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Audit Guidelines Related to Section 936 Conversion Issues

Attachment to Industry Directive on Section 936 Exit Strategies
Audit Guidelines Related to Section 936 Conversion Issues

The following audit guidelines are intended to provide examiners with assistance in developing issues that relate to taxpayers who have terminated their section 936 election and restructured into a CFC / Licensee arrangement.  This guidance is based on the Issue Management Team’s experience with cases to date and may be supplemented on an as-needed basis, as new issues arise.

Transfer Pricing Best Practices: The following guidelines are recommended for all transfer pricing issues as well as section 936 conversion cases. The list below is not intended to be comprehensive, but represents minimum requirements applicable to section 936 conversion cases:

a. Issue Mandatory Transfer Pricing IDR: The transfer pricing pro-forma IDR attached will request the taxpayer to provide its contemporaneous documentation, typically in the form of a transfer pricing study, supporting the taxpayer’s transfer pricing methodology employed on its tax return. 

  1. The examiner should obtain copies of the transfer pricing studies for the current year(s) under audit, the year or years when the section 936 conversion occurred, and all intervening years. 
  2. In some cases, the possession corporation converted out of section 936 in a prior audit cycle.  Significant audit issues from the year of conversion may impact subsequent audit years – such as section 351/367(d) transfers of intangible property, outbound transfers of foreign goodwill and going concern, and arm’s length nature of the license/royalty.
  3. If the taxpayer has adopted a cost sharing arrangement under Treas. Reg. § 1.482-7, teams should look to guidance provided by the Cost Sharing IMT for cost sharing issues.

b. Perform a Functional Analysis: A functional analysis will typically identify and describe the functions performed, assets used, and risks assumed by each party in a controlled transaction. The taxpayer’s contemporaneous documentation from item a. above will often provide an analysis of the functions, risks, and economic conditions surrounding the controlled transaction(s).

  1. If the examiner obtains the functional analysis as a result of the mandatory transfer pricing IDR, the examiner should remember this is the “taxpayer’s position” with regard to the functions and risks assumed by each party.  The examiner should review the contemporaneous documentation provided by the taxpayer and, if necessary, correct the description of functions and risks based on any additional facts developed by the examiner.  Although the documentation may comply with the requirements of section 6662(e) and the applicable regulations, disagreements may nonetheless exist between the taxpayer and IRS concerning the functions performed, assets used, and risks assumed by members of the controlled group.
  2. If the taxpayer does not provide contemporaneous documentation under section 6662(e), the examiner must develop the facts through the issuance of IDRs.

c. Plant Tours: 

  1. A tour of the manufacturing facilities in Puerto Rico may provide valuable information to the audit team, especially the IRS Economist, IRS Engineer, and the Outside Expert, if one has been retained.
  2. Not all teams will be able to take a tour of manufacturing facilities, due to limited availability of travel funds or other internal constraints, therefore this step is recommended, but not required.  It should be noted, however, that a plant tour generally improves the IRS position for consideration by Appeals or in litigation.
  3. When plant tours cannot be performed, other options may include interviewing employees in the US and/or Puerto Rico (in person or via phone), submitting questions via the IDR process, obtaining copies of any video materials the taxpayer may have with regard to the plant(s) in Puerto Rico, or visiting “mirror plants” in the US. Mirror plants are plants in the US that are identical (or very similar) to the plant located in Puerto Rico.

d. Identify organizational changes made by the taxpayer after terminating its section 936 election.  

  1. Describe the steps involved in the taxpayer’s conversion of the former section 936 entity into its current organizational and legal structure.
  2. See IRS Notice 2005-21, released on February 17, 2005 (includes descriptions of organizational changes generally used by taxpayers in section 936 conversions).  

e. Best Method Considerations:

  1. Best Method Selected by Taxpayer – The examination report must analyze and determine whether the transfer pricing method selected by the taxpayer is the best method, as required by the section 482 regulations. Guidance may be found at Treas. Reg. §§ 1.482-1(c) and 1.482-8.
  2. Best Method Selected by IRS – If the transfer pricing method chosen by the taxpayer is not the best method, the report must explain why the transfer pricing method selected by the IRS is more reliable than the transfer pricing method selected by the taxpayer.

f. Taxpayer use of Comparable Uncontrolled Transaction (CUT) Method.

  1. If the taxpayer selects the CUT method as the best method, examiners should fully consider the comparability standards for that method in Treas. Reg. §§ 1.482-4(c)(2) and 1.482-1(d).
  2. If the exam team determines the CUT method is not the “best method”, the examination report should explain why the CUT transactions presented by the taxpayer do not meet the comparability and reliability standards applicable to the CUT method.

g. Taxpayer use of Comparable Profit Split Method.

