Suspect Transactions (?)
It is axiomatic that a transaction between related businesses – i.e., businesses that are owned or controlled directly or indirectly by the same interests (a “controlled group”) – will generally be subject to heightened scrutiny by the IRS to ensure the transaction was not undertaken or structured for the purpose of gaining an improper tax advantage.
For example, when the IRS determines that related businesses have engaged in a transaction that lacked economic substance or a bona fide business purpose, but which generated a tax benefit, the IRS may, depending upon the facts and circumstances, void the transaction as a sham, collapse into one integrated transaction the ostensibly separate steps implemented by the related businesses, or ignore the form of the transaction to focus on its economic result, for the purposes of establishing the correct tax treatment of the transaction and ascertaining each business’s proper tax liability.[i]
Evasion of Tax, Distortion of Income
Even when the transaction between the related businesses must be respected as a bona fide commercial event, and especially where the parties are commonly controlled, the IRS may still determine that the particulars of the transaction may result in the evasion of taxes or may not clearly reflect the income of the businesses, on the theory that such controlled taxpayers have an unfettered ability to allocate income amongst themselves.
The IRS is statutorily[ii] authorized, in that case, to distribute, apportion, or allocate gross income, deductions, credits, or allowances between the related businesses[iii] if the agency determines that such “corrective” action is necessary to prevent the evasion of taxes or the distortion of income with respect to the transaction. The statute also provides that, in the case of any transfer (or license) of intangible property, the income with respect to such transfer or license must be commensurate with the income attributable to the intangible.[iv]
In such a situation, the IRS will generally seek to accomplish these anti-evasion or anti-distortion enforcement goals by placing a “controlled” taxpayer (the related business) on a tax parity with an uncontrolled taxpayer by determining the “true taxable income” of the controlled taxpayer.[v]
Controlled Taxpayer
A “controlled” taxpayer, for this purpose, means any one of two or more taxpayers that are owned or controlled by the same interests, including the taxpayer that owns or controls the other taxpayers.
One taxpayer’s control over another may be direct or indirect; it may be legally enforceable or not. The means or manner by which such control is exercised is not determinative – it is the reality of the control that is decisive, not its form or the mode of its exercise.[vi]
True Taxable Income
The true taxable income of a controlled taxpayer means the taxable income that would have resulted had such taxpayer dealt with the other member or members of its controlled group at arm’s length – the standard to be applied is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer.[vii]
Arm’s Length
A transaction[viii] or transfer between two or more members of the same controlled group of taxpayers (a “controlled transaction”) meets the arm’s length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances – an arm’s length result.[ix]
The IRS has promulgated regulations that provide the general principles to be applied in determining the arm’s length results of controlled transactions. These regulations also provide specific methods to be used to evaluate whether different types of transactions between members of the controlled group – such as transfers of property, services, loans, and rentals – satisfy the arm’s length standard, and if they do not, to determine the arm’s length result. The arm’s length result of a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable measure of an arm’s length result.
Corrective Action
Once the IRS has ascertained the “correct” economic outcome and tax consequences for the controlled transaction in question, the IRS may reallocate items of income, deduction, etc., between the related parties to the transaction to the extent necessary to reflect such parties’ true taxable income.[x]
Blocked Income
The Eighth Circuit Court of Appeals recently considered a situation[xi] in which the IRS exercised its statutory authority by requiring a U.S. taxpayer (“Corp”) to increase its gross income by almost $24 million.
Interestingly, Corp agreed with the IRS that the amount actually paid to Corp by one of its corporate subsidiaries in exchange for the use of Corp’s intellectual property was less than the amount of consideration that an uncontrolled corporation would have paid for the use of such property.
What’s more, Corp and the IRS also agreed on the dollar amount of the arm’s length payment that an uncontrolled corporation would have made to Corp for the use of the intellectual property.
Based on the foregoing, you may be wondering about the nature of the dispute that still separated the two parties.
The Dispute – Foreign Law
One of Corp’s most important assets is its intellectual property, which Corp regularly licenses to its foreign subsidiaries in exchange for royalty payments.
