As an introduction to International Financial Centers and the pricing concepts between structures of entities, an integration of international law principles and taxation concepts is desirable. This is the essence and difficulty of understanding Financial Centers Offshore. It requires a melding of international financial law, international civil and criminal law, and international taxation rules. It is the bifurcation of these disciplines that makes International Financial Centers so elusive.
The foundation to a discussion of entity structure concepts is melding the taxation rules peculiar to foreign corporate entities; controlled entity rules, source of income principles, and inter-company pricing rules. Source of income principles establish what activities and asset location rules operate to make income taxable by United States authorities. The arrangement of many entities convenient to International Financial Centers offshore normally has a business purpose of accomplishing an objective in facilitating global enterprise.
The use of Financial Centers involves structuring of related entities in carrying out bona fide business activities. The Internal Revenue Service has developed complex rules that seek to guide, police, and make adjustments to tax related parties. These rules are designed to discourage prohibitive shifting of income, deductions, and credits between related taxpayers in a corporate structure.
Importantly in the discussion of Section 482 and related taxpayer issues is to bear in mind the concepts of controlled foreign corporate legislation. The entity activities in a corporate structure of conduits utilized to fulfill business purposes can determine whether an entity is subject to Subpart F controlled foreign corporate treatment. In recollection, a foreign corporation first is deemed subject to controlled status determined by ownership percentages.
If that percentage does not subject it to controlled status, the corporate activities become irrelevant. However if those percentages effectively make the entity subject to Subpart F taxation, the second condition, the activities of the foreign corporation, can enable it to avoid Subpart F treatment.
What is to be understood about the activities factor of controlled corporate status is that the application of pricing concepts pursuant to Section 482 must be structured and molded to satisfy both of those concepts to enable the corporation to be in compliance with Section 482 and avail itself of a non-controlled status. One then must be mindful that the activities satisfying Section 482 pricing concepts may not necessarily comply with the activities of Subpart F controlled foreign corporate status.
Overview of Section 482
In making use of Offshore Financial Centers taxpayers will invariably have a structure of entities that are related taxpayers by virtue of common ownership. Because these related taxpayers engage in transactions among themselves, they present opportunities to shift items of income, deductions, and credits through the process of allocations in accounting for deductible items and income.
A normal instance would be an offshore subsidiary situated in a Financial Center accounting for income received from the service or sale from a parent for services provided. The parent corporation in making payment to its related subsidiary would ordinarily account for this payment by deducting from its income an amount equal to the payment for services rendered by its Financial Haven, subsidiary. The subsidiary will normally reflect the payment received from its parent in gross receipts of income. Income is thereby shifted to the subsidiary from the parent.
The subsidiary is located in a tax favorable environment, ordinarily a Financial Center not imposing an income tax. It may conceptually be able to defer tax liability for the income received for services or greatly minimize the payment of any tax. Using this type of structure, the parent corporation has the ability to vastly influence its own taxable income by the amount of the services paid to its subsidiary shifting taxable income to its foreign Financial Offshore subsidiary. The same principle would be applicable to a foreign production or manufacturing, subsidiary, making payments for services to a related Financial Offshore subsidiary. The foreign production or manufacturing parent or subsidiary would realize a deduction for services, reducing its tax obligation to the foreign sovereign in which it operates.
The financial planning utilized in this manner is not to facilitate transactions between and among related taxpayers for manipulation. The amounts paid and received may not be arranged to achieve an artificial shifting of income and deductions among a structure of related parties or entities. These types of transactions between related parties are to be regulated to prevent what may be perceived to be abuse and avoidance of tax; Section 482 of the Code is designed to implement these regulations.
It has a basic concept in policing these transactions to bring about a true taxable income. Related taxpayers are required to charge and take into account income, deductions, and credits in a manner consistent with similar types of transactions occurring between unrelated taxpayers. This is referred to as an arm’s length transaction. Section 482 seeks to establish guidelines governing arm’s length standards.
Section 482 is detailed and complex in its theory of transactional analysis. Its possible application is involved in every related party or structured analysis in foreign financial planning. Its coordinated meshing with other Offshore Financial Center and Financial Haven concepts of controlled status of ownership, Subpart F Income, and sourcing of income from activities is imperative to any effective offshore financial planning. Those are the basic financial planning concepts that must be analyzed for any Financial Center transaction: (a) ownership structure of the entity; (b) Subpart F Income activity principles, (c) sourcing of income rules, and (d) the Section 482 arm’s length concepts in the corporate structuring of related parties.
The concepts of Section 482 are perhaps best explained with an emphasis upon distinctions between types of assets, activities, and services. The ability to ascertain an appropriate pricing method to be applied in making an arm’s length determination will vary with respect to the type of asset or service provided between related entities. These pricing methods utilized as guidelines are proffered in groupings with different methods of pricing applying to the various categories of transactions. These general groupings are loans or advances, services, and tangible and intangible property transactions.
Loans and advances are transactions one would normally associate with financing global enterprise along with resulting interest income and deductions. These would be offshore finance companies. Services provided among related taxpayers would be those usually associated with administration, sales, accounting, and legal activities. These would be foreign base company service and sales enterprises.
