United States: Reg. § 1.482-1(a)(3): Has The Ship Sailed With Intersport?

Last Updated: December 30 2014

Article by Lewis J. Greenwald, Brian W. Kittle and Lucas Giardelli1

Keywords: tax returns, Intersport, Reg. § 1.482-1(a)(3), income tax, Intersport Fashions West Inc. v. United States,

As long as there is nothing expressly prohibiting the adjustment, taxpayers may generally file amended returns reporting an amount of tax owed that is less than what they had previously reported on their originally filed return. Although we disagree, some have read Reg. § 1.482-1(a)(3) as presenting an absolute bar to reducing taxable income in an amended or untimely return through any type of correction to the prices of controlled transactions. The Court of Federal Claims seemingly upheld that interpretation in Intersport Fashions West Inc. v. United States.2

In this article, we pay particular attention to each of the different parts of Reg. § 1.482-1(a)(3), ensuring that each sentence is interpreted in the context of the remainder of the regulation. This reading of the provision facilitates the correct definition of its scope which, in turn, informs the determination of what type of transfer pricing corrections a taxpayer should be allowed to make in an amended return, notwithstanding Reg. § 1.482-1(a)(3). We then summarize the Intersport case and identify what we consider to be crucial mistakes in the court's opinion. Finally, we consider certain circumstances where we believe the taxpayer should be allowed to make corrections to its transfer prices even under Intersport. These include:

  1. a taxpayer-initiated mutual agreement procedure ("MAP") under a US income tax treaty;
  2. an amendment to an Advance Pricing Agreement ("APA") annual report;
  3. an adjustment to an NOL carryforward schedule (as opposed to an amended return);
  4. a court-ordered downward adjustment; and
  5. an explicit contractual provision in an intercompany agreement that calls for upward and downward transfer pricing adjustments.

Types Of Transfer Pricing Corrections

To interpret Reg. § 1.482-1(a)(3), it is important to distinguish among the different types of transfer pricing corrections that a taxpayer may try to undertake in an amended or untimely tax return. Rather than attempting to classify every possible type of correction into perfectly defined categories, we believe the different types of transfer pricing corrections span across a spectrum ranging from the correction of mere clerical or arithmetic errors to retroactive changes to the taxpayer's transfer pricing methodology.

On one end of the spectrum, there is the correction of errors. Errors may come in different shapes and sizes, but they share a common basis: an error is something that was not the result of the taxpayer's own volition. A common type of error results from mere scrivener's errors when transcribing the results of intercompany transactions to the tax return. A pure arithmetic mistake is another type of error that may be commonly made when pricing intercompany transactions.3 On the other end of the spectrum, there are corrections or changes to the taxpayer's voluntary decisions involved in the application of the § 482 principles that underlie the results reported on its original tax return. This may occur, for example, through a change in the transfer pricing method, the profit level indicator or the comparables originally selected by the taxpayer.

Of course, there is a gray area along this spectrum where it is not clear whether the proposed correction involves the correction of a mistake or, instead, an attempt to retroactively revisit the taxpayer's original transfer pricing positions and analysis. In these cases, the determination may ultimately depend on a detailed inquiry into the facts and circumstances surrounding the purported mistake or error.4

Defining The Scope Of Reg. § 1.482-1(A)(3)

For more than 75 years, the Treasury Regulations have provided that a taxpayer cannot require the IRS to apply § 482 in order to reallocate income or expenses, and that the taxpayer cannot itself apply such Code section affirmatively.5 This appears to be fairly consistent with the plain language in § 482, which provides that 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" (emphasis added).

The 1993 temporary regulations clarified, however, that "a controlled taxpayer may report the results of its controlled transactions based upon prices different from those actually charged if necessary to reflect an arm's-length result."6 This language made it clear that a taxpayer can affirmatively adjust the pricing of intercompany transactions in order to meet the arm's-length standard. However, the 1993 temporary regulations did not specify the timing of such adjustments, leaving open the issues of whether such changes had to be made before year end or before the due date for the original return, or if they could be made in an amended return. In 1994, the IRS finalized the 1993 temporary regulations, including Reg. § 1.482-1(a)(3) which addressed the taxpayer's use of § 482 and clarified the timing issue.7 Reg. § 1.482-1(a)(3) reads as follows:

Taxpayer's use of section 482. If necessary to reflect an arm's length result, a controlled taxpayer may report on a timely filed US income tax return (including extensions) the results of its controlled transactions based upon prices different from those actually charged. Except as provided in this paragraph, section 482 grants no other right to a controlled taxpayer to apply the provisions of section 482 at will or to compel the district director to apply such provisions. Therefore, no untimely or amended returns will be permitted to decrease taxable income based on allocations or other adjustments with respect to controlled transactions. See § 1.6662-6T(a)(2) or successor regulations.

A contextual reading of each of the different parts of Reg. § 1.482-1(a)(3) reveals that the provision lays out: (i) a general rule (contained in the second sentence); (ii) an exception to that general rule (contained in the first sentence); and (iii) an application of that general rule (contained in the third and last sentence).

