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. (See TaxConnections, Introduction to Section 482 and International Financial Centers, April 24, 2014) 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 that regulation.
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 utilize as guidelines different methods of pricing to various categories of transactions. These general groupings are loans or advances, services, tangible (See TaxConnections, Tangible Property Section 482 and International Financial Centers, May 9, 2014) and intangible property transactions structured between related entities. (See TaxConnections, Intangible Property – Section 482 and International Financial Centers, May 2, 2014)
Loans and advances are transactions one normally associates 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 companies that are also subject to Subpart F controlled foreign corporate provisions. Tangible property is utilized as a pricing method category to establish guidelines with respect to the activities such as leasing and transferring of property. These would be leasing companies and foreign personal holding companies among others. A fourth common category, intangible property transactions, is directed to royalties and technology that have benefited from traditional Financial Offshore structuring. These would be licensing and royalty companies. These delineated areas are not inclusive but provide an understanding of the mainstream use of related entities.
Purpose and Concurrent Correlative Adjustments
The purpose of Section 482 is to place a controlled taxpayer on parity with an uncontrolled taxpayer in an attempt to achieve a proper reflection of true taxable income. In carrying out this endeavor, the Service is provided the authority to intervene and make requisite allocations as may be required. (1) In making a determination of true taxable income of a controlled taxpayer, the Service is not restricted to a case of improper accounting, fraudulent, colorable, or sham transactions. Nor is it restricted to cases of evasive design to reduce or avoid tax by shifting or distorting income, deductions, credits, or allowances. (2)
The means of making these allocations occurs through the use of what is referred to as primary and correlative adjustments. An allocation to the income of a member of a controlled group is the primary adjustment. By virtue of such an adjustment, another member of the controlled group is affected through the occurrence of the primary adjustment. Because of this effect, a correlative adjustment to the income of a controlled member is made concurrently with the primary adjustment. (3)
The concurrent correlative adjustment is made when the effect is that the United States income tax liability of the other member would be influenced by the adjustment for any pending taxable year. A general understanding of the effect on a taxable year for this purpose is in reference to a year in which a refund of taxes is not barred by a statute of limitations. (4)
Courts have held that proper allocation pursuant to Section 482 requires an appropriate correlative adjustment in the administration of this Code provision. (5) A correlative adjustment is not required to be made, however, until the time of the first occurring of the following events as it pertains to a primary adjustment:
1. The date of assessment of the tax following execution by the taxpayer
of a Form 870 (waiver) of restriction on assessment and collection of
deficiency in tax and acceptance of over-assessment with respect to such
2. Acceptance of Form 870-A.D. (offer of waiver of restriction on assessment
and collection of deficiency in tax and acceptance of over-assessment);
3. Payment of the deficiency;
4. Stipulation in the Tax Court of the United States; or
5. Final determination of tax liability by offer-in-compromise, closing agreement
or court action. (6)
It logically follows that the Service will not treat correlative adjustments or final adjustments until such time that a taxpayer is subject to a primary adjustment and has concurred or exhausted its remedies. Additionally, there are instances when a correlative adjustment, because of lack of jurisdiction or an income blockage due to foreign law, requires the adjustment be deemed to have been made for purposes of determining United States tax liability of a controlled member. (7) A deemed allocation to the correlative controlled member addresses the circumstance where an allocation is permitted but cannot be made currently.
The United States Supreme Court has taken the position previously that an allocation may not be made if the person whose income is to be increased is prohibited by law from receiving the income. The inverse argument can be made that an allocation is prohibited when the correlative taxpayer whose income is to be decreased is prohibited by law from making payment. (8) Regardless there is no requirement that a correlative adjustment is required to be made to make a primary adjustment. (9) A primary adjustment is permitted even though the correlative adjustment taxpayer is veiled by a statute of limitations. This is the position of the Tax Court. (10)
An issue arises incident to these types of adjustments with respect to timely notice by the Service to the taxpayer enabling the correlative adjusted taxpayer to avail itself of refund and not to be precluded from this right by a failure to receive timely notice. Timely notification to the correlative taxpayer to enable the taxpayer to file a protective claim with respect to the correlative adjustment may have a bearing on the validity of the primary adjustment. (11) Additionally, the Service is empowered to make allocations and permit set-offs in non-arm’s length arrangements. (12)
Nonrecognition provisions of the Code and the coordinated application of a Section 482 allocation are of particular importance. The relation between the nonrecognition provisions and Section 482 results from instances in which a taxpayer avails itself of a nonrecognition provision, but it is not done with the intention of fulfilling a business purpose. Rather, the nonrecognition of realized gain is used to shelter and shift income under the guise of a legitimate purpose.