  1. If the taxpayer selects the Comparable Profit Split Method (CPSM) as the best method, or as a confirming method, examiners should fully consider the comparability / reliability standards including, but not limited to Treas. Reg. §§ 1.482-6(c)(2), 1.482-1(d), 1.482-4(f)(2), and 1.482-5(c)(2).
  2. Although the CPSM method is a specified method, historically, it has proven difficult to find uncontrolled transactions that meet the comparability standards for this method.
  3. In cases where taxpayers have attempted to apply the CPSM method, the Issue Management Team has found the following issues:

    a. In some cases, the uncontrolled transactions selected by the taxpayer do not qualify as comparable transactions under the CPSM as described in Treas. Reg. § 1.482-6. In such cases, the taxpayer attempts to convert an uncontrolled transaction, for example, a license arrangement, into a profit split arrangement by making adjustments or modifications to the license agreement to obtain a notional split of profits. That is, the taxpayer attempts to convert a transaction that is not structured as a profit split into an arrangement that simulates a profit split.  This analysis raises significant reliability concerns.

    b. The CPSM usually provides for an allocation of profits between the two related entities. In some cases, this allocation may appear reasonable (e.g. 70% of profits to the US, 30% to the CFC). The royalty determined by the use of the CPSM is payment for the use of the intangible assets.  Because intangible assets generate residual profits, a more important indicator of reasonableness is how residual profits are allocated between the parties.  That is, examiners should test the allocation of residual profits after the controlled parties are compensated for all routine functions.
  4. If the exam team determines the CPSM method is not the best method, the examination report should document why the transactions presented by the taxpayer do not meet the comparability and reliability standards applicable to the CPSM method.


Section 936 Conversion Audit Issues/Audit Steps:

a. Determine date(s) when the taxpayer converted its 936 operations to a new corporate structure (such as a new CFC).  Taxpayers may have entered into partial or staged conversions prior to the termination of the corporation’s section 936 status. This may have involved a single transfer or multiple, partial transfers of assets.

b. Identify all assets transferred under section 351 (or section 361). 

  1. This includes both tangible assets and intangible assets.
  2. Determine if any other intangible assets subject to section 367(d) were transferred. (For example, patents, trademarks, workforce-in-place, etc.).
  3. Significant audit issue. A taxpayer may improperly assign items to foreign goodwill or going concern value that should be correctly classified as intangibles for purposes of section 367(d).
  4. Obtain a breakdown of all assets the taxpayer classifies as foreign goodwill and going concern value and, determine the value placed on each asset by the taxpayer.
  5. For all assets discussed above, request copies of all valuation reports prepared by the taxpayer or an outside expert hired by the taxpayer and any other documentation related to the valuations of such assets.  This may include documentation prepared for general business purposes, foreign tax compliance, etc.

c. Determine whether the taxpayer transferred any assets under any code provisions other than sections 351/361. All such transfers should be reviewed to determine if they constitute intangible assets transfers that need to be evaluated under section 482.

d. Significant Audit Issue: Valuable Workforce in Place.  Taxpayers may improperly classify workforce in place as foreign goodwill and going concern value or take the position workforce in place may be transferred tax free.  Workforce in place is an intangible asset for purposes of section 936(h)(3)(b) and must be analyzed: 1) under section 367(d), if transferred offshore under sections 351 or 361; or 2) under section 482 in the case of all other controlled transactions.

e. Request documents filed with the foreign country identifying a) all assets transferred from a US entity to the foreign controlled party; and b) the taxpayer’s valuation of those assets. If the assets and/or values differ from what was reported to the IRS – ask for an explanation for such differences.

f. Compensation to the US parent for intangibles transferred outbound may continue to be paid (as in the form of a royalty) in audit cycles subsequent to the year(s) the section 351 or 361 transfers were made or the license agreements originated.  Thus, where this transfer occurred in a prior audit cycle, the issue is still viable and should be fully considered.

  1. Under section 482, a licensing issue may be examined in any tax year under audit, regardless of the year the intangibles were licensed. Under a section 351/361 transfer taxable under section 367(d), the rules of section 482 are used to value the intangible, and the valuation requires an analysis of the royalty stream over the expected life of the intangible. Thus, an intangible transfer that is taxable under section 367(d) may be examined in an audit cycle subsequent to the year of transfer and an adjustment may be made for the current audit year.  However, any adjustment applicable to the prior year(s) is barred if the statute of limitations has expired, or if the IRS has decided the tax year will not be reopened for this issue.  (This issue may affect net operating loss carry-forwards.  Please consult with International Technical Advisors or LMSB counsel).

