Transfer Pricing Litigation Update

Tax Notes legal reporter Ryan Finley discusses the latest updates in recent transfer pricing cases, including Coca-Cola and Medtronic, and reviews the upcoming Amgen case.

The Coca-Cola episode can be listened to here: Coca-Cola Transfer Pricing Challenge Fizzles

For additional coverage, read these articles in Tax Notes:

• Amgen Disputes $3.6 Billion Deficiency in Transfer Pricing Case
• Medtronic Doubles Down on Its Use of CUT Method in New Trial
• Tax Court Sides With IRS in Coca-Cola Transfer Pricing Case
• Citing Comparability Questions, Eighth Circuit Vacates Medtronic
• Court Finds IRS Arbitrary and Capricious in Medtronic Transfer Pricing Case

In our “In the Pages” segment, Stephen Curtis, president of Cross Border Analytics Inc., chats about his Tax Notes piece, “Apple’s Cost-Sharing Arrangement: Frankenstein’s Monster.”

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Credits
Host: David D. Stewart
Executive Producers: Jasper B. Smith, Paige Jones
Showrunner and Audio Engineer: Jordan Parrish
Guest Relations: Christa Goad

Transcript

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David D. Stewart 0:01

Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: transfer pricing on trial. Over the years, we've covered a number of U.S. court cases focused on transfer pricing issues. And for much of the history of U.S. transfer pricing litigation, there's been a nearly uninterrupted streak of taxpayer wins. But that situation has changed. And today we're going to check in on a case that we've covered a few months ago, hear about a recent trial in the U.S. Tax Court, and take an early look at a dispute that's just getting started. Here to go over all of this is Tax Notes legal reporter Ryan Finley. Ryan, welcome back to the podcast.

Ryan Finley 0:44

Thanks for having me.

David D. Stewart 0:45

Now, I mentioned at the top that the government has had kind of a track record of losing transfer pricing cases, but that that seems to be turning around. Could you tell us about that?

Ryan Finley 0:53

Sure. So the IRS's track record, particularly in some of the highest profile cases involving the largest dollar sums, has been relatively poor going back for decades. Just sort of looking at the last couple of years, the IRS lost the Altera case before the Tax Court in 2015. It lost the Medtronic case, which I think we might cover in a few minutes, before the Tax Court in 2016. And it lost the Amazon case before the Tax Court in 2017. Now the Amazon opinion by the Tax Court was eventually upheld by the Ninth Circuit, but the IRS succeeded in getting Medtronic vacated and remanded in 2018. And it also succeeded in getting Altera reversed in 2019. So really starting with maybe around 2018 or there was some cases slightly before that may have augured in this shift, but in the last couple of years, it has been looking a lot more favorable for the IRS. And the Coca-Cola opinion, which I think we'll also discuss is probably the biggest indication of that new trend.

David D. Stewart 1:54

All right . So let's start with Coca-Cola. Now you were on in late 2020 to talk about this case, which we'll link to in the show notes, but could you start off with an overview of the issue and what the Tax Court decided?

Ryan Finley 2:07

Sure. So in Coca-Cola there were a number of issues. One of the issues was whether a profit allocation formula approved in a closing agreement that covered 1987 through 1995, and was subsequently accepted for a decade thereafter, was binding on the IRS for the 2007 through 2009 tax years. The IRS for those tax years, after having accepted this profit allocation formula for nearly two decades, decided that the method was unreasonable and required the application of a different method. In this case, a comparable profits method or CPM. There's a dispute in addition to the sort of binding nature of the closing agreement about whether the CPM under the U.S. section 482 regulations was the best method or whether the sort of routine return on assets that it left Coca-Cola's foreign subsidiaries with was insufficient in relation to the intangibles and risks held by these affiliates.

David D. Stewart 3:01

So, what's happened more recently?

