Enough of the sales pitch for Mr. Lutz!  What he doesn’t discuss is the role that tax law plays in our plunge into mediocrity.  As the transfer pricing rules become more stringent, penalizing companies for doing R&D in the US, it is simply common sense to realize that R&D is going to migrate out of the US just as manufacturing jobs have, and continue to.  Somehow, we need to get some long-term thinking in the rule-making process.  Good luck with that one!! – Deloris R. Wright

That, of course, is extremely harsh and totally not arm’s length.  Companies, operating at arm’s length, frequently license or sell very valuable IP to unrelated third parties.  There are a variety of reasons why this might happen, e.g., the IP produces a product that does not fit into the licensor’s product strategy; the licensor does not have the capacity to make the product, or the willingness to take on additional production risk; etc.  There are lots of reasons why licensing of valuable IP exists in the real world.  And, royalty rates and/or prices for those third party transactions do not produce a contract manufacturer’s rate of return for the licensee.  Never mind that the IRS view is that every company has extremely valuable, world-beater IP — that isn’t the case very often, at least in the companies I’ve worked with over the years.

I could go on a lot more on this topic, but suffice it to say that the US is rapidly moving away from arm’s length for reasons that are not entirely clear, but do not bode well for the competitiveness of US business (why do R&D in the US if you’re not allowed to use it globally?  Why develop operations outside the US if they are not allowed to earn an arm’s length rate of return?).  A return to the arm’s length standard would benefit us all, in my view. – Deloris R. Wright

Because the quality of arguments and analyzes is so low these days, several things seem to be happening.  First, the IRS agents rarely accept any aspect of the taxpayer’s analysis/documentation, which leads to the second problem, i.e., many taxpayers don’t see the need to produce good quality analysis because it is so often ignored.  It has become a corkscrew to the bottom, and it is almost impossible to know which party started the nosedive (companies or IRS).   It really doesn’t matter though.  What matters is what we do about it.  It seems to me that there are 2 problems.  The first is the quality of analysis and the second is the training and expertise of the people evaluating that analysis.

Many of our clients do produce good analysis that has served them well, which means that this aspect of the problem can be solved quite easily.  The bigger issue is the training and expertise of IRS field economists.  I think that it is always better to argue with someone who is smart, well-trained and tough than someone who is ill-trained and tough.  Today we’re too often dealing with the latter.  It would be good to get back to the well-trained and tough situation, which can probably only be achieved by making IRS as good a career option (i.e., higher salaries) for international tax and economics professionals, as it once was.  That, of course, is a whole other blog — one too much of a pipe dream, even for me.

The solution, then, is probably for IRS to use outside experts to assist with audits (see an earlier post on this point).  – Deloris R. Wright

While we’re on the topic of economic experts, whatever happened to the proposal that tax court judges would hire their own economic experts to assist him/her in “getting it right” from an economic standpoint?  It was an idea that made infinite sense in that very little economics is taught in law school, and transfer pricing cases virtually always end up in a discussion of economics. – Deloris R. Wright

I know that this is typically the way that litigation is handled, but it seems fairly clear (at least to me) that this approach hasn’t really benefited either IRS or taxpayers very much.  IRS has litigated and lost most of the transfer pricing cases it has tried, e.g., Lilly, B&L, Compaq, Veritas, Xilinx.  Taxpayers, on the other hand, may have won the legal issues, but many times the courts decided on a significant additional tax even though the company won the legal issues.  And, the legal fees can be staggering, not to mention the fact that management’s attention is tied up in litigation for years on end.  There has to be a better way.

I used to think that arbitration was a better avenue, but I’ve been involved in international arbitration hearings, and that is almost as time consuming and just as litigious.  The Apple Computer baseball arbitration may have been easier, we know the result (not good for Apple), but the rest is confidential so it isn’t clear whether this is more efficient than litigation.

I have long believed that if both sides could take reasonable positions, cases could be settled at the audit or appeals level and the time/cost involved in transfer pricing issues would decline enormously. – Deloris R. Wright

Finding someone you can work with is equally important.  You want someone who shares your goals (e.g., practical vs. theoretical; simple vs. complex).  That can only be evaluated with a face-to-face discussion.  We think that the typical proposal process, with its formal presentations, is not a very good forum for evaluating this.  Companies are better served to narrow the field to two or three potential advisors and then spend a day (or half a day) with each of them to discuss your particular situation.  During that time, competence, approach, and personality can be evaluated.