STEP 3:   

Examination of Transfer Pricing Issues – Post 936 Conversion:

In general, after addressing the transfer pricing / valuation issues for intangible transfers from STEP 2 above, the only remaining major issues will relate to intangibles that are either licensed by the US Parent to a CFC or covered by a Cost Sharing Arrangement between the US Parent and the CFC.

a. If the taxpayer used an intercompany license agreement, determine the arm’s length royalty to the US Parent/Licensor, using the principles under Treas. Reg. § 1.482-4 and other applicable regulations.

  1. CUT Method – Review CUTs raised by taxpayer, look for internal CUTs (licenses between the taxpayer and one or more uncontrolled parties) and external CUTs (licenses between two uncontrolled parties – not involving the taxpayer.).
  2. Residual Profit Split Method (RPSM) 
  3. Comparable Profit Split Method (CPSM)
  4. Comparable Profits Method (CPM)
  5. Unspecified Methods.

b. Confirming Transfer Pricing Methods

If a second transfer pricing method reaches results that are similar to those under the best method chosen by the IRS, the examination report should describe and apply both methods.  Inclusion of the second method indicates increased reliability of the IRS choice of the best method.  However, there is no requirement that more than one transfer pricing method be employed before closing the case.

c. Functional and Risk issues used by taxpayers in an attempt to justify shifting of profits offshore. 

Taxpayers may claim that the CFC / Licensee performs entrepreneurial functions and/or assumes significant business risks. The functional analysis under step 1 will identify the functions and risks assumed by both the US Parent/Licensor and the CFC/Licensee.  In some cases, the taxpayer will point to one or more functions or risks as entitling the licensee to retain a substantial amount of profit.

In such cases, the functions and risks highlighted by the taxpayer should be fully evaluated by the audit team and a determination should be made as to the arm’s length return attributable to those functions or risks. Examiners should determine whether risks were actually shifted to the CFC/Licensee, or whether in fact the US Parent/Licensor retains some or all of this risk.  Case development requires examiners to review and analyze the functions and risks that taxpayers claim are performed/assumed by the CFC in a low-tax jurisdiction.

In numerous cases, exam teams have found the taxpayer’s position overstates the value of these functions and risks and results in excessive profits being shifted to the CFC/Licensee. Some examples may include:

  1. Product Liability Risk
  2. Inventory Risk
  3. Market Risk

          Product Liability Risk Example:

In some cases, taxpayers have drafted the license agreement(s) between the US Parent/Licensor and the CFC/Licensee to indicate that the CFC/Licensee assumes substantial product liability risk.  The taxpayer may claim this product liability risk could result in huge losses to the CFC/Licensee, and thus, the taxpayer’s transfer pricing model shifts large amounts of profits to the CFC/Licensee to compensate it for these risks.  To the extent taxpayers over-compensate the CFC/Licensee for this risk, profits may be inappropriately shifted to the CFC/Licensee.  In evaluating a taxpayer’s position and fact pattern related to this issue, examiners should consider:

  1. Whether the license agreement in fact transfers product liability risk (and if so, what type of risk has been transferred--design defect, manufacturing defect, etc.).  In addition, whether the taxpayer’s conduct over time is consistent with the purported allocation of risk between the controlled parties based on contractual arrangements.  See Treas. Reg. § 1.482-1(d)(3)(ii)(B).
  2. Whether the CFC/Licensee has the financial capacity to fund losses that might be expected to occur as a result of the assumption of the risk, or whether, at arm’s length, another party to a controlled transaction would ultimately suffer the consequences of such losses. In many cases the CFC is located in a low-tax jurisdiction and is a subsidiary of a higher tier CFC.  Even though the CFC/Licensee is located in a low-tax jurisdiction and may be generating substantial profits, it may not have the financial capacity to fund losses because almost all of its profits may be distributed to the higher tier CFC.
  3. The extent to which each controlled taxpayer exercises managerial or operational control over the business activities that directly influence the product liability risk at issue. (See Treas. Reg. § 1.482-1(d)(3)(iii)(B))

In evaluating the product liability risk issue, examiners should request the following types of information from taxpayers to assist with the valuation of this risk: 

  1. A copy of the intercompany licensee agreement, including but not limited to, provisions and attachments relating to product liability risk.
  2. A history of the company’s actual losses related to the specific liability risk assumed by the CFC/Licensee.
  3. Description of any pending litigation or claims against the company for product liability issues.
  4. If any actual product liability costs have been incurred, evidence indicating whether the CFC/Licensee or the US Parent/Licensor paid the costs.
  5. Is there an insurance policy covering these costs?

a. If so, who selects the insurance carrier and determines the level of coverage?
b. Who is the policy holder?
c. What is the cost of the insurance premiums?
d. Who pays the insurance premiums?
e. Who deducts the expense?

List of additional documents Examiners may find helpful to request on all Licensing cases:

  1. Product Line Profit and Loss Statements.
  2. Product Line Balance Sheet Statements.
Page Last Reviewed or Updated: 06-Nov-2014