During the tax year in question, Corp licensed certain trademarks to one of its wholly owned foreign subsidiaries (“Sub”) to be used by Sub in its business operations. However, the law of the foreign country under which Sub was organized limited the amount of royalties that one of its domestic corporations, such as Sub, could pay to a foreign (U.S.) controlling corporation, such as Corp.[xii]
If a subsidiary corporation (Sub) failed to comply with this law, the responsible foreign authority would refuse to record the subsidiary’s agreement with its foreign parent (Corp). Such recordation, however, was necessary for the following purposes: to permit payments to the foreign parent; to qualify the subsidiary for deductions under local tax law; and to make the agreement effective against third parties.
In other words, for all intents and purposes, Sub was compelled by foreign law to pay Corp below-market royalty rates.
Thus, in compliance with this law, Sub paid Corp only $5 million (as opposed to almost $24 million) for the use of Corp’s trademarks, and Corp duly reported that amount on its federal tax return for the tax year I question.
Notice of Deficiency
Several years later, the IRS sent Corp a Notice of Deficiency in which the agency asserted that Corp owed considerably more federal income tax. In determining the royalty amount Corp should have reported as income, the Notice did not consider the effect of the above-referenced limitation under foreign law. Instead, the Notice explained that Corp should have included nearly $24 million in additional royalty income on its U.S. tax return to reflect what, in the agency’s view, Corp should have received from Sub for the use of the trademarks in accordance with the applicable arm’s length standard.
As indicated earlier, both Corp and the IRS agreed that the amount of the royalty stated in the Notice reflected the consideration that an unrelated entity would have paid to use Corp’s intellectual property.[xiii]
The Issue
The dispute between the parties focused on whether the IRS could reallocate to Corp the “unpaid” royalties that Sub would otherwise have been obligated to pay Corp for the use of the property in an arm’s length arrangement, but which Sub was legally forbidden to pay under the applicable foreign law.
Tax Court
Corp petitioned the U.S. Tax Court to challenge the IRS’s reallocation of the unpaid royalties from Sub to Corp and, in effect, accused the IRS of circumventing the foreign law in order to shift income away from the foreign jurisdiction and into the U.S.
Corp argued that the IRS could not tax the royalty that foreign law blocked Sub from paying Corp – the agency could not treat Corp as having received a payment from Sub that Sub was legally prohibited from making.[xiv] Instead, Corp asserted that under the circumstances, the arm’s length amount should correspond to the maximum amount that B could have paid for the use of the intellectual property under the laws of the foreign jurisdiction.
In response, the IRS relied on its “blocked income” regulation, which provides that a foreign legal restriction[xv] that prevented or limited payment of an arm’s length amount will be respected for purposes of determining an arm’s length consideration only if there is evidence of a comparable uncontrolled transaction in which unrelated parties agreed to enter a similar transaction subject to the restriction. In other cases, the foreign legal restriction will be disregarded in determining an arm’s length amount, but the taxpayer is permitted to elect a deferred method of accounting to defer recognition of additional income until such time as the restriction is lifted, subject to the consistent deferral of related expenses.[xvi]
The Tax Court determined that the restrictions under the foreign law to which Sub was subject did not meet the above regulatory requirements.[xvii] Specifically, by a vote of nine to eight, the Tax Court rejected Corp’s arguments, with the majority finding that the IRS had acted within its authority, and with the dissenters arguing that the Code prohibited the IRS from reallocating income that Corp could not legally receive.
Corp appealed the Tax Court’s decision[xviii] to the Eighth Circuit.
The Court of Appeals
The Court pointed out that, notwithstanding the IRS’s having issued a regulation in compliance with applicable federal administrative law, the Court was free to adopt the “best reading of the statute” – i.e., not necessarily the IRS’s interpretation as reflected in the regulation but the one “the court would have reached if no [federal] agency were involved.”[xix]
IRS’s Power to Reallocate
The Court acknowledged that the IRS has the statutory authority to “distribute, apportion, or allocate” income among commonly controlled companies, subject to certain limitations (described below).