Then, when you’ve decided which advisor fits your needs best, hire them!  And, good luck.  It should be an interesting experience for both sides. – Deloris R. Wright

In addition, you need an advisor who works well with you and takes your interests as his marching orders.  Too many times, advisors try to sell a “canned study” that is a one-size-fits-all approach, e.g., database dump CPM.  Or, there are some advisors who are economists who want to turn your engagement into a sophisticated economic analysis that only they can understand.  Sometimes you want something dense and impenetrable by normal people, but most companies don’t benefit from it.  Most companies want advice they can understand, use, and implement.  That’s what this blog is all about.

Second, our experience is that companies need advice as much or more than they need the typical economic study.  You want somebody who understands your situation (the size of the transaction relative to your company’s size, etc.) and can help devise a strategy that meets your needs.

Third, ask yourself whether you’re looking for an advisor who takes a theoretical approach, e.g., “the regs say you have to do this, so this is what you have to do.”  The alternative is the practical approach that tries to fit advice to your situation.  Sometimes, it is wise to sacrifice theoretical purity for an approach that the company can manage and maintain over time.  The longer we do this work, the more convinced we are that simpler is preferred to complex.  Missing some of the theoretical detail is preferred to putting together a policy that can’t be managed.  We quickly point out, however, that transfer pricing is, by its very nature, complicated.  You can’t avoid all complications.  It is important to know, however, how and when you can cut corners to make a policy workable within the company.

Theory is fine if you’re a Fortune 10 company that is in the middle of a litigation battle where you want to use academics to make your case.  The rest of us need a practical, common-sense approach that will ensure that you keep the cost reasonable.  You also need an approach that won’t blow up because the people who need to manage the day-to-day affairs don’t understand its complexity.  You want this policy to work for years – or until the facts change.

More on advisor selection in the next blog. – Deloris R. Wright

Middle market companies have a tough decision to make.  We’ll finish this series of blogs by suggesting that taking the time to discuss transfer pricing planning with a capable advisor is time, and money, well spent.  A relatively short discussion can flesh out the probable exposures that you may have and may suggest more tax efficient structures as well.  It is a small price to pay for peace of mind.  Then, when we see what IRS is going to do, you will know what, if anything, should be done next. – Deloris R. Wright

The question is, what are the significant transactions?  There are two options, in general.  First, the big transactions usually relate to sales of tangible property, e.g., raw materials, work in process, or finished goods inventory.  On the other hand, the transactions that IRS is currently focusing on are transfer of intangibles (e.g., patents, know-how, trademarks, etc).  These transactions are pretty universally unrecognized by middle market companies (and many of the big boys), and can involve enormous amounts of money.  Our advice is to begin with either or both of these types of transactions.

Then, pursue one of the previous three approaches.  We should point out that in our experience, middle market companies ordinarily put tax-inefficient structures in place.  For that reason, spending a bit of time thinking through the structure is wise (e.g., is this just a service fee issue, or can we reorganize the transactions to better reflect business reality and, at the same time, defensibly lower the global taxes that the company pays). – Deloris R. Wright

The benefit of this approach is clear – it is cheap.  What are the issues with it?  (1)  We need to be honest and recognize that some international tax lawyers like this approach.  As one of them told us recently, “I like these database dump CPM analyses because they are so clearly indefensible that I know if there is a serious audit I can simply say, ‘that study is junk’ and then I can do whatever I want to do to defend what the company did.”  For people who take this view, they also believe that the hurdle to obtain penalty protection is very low.  That may or may not be the case, but it is certainly perceived to be so by a number of good international tax lawyers.

(2)  The primary issue, from a technical standpoint, relates to whether or not an adversary could pick apart this approach to the detriment of the company.  And, the answer is definitely yes.  The so-called comparable companies will be all over the ball park.  Some will be distributors, some will be manufacturers, some will be in the client’s industry and some will not, etc.  It doesn’t take a rocket scientist to pick apart such a study and come up with a range that is detrimental to the company.

(3)  Another issue is whether IRS will agree, in the new world that they are creating, that this type of documentation is adequate for penalty protection.  We have been waiting for years to see whether IRS will raise its standards.  So far, they haven’t.  It is going to be interesting to see whether things will change in the future. – Deloris R. Wright