Tangible property is utilized as a pricing method category to establish guidelines with respect to the activities such as leasing property. These would be leasing companies and foreign personal holding companies. The final category that this writing contemplates is intangible property transactions that are directed to royalties and technology that have benefited from traditional Financial Offshore structuring. These would be licensing companies. These delineated areas are not inclusive but enable the reader to understand the mainstream use of related entities.
A primary objective of the business use of Offshore Financial Centers is to utilize their attributes as a vehicle to reduce tax disparity, liability, and regulatory burdens. Where a conduit entity is established to fulfill these needs for reducing these burdens, the financial structure becomes susceptible to the shifting of gross income, deductions, and credits between entities comprising the corporate structure. It also gains the scrutiny of the Service.
The Service utilizes Section 482 in the examination of corporate structures to insure that taxpayers are clearly reflecting income attributable to controlled transactions. (1) Involved in this scrutiny is a focus upon the economic links of a taxpayer’s substantive structure and its related entities. It is necessary to devise mitigation techniques when evaluating planned offshore structures for potential Section 482 allocation results.
One of the underpinnings of Section 482 is to place a controlled taxpayer on parity with an uncontrolled one. (2) This is accomplished by calculating the true taxable income of the controlled taxpayer in a manner reasonably reflecting the relative economic realities actually undertaken by each taxpayer. Economic realities are the cornerstone of corporate structure planning. A general technique to analyze economic realities is to isolate each transaction between related parties.
In utilizing this technique, the focus is to determine the actual ownership of each item of allocation subject to Section 482 because the taxpayer has command of the income and its benefits. This method provides a safeguard to avoid pitfalls inherent in the broad reach of this statute in policing related party transactions.
The statute grants the authority for the distribution, apportionment, or allocation of gross income, deductions, and credits between or among organizations or businesses to prevent evasion of taxes in order to arrive at a clear reflection of income. (3) With these thoughts of the statute as the safe harbor, one looks through the form of each item with respect to its allocation and substance to determine from where the command of income and benefits is derived. This technique provides an analysis to determine whether there is a shifting from one commonly controlled entity to another.
A shifting of taxation attributes can be for a valid business purpose because it is peculiar due to varying factors of each business. Allocation analysis is founded upon economic reality. This will be true even where there is a bona fide purpose in the allocation reasoning. The Service may assert an allocation is inappropriate due to a finding that an evasion of taxes results because of the economic realities. This is the essence of the government’s position. (4) In this regard, intent to defraud encompasses the breadth of the avoidance of taxes. (5) Where the allocation assertion is made, the taxpayer has the burden of proving the government’s contention is arbitrary, capricious and unreasonable. (6)
Arm’s Length Concepts
It is prudent to use the allocation authority guidelines granted pursuant to Section 482 that focuses upon the terminology arm’s length standards. This is the standard to analyze whether a violation of the shifting of income among related enterprises through allocation has occurred. An arm’s length standard for the purposes of determining the true taxable income of a controlled taxpayer is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer. (7) In the case of a controlled taxpayer, true taxable income means the taxable income that would have resulted had it dealt with the other members of the group at arm’s length. (8)
The authority to determine the true taxable income of a controlled taxpayer extends to any situation that arises, whether by inadvertence or design, where the taxable income differs from transactions between uncontrolled parties. By definition, the applicability of Section 482 and arm’s length standards are intertwined with the distinctions drawn between a controlled taxpayer and an uncontrolled taxpayer when determining the true taxable income. (9)
Implementing this process, the Service is required to select the appropriate method or methods applicable to controlled transactions. It may apply different methods to related transactions when transactions would be most reasonably tested on a separate basis. (10) From this process, a best method rule doctrine has evolved. This doctrine requires determining a controlled transaction is arm’s length by a method most accurately measuring the results of an arm’s length transaction under the particular facts and circumstances of the transaction. (11)
This doctrine is intended to result in the selection of a method that addresses the circumstances but recognizes instances may arise where it may be appropriate to utilize several methods of equal applicability. Where the best method process does not necessarily indicate a prerequisite method, it is permissible to introduce the applicability of competing methods. The objective of interjecting competing methods is to achieve results consistent with the results obtained under alternative method. This is referred to as a multiple methods approach which is recognized when two or more methods produce inconsistent results. (12)
The process of determining the correctness of an arm’s length transaction in a controlled transaction can be termed a comparative determination. This determination results through an analysis and comparison of transactions which are controlled and uncontrolled. (13) The use of comparability guidelines involves function and risk factors. These two guidelines are the most essential in any method used in a comparative analysis of transactions. (14) Other factors that comprise the comparative tools are contractual terms, economic conditions, and the property or services involved. (15)
This comparable process does not require a controlled transaction to be identical or exactly comparable to an uncontrolled transaction in arriving at an arm’s length conclusion. (16) Prices of profits in calculations are permitted some flexibility in the comparability process if there are reasonable ascertainable differences. These flexibilities are referred to as comparability adjustments and contemplate variances based upon commercial practices, economic principles or statistical analysis. A comparable adjustment is permissible in the context of an uncontrolled transaction. Price, profit, or margin is required to have a reasonably ascertainable effect in order to account for any material differences. (17)
These focal factors of function and risk have the most essential impact. Functional analysis has as its purpose the identification and comparative analysis of the economically significant activities undertaken by the taxpayer in controlled and uncontrolled transactions. The analysis when based upon the function factor is not a pricing method and is not itself determinative that a transaction has met arm’s length standards. The instrumental determinative functions comprise research and development, product design, engineering, manufacturing or process engineering, and marketing distribution. Other factors such as advertising, marketing, transportation, warehousing, managerial, legal, accounting, finance, credit and collection, training, and personnel management services are utilized in part in making a comparison of transactions. (18)
The risk functional factors employed in making a comparative analysis in applying an arm’s length standard are normally comprised of a two-step process. The analysis takes into consideration that there are circumstances where a question arises whether a transaction can be compared by a controlled versus uncontrolled approach. This reasoning recognizes that different transactions require recognition that each may have different risks.
