Suggestions For The Next Revision

It will probably be a long time before Congress redrafts section 482, but it’s never too early to propose improvements to the flawed statute that authorizes Treasury’s transfer pricing regulations.

The predecessor of what now appears in section 482 of the Internal Revenue Code was first introduced as section 45 of the Revenue Act of 1928, and the oddly drafted statute has remained remarkably stable over the last 95 years. The statute contained only a single sentence between 1928 and 1986, but that sentence seemingly granted almost unlimited power to Treasury and the IRS (via the Treasury secretary) to shuffle income and deductions across entities that are commonly owned or controlled. Courts, however, have rarely read that sentence or the corresponding Treasury regulations as broadly as the literal statutory text would suggest.

The original sentence remains in place. But frustration with courts’ strong preference for allocation methods that rely on comparable arm’s-length transactions — even when the transactional comparables weren’t really comparable — led Congress to add a second sentence as part of the Tax Reform Act of 1986. That sentence seemed to represent a drastic expansion of a statutory grant of authority that had been whittled down by case law. But courts didn’t seem to get the message. Proceeding as though TRA 1986 had never been enacted, the Tax Court and most federal courts of appeal maintained their preference for the kinds of traditional transactional methods that typically generate lowball values for unique and valuable intangible property.

Congress eventually responded — over 30 years later — with the Tax Cuts and Jobs Act. This 2017 response added a third sentence that says, essentially, that Congress actually meant what it said in 1986. Cases subject to the post-TRA 1986 but pre-TCJA version of section 482 are still working their way through the courts, showing that the 1986 sentence didn’t resolve the ambiguities or other flaws contained in the original sentence and that it introduced ambiguities and flaws of its own. Considering this history and the nature of the TCJA amendments, there’s reason to question whether the post-TCJA version of section 482 will fare any better.

Although the current version of section 482 is badly in need of an overhaul, the historic update interval suggests that it will be decades before Congress reexamines the statute and considers revisions. But when that eventually happens, it will be helpful to have some suggestions on hand.

Seeking a Clear Reflection

The first sentence of section 482 now reads as follows:

In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.

One problem with this sentence is its lack of readability. It relies on distractingly long incantations to identify the taxpayers it affects (“two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests”), the action the secretary may take (“distribute, apportion, or allocate”), and the potential objects of that action (“gross income, deductions, credits, or allowances”). The sentence then compounds the resulting readability problem by partially repeating the first list and completely reproducing the second in grammatically modified form. It would be understandable if first-time readers forget what the sentence is about by the time they finally reach the end.

But the more fundamental flaws are the nebulous preconditions for the secretary’s exercise of the authority granted by the sentence. The sentence allows the secretary to make an adjustment under section 482 “if he determines that” doing so “is necessary in order to prevent evasion of taxes or clearly to reflect the income.” Besides its use of a gendered pronoun that, as of 2023, is both generally disfavored and factually inaccurate, this language presents at least two major problems. First, it provides no coherent standard or principle to assess whether income has been clearly reflected. And second, it literally suggests that the secretary’s perception that an adjustment is necessary — rather than any objective need for one — is sufficient to justify an adjustment.

Fortunately, these flaws can probably be addressed without distorting the sentence’s intended meaning. One possible approach would be to restructure the sentence into a more familiar and succinct subsection-paragraph-subparagraph format, eliminate the excess verbiage, and synchronize the statutory language with regulatory terms and concepts. Using this approach while preserving the breadth of the existing statute’s grant of authority — without accidentally suggesting that the authority is infinite — would yield something like this:

(a) In general. The Secretary may reallocate income, deductions, and credits between or among controlled taxpayers as necessary to ensure the clear reflection of any such taxpayer’s true taxable income.

(1) Controlled taxpayers. For purposes of this section, any two or more organizations, trades, or businesses (regardless of the location and form in which they were organized) shall be considered controlled taxpayers if they are owned or controlled, either directly or indirectly, by the same interests.

(2) True taxable income.

Whether a controlled taxpayer’s true taxable income has been clearly reflected shall be determined in accordance with the principles and methods set out in regulations issued by the Secretary. Except as otherwise provided, nothing in this section shall be construed as favoring any method or category of methods over others.