According to the Court, however, the “best reading” of the statutory language[xx] ruled out what the IRS did with respect to the arrangement between Corp and Sub.
The Court explained that, pursuant to the statute, the IRS may “distribute, apportion, or allocate gross income, deductions, credits, or allowances” between “two or more … businesses” that are “owned or controlled … by the same interests.” It is a way, the Court continued, for the IRS to “prevent artificial shifting, milking, or distorting of the true net incomes of commonly controlled enterprises.”
When a commonly controlled corporation files its consolidated tax return for the whole group, the Court stated, it reports how much each individual company made. These amounts can be “arbitrary,” the Court observed, because the parent company usually has the flexibility to structure the transactions among individual subsidiaries or between the subsidiary and the parent to avoid certain unfavorable tax consequences. When the parent acts in this manner, it opens the door to distortion through the shifting of “income, deductions, credits, or allowances.”
“The congressional answer to that problem,” the Court continued, was reallocation by the IRS, which involves the shifting of individual line items to reflect each entity’s true income. When it exercises the reallocation power, the Court explained, the IRS typically uses the “arm’s length” standard to approximate how “uncontrolled taxpayers” would have structured the transaction.[xxi]
Limitations on the Power
The Court asked whether the IRS’s reallocation in the present case was, in accordance with the first limitation on the IRS’s statutory authority, “necessary” to “prevent evasion of taxes” or to “clearly … reflect the [controlled entities’] income.”
Given that Sub was just following foreign law, the IRS did not suggest that Corp or Sub were trying to evade taxes. Rather, the agency’s position was that the foreign law distorted Corp’s income because an unrelated entity would have paid a little over five times as much as Sub for the use of Corp’s intellectual property. “These types of payments, after all, can take place” between uncontrolled entities, “just not to a controlling foreign entity.”
The Court then turned to a second limitation. For income to come within the reach of the IRS’s reallocation authority, a taxpayer must have “complete dominion over it”; meaning, it is money that “could have [been] received” by the taxpayer and, so, could have been shifted by the taxpayer among its controlled companies.
Control Over Income
In other words, the IRS is authorized to reallocate income only where the taxpayer has and exercises its power over the payment of money in such a way that the “true taxable income” of the taxpayer or of its a subsidiary has been understated.
In the present case, however, the foreign government[xxii] prohibited “the transaction that the IRS [asked the Court] to envision.”
Starting from the “foundational principle” that a person cannot have income that they did not receive and were prohibited from receiving, the Court concluded that Corp and Sub could not have “shifted or distorted” their income through the licensing transaction.
The Court stated further that attributing almost $24 million in extra royalties to Corp was “inconsistent with the reality that it could not receive them” without placing Sub in legal jeopardy under foreign law. “The point is that, from a plain-and-ordinary-meaning standpoint, shifting income to” Corp would not “clearly reflect its income.”
The IRS Pivots . . . to No Avail
The Court then addressed the IRS’s alternative argument, based on the statutory language requiring that the income with respect to the transfer or license on an intangible be commensurate with the income attributable to the intangible.
According to the agency, any income “attributable” to intellectual property is covered by this statutory directive, including whatever Sub earned from the property, even if it could not legally pay (as a matter of foreign law) for what it used.
Again, the Court rejected the IRS’s assertion. According to the Court, the IRS can “allocate” income, but only when the taxpayer has “dominion or control” over it. The second sentence of the statute, which refers to intangible property, directs how to effect the allocation when it involves such property, and provides a method to measure the income produced by such property: it “shall be commensurate with the income attributable to the intangible.”
