United States: GLAM's Realistic Alternatives Analysis Adopts Corporate Valuation DCF Concepts

In November, the IRS Office of Chief Counsel issued a generic legal advice memorandum ("GLAM") AM-2022-006, titled "Realistic Alternatives and Tax Considerations in the Application of Sections 482 and 367(d)." As the title suggests, the GLAM analyzes the realistic alternatives principle, which was codified in section 482 by the Tax Cuts and Jobs Act (Pub. L. No. 115-97).

The realistic alternatives principle, of course, is not new and has been part of the section 482 regulations since 1993. See Treas. Reg. § 1.482-1(d)(3)(iv); 58 Fed. Reg. 5253, 5266, 5275 (Jan. 21, 1993). But the realistic alternatives regulatory provisions were short on practical substantive guidance. Thus, the GLAM provides new insight into how the IRS currently thinks the realistic alternatives principle ought to be applied. In sum, the GLAM applies concepts from the corporate finance discounted cash flow ("DCF") valuation method to make its realistic alternative comparisons.

The Scenarios

The GLAM introduces three interchangeable scenarios regarding a U.S. parent corporation's 1) license of a patent to its CFC, 2) contribution of the patent in a section 351 transaction, or 3) formation of a cost-sharing arrangement with its CFC to further develop the patent and share the rights to use it. GLAM at 3–4.

To analyze these scenarios, the GLAM concludes that the determinative factor is whether the "expected post-tax present value income" from entering each proposed scenario is greater than the "expected post-tax present value income" the U.S. parent could have earned by retaining its rights to the patent. GLAM at 6–7. The GLAM explains that "present value" is calculated by applying a "risk-adjusted discount rate to reliable projections of outcomes" wherein the "risk-adjusted discount rate incorporates adjustments for all risks associated with an uncertain future income stream." See GLAM at 2, fn. 3.

The GLAM then proposed a risk-adjusted present value for each scenario, and found that only scenarios that generate a present value greater than the expected present value of retaining the patent rights satisfies the newly codified realistic alternatives requirement. GLAM at 6. Further, to analyze the third scenario related to cost-sharing arrangements, the GLAM also compared the present value of that scenario to the one associated with licensing the patent to its CFC. GLAM at 9–10.

While relying on present value and risk-adjusted discount rate concepts frequently associated with DCF analyses is not new for the IRS, see, e.g. Amazon.Com, Inc. v. Comm'r, 148 T.C. 108 (2017), it is striking that the GLAM assumes without explanation that there is no other consideration. Indeed, the GLAM simply concludes without relevant citation that:

"[T]he Commissioner will consider that uncontrolled parties to a transaction aim to maximize their post-tax profit, which represents the economic return for the transaction. Therefore, for example, the price the transferor receives for the sale of an asset must be sufficient to provide the transferor with income with a post-tax present value at least equal to the post-tax present value the transferor would have realized had it not transferred the asset."

GLAM at 6.

For the first two scenarios, the GLAM at best points to atmospheric statements in the section 482 regulations regarding the use of unspecified methods to support its claim. Id. at 5; Treas. Reg. § 1.482-4(d)(1) (use of unspecified method to value the transfer of intangible property); Treas. Reg. § 1.482-3(e) (use of unspecified method to value the transfer of tangible property); Treas. Reg. § 1.482-9(h) (use of unspecified method to value the transfer of services). For the third scenario, the GLAM cites Treas. Reg. § 1.482-7(g)(2)(iii), which discusses analyzing realistic alternatives before entering a cost-sharing arrangement along lines similar to those used in the GLAM. But applying this concept to transfer pricing transactions outside of cost-sharing arrangements is quite the interpretive stretch.

Conclusion

The recent GLAM shows that the IRS has interpreted the realistic alternatives requirement to be almost wholly dependent on DCF concepts regarding the risk-adjusted present value of future cash flows associated with transactions. For now, it is arguable that this could be viewed as a safe-harbor of sorts for realistic alternatives analyses, because the GLAM's singular application of these concepts to transfer pricing transactions beyond cost-sharing arrangements lacks concrete statutory and regulatory support. Nevertheless, the GLAM may be relevant to determining whether a financial statement reserve is required when implementing a cost-sharing or other IP transaction.

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