Executive summary

On 29 February 2016, the U.S. Tax Court issued an opinion¹ denying Guidant LLC's² motion for partial summary judgment. Guidant asked the court to rule that the Internal Revenue Service ("IRS" or "Service") transfer pricing adjustments were arbitrary, capricious and unreasonable as a matter of law because (1) the IRS failed to determine the separate taxable income ("STI") of each member within the consolidated group and (2) the IRS inappropriately aggregated transactions; i.e., intangible, tangible and services transactions, that should have been evaluated independently. The court held that although the IRS will eventually have to determine the STI of each consolidated group member, Section 482³ and the regulations thereunder do not require the IRS to determine STI contemporaneously with the transfer pricing adjustment. In addition, the court further held that the Section 482 regulations permit the IRS to aggregate interrelated transactions to produce the most reliable arm's length result. Thus, whether the IRS's aggregation of the separate transactions produced an arm's length result is solely a question of fact to be determined at trial, just as the validity of the transfer pricing adjustment itself.

Factual background

From 2000 to 2006, Guidant Corp. was the parent of an affiliated group that included several U.S. subsidiaries (collectively, Guidant Corp. and its U.S. subsidiaries are referred to as "Guidant"). In addition to its domestic subsidiaries, Guidant Corp. also had foreign subsidiaries operating in the Netherlands, Luxembourg, Puerto Rico, and Ireland. Together, the domestic and foreign subsidiaries formed various business units operated by separate companies, all in furtherance of Guidant Corp.'s core business of developing, manufacturing and selling medical devices.

On April 21, 2006, Boston Scientific Corp. ("BSC") acquired Guidant Corp., and Guidant, including its foreign affiliates, became separate members of an affiliated group, of which BSC was the parent. Under BSC's ownership, Guidant Corp. was still the intermediate parent of the remaining Guidant subsidiaries for which it had been the ultimate parent prior to the acquisition.

The Service conducted an audit of Guidant's consolidated federal income tax returns for tax years 2000 through April 21, 2006, and the consolidated federal income tax returns for BSC and its U.S. subsidiaries filed for 2006 and 2007. The intercompany transactions under review involved

— the sale of tangible goods (medical device components and/or finished goods) between Guidant Corp. affiliates for ultimate resale to unrelated third parties;⁴
— the licensing of intellectual property required for the manufacture of various components of Guidant Corp.'s products; and
— the provision of administrative intercompany services from Guidant Corp. to various foreign subsidiaries.

The Service conducted a review of Guidant's transfer pricing documentation studies, as well as financial data that was both furnished by Guidant and publicly available. In concluding that the transfer prices for the above-mentioned intercompany transactions were not at arm's length, the Service determined federal income tax deficiencies and Section 6662 accuracy-related penalties of approximately $3.5 billion. In so doing, the Service assessed the entire amount of the adjustment against Guidant Corp.'s STI, which effectively resulted in a pro tanto adjustment to Guidant's consolidated taxable income ("CTI") for the years at issue.

Detailed discussion

In judicial proceedings challenging the Service's imposition of adjustments made pursuant to Section 482, a taxpayer must clear two hurdles to prevail. First, it must prove that the Commissioner abused his discretion by making allocations that are arbitrary, capricious and unreasonable.⁵ Second, it must show that its transfer pricing methodology results in allocations that comport with the arm's length standard.⁶ The Tax Court noted that in the review of motions for summary judgment, the facts are taken in the light most favorable to the opposing party, and the moving party has the burden of proving that there are no genuine issues of material fact, thereby supporting the entry of a decision in its favor as a matter of law.⁷

Guidant offered two arguments to support its position that the Service's transfer pricing adjustments were arbitrary and capricious as a matter of law. First, Guidant argued that the Service erred in its failure to determine each consolidated group member's true STI, in derogation of the requirements of Treas. Reg. Section 1.482-1(f)(1)(iv). Second, Guidant took the position that the Service improperly aggregated separate types of controlled transactions (i.e., the intercompany services, tangible goods and intangibles transactions) when determining the amounts of the transfer pricing adjustments it imposed.

1. Separate taxable income

In addressing the first argument, the Tax Court noted that the statute is silent on the issue, and thus turned its attention to an analysis of Treas. Reg. Section 1.482-1(f)(1)(iv):

"(iv) Consolidated returns. — Section 482 and the regulations thereunder apply to all controlled taxpayers, whether the controlled taxpayer files a separate or consolidated U.S. income tax return. If a controlled taxpayer files a separate return, its true separate taxable income will be determined. If a controlled taxpayer is a party to a consolidated return, the true consolidated taxable income of the affiliated group and the true separate taxable income of the controlled taxpayer must be determined consistently with the principles of a consolidated return."