  1. The general rule: The second sentence of Reg. § 1.482-1(a)(3) sets forth the general rule that a taxpayer may not apply § 482 at will. This sentence defines the overall scope of Reg. § 1.482-1(a)(3): the regulation addresses the application of § 482 by the taxpayer and the taxpayer's ability to report the results of its controlled transactions based upon prices different from those "actually charged"8 pursuant to the application of such Code section.
  2. The exception to the general rule: The first sentence of Reg. § 1.482-1(a)(3) introduces an exception to the above-mentioned general rule: the taxpayer may apply § 482 to report the results of its controlled transactions based upon prices different from those actually charged to the extent this is done on a timely filed US income tax return (including extensions).
  3. The application of the general rule: The third sentence of Reg. § 1.482-1(a)(3) describes an application of the general rule stated in the second sentence of the regulation. Specifically, the third sentence concludes, in light of the prior two sentences, that a taxpayer cannot file an amended or untimely return to decrease taxable income based on allocations or other adjustments with respect to controlled transactions.9

This third sentence must be read in the context of the remainder of Reg. § 1.482-1(a)(3). The bar imposed on the filing of amended or untimely returns to decrease taxable income only applies to the extent such a decrease in taxable income is the result of an application by the taxpayer of § 482. As such, the third sentence of Reg. § 1.482-1(a)(3) should have no effect on the filing of any amended or untimely return that does not constitute an application or reapplication of § 482 principles. In other words, the regulation read in totum allows taxpayers to correct the results of their controlled transactions in amended or untimely returns provided those corrections do not require the taxpayer to revisit its application of § 482. This provision prevents taxpayers from re-applying the decision-making analysis and rules set forth in § 482 and its corresponding regulations. Several arguments support this conclusion.

Specifically, the use of the adverb "therefore" at the beginning of the third sentence means that sentence is simply setting forth the consequence of the rule and exception from the prior two sentences. In addition, the third sentence refers to "allocations" made by the taxpayer with respect to controlled transactions, a term used in § 482, indicating that only reapplications of § 482 principles are precluded.10 Finally, this interpretation of the third sentence is consistent with the fact that the heading of Reg. § 1.482-1(a)(3) reads "Taxpayer's use of section 482" (emphasis added).11

Based on this reading of Reg. § 1.482-1(a)(3), not all corrections made in an amended return to the results of the taxpayer's controlled transactions would be prohibited.

First, a taxpayer should be allowed to make corrections in its amended return for anything that is clearly an error, such as a mere scrivener's errors or an arithmetic mistake (even if such a correction results in a decrease to its US taxable income). Both the language and the purpose of Reg. § 1.482-1(a)(3) support this conclusion. As explained above, the reasonable interpretation of the regulation indicates that the taxpayer is barred from decreasing its taxable income through corrections made in an amended or untimely return if (and only if) such corrections involve an application of § 482. Corrections that represent anything other than an application of § 482 should be permitted. Further support for this position is found in the preamble to the 1994 final regulations which states that "the limited exception provided by this rule [referring to the first sentence of Reg. § 1.482-1(a)(3)] does not permit taxpayers to apply section 482 at will; thus, for example, a taxpayer may not rely on section 482 to reduce its taxable income on an amended return." (emphasis added). In correcting a scrivener's error or an arithmetic mistake, a taxpayer is not relying on § 482.

Also, correcting an error does not compromise the policy behind Reg. § 1.482-1(a)(3). It has been noted that Reg. § 1.482-1(a)(3) is mainly intended to prevent taxpayers from using transfer pricing adjustments to engage in retroactive tax planning.12

The correction of a scrivener's error or an arithmetic mistake does not give rise to the taxpayer attempting to undertake retroactive tax planning or to otherwise revisit the decision-making process of its transfer pricing.

That said, as the transfer pricing corrections move along the spectrum toward the realm of the multiple, and often complex, computational issues involved in the application of § 482, one can conceive of certain gray areas where it may be difficult to determine whether Reg. § 1.482-1(a)(3) prohibits the intended correction or not. An analysis of the facts and circumstances surrounding the purported mistake should help in this determination.

To this effect, if the taxpayer can provide evidence of a bona fide pre-existing intercompany agreement setting forth the transfer pricing method, any correction aimed at bringing the results reported on the tax return in line with such agreement should be allowed because it would not involve a re-application of § 482. Likewise, to the extent the taxpayer can prove through other contemporaneous documentation (e.g., internal communications) or through its course of conduct (e.g., practice in prior and subsequent years) that the correction is merely aimed at amending an involuntary error, the taxpayer should be allowed to include such a correction in an amended return. Those corrections would not involve an allocation of income through an application of § 482 at will, but would simply be a means of guaranteeing that the tax return reflects what the controlled parties had originally determined ought to be the arm's-length pricing for the controlled transaction.