Like the existing statutory text, this potential revision would allow Treasury and the IRS to continue their adherence to the arm’s-length standard without irrevocably committing them to it. And it would do so in a way that better aligns the statutory text with the existing regulations: The term “true taxable income” is already defined in reg. section 1.482-1(i)(9), and the regulations expressly equate it with the arm’s-length standard in reg. section 1.482-1(b)(1). And by stipulating that no method or category of method is inherently favored, it would also protect the integrity of the best method rule in reg. section 1.482-1(c)(1) and the reliability factors for specific transactions and methods identified elsewhere in the regulations.

This proposed revision obviously wouldn’t please everyone. Paragraph (a)(2) would still hand Treasury and the IRS almost complete power to dictate the statute’s meaning. This would deny taxpayers any plausible basis for suggesting that profit-based methods, like the comparable profits method and the income method, are inherently flawed or inferior to traditional transactional methods. And in the highly unlikely event that Treasury and the IRS ever want to sever the link between the term “true taxable income” and the arm’s-length standard, my suggested version wouldn’t stop them from doing so.

To appease arm’s-length fundamentalists, this result can be avoided by amending suggested paragraph (a)(2). Binding Treasury and the IRS to the arm’s-length standard wouldn’t maintain the existing statute’s meaning, but codifying the arm’s-length standard likely could be done without fundamentally altering existing policy. One approach would be to extract regulatory language from reg. section 1.482-1(b)(1) and (c)(1):

(2) True taxable income.

In determining the true taxable income of a controlled taxpayer, the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer. Whether this standard has been satisfied must be determined using a method that, under the facts and circumstances, provides the most reliable measure of an arm’s length result in accordance with regulations issued by the Secretary.

The Intangible Questions

Amending the second and third sentences of section 482 in a way that effectively conveys meaning, maintains consistency with legislative intent, and minimizes the risk of further judicial misinterpretation is a more ambitious undertaking. The second sentence, which was added by TRA 1986, currently reads as follows:

In the case of any transfer (or license) of intangible property (within the meaning of section 367(d)(4)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.

As explained by the House Ways and Means Committee report (H.R. Rep. No. 99-426) on TRA 1986, Congress codified the commensurate with income standard established by this sentence to counter what legislators perceived to be an overemphasis by courts on transactional comparables and to require ex post adjustments to the compensation required in controlled intangible transfers. According to the report, courts’ overreliance on comparables was “sufficiently troublesome where transfers of intangibles are concerned that a statutory modification to the intercompany pricing rules regarding transfers of intangibles is necessary.” The conference report on TRA 1986 (H.R. Rep. No. 99-841) added that Congress’s intent was that “the division of income between related parties reasonably reflect the relative economic activity undertaken by each.”

This amendment didn’t exactly achieve Congress’s stated objectives. Taxpayers in high-profile transfer pricing cases, including Amazon.com v. Commissioner, 148 T.C. No. 8 (2017), aff’d, 934 F.3d 976 (9th Cir. 2019), and Veritas Software Corp. v. Commissioner, 133 T.C. 297 (2009), nonacq., AOD 2010-05, successfully persuaded courts that the kind of income-based intangible valuation methods that Congress seemingly mandated in 1986 were legally defective because of the section 482 regulations’ leaky definition of an intangible. Because they held that these methods included the value of items that weren’t covered by reg. section 1.482-1(b), were never actually “transferred,” or did not yet exist, courts reverted to the transactional comparables-based approach that Congress tried to discourage.

More than 30 years later, Congress revisited the problem. The TCJA revised former section 936(h)(3)(B)’s definition of intangible property, which now appears in section 367(d)(4), to expressly include goodwill, going concern value, and workforce in place. It also amended section 482 by adding the third and final sentence:

For purposes of this section, the Secretary shall require the valuation of transfers of intangible property (including intangible property transferred with other property or services) on an aggregate basis or the valuation of such a transfer on the basis of the realistic alternatives to such a transfer, if the Secretary determines that such basis is the most reliable means of valuation of such transfers.

The TCJA conference report explains that the amendments to sections 482 and 367(d)(4) were intended to address “recurring definitional and methodological issues that have arisen in controversies,” and it specifies that the controversies Congress had in mind were Amazon and Veritas. By codifying the secretary’s authority to apply the aggregation and realistic alternatives principles to price transfers or licenses of any item covered by the newly expanded definition of intangible property, the TCJA affirmed two long-standing regulatory concepts that the IRS had unsuccessfully invoked in support of its valuation methods in Amazon and Veritas.