Looking at the plain language of the regulation, the Tax Court noted where the controlled party is a party to a consolidated return, both STI and CTI must be determined. However, it also found that there was nothing in the regulation requiring the determination of STI to be made contemporaneously with the imposition of a Section 482 adjustment.

The Tax Court went on to address the "consistently with the principles of a consolidated return" clause of the regulation, and reviewed both Supreme Court precedent and legislative history before concluding that "the primary principle underlying the consolidated return regime is a taxing of the true net income of the consolidated group as a whole."⁸ The Tax Court acknowledged that Treas. Reg. Section 1502-11 mandates that each group member's STI be calculated before determining the consolidated group's CTI — or a "bottom to top" approach — and that doing so would yield the most reliable result. Moreover, the primary aim of Section 482 " ... is to prevent a distortion of income or an evasion of tax on account of controlled transactions that distort the taxable base."⁹ Given that the calculations of the STI and CTI are made within the context of determining amounts of transfer pricing adjustments, the goal is to clearly reflect the consolidated group's income and prevent an avoidance of the consolidated group's tax liability. Accordingly, Treas. Reg. Section 1.482-1(f)(1)(iv) does not preclude the Service from first imposing transfer pricing adjustments against the group's CTI, and deferring the determination of each group member's true STI until such time as it becomes necessary; e.g., when processing set-off amounts or separate return limitation year items.

Further, the Tax Court noted that as a matter of policy, to require the Service to determine true STI at the same time it imposes Section 482 adjustments would frustrate the purpose of the statute and eliminate the Service's ability to impose transfer pricing adjustments where " ... the taxpayer consciously withholds or fails to maintain records of information necessary for STI adjustments."¹⁰ Here, Guidant and its foreign affiliates each performed functions on behalf of business units and individual related parties, and each owned valuable intangibles. Although Guidant maintained all the necessary information and records to make the STI determinations, it was too costly and burdensome to extract that information at the time of the audit.¹¹

Accordingly, the Court held "only that [the IRS's] section 482 adjustments are not arbitrary and capricious as a matter of law. Whether [the IRS's] section 482 adjustments are or are not arbitrary, capricious, or unreasonable will be decided, to the extent necessary, on the basis of the evidentiary record built at trial."¹²

2. Aggregation of transactions

With respect to Guidant's second argument that the Service erred in aggregating the different types of controlled transactions under review, the Court pointed out that Treas. Reg. Section 1.482-1(f)(2)(i) expressly allows for aggregation of controlled transactions " ... if such transactions, taken as a whole, are so interrelated that consideration of multiple transactions is the most relatable means of determining the arm's length consideration for the controlled transactions," and they involve "related products or services." Further, the Service's ability to aggregate transactions is confirmed by two examples in the regulations, which support aggregation when the controlled transactions are sufficiently interrelated or when reliable controlled group comparables would not support a determination of an arm's length result on a separate transaction basis.¹³ Accordingly, the Service's decision to aggregate the controlled transactions was not arbitrary and capricious as a matter of law. However, the Court stated whether the Service "abused its discretion by aggregating transactions involving intangibles, tangible goods, and provision of services, thus, is a question of fact that should be resolved on the basis of the trial record."¹⁴

———————————————

———————————————
ENDNOTES

¹ 146 T.C No. 5.

² For purposes of trial, briefing and opinion, several cases involving the former Guidant Corporation and its subsidiaries have been consolidated.

³ All "Section" references are to the Internal Revenue Code of 1986, and the regulations promulgated thereunder.

⁴ The ultimate sales to unrelated third parties were effectuated via (1) direct sales to domestic end-users; (2) related party foreign sales affiliates; or (3) independent third-party foreign distributors.

⁵ 146 T.C. No. 5, at 22 (citing Eli Lilly & Co. v. Commissioner, 856 F.2d at 860; Sundstrand Corp. v. Commissioner, 96 T.C. 226, 353 (1991)).

⁶ Id. at 23 (citing Sundstrand, 96 T.C. at 354).

⁷ Id. at 25 (citing Craig v. Commissioner, 119 T.C. at 260).

⁸ Id. at 29.

⁹ Id. at 31.

¹⁰ Id. at 32.

¹¹ Id. at 33.

¹² Id. at 34.

¹³ Treas. Reg. Section 1.482-1(f)(2)(i)(B), Examples 2 and 3.

¹⁴ 146 T.C. No. 5, at 39-40.