Ryan Finley 3:03

So, the biggest recent development is a motion for reconsideration that was filed by Coca-Cola in June. Since the Tax Court opinion came out in 2020, which basically it upheld nearly $10 billion in transfer pricing adjustments, Coca-Cola has given every indication that it planned to appeal, but it can't appeal Coca-Cola until a Tax Court opinion in another case, 3M is released. And that case deals with a specific issue, the blocked income issue. The Coca-Cola opinion was released, but stayed that issue. So, in the meantime, the company filed a motion for reconsideration with the Tax Court, and it previews a lot of the arguments that Coca-Cola would be likely to bring on an appeal. The arguments generally focus more on administrative law and alleged constitutional violations by the IRS. Basically, the argument is that the company's agreement with the IRS on a profit allocation formula and then the IRS's subsequent acceptance of that formula for over 10 years, in combination with this penalty protection provision that the closing agreement extended for Coca-Cola, if it continued applying the same method, that all that together gave Coca-Cola what it called reasonable reliance interests in the IRS's continued acceptance of that formula. The motion also criticizes the Tax Court's acceptance of the IRS's preferred method, the CPM. According to the motion, the supply points were risks by virtue of the marketing costs that were allocated to them, and that they also held rights and intangibles under their licenses with Coca-Cola. And that these risks and intangibles entitled these foreign affiliates or supply points to a higher return under the section 42 regulations.

David D. Stewart 4:44

So, how much money are we talking about being at risk in this case?

Ryan Finley 4:49

Well the original deficiencies associated with the roughly $10 billion transfer pricing adjustments added up to about $3.3 billion. Now, that doesn't directly translate into what the deficiency would be now because the Tax Court accepted Coca-Cola's sort of secondary argument about whether repatriated dividends could be credited against the transfer pricing adjustments. So, we don't know exactly what the amount of the deficiencies will be, but somewhat less than the original $3.3 billion.

David D. Stewart 5:17

All right. Have you heard from practitioners about how they view this motion for reconsideration?

Ryan Finley 5:21

The practitioners I've spoken to have been largely skeptical of these arguments, particularly the arguments regarding alleged constitutional violations, which is somewhat striking. Usually private practitioners are a little more critical of decisions that go in favor of the IRS. So, in light of the general reception, which has generally been more or less approving of the Tax Court's decision, Coca-Cola's prospects of success are unclear.

David D. Stewart 5:49

All right . So, let's turn to the more recent trial that you covered. That would be Medtronic. Could you first give us an idea of what is the main issue in that case?

Ryan Finley 5:57

Well, so the main issue is the proper selection of method. As in Coca-Cola, it's also a dispute about whether the comparable profits method, the IRS's chosen method, is the best method. Or, in this case, whether the comparable uncontrolled transaction method or CUT method was a more reliable method. This is actually the second trial on the case, which was remanded by the Eighth Circuit. After the Tax Court basically handed Medtronic an almost complete win in a 2016 decision, that decision was vacated on appeal in 2018. According to the Eighth Circuit, the Tax Court had failed to support its opinion with the factual findings required by the regulations. The focus to the second trial was on the selection of transfer pricing method and determination of any necessary adjustments to the results of applying that method. So, as it argued in the first trial, Medtronic said that the CUT method was the best method, which it applied on the basis of a 1992 litigation settlement agreement with Siemens Pacesetter, Inc. The Pacesetter agreement was a cross-license of both parties' cardiological device patent portfolios. And it settled a number of disputes between the companies, including patent infringement claims. But Medtronic argues that the differences between the Pacesetter agreement and a 2001 license of cardiological and neurological device patents, along with a range of other intangibles relating to those patents, to its manufacturing subsidiary, that those differences can be reliably accounted for through adjusting the royalty originally charged in that Pacesetter agreement. And the Tax Court had originally accepted this approach in 2016. The IRS, on the other hand, says that the differences between these two licenses, in terms of the circumstances of the transaction and the scope of license intangibles, are just too great to be resolved through adjustments. And that the allocation of profit that results from applying this method between Medtronic U.S. and Puerto Rico was unreasonable. And as a result, according to the IRS, these differences required using a different transfer pricing method or the CPM.

David D. Stewart 7:58

All right, so what sort of things did you hear at the trial?