The amendments explicitly allow the secretary to price interrelated intangible transfers or licenses in the aggregate to reflect what the TCJA conference report describes as “the additional value that results from the interrelation of intangible assets,” even if that aggregate value includes goodwill, going concern value, or workforce in place. They also expressly authorize methods that, as the conference report explains, use a transaction “that is different from the transaction that was actually completed” to determine the arm’s-length price for the transaction that did take place — a principle that the Tax Court rejected as recharacterization in Amazon.

So problem solved? If the history of the 1986 amendment is any indication, probably not. Taxpayers have been surprisingly successful in their efforts to obscure, narrow, or otherwise avoid the consequences intended by TRA 1986’s commensurate with income amendment. The taxpayer successfully defended its selection of a transactional method — the comparable uncontrolled transaction method or some variant thereof — over an income- or profit-based method to price an intangible transfer or license in Amazon, Veritas, and Medtronic Inc. v. Commissioner, T.C. Memo. 2022-84.

The taxpayer also very nearly succeeded in Altera Corp. v. Commissioner, 926 F.3d 1061 (2019), rev’g 145 T.C. 91 (2015), a case in which the taxpayer insisted that Treasury and the IRS were compelled to justify a regulation (T.D. 9088) requiring the sharing of stock-based compensation in a cost-sharing arrangement (CSA) based on the terms and practices reflected in purportedly comparable arm’s-length transactions. The company also argued that sharing intangible development costs under a CSA isn’t an intangible transfer or license, and therefore isn’t even subject to the commensurate with income standard, because the costs fund the development of future intangibles. The Ninth Circuit ultimately rejected these arguments, but it had to reverse a unanimous 15-0 Tax Court decision by a narrow 2-1 majority and then refuse an en banc rehearing request over the strong objections of some judges to do so. And the Ninth Circuit’s holding has no binding effect on cases subject to other appellate jurisdictions.

Taxpayers are still making arguments that run contrary to the commensurate with income standard, including in some of the highest-profile ongoing cases. Facebook Inc. v. Commissioner, No. 21959-16, features a taxpayer challenge of Treasury’s authority to apply the cost-sharing regulations’ income method under the same statute that codifies the commensurate with income standard, and the company’s arguments have been seriously entertained in Tax Court. Along with its many other counterintuitive arguments, Facebook claims that residual business assets like goodwill, going concern value, and workforce in place fall outside the scope of section 482 entirely. Similarly, the effect of the periodic adjustment regulations that — at least partially — implement Congress’s unambiguously stated intent for Treasury to establish an ex post adjustment mechanism for intangible transfers has been questioned in the ongoing litigation in Perrigo Co. v. United States, No. 1:17-cv-00737.

These kinds of disputes are all but certain to continue, albeit in slightly altered form, under the post-TCJA statute. Seizing on what they perceive to be the limits associated with “transfer” or “transfers,” as the words appear in section 482, and language used in the regulations, practitioners have predicted that taxpayers will still be able to discredit income-based methods that rely on aggregation under the TCJA. Considering the history of section 482 litigation under the commensurate with income standard, these predictions cannot be easily dismissed. Putting an authoritative end to the “recurring definitional and methodological” disputes referred to in the TCJA conference report will likely require a revised version of section 482 that more clearly and firmly establishes the secretary’s authority to enforce the commensurate with income standard, value transactions on an aggregate basis, and apply the realistic alternatives principle.

Scope and Methods

The required changes to the statutory text are more than enough to warrant a new subsection (b) devoted entirely to controlled intangible transactions, and the first priority of the new subsection should be to clearly establish its scope. To preempt the predicted semantic disputes over the meaning of the term “transfer,” the scope-related provisions should use broader language to describe the kinds of arrangements covered by the new subsection. One way to achieve this would be to begin the new subsection by introducing a newly defined term and generally outlining its scope:

(b) Special rules for controlled intangible transactions.

(1) Controlled intangible transaction.

A controlled intangible transaction is any arrangement by which a controlled taxpayer transfers, licenses, or otherwise makes available any rights in intangible property as defined by section 367(d)(4), including any rights in reasonably anticipated future intangible property, to another controlled taxpayer.

