the Regional Counsel and

Associate Chief Counsel, or if they cannot agree, by the Chief Counsel or Deputy

Chief Counsel.

(4) Coordination Through Field Service. In general, information or written

material required to be submitted from the Field to the National Office will be

submitted to the Assistant Chief Counsel (Field Service), who will forward such

information or material to the affected Associate Chief Counsel and Special

Counsel (MSP) within 2 days of its receipt in the National Office. The Field may,

however, provide information or material directly to the affected Associate Chief

Counsel, in which case such Associate Chief Counsel will provide copies to the

Assistant Chief Counsel (Field Service) within 2 days of the material being

received in the National Office.

(5) Role of Special Counsel (MSP). These procedures do not modify the role of

the Special Counsel (MSP) as the successor to the Special Counsel (Large Case)

as a program manager charged with monitoring and coordinating current

activities, and designing strategic goals and plans for better identifying and

litigating large cases and large case issues, as set forth in Chief Counsel Notice

N(30)000-191, April 18, 1991. On January 15, 1995, the duties of the Special

Counsel (Large Case) were assumed by the Special Counsel (Modernization and

Strategic Planning).

(6) Role of Appeals in Notice Cases. These procedures do not modify the role

of Appeals in docketed cases. However, because of the importance of the case,

how, when, and under what terms, the case or issues therein are referred to

Appeals should be a conscious decision of both Counsel and Appeals. Appeals

and Counsel shall work cooperatively together, understanding that it is Counsel’s

role to try the case, and Appeals’ role to make an independent effort to settle the

case.

(a) The roles of, procedures, and the relationship between Counsel and

Appeals are set forth in Rev. Proc 87-24 [to be updated in 1995] and Proc. Reg.

§601.106 [as finally amended in 1995]. The selection of a case to be a Notice

Case does not, in itself, constitute a “designation for litigation” under the

procedures of (35)3(14)0.

(b) In general, Appeals will have exclusive jurisdiction over a Notice Case once

it has been referred to Appeals by Counsel.
15

(c) Upon the case becoming at issue, Counsel and Appeals shall examine the

case to determine whether the case (or specific issues) should be considered by

Appeals immediately or whether that consideration should be delayed (whether or

not the case has already been transferred to appeals for consideration). Deferral

of Appeals consideration may be appropriate when:

1 A recommendation is made to designate an issue for litigation under the

procedures of (35)3(14)0.

2 An issue before the court is so insufficiently factually developed that a fair

and objective determination of the litigation hazards cannot be made. In this

event, field counsel will immediately begin discovery on that issue to develop it.

The work plan shall set reasonable limits on the time for development and the

referral to Appeals.

(d) Rev. Proc. 87-24, Sec. 1.06, provides that in appropriate cases, such as

those involving significant issues or large deficiencies, Counsel and Appeals may

work together on a case. When this is done, Appeals has settlement jurisdiction

and Counsel acts in an advisory role.

(e) The taxpayer, through counsel, should be advised of Appeals’ settlement

role in the case or that the case has been referred to Appeals generally.

(7) Application to Pending Cases. These procedures will be applied to all cases

docketed on or after June 1, 1995, and to pending cases docketed to June 1,

1995, to the extent practical based on consultations between the appropriate

Field and National Office managers.

Sub-Section (35)3(19)6 , Review of AIR Agreements

 Date document last amended: 7-13-1995.

 [omitted]