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TAX CLINIC

become competent authority cases, in- practice, the “economic substance” test and these differences are underscored
cluding advising exam teams on whether under Sec. 482 may pose a higher bar when it comes to DEMPE and risk
a contemplated adjustment would likely for risk reallocation than the OECD allocation. Therefore, MNEs and tax
be sustained in the competent author- Guidelines, and the IRS and U.S. Tax practitioners need to keep following
ity process. Even though this guidance Court have generally respected contrac- and complying with the U.S. regulations
does not expressly refer to DEMPE, as a tual allocations of risk by taxpayers. In but always keep an eye on DEMPE
practical matter, APMA would take into other ways, however, the U.S. regulations rules to be prepared when these two
account any DEMPE-based arguments may prove harsher: The OECD Guide- similar, but in practice not identical, ap-
that it anticipates the counterparty com- lines contemplate that contractual terms proaches interact.
petent authority would make. “may also be found in communications From Sean Foley, J.D., LL.M., Silicon
However, there remain significant between the parties other than a writ- Valley, Calif., and Cristian Faundez,
differences between the Treasury regula- ten contract” (paragraph 1.42), while LL.B., LL.M., Atlanta
tions under Sec. 482 and the OECD Regs. Sec. 1.482-1(d)(3)(ii)(B)(2), in
Guidelines on DEMPE and risk. For the absence of a written contract, allows Secondary transfer-pricing
example, regarding contractual arrange- the IRS to impute contractual terms adjustments
ments, the U.S. transfer-pricing regula- consistent with the economic substance Taxpayers facing transfer-pricing adjust-
tions respect allocations of risk pursuant of the transaction. ments should be aware of rules requiring
to a written contract as long as they are With respect to transactions in- secondary adjustments. The purpose
consistent with the “economic substance” volving intangibles, the apparent gap of these adjustments is to resolve dis-
of the transaction (Regs. Sec. 1.482-1(d) between the Sec. 482 regulations and crepancies that arise from primary and
(3)(ii)(B)). In considering the economic the OECD Guidelines is broader. Regs. corresponding adjustments. A primary
substance of the transaction, the fol- Sec. 1.482-4(f)(3) provides that for adjustment occurs when a tax author-
lowing facts are relevant (Regs. Sec. U.S. transfer-pricing purposes, the legal ity or a taxpayer adjusts taxable profits
1.482-1(d)(3)(iii)(B)): owner of an intangible will be consid- as a result of applying the arm’s-length
■ Whether the taxpayer’s conduct over ered its sole owner unless the ownership principle to transactions between related
time is consistent with the purported is inconsistent with economic substance. parties. A corresponding adjustment
allocation of risk or, where the pat- While a DEMPE analysis could be used is the offsetting income reduction in
tern is changed, whether the relevant to determine whether legal ownership the counterparty jurisdiction. Typically,
contractual arrangements have been is consistent with economic substance, getting a corresponding reduction to be
modified accordingly; the economic substance test remains a recognized by the tax authority of the
■ Whether a controlled taxpayer has relatively high bar. second tax jurisdiction affected requires
the financial capacity to fund losses In Coca-Cola Co., 155 T.C. 145
that might be expected to occur as (2020), the Tax Court placed significant
the result of the assumption of a risk, weight on the importance of contractual
or whether, at arm’s length, another arrangements regarding intangible own-
party to the controlled transaction ership and held that the taxpayer could
would ultimately suffer the conse- not invoke the economic substance
quences of such losses; and exception to prove that an entity other
■ The extent to which each controlled than the contractual owner possessed in-
taxpayer exercises managerial or tangibles. In a clear divergence from the
operational control over the business OECD Guidelines, the Sec. 482 regula-
activities that directly influence the tions regarding cost-sharing arrange-
amount of income or loss realized. In ments allow cost-sharing participants
arm’s-length dealings, parties ordi- to receive intangible-related returns
narily bear a greater share of those without regard to operational control
risks over which they have relatively over DEMPE functions.
more control. To conclude, even though U.S. gov-
Broadly speaking, the U.S. rules on ernment officials have maintained that IMAGE BY HAPPYPHOTON/ISTOCK
risk allocation are conceptually similar the Sec. 482 regulations are consistent
to the OECD Guidelines, although the with the OECD Guidelines, actually,
Sec. 482 regulations are less precise. In there are clear differences in application,

14 June 2022 The Tax Adviser