There’s no reason that the term introduced in paragraph (b)(1) has to be “controlled intangible transaction.” But the chosen term’s definition should include some kind of catchall phrase (in this case, “otherwise makes available”) that can be extended to arrangements other than “transfers” or “licenses.” To prevent courts from attaching any significance to the distinction between existing and future intangible property in ways that echo Amazon and Veritas, the term in paragraph (b)(1) should also expressly cover rights in intangible property to be developed in the future.

However, establishing an expansive definition in general terms probably won’t be enough. The revised version of section 482 should retain something that resembles the existing statute’s express inclusion of “intangible property transferred with other property or services” and add language that covers CSAs. The TRA 1986 conference report clarifies Congress’s intent that CSAs and their constituent elements be covered by the commensurate with income standard, and this should be confirmed in a new subparagraph under paragraph (b)(1):

(A) Any arrangement with the features described in paragraph (b)(1) shall be considered a controlled intangible transaction, including arrangements that combine the elements of a controlled intangible transaction with the provision of related services or the transfer of related items other than intangible property.

(B) Any arrangement between or among controlled taxpayers for the joint development of future intangible property shall be considered a controlled intangible transaction.

This would prevent taxpayers from rehashing Altera’s claim that sharing intangible development costs under a CSA isn’t a “transfer (or license) of intangible property” because it generates intangibles instead of transferring rights in existing intangibles.

The rest of the new paragraph (b)(1) could be used to clear up lingering doubts and reinforce subsequent pricing-related provisions. Although the aggregation of interrelated transactions is ultimately a pricing concept, the secretary’s aggregation authority could be more firmly established by building it into the definition of controlled intangible transaction itself, providing some specific aggregation criteria, and adding an express delegation of regulatory authority:

(C) Any combination of transactions or other arrangements that transfers, licenses, or otherwise makes available rights in multiple items of intangible property shall be considered a single controlled intangible transaction if such transactions or other arrangements are too closely interrelated to be reliably considered in isolation. In making this determination, it will be necessary to consider:

(i) Whether the different intangible property rights transferred, licensed, or otherwise made available serve complementary roles or relate to the same or similar products, services, or business activities;

(ii) Whether the individual transactions or arrangements were entered into contemporaneously or in close succession;

(iii) Whether the aggregate value of access to the full range of rights transferred, licensed, or otherwise made available by the series of transactions or arrangements exceeds the sum of the amounts determined by independently valuing the rights conveyed by each individual transaction or arrangement; and

(iv) Any other factors identified in regulations issued by the Secretary.

Considering Facebook’s arguments attacking the income method, it would probably be wise to disavow any artificial limitations for residual business assets that are now expressly included as items of intangible property under section 367(d)(4):

(D) Nothing in this section shall be construed as excluding any item listed in, or otherwise covered by, section 367(d)(4) from the scope of this subsection.

After establishing the scope of the subsection in paragraph (b)(1), the revised version should create a new paragraph (b)(2) that more clearly and directly addresses the key concepts now codified in the second and third sentences of the statute. As explained in the House Ways and Means Committee report on TRA 1986, the policy objective of the 1986 amendment was to counteract courts’ undue emphasis on comparables by establishing that “the profit or income stream generated by or associated with intangible property is . . . given primary weight.” Congress is always free to abandon this objective in future versions of section 482, but the most recent statutory amendment doubled down on the same policy that Congress enacted, or intended to enact, in 1986. Assuming that Congress wishes to preserve this policy, it should clearly identify the commensurate with income standard as the overriding principle for pricing controlled intangible transfers and explain, in broad terms, what the standard actually requires.

One option would be to draw directly on the language included in the House Ways and Means Committee report on TRA 1986:

(2) Commensurate with income.

Notwithstanding any other provision of this section, the consideration required in any controlled intangible transaction shall be commensurate with the income attributable to the intangible property rights transferred, licensed, conveyed, or otherwise made available.

(A) Income given primary weight.

Whether the consideration in a controlled intangible transaction is commensurate with income shall be determined in accordance with the principles and methods set out in regulations issued by the Secretary. Notwithstanding paragraph (a)(2), such principles and methods shall give primary weight to the profit or income stream generated by, or associated with, the intangible property rights transferred, licensed, or otherwise made available.

This revision would identify the basic premise underlying the commensurate with income standard while clearly delegating to Treasury the authority necessary to establish specific methods for applying it. It should also clarify that the commensurate with income standard isn’t subordinate to any other principle, including the arm’s-length standard.