The more notable of the Section 482 nonrecognition challenges have dealt with Section 351 transactions. The Service has taken the position that if a taxpayer utilizes a nonrecognition provision to evade taxes, Section 482 can be asserted to require a taxpayer to recognize the gain realized. (13) The Section 351 transactions subject to scrutiny are transfers of appreciated assets to a foreign subsidiary by a parent or other foreign subsidiary and a subsequent resale or type of transfer tantamount to an assignment of income. (14) The focus of the Service in these instances is often characterized as an attempt to separate income from the expenses generating the income. (15)
The applicability of Section 482 to nonrecognition tax deferment is in circumstances where the Service determines an allocation is to be made in order to properly reflect income. Section 482 will be the controlling section when it conflicts with nonrecognition of Section 351, provided the Service does not abuse its discretion in making reallocations. (16) Where reallocations of nonrecognition transactions have come about, taxpayers have defended based upon the requirement that a tax avoidance motive must be present. (17)
The United States Court of Federal Claims has taken issue with the United States Tax Court’s acquiescence with the Service’s position. That conflict has been whether Section 482 controls without any additional burdens. It is the Federal Claims Court’s position that Section 482 cannot be utilized to assess tax of a nonrecognition transaction in the absence of a showing that the nonrecognition transaction is tainted by motive. A showing of a tax avoidance motive must be established.
There is a sense that the United States Tax Court has uneasiness with overriding a nonrecognition transaction by invoking Section 482. This can be gathered from several cases. In the case of Eli Lily & Co. & Subs. v. Commissioner, (18) the Tax Court recognized the Service’s position that a Section 482 allocation was acceptable when nonrecognition of a Section 351 transaction was subject to reallocation. The court displayed its reluctance to override a nonrecognition conflict by seeking to resolve the allocation by using a pricing method concept. This approach was taken in opposition to the Service’s attempt to deny nonrecognition treatment of a transfer of an intangible to a wholly owned subsidiary of the taxpayer by use of Section 482 reallocation.
Again in the case of G.D. Searle & Subs. v. Commissioner, (19) the United States Tax Court acknowledged Section 482 was not precluded from nonrecognition transactions but sought to take the opportunity to depart from the Services intangible transfer theory of contract manufacturing. The court sought to develop its own application of reason. These cases taken collectively acknowledge the courts will adhere to the notion that Section 482 can be utilized in nonrecognition analysis, but it establishes these instances of allocation are regarded as something of a departure from the intended Section 482 allocation authority.
Accounting standards and provisions are additional areas affected by and in conflict with Section 482 and reallocations. The Service is authorized by the authority of Section 446 of the Code to make necessary changes to a taxpayer’s accounting method in order to more clearly reflect income. It is established authority that a Section 482 allocation can be made in circumstances where there is a conflict of accounting provisions. (20)
Similar authority has been used by the Service in Section 482 allocations in instances of the creation of income. Where two members of a controlled group engage in transactions with each other, inter-company allocations can be subject to Section 482 even though one of the members may not realize income from the transaction. (21) It has been established that the Service does not have authority to make allocations pursuant to Section 482 without deference to whether gross income is generated to a taxpayer. (22)
In the case of Lantham Park Manor, Inc., (23) the United States Tax Court took the opportunity to clarify conflicts accumulated through regulations and cases. The court in its interpretation stated it was not its position that a Section 482 allocation was precluded in a transaction where the proceeds from a related transaction gave rise to gross income. In a later decision, Alladin Industries, Inc., (24) a reaffirmation was made that Section 482 permits the Service to create income in circumstances where it is appropriate to do so by virtue of the nature of commonly controlled entities participating in transactions not determined to be arm’s length.
