Industry Focus Approach to Compliance

The Large and Midsize Business Division (“LMSB”) of the IRS, which is responsible for examining businesses with assets of $10 million or more, has implemented an Industry Issue Focus (“IIF”) approach to compliance in order to improve consistency in the resolution of issues across industries, improve currency, increase coverage of non-compliant taxpayers by maximizing limited resources and achieve greater oversight on, and accountability for, important issues. This strategy represents a shift towards centralization of the resolution of issues that the IRS considers to be most prevalent and subject to the greatest compliance risk.

During fiscal year 2006, the businesses under jurisdiction of the LMSB filed 175,862 tax returns, some of which were thousands of pages in length, and paid $206 billion in taxes. The LMSB has 5,132 revenue agents and specialists to examine these filings. According to the IRS, these businesses are responsible for $25 billion or 7 percent of the “tax gap,” the difference between estimates of taxes that should be paid and taxes actually collected. The new IIF strategy is intended to allow the LMSB to keep pace with the changing business environment where very sophisticated taxpayers with global operations reduce U.S. taxes by devising increasingly complex transactions.

Compliance issues are identified by field agents through examinations, reviews of Schedule M-3s and other sources. The issues are then prioritized and tiered.

Tier I issues are high priority issues with significant impact on one or more industries. Issue owner executives, who are responsible for oversight and control, are identified for each Tier I issue, and the disposition or resolution of the issue must be in accordance with that executive’s guidance. Tier II issues are areas of potential high non-compliance and/or significant compliance risk to LMSB or an industry.

Of the 15 Tier I issues identified by the IRS and posted on its Web site in March 2007, two are transfer pricing issues: §936 Exit Strategies and Transfer of Intangibles Offshore/Cost Sharing.

Section 936 Exit Strategies

Section 936 provided a tax credit against U.S. income taxes on income earned by a U.S. corporation with a trade or business in Puerto Rico (“Possession Corporation”). Income earned by a Possession Corporation was determined under special rules in Section 936(h) (5) (cost sharing and profit split) and limited the credit to manufacturing profits from Puerto Rican operations. After a ten-year phase-out period, taxpayers are no longer able to claim this credit for tax years beginning after December 31, 2005, and many U.S. corporations that operated in Puerto Rico and enjoyed the benefits of Section 936 have been reorganizing their international structures.

Earlier this year, an LMSB industry director issued an Industry Director Directive entitled “Tier 1 Issue–Industry Director Directive on Section 936 Exit Strategies #1.” This directive provides direction to field agents for efficient examinations of this issue in an audit. The premise of this directive is that controlled foreign corporations (“CFCs”) that U.S. taxpayers organized to replace their Section 936 corporations retain an inordinate amount of group profits. As a Tier 1 issue, LMSB-wide coordination and executive oversight is required for Section 936 Exit Strategies, specifically, (1) the determination of an arm’s length royalty payable to the U.S. licensor by a CFC; (2) the determination of the proper transfer prices for other associated inter-company charges for services, marketing and distribution activities and other manufacturing activities conducted by the U.S. parent; and (3) taxation under Section 367(d) for any intangibles transferred to a new CFC to be determined on an arm’s length basis. While assuming that the U.S. parent usually owns all significant intangible property related to the former Possession Corporation, the directive recognizes that to the extent the CFC has taken on some or all of the entrepreneurial risks and responsibilities, the royalty should reflect the contributions of both the U.S. parent and the CFC. An Issue Management Team (“IMT”) has been established to review and approve all issues under examination that are related to Section 936 Exit Strategies.

Transfer of Intangibles Offshore/482 Cost Sharing

In a typical cost sharing arrangement (“CSA”), one party, usually the U.S. taxpayer, contributes intangibles developed prior to entering into the CSA for further development under the CSA. The other party, usually the foreign participant, must pay arm’s length consideration (“buy-in payment”) for the deemed transfer abroad of an interest in such intangible.

On April 5, 2007, an LMSB industry director issued a Memorandum for Industry Directors “Tier 1 – Transfer of Intangibles Offshore/§482 Cost Sharing Buy-in Payment.” The LMSB position is that cost sharing arrangements “are often used by taxpayers inappropriately to transfer intangible assets and associated profits offshore to related foreign affiliates for inadequate consideration,” resulting in material underreporting of taxable income by U.S. corporations.

It states that an IMT has been formed to identify, develop, resolve and improve IRS-wide coordination of §482 cost sharing buy-in issues. In other words, for the IRS, cost sharing buy-in issues are under the central control of the IMT. Subject to a documented risk and materiality analysis, international examiners (or other agents) are instructed to raise and fully develop the §482 cost sharing buy-in issue.

Conclusion

On May 11, the deputy commissioner said, “‘Tier 1 issues are not controlled at the national level,’” but he added that, “settlements of cost sharing and other high-risk cases are required to conform to the IRS’s nationwide strategy.”1 Since, in most cases, it will be difficult for field agents to know whether a proposed settlement conforms to the nationwide strategy, as a practical matter, settlements of Tier 1 issues will not occur without consultation with the IMT.

The IRS believes that transfer pricing is often used for tax avoidance purposes and is intent on aggressively reviewing the transfer pricing aspects of certain “high risk” transactions, and that the best way to deal with such transactions is by centralized coordination. While LMSB issued the directives listed above, the testimony of the commissioner of Internal Revenue before the Senate Finance Committee on June 13, 2006, makes clear that these initiatives are key elements in the IRS’s effort to capture part of the “tax gap.” It remains to be seen whether this initiative will lead to increased controversy or coordinated issue resolution.