Ryan Finley 8:00

Well, the parties for the most part sort of repeated the—in many ways, the arguments that they've made since the beginning. But Judge Kathleen Kerrigan, the judge who oversaw the first trial and this one as well, she said that she would approach the issue of adjustments differently than she did in her 2016 opinion. But at the same time, she indicated that she's still leaning in favor of using the Pacesetter agreement, and then adjusting the royalty to account for differences between it and Medtronic's controlled license. Judge Kerrigan acknowledged flaws in both parties' approaches, but in her remarks at the conclusion of the trial, she suggested that the IRS's CPM based approach was the more flawed of the two. She said the adjustments that she's sort of envisioning may turn the method into an unspecified method instead of a version of the CUT method. But at the same time, this unspecified method would still use the Pacesetter agreement as the original reference point. And it's an interesting position in light of the Eighth Circuit's seeming skepticism of whether the Pacesetter agreement could be used as a comparable, even though the Eighth Circuit's opinion sort of focuses on the failure to make factual findings that were necessary under the regulation's comparability standards. It generally strikes a skeptical tone about whether the agreement should be considered comparable. And one of the judges issued a concurring opinion that very strongly suggests that that this agreement could not be considered comparable. So, it's not clear whether the Eighth Circuit, if an eventual appeal takes place, whether the Eighth Circuit would share Judge Kerrigan's views on the case.

David D. Stewart 9:35

So, I understand that there is also a new transfer pricing case that the transfer pricing community will be tracking closely. Can you tell us about that?

Ryan Finley 9:42

Sure. So, in early August, U.S. biotech company Amgen Inc. told its investors that it filed a Tax Court petition contesting $3.6 billion in deficiencies. And these deficiencies related to transfer pricing adjustments for the 2010 through 2012 tax years. It's interesting in that the announcement suggest some strong parallels with Medtronic. Like Medtronic, the case involves the allocation of profit to a Puerto Rican manufacturing subsidiary and whether the returns initially allocated by the company and then argued by the IRS are reasonable in light of the transfer pricing regulations. It's also interesting just in light of the amounts involved, that $3.6 billion figure represents only deficiencies, not interest and penalties. And on top of that, the company announced that there are similar adjustments for 2013 through 2015 that are currently in the IRS appeals process. And that more adjustments may be forthcoming based on similar grounds for 2016 through 2018. Amgen hasn't provided any dollar amounts for those adjustments, but judging from the deficiencies for 2010 through 2012, they're likely to involve significant amounts.

David D. Stewart 10:52

Alright, well, we'll have to watch this space. Ryan, thank you for being here.

Ryan Finley 10:54

Thank you.

David D. Stewart 11:06

Now coming attractions each week, we highlight new and interesting commentary in our magazines. Joining me now is Acquisitions and Engagement Editor in Chief Paige Jones. Paige, what will you have for us?

Paige Jones 11:08

Thanks, Dave. In Tax Notes State, Annette Nellen suggests five appropriately challenging state tax tasks for the State Tax Pentathlon in honor of the Summer Olympics in Tokyo. Two professors examine the 2020 Mississippi law taxing some retirement benefits from the state’s Public Employees’ Retirement System. In Tax Notes International, Andrew Hughes outlines the strategy Coca-Cola used in its motion for reconsideration before the U.S. Tax Court and considers whether the company chose the best strategy. Lucas de Lima Carvalho examines the term “best practices” in international taxation and considers how the concept could affect the adoption of a multilateral instrument. In Featured Analysis, Roxanne Bland examines the Ninth Circuit’s decision in Big Sandy, and the complicated limits of state tax and regulatory authority on Native American tribes. On the Opinions page, Nana Ama Sarfo examines a proposal to collect tax from the largest polluters in the United States. And now, for a closer look at what’s new and noteworthy in our magazines, here is Tax Notes Federal Editor in Chief Ariel Greenblum.

Ariel Greenblum 12:14

Thanks Paige. I'm here with Stephen Curtis, the president of Cross Border Analytics Inc., to discuss the two-part article he coauthored with David Chamberlain titled, "Apple's Cost-Sharing Arrangement: Frankenstein's Monster." Welcome to the podcast, Steven.

Stephen Curtis 12:32

Thank you, Ariel . Glad to be here.

Ariel Greenblum 12:34

To begin, could you give us a brief overview of the article?