Risk as a factor of comparability is accomplished by first determining which controlled taxpayer is bearing the risks associated with the transaction. That entails the consideration of whether income earned by a controlled taxpayer is commensurate with the risk assumed. A second step in this analysis is to determine whether the risks borne by the controlled taxpayer are comparable to those borne by an uncontrolled taxpayer. (19)
The most significant risks in the comparison analysis are market risks, risks associated with the success or failure of research and development activities, financial risks, credit and collection risks, product liability risks, and general business risks. (20) These various risks are used in the analysis as they relate to ownership of property, plan, and equipment. This analysis is a balancing of the economic substance of income being earned and its relation to the risk assumed.
The heart of balancing risks is whether the income earned is commensurate with risk taken on. The essence is whether income in conjunction with function is commensurate with the risk assumed. The core of risk determination considers contracted terms, economic conditions, and the property or services involved. Therefore in a comparative setting it is appropriate that the substance of the transaction be made to reflect an equal footing of controlled and uncontrolled business transactions. (21) These general concepts provide the necessary general backdrop to an understanding of the governing methods and principles in determining the proper allocations between related taxpayers.
1. Treas. Reg. Section 1.482 -1 (a) (1) of the IRC of 1986 and as thereafter amended.
2. Id. at 1.
3. IRC Section 482 (1986).
4. Your Host, Inc. v. Commissioner, v. Commissioner, 48 T. C. 10 (1972) aff’d 489 F.2d 957 (2d. Cir. 1973).
5. Asiatic Petroleum Co. v. Commissioner, 79 F.2d 234 (2nd Cir. 1935), aff’d 31 B.T.A. 1152, cert. denied, 296 U.S. 645 (1935).
6. Grenada Industries, Inc. v. Commissioner, 2002 F. 2d 873 (5th cir. 1953), aff’d 17 T. C. 231. Also see, Cobo Cleaners, Inc. v. United States, 76-1 USTC 9388 (6th Cir. 1976). Note that the courts have upheld instances of government abuse. See Davis v. Commissioner, 64 T. C. 1034 (1975). Of particular interest is Bernard F. Pacella, 78 T.C. 604 (1982) which addresses personal service corporation allocations.
7. Treas. Reg. Section 1.482 -1 (b) (1) of the IRC of 1986 and as thereafter amended.
8. Id. at 7.
9. Treas. Reg. Section 1.482 – 1 (b) (1) of the IRC of 1986 and as thereafter amended. However, because identical transactions can rarely be located, whether a transaction produces an arm’s length result generally will be determined by reference to the results of comparable transactions under comparable circumstances.
10. Treas. Reg. Section 1.482 -1 (b) (2) (ii) and (ii) of the IRC of 1986 and as thereafter amended.
11. Treas. Reg. Section 1.482 -1 (c) (1) of the IRC of 1986 and as thereafter amended.
12. Treas. Reg. Section 1.482 -1 (c) (2) (iii) of the IRC of 1986 and as thereafter amended.
13. Treas. Reg. Section 1.482 -1 (d) (1) of the IRC of 1986 and as thereafter amended.
14. Treas. Reg. Section 1.482 -1 (d) (1) (i) and (iii) of the IRC of 1986 and as thereafter amended.
15. Treas. Reg. Section 1.482 – 1 (d) (1) (ii), (iv) and (v) of the IRC of 1986 and as thereafter amended.
16. Treas. Reg. Section 1.482 – 1 (d) (2) of the IRC of 1986 and as thereafter amended.
17. Id. at note 16.
18. Treas. Reg. Section 1.482 – 1 (d) (3) (i) of the IRC of 1986 and as thereafter amended.
19. Treas. Reg. Section 1.482 – 1 (d) (3) (iii) (B) of the IRC of 1986 and as thereafter amended.
20. Treas. Reg. Section 1.482 – 1 (d) (3) (iii) (A) (1), (2), (3), (4), (5), and (6) of the IRC of 1986 and as thereafter amended.
21. Treas. Reg. Section 1.482 – 1 (d) (2) of the IRC of 1986 and as thereafter amended.