In accordance with Circular 230 Disclosure
1. Treas. Reg. Section 1.482 -1 (a) (2) of the IRC of 1986 and as thereafter amended.
2. Treas. Reg. Section 1.482 – 1 (f) (1) (i) of the IRC of 1986 and as thereafter amended
3. Treas. Reg. Section 1.482 – 1 (g) (2) of the IRC of 1986 and as thereafter amended.
4. Treas. Reg. Section 1.482 – 1 (g) (2) (ii) of the IRC of 1986 and as thereafter amended.
5. B. Foreman Co. Inc. v. Commissioner, 72-1 USTC 9182, 453 F. 2d 1144 (2nd Cir. 1972); aff’g and rev’g 54 T. C. 912 (1970); cert. denied 407 U.S. 934 (1972).
6. Treas. Reg. Section 1.482 – 1 (g) (2) (iii) (A), (B), (C), (D) and (E) of the IRC of 1986 and as thereafter amended.
7. Commissioner v. First Security Bank of Utah, 72-1 USTC 9292, 405 U. S. 394 (1972). See also Revenue Ruling 82-45, Cumulative bulletin, 1982-1 C.B. 89, where a distinction is made regarding a prohibition occurring by the laws of the United States and those of a foreign country. (The Service will not follow this case if the law of prohibition of payment is that of a foreign government).
8. Fitzgerald Motor Company, Inc. v. Commissioner, 508 F. 2d 1096 (5th Cir. 1975), aff’g 60 T.C. 957 (1973).
9. Collins Electrical Co., Inc. v. Commissioner, 67 T. C. 911 (1975).
10. See, George Powers, 44 T. C. M. 1265 (1982).
11. See generally, Liberty Loan Corp. v. United States, 74-1 USTC 9474; 498 F.2d 225 (8th Cir. 1974), cert. denied, 419 U. S. 1089. See, also, National Securities Corporation v. Commissioner, 137 F.2d 600 (3rd Cir. 1943), cert. denied, 320 U.S. 794 (1943).
12. Treas. Reg. Section 1.482 – 1 (g) (4) of the IRC of 1986 and as thereafter amended.
13. West v. United States, 72-1 USTC 9117 (N.D. Tex. 1971); aff’d per curiam, 72-2 USTC 9666 (5th Cir. 1972). This case illustrates a Section 337 liquidation sale by a transferee subsequent to nonrecognition accorded by Section 351 to the transferor. (Note, Section 337 liquidation transactions were eliminated by the Tax Reform Act of 1986).
14. See generally, Central Cuba Sugar Co. v. Commissioner, 52-2 USTC 19390 (1958). This case reflects taxpayer nonrcognition on reorganization and separation of income from expense which generated the income. See also, Rooney v. United States, 62-2 USTC 9598, 305 F. 2d 681 (9th Cir. 1962).
15. Rooney v. United States, 62-2 USTC 9598, 305 F. 2d 681 (9th Cir. 1962).
16. Ruddick Corporation, 83-2 USTC 9480 (1983).
17. Id. at note 16.
18. 84 T. C. 996 (1985), reversed in part, aff’d in part, 88-2 USTC 950 (7th Cir. 1988).
19. 88 T. C. 252 (1987).
20. Pitchford’s, Inc. v. Commissioner, 34 T. C. M. 384 (1975); Grace Cappucilli v. Commissioner, 668 F. 2d 138 (2nd Cir 1981), aff’g 40 T. C. M. 1084, Jud Plumbing and Heating, Inc. v. Commissioner, 153 F.2d 681 (5th Cir. 1946), 46-1 USTC 9177.
21. See generally, B. Forman v. Commissioner, 72-1 USTC 9182, 453 F.2d 1144 (2nd Cir. 1972), aff’d and rev’g 54 T. C. 912 (1970), cert. denied, 407 U. S. 934 (1972). See also, Kabler Corp., 46 T. C. M. 974 (1983). See also, Kerry Investment Co., 58 TC 479, non acq., 1972-2 C. B. 3; rev’d 500 F. 2d 108 (9th Cir. 1974), 74-2 USTC 9522.
22. Fitzgerald Motor Co., Inc. v. Commissioner, 75-1 USTC 9275, aff’d 60 TC 957 (1973), 508 F.2d 1096 (5th Cir. 1975).
23. 69 T. C. 199 (1977).
24. 41 T. C. M. 1515 (1981).