Stephen Curtis 12:38

Sure. The article is a summary or an overview or even an examination, if you will, of Apple's cost-sharing arrangement. And the paper looks at Apple's cost-sharing arrangement really through the lens of section 42-7, a little bit sort of the history of this regulation and its intent. And sort of the outcome of the regulations and Treasury's attempts to revise the regulations, reform the regulations to prevent some of the negative outcomes of this regulation. And so, when you look at it through that lens, and this is a reference to the title, you can probably surmise that we believe that the cost-sharing regulations themselves are really this sort of Frankenstein regulation that the Treasury wrote beginning back in the late 1960s with the idea that this would increase multinational pre-tax income. But in reality, like Dr. Frankenstein's monster, it didn't really have that intended effect. And in fact, it had quite the opposite effect where it undermined and really eviscerated the arm's-length principle and resulted in what you might describe as unlimited profit shifting to foreign jurisdictions, usually a low-tax tax haven type holding companies and shell companies. So, through that lens, we look at Apple's cost-sharing arrangement. And the paper unfolds by first looking at Apple as you might in a typical transfer pricing analysis or evaluation. Where we look at where is the value Apple created and where are the profits of Apple booked? So to the extent that there's a divergence there, that would give us some information to work with. And in doing that, we look at Apple's SEC filings, and we actually looked at books, any information that's in the public domain, to sort of build the cases of what we think might be going on. But then we move on to a regulatory analysis of the facts that are there. And this opens up a whole new door of analysis, if you will, because, as the listeners may be aware, Apple was investigated back in 2013 by the Senate Permanent Subcommittee on Investigations. And from that investigation, a lot of documents came out from Apple's operations and their tax compliance. And that also triggered an investigation of state aid by the European Commission. And that's ongoing in the courts, in the general court of the European Union, and Apple has filed some documents there. So out of the European Commission investigation, we got even more insight into Apple's operations. And then documents that Apple filed to the court gave us even more information. So, there's a plethora of information that's out there in the public domain that allows us to really perform a maybe reliable, indicative analysis, if you will, of what we think could be going on. So, when we apply the regulatory analysis, we really focus on these 2008 transfer pricing regulations for cost-sharing, which introduced this new concept of periodic adjustment under the regulation 42-7i6. We also focus on the transition rules in these regulations, which is the 42-7m rules. So, what we find in comparing these documents that are coming out of these various investigations, and also other supporting information in the public domain, it looks like the transition rules do not appear to have been complied with, which would then trigger some outcomes. Interestingly, the regulations never envisioned that a taxpayer would not comply with the transition rules and that the IRS would subsequently sanction or not challenge the cost-sharing arrangement because the transition rules basically say that if you don't comply with these transition rules, you don't have a cost-sharing arrangement. But, of course, the IRS has closed all of Apple's tax years through 2015 and has respected Apple's cost-sharing arrangement . So, this opens up this unanswered question within the regs that OK, what happens now? Our understanding and interpretation of the regulations is that from 2009 onward, this would create a fact pattern in which Apple would be deemed to have a new cost-sharing arrangement under these 2008 cost-sharing rules. And under those conditions, we would apply a periodic adjustment. And in doing so, the paper performs these calculations and we come up with a result. And so, this is basically how the paper is laid out. And it does indicate that there would be a fairly substantial adjustment at Apple from not complying with these regulations on the order of around $80 to $84 billion. But these are under very conservative assumptions that we explain in the paper.

Ariel Greenblum 17:52

Thank you. Where did you get the idea to write this piece?