A revised version of the statute should then address aggregation and the realistic alternatives principle in a way that ties them to the overarching commensurate with income standard, which would be consistent with the legislative intent described in the TCJA conference report. If the concept of aggregation has already been established by the preceding paragraph on scope, the subparagraph authorizing aggregate-based pricing can be succinct:

(B) Aggregation.

The required consideration shall be determined on an aggregate basis for:

(i) Any controlled intangible transaction described in subparagraphs (b)(1)(A) or (b)(1)(C) of this section; and

(ii) Any other combination of transactions or other arrangements, including transactions or other arrangements that do not constitute controlled intangible transactions, that the Secretary determines is most reliably valued in the aggregate.

This approach uses cross-references to identify specific circumstances that warrant aggregation: multiple transactions that transfer interrelated intangible property rights and transactions that combine a transfer of intangible property rights with related services or other transfers. But it makes clear that aggregation isn’t restricted to those particular circumstances. It also allows aggregation to be applied outside the context of controlled intangible transfers on the assumption that Congress didn’t intend the TCJA amendments to narrow the aggregation authority granted to Treasury and the IRS. The TCJA was enacted before the sunset of reg. section 1.482-1T(f)(2), and neither the temporary regulation nor the regulation it replaced limits aggregation to controlled transactions that involve intangible property.

The revised version of the statute should also address the other concept codified by the TCJA: the realistic alternatives principle. To prevent any further confusion with recharacterization, the revision should explicitly frame the realistic alternatives principle as a pricing concept. And assuming that Congress didn’t intend to restrict the realistic alternatives principle when it enacted the TCJA either, it should also allow for the principle to apply to controlled transactions that don’t involve intangibles:

(C) Realistic alternatives.

(i) The consideration required in a controlled intangible transaction or any other transaction or arrangement between or among controlled taxpayers shall be determined by reference to alternative transactions realistically available to the controlled taxpayers if the Secretary determines that such an approach yields the most reliable result.

(ii) Where this paragraph applies, the consideration shall equal the amount by which the economic benefits to a controlled taxpayer of entering the controlled intangible transaction exceed the economic benefits associated with a realistically available alternative transaction.

The last issue that should be addressed by any comprehensive reorganization and revision of section 482’s second and third sentences, and potentially the most controversial, is the authority granted to Treasury and the IRS to make retrospective adjustments. One way to clarify the issue in a manner that reflects the legislative intent underlying the commensurate with income standard would be to add a third and final paragraph to subsection (b):

(3) Ex ante and ex post evaluation.

(A) Ex ante evaluation.

The required consideration must be determined at the time of the controlled intangible transaction in accordance with paragraph (b)(2) and any corresponding regulations issued by the Secretary. This determination must reliably account for all relevant information, including profit or income stream projections, available at the time of the transfer.

(B) Ex post evaluation.

(i) The Secretary shall adjust the consideration determined in accordance with subparagraph (b)(3)(A) over time to the extent necessary to ensure that the consideration remains commensurate with the profit or income stream attributable to the rights transferred, licensed, or otherwise made available in the intangible property transaction. In accordance with regulations issued by the Secretary, such adjustments will be required when there is a major variation between the profit or income stream projected at the time of the controlled intangible transaction and the profit or income stream actually realized.

(ii) Whether an ex post adjustment is required under this subparagraph shall be determined without regard to the information available at the time of the controlled intangible transaction or the reasonableness of the controlled taxpayer’s ex ante profit or income stream projections.

Like the commensurate with income standard or any other policy objective tied to section 482, the retrospective nature of the adjustment mechanism could be tempered — for example, by adopting the OECD’s optional approach to hard-to-value intangibles — or altogether eliminated. But if the intent is to preserve the purely retrospective approach described in the House Ways and Means Committee report on TRA 1986, a revised statute should clearly say so.

These changes wouldn’t put an end to disputes involving transfer pricing, which will likely always be a subjective and controversial area of U.S. tax law. And they wouldn’t offer any magical solutions to most of the problems inherent in allocating taxable income across controlled taxpayers. But they would significantly clarify a uniquely problematic statute by replacing nebulous terminology, specifying the scope of Treasury’s regulatory authority, and identifying the principles the regulations should implement. This would at least minimize the risk that the same “recurring definitional and methodological issues” identified in the TCJA conference report will keep recurring indefinitely.