24 January 2025

IRS Office of Chief Counsel issues general legal advice memorandum on interaction among periodic adjustment, general arm's-length standard and best method rules

  • The GLAM analyzes two scenarios relating to periodic adjustments for transfer of high-profit-potential intangible property.
  • The IRS concludes in both scenarios that the taxpayer could not overcome the periodic adjustments because it failed to establish that it satisfied one or more of the relevant exceptions.
 

In generic legal advice memorandum AM 2025-001 (GLAM),1 released on January 17, 2025, the IRS discusses the relationship between the general arm's-length standard and the specific periodic adjustment rules.

The IRS reaches the following conclusion in two factual scenarios: if the IRS makes a periodic adjustment under Treas. Reg. Section 1.482-4(f)(2) or 1.482-7(i)(6) with respect to high-profit-potential intangible property that is transferred, or contributed to, a cost sharing arrangement (CSA), and none of the Treas. Reg. Sections 1.482-4(f)(2)(ii) or 1.482-7(i)(6)(vi) exceptions apply, then a taxpayer may not overcome the periodic adjustment by invoking the general arm's-length standard under Treas. Reg. Section 1.482-1(b)(1) or the best-method rule of Treas. Reg. Section 1.482-1(c).

Two scenarios

Scenario 1, periodic adjustment for the license of intangible property

A taxpayer licenses unique, high-profit-potential intangible property to a controlled party in exchange for a fixed annual royalty over 10 years. The royalty is determined by applying the comparable uncontrolled transaction (CUT) method based on the terms of a license agreement between two unrelated parties involving a different intangible that taxpayer maintains is comparable to the intangibles licensed in the controlled transaction. Both the controlled and uncontrolled licenses limit the use of the intangible property, but not in the same way. In addition, the period for which the agreements were effective differ for each license. Taxpayer's license was still effective in the seventh year of the license (and presumably the uncontrolled license was no longer effective, though the GLAM does not explicitly say this).

After six years, the licensed intangible property has grown in value and the IRS uses the actual profits from the licensed intangible property as the basis for a periodic adjustment under Treas. Reg. Section 1.482- 4(f)(2). The taxpayer contends that the periodic adjustment is not appropriate based on the general arm's-length standard and that use of the CUT method overcomes the application of periodic adjustments based on actual profits.

The IRS concludes that the taxpayer did not establish that it was entitled to an exception to periodic adjustments under Treas. Reg. Section 1.482-4(f)(2)(ii) for the following reasons:

  1. The taxpayer's CUT method was based on an uncontrolled transaction involving intangible property that was not the same as that licensed in the controlled transaction (i.e., the taxpayer did not meet the exception in Treas. Reg. Section 1.482-4(f)(2)(ii)(A))
  2. The IP licensed in the controlled and uncontrolled transactions was not transferred under substantially the same circumstances (i.e., the taxpayer did not meet the exception in Treas. Reg. Section 1.482-4(f)(2)(ii)(B)(3)
  3. The controlled license agreement did not limit use of the intangible property consistently with the uncontrolled license agreement (i.e., the taxpayer did not meet the exception in Treas. Reg. Section 1.482-4(f)(2)(ii)(B)(4)

The IRS also said the taxpayer's CUT method would be the best method for pricing the license in a best-method analysis under Treas. Reg. Section 1.482-1(c).

Scenario 2, periodic adjustment for the platform contribution

A taxpayer enters into a CSA with another controlled participant. At that time, the taxpayer develops and contributes to the CSA resources, capabilities or rights (including intangible property) reasonably anticipated to contribute to the intangible development activity, thus triggering a platform contribution transaction (PCT). The taxpayer prices its PCT payments using the income method under Treas. Reg. Section 1.482-7(g)(4) based on projecting future profits from the cost-shared intangibles reasonably anticipated to be developed under the CSA. The CSA remains in place through at least seven tax years.

After six years, the actual profits attributable to the contributed and cost-shared intangibles are significantly greater than the profits taxpayer had projected at the time of the PCT. In examining the sixth and seventh tax year, the IRS uses actual profits as the basis for a periodic adjustment under Treas. Reg. Section 1.482-7(i)(6). The taxpayer contests the periodic adjustment under the general arm's-length standard of Treas. Reg. Sec. 1.482-1(b)(1) and contends that its income method based on forecasted projections (ex-ante) overcomes the application of periodic adjustments because the latter is based on actual results.

The taxpayer does not establish to the IRS's satisfaction that it met any of the exceptions under Treas. Reg. Section 1.482-7(i)(6)(vi). In particular the IRS determines that the exception in Treas. Reg. Section 1.482-7(i)(6)(vi)(A)(2) ("results not reasonably anticipated") does not apply because the taxpayer did not establish that the actual profits in excess of those projected both (1) were due to events beyond the taxpayer's control, and (2) could not reasonably have been anticipated.

Law and analysis

IRC Section 482, in its "commensurate with income" standard, authorizes the IRS to achieve an arm's-length result by applying periodic adjustments under Treas. Reg. Sections 1.482-4(f)(2) and (6) and 1.482-7(i)(6) by reference to information on the actual results (ex-post) rather than ex-ante information (except for ex-ante information that is relevant to exceptions). The IRS, in its discretion, may use the income actually generated by the transferred intangible as the basis for periodic adjustments. Taxpayers may overcome periodic adjustments only in limited exceptions.

Treas. Reg. Section 1.482-4(a) clarifies that the Commissioner's authority to make periodic adjustments exists alongside the general best-method rule, and the specific periodic adjustments override the general-rule arm's-length standard and best-method rules to the extent of a conflict.

In addition, Treas. Reg. Section 1.482-7(i), which describes the allocations the Commissioner may make to achieve an arm's-length result in a controlled transaction connected with a CSA, allows the Commissioner to make either a PCT allocation under paragraph (i)(3) or a periodic adjustment under paragraph (i)(6).

Conclusion

In both scenarios, the IRS concludes that the taxpayer could not overcome the periodic adjustments because it failed to establish that it satisfied one or more of the relevant exceptions. "[T]he taxpayer's focus solely on comparables or other ex-ante information, while ignoring actual profit performance, would be contrary to the statute, would disregard the legislative intent, and would impermissibly make surplusage of the exceptions in Treas. Reg. [Sections] 1.482-4(f)(2)(ii) and 1.482-7(i)(6)(vi) and, in the case of Treas. Reg. [Section] 1.482-4(f)(2)(ii), of the provisions withdrawing those exceptions when actual profits fall outside of the prescribed range."

Implications

AM 2025-001 emphasizes the importance of conducting proper comparable analyses when implementing the CUT method, and illustrates that taxpayers should be aware of the two comparability thresholds. The first threshold ensures that there is enough similarity between the controlled and uncontrolled transactions such that the CUT method is the best method. The second threshold ensures that the exceptions in Treas. Reg. Section 1.482-4(f)(2)(ii)(A) or (B) are met. As outlined in the GLAM, the taxpayer satisfied the first threshold but not the second.

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Endnote

1 GLAMs are prepared by the Office of Chief Counsel and issued to IRS personnel for purposes of providing opinions on technical and other related issues. They cannot be used or cited as precedent.

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Contact Information

National Tax Department, International Tax and Transactions Services, Transfer Pricing

Published by NTD’s Tax Technical Knowledge Services group; Andrea Ben-Yosef, legal editor

Document ID: 2025-0326