To make its point, the Court posited the following scenario: suppose that the foreign country imposed no legal restrictions on the payment of royalties among commonly controlled companies. In that case, Corp would have “dominion or control” over the income that its intellectual property produced for Sub. With no barrier to royalty payments, the Court continued, the IRS could reallocate Corp’s income, even if Sub never actually paid any. If the IRS chose to do so, the income attributed to Corp would have to “be commensurate” – that is, equal or proportionate – to “the income attributable to the intangible.” The second sentence of the statute, the Court reiterated, answers the “how-much” question, not the “what-gets-allocated” question that the first [sentence] already answers.[xxiii]
Still, the IRS insisted that, under the regulation, the agency could “take into account the effect of a foreign legal restriction” if it “affected an uncontrolled taxpayer under comparable circumstances.”[xxiv] Whether it did or not depended on several non-statutory criteria, like whether the “restriction was publicly promulgated,” it “expressly prevented the payment or receipt” of the money, and the taxpayer had “exhausted all remedies prescribed by foreign law.”[xxv]
The Court observed that none of these criteria singled out intangible property for “a bright-line always-reallocate” rule. To the contrary, the Court stated, the regulation allowed the IRS to pick and choose its “distribution, apportionment, and allocation battles.”
Finally, the IRS argued that Corp had “dominion or control” because Sub could have paid dividends in lieu of royalties. For support, it pointed to the fact that Sub distributed $64.5 million in dividends to Corp during the year in question. Nothing prevented Sub, the IRS asserted, from paying nearly $24 million more to account for the extra income it received from the use of Corp’s intellectual property.[xxvi]
The Court interpreted the IRS’s argument as suggesting that Corp had a choice: receive the royalties as dividends or have Sub stop using the intellectual property. The Court then pointed out there were some practical problems with the suggestion. “For one thing, dividends and royalties are different, both in form and function. Declaring dividends, which take the form of nondeductible returns on contributed capital, is discretionary. Paying royalties, which are fixed by contract and deductible as business expenses, is not. The power to do one has no bearing on the other.”
The IRS’s argument, the Court continued, “is also breathtaking in its potential reach. Why stop at dividends? If a parent company could force a foreign subsidiary to liquidate to get the royalties it thinks should have been paid, what would prevent the IRS from reallocating” income in those circumstances too? The Court asserted that “Treating income sources as interchangeable,” as proposed by the IRS, “would mean that ‘the tax’ would no longer ‘fall on the party that actually receives the income rather than on the party that cannot.’” In other words, the IRS’s reallocation would distort taxpayers’ “true incomes.”
With that, the Court reversed the Tax Court, and remanded the case to redetermine the taxes owed by Corp.
What If?
The Circuit Court reached the right decision; thus, Corp’s tax liability remained unchanged.
That said, let’s briefly consider what would have followed if the Tax Court’s decision had been upheld. What then?
Well, as we saw earlier, Corp’s income would have been increased by the not insignificant amount of the unpaid, arm’s length royalties owing from Sub.
However, additional adjustment and allocations would also have been considered and implemented. Specifically, an appropriate correlative allocation (in the form of an increased deduction for royalties paid) would have been made with respect to Sub as the member of the Corp controlled group that was affected by the allocation of additional income to Corp. Thus, the IRS would have decreased the income of Sub, and this adjustment would have been reflected in the documentation that Corp’s controlled group maintained for Sub for U.S. tax purposes.
The allocation and adjustment could have had an immediate U.S. tax effect, by changing the computation of the taxable income of Sub’s shareholder – i.e., Corp – under the provisions of subpart F of the Code.[xxvii]
In addition to the above correlative adjustment, appropriate adjustments would also have been made to conform the controlled taxpayers’ accounts to reflect the above allocations. For example, in order to reconcile Corp’s and Sub’s cash balances with the allocation for tax purposes of income from Corp to Sub, Corp may be treated as having made a capital contribution to Sub.
Alternatively, Corp may have been able to establish an interest-bearing account receivable from Sub, as the controlled corporation from which the allocation was made to Corp.[xxviii]
It doesn’t take an expert to see how convoluted a controlled group’s U.S. tax situation can get when members of the group transact with each other at other than arm’s length.
Sign up to receive my blog at www.TaxSlaw.com.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] There are several judicially created doctrines IRS may use in performing its enforcement function, including the economic substance, step transaction, and substance over form doctrines.
[ii] IRC Sec. 482.
[iii] Whether or not incorporated, and whether or not organized in the U.S.
[iv] IRC Sec. 482.
[v] In general, it is much more likely that controlled taxpayers will cooperate to achieve an improper tax outcome.
[vi] Thus, for example, control may result