Lastly, those corrections made in amended returns that involve changes to the different aspects of the transfer pricing methodology originally and voluntarily selected by the taxpayer would fall more squarely within the purview of the prohibition of Reg. § 1.482-1(a)(3) (to the extent they result in a decrease to the taxpayer's taxable income). In fact, it is precisely this type of correction that generally presents an opportunity for the retroactive tax planning that Reg. § 1.482-1(a)(3) was clearly intended to prevent.

Get the full article.

This article first appeared in Bloomberg BNA's Tax Management Memorandum on 12/01/2014.

Originally published December 24, 2014

Footnotes

1. Lewis J. Greenwald is a Partner in the Tax Transactions & Consulting Practice, Brian W. Kittle is a Partner in the Tax Controversy & Transfer Pricing Practice and Lucas Giardelli is an Associate in the Tax Transactions & Consulting Practice, each of the New York office of Mayer Brown. The authors wish to thank their Mayer Brown colleagues Brendan Sponheimer (Associate in the Tax Controversy & Transfer Pricing Practice) and Christopher K. Mayer (Associate in the Tax Transactions & Consulting Practice) for their assistance with this article.

2. 103 Fed. Cl. 396 (Fed. Cl. 2012). See also Morton-Norwich Prods., Inc. v. United States, 602 F.2d 270, 275 (Cl. Ct. 1979) (describing a prior version of the regulation as providing that "section 482 is not available to a taxpayer nor may a taxpayer force the Service to exercise its discretion [under section 482]").

3. For example, an error of this type may occur when an intercompany cost-plus services agreement provides that certain costs should be included in the "cost pool," but such charges were inadvertently excluded from the prices actually charged by the service provider. This type of error would also occur where a licensor accidentally charges a 6% royalty even though an intercompany license agreement required the licensee to pay an 8% royalty.

4. Assume, for example, that a taxpayer intends to change the comparables it had originally selected for purposes of its transfer pricing analysis under the argument that there has been a clerical error when setting up the metrics or criteria to filter and select the comparables (e.g., the taxpayer argues it intended to exclude any companies with turnover over $10 billion, but accidentally set up the filter to exclude companies with turnover over $15 billion). In such a case, contemporaneous documentation, as well as the practice in prior and subsequent years, may help determine whether the taxpayer actually made an involuntary mistake when selecting its pool of comparables or if, instead, it is trying to revisit and modify a prior determination regarding its comparability criteria.

5. Reg. § 1.482-1(b)(3). T.D. 6952, 33 Fed. Reg. 5848 (Apr. 15, 1968).

6. Reg. § 1.1482-1T(a)(3). T.D. 8470, 58 Fed. Reg. 5263 (Jan. 21, 1993).

7. T.D. 8552, 59 Fed. Reg. 34971 (July 8, 1994).

8. For purposes of this article, the prices "actually charged" are understood to be the prices recorded in the taxpayer's internal accounting (prior to any consolidation/elimination of intercompany transactions).

9. Although the regulations are silent on the point, the IRS's position is that an untimely or amended return may be used, however, to increase US taxable income. Rev. Proc. 99-32, 1999-2 C.B. 296 ("If the adjustment results in an increase in taxable income, the increased income may be reported by the taxpayer at any time."). It should also be noted that Reg. § 1.482-1(a)(3) ends with a cross-reference to Reg. § 1.6662-6T(a)(2). Reg. § 1.6662-6(a)(2), which mirrors Reg. § 1.6662-6T(a)(2), suggests that a taxpayer may correct the results of its controlled transactions in an amended return for penalty protection purposes (of course, this provision involves a correction that results in an increase to the taxpayer's US taxable income). See also FSA 200031025.

10. The third sentence also mentions "other adjustments," but this should not be interpreted as encompassing any possible type of correction to the reported transfer prices. Read in context with the overall scope of Reg. § 1.482-1(a)(3), it is reasonable to conclude that the term also refers to adjustments to the taxpayer's original application of § 482.

11. Courts have long recognized that the heading of a section cannot limit the plain meaning of the text and that, for interpretative purposes, it is only of use when it sheds light on some ambiguous word or phrase; "they are but tools available for resolution of a doubt. But they cannot undo or limit that which the text makes plain." Brotherhood of Railroad Trainmen v. Baltimore & O.R. Co., 331 US 519, 528–529 (1947). See also § 7806(b); Grapevine Imports, Ltd. v. United States, 71 Fed. Cl. 324, 331 and n. 6 (2006). However, in this case, nothing in the plain language used in the third sentence of Reg. § 1.482-1(a)(3) indicates that it is intended to apply to any type of correction to the results of controlled transactions, regardless of whether such correction constitutes an application of § 482 or not. Rather, the language suggests that the scope of the prohibition is limited to amendments to an application of § 482 and the heading does nothing but confirm this understanding.

12. See, e.g., Erin Collins, David Chamberlain and George Hirsch, U.S. Transfer Pricing: Ups and Downs on Amended Returns, 68 Tax Notes Int'l 307, 308 (2012).

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This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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