AM-2007-007 is generic legal advice from the associate chief counsel (international) to the Large and Mid-Sized Business operating division of the IRS, answering questions about the section 482 commensurate with income standard for determining an arm’s length royalty in the transfer of intangibles between related parties. One question in the memo is whether the taxpayer can affirmatively assert the commensurate with income standard in a section 482 adjustment. The answer predictably is no, although the memorandum states that the taxpayer must use the commensurate with income standard in arriving at a royalty.
The most interesting question is this: Does the word “income” in the phrase “commensurate with the income attributable to the intangible” in section 482 refer to income received prior to the transfer or license of an intangible (past profits), income anticipated to be received after the transfer or license of an intangible (projected profits), income actually received after the transfer or license of an intangible (actual profits), or some other measure of income?
Based on the common reference to the commensurate with income standard as a “super royalty,” one might think the answer would be actual profits. No. The AM’s answer is reasonably projected profits, subject to the ability of the IRS to infer that the taxpayer’s initial anticipation of profits was not reasonable, based on actual profits, and to thereby leave the burden on the taxpayer to prove why its anticipation was reasonable, despite the actual profits. This is not “new law,” although section 482, and its interpretations, are not paragons of clarity.
Tax Reform Act of 1986
Readers will recall that in 1986 Congress added a second sentence to section 482, which modifies the general rule of the section for transfers between related parties, with respect to the transfer or licensing of intangible property. The modification requires that “the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.” This language was also added to section 367(d)(2) in 1986. In the Tax Reform Act of 1984, Congress enacted section 367(d) to treat outbound transfers of intangible property pursuant to tax-free transactions as sale of such property for a deemed annual payment that is contingent on the productivity and use of the transferred property. The commensurate with income standard replaced the contingent on productivity standard.
One obvious problem with the statutory language is the word “shall.” It speaks of futurity. It says that the income that the secretary may attribute to the transferor of the intangible shall be commensurate with what sounds like future actual income.
The use of the word “shall” may make more sense in section 367(d)(2) to define the royalty that must be imputed when the taxpayer transfers the intangible abroad in a section 351 or 361 exchange rather than in section 482 as a means to evaluate the royalty for an intangible transfer between related parties. Normally there will be no stated royalty in such case (although there may be), and so the issue is not correcting an incorrect royalty but creating a royalty. One might have thought that section 367(d)(2) really did intend a profit split based on what actually happens, and not an arm’s length front-end royalty, in contrast with section 482, which attempts to correct what is supposed to be an arm’s length royalty. If there were such a difference, then the use of the word “shall” in section 482 should not mean what it means in section 367(d)(2).
But there is no such difference. In fact, there is a convergence of the two sections in regulations. Based on the legislative history of the Tax Reform Act of 1986, Reg. section 1.367(d)-1T(c)(1) states that an arm’s length charge should be imputed based on section 482 regulations.
Back to the section 482 regulations, one would think that (1) it would be highly unlikely that a fixed front-end payment could suffice, and (2) a percentage of income royalty should be unassailable, if the percentage met comparability standards.
As it turns out, both points are wrong. Reg. sec. 1.482-4(f)(6) (effective after 2006) provides that lump sum royalties are permissible if equal to the present value of the equivalent required royalty. Reg. sec. 1.482-4(f)(2) Example 2 illustrates that not only the royalty rate, but the anticipated profits to which it would be applied, can be evaluated by the secretary on a lookback basis. If the intangible earns much more (or less) for the transferee than was anticipated at the time of the license, additional (or reduced) royalty may be imputed, even though the actual royalty payments rode up (or down) as a fixed percentage of the transferee’s profits.
Same Standard for Super Royalty
Apparently the “worst case” is the lump sum royalty that does not take account of profits that actually occur. The AM announces that the relevant “income” for the analysis is the projected profits, i.e., what uncontrolled taxpayers would have reasonably anticipated. This, of course, is but an embellishment on the normal rule of section 482 that the controlled taxpayers’ pricing must approximate uncontrolled taxpayers’ arm’s length pricing. The embellishment directs a focus on profit potential, which would be an element of arm’s length pricing in any event.
The key to the regulation’s approach is Reg. sec. 1.482-4(f)(2), which allows periodic adjustments by the secretary to stated royalties. These must both be “commensurate with income attributable to the intangible” and also must be consistent with the arm’s length standard generally applied. Let us presume that parties dealing at arm’s length would not normally contractually provide for an uncontrolled renegotiation of their royalty deal if reality did not conform to the original expectations of the parties. Therefore, what can “commensurate with income” mean in this context? Can it possibly mean that the secretary can impute more royalties if the intangible hits a home run that could not reasonably have been anticipated by unrelated parties?
No. The AM makes this clear. One wonders how that point could have been unclear 21 years after enactment of the second sentence of section 482. The AM notes that taxpayers might argue that actual profits should control rather than anticipated profits. Presumably taxpayers would make this argument only if expectations were not met.
Why did this question have to be clarified and why has it taken so long? Presumably agents were enforcing the law based on hindsight alone and the National Office wanted to correct that, at least conceptually. Maybe it took so long to say this plainly because it is hard for the government to give up pure hindsight.