Stephen Curtis 17:55

You know, we've been doing work on transfer pricing compliance and enforcement for a couple of years, maybe six to eight years, where we're looking at the use of forensic technology and capabilities in transfer pricing compliance and enforcement. In fact, we have an academic paper, that's the title of one of our academic papers, where we go into some of the research behind our technologies and models. And we've been focused on this for a while . We wanted to be part of the discussion around tax compliance and enforcement, if you will, which seems to have gotten a lot of attention lately especially in the press. So, for instance, when the Biden administration came in and began proposing to invest money into the IRS to increase in IRS enforcement capability, with this idea that we could reduce the tax gap and that this would be a pay-for for some of the infrastructure spending, this triggered a whole bunch of research that looks like it was ongoing anyway, but it focused certainly more intention on this research. So, for instance, we had been working with Kimberly Clausing at Reed College, who is now at Treasury, because her research is focused directly on offshore profit shifting by multinational corporations. So, her estimates of this have been around $100 billion per year of tax underpayments that come about because of offshore profit shifting by U.S. multinationals. This is not included in the tax gap estimate by the IRS. International tax avoidance and evasion is not included in the tax gap e stimates. So, t here's information on this from various GAO reports and such. But when Commissioner Rettig came out and sort of agreed with some of this research effectively by saying that the tax gap might actually be closer to $1 trillion a year, and that this— a big part of this was wealthy and corporate tax underpayments. We already sort of knew that I think in the industry. But how we wanted to contribute to this debate, and let me just say before I talk about this. So then there was research by Larry Summers and Natasha Sarin, who is now at Treasury as well, on the return on investment from these investments in IRS enforcement. And he's—they're putting out some numbers on the order of 50 to 1. So, if you just look at the $100 billion of what we might call tax underpayments from offshore profit shifting, mostly occurring through transfer pricing, it might take investments on the order of $2 billion to attempt to get back $100 billion per year. So, these are big numbers. So, the question is, well, how real are these numbers? And could you identify one or more cases out there that would either validate these estimates or really maybe undermine them? You know, they're either about par with what's really there, or maybe they're vastly overstated, or maybe they are understated. So, we thought, "Well, let's use some of the technologies and capabilities that we have developed. Let's find a case out there and let's look at it." Apple looked like it was the perfect case because there's so much information in the public domain on Apple's cost-sharing arrangements that OK, we can go out and do this analysis. And if it supports that there's a big number there, maybe some of these estimates are quite valid. And maybe 50 to 1, maybe it's 100 to 1 in some segments of tax enforcement. So, what we found was essentially that, yes, it looks like in certain cases, and I'll point out that Apple is engaged in this— in a cost-sharing arrangement that we've analyzed and come to some conclusions that looks like it's aggressive, looks like there was some noncompliance. The numbers are big. But there's dozens, if not hundreds or more, taxpayers that are engaged in cost-sharing arrangements that set them up pretty much like Apple did. This Frankenstein result from the regulations that the IRS has found virtually impossible to enforce. So, we may conclude from this analysis that, well, it looks like the money's there. If only the IRS can bend over and sort of pick it up. And then the question is, "Well, OK, what's it going to take to get from A to B? To actually recover some of this—these tax underpayments on the scale that they seem to be?" So, one area is technology devoted to risk analysis and risk detection. Another technology might be devoted towards forensic investigation. So, if the IRS were to approach enforcement, and I'm speaking mostly about LB&I, because you're actually seeing some of this in the criminal investigation division where they're— I think they just announced they're creating a forensic center, a centralized forensic capability for enforcement to support enforcement. So, you may be looking at something like this, where you can actually bring in these technologies and advanced resources to be able to sort of perform this more capable type of enforcement, technology enabled enforcement. And if you look at our paper, it's almost let's just say, you look at it as a, let's say a revenue agent report, you look at it as an outcome of an examination. It would seem a little unrealistic, I think, to expect that an international examiner performing an exam in LB&I would do this much research. And they would need some capabilities that we're using to do this level of analysis to then get it something to the point that the IRS and council would be comfortable sort of going after. So, this was our contribution, if you will, to this ongoing debate, which I think has captured more attention in the public sphere and more interest among people outside of the tax profession, especially in Congress and the executive branch.

Ariel Greenblum 24:15

Really fascinating. Thank you. Before we go, could you tell us where listeners can find you online?

Stephen Curtis 24:22

Sure. So, I'm up on LinkedIn, so anyone can contact me on LinkedIn. We have a website xba.com, but I'm also at s.curtis@xba.com. So, happy to hear from any listeners with opinions. I've heard from a few already. Welcome all commentary and reviews, and I'm happy to be part of the debate and the discussion on these topics.

Ariel Greenblum 24:49

Thanks for joining us today on the podcast, Steve.

Stephen Curtis 24:51

Thank you, Ariel.

Ariel Greenblum 25:11

You can find Stephen's article online at taxnotes.com and be sure to subscribe to our YouTube channel Tax Analysts for more in-depth discussions on what's new and noteworthy in Tax Notes. Again, that's Tax Analysts with an S. Back to you, Dave.

David D. Stewart 25:12

That's it for this week. You can follow me online @TaxStew, that's S-T-E-W. And be sure to follow @TaxNotes for all things tax. If you have any comments, questions, or suggestions for a future episode, you can email us at podcast@taxanalysts.org. And as always, if you like what we're doing here, please leave a rating or review wherever you download this podcast. We'll be back next week with another episode of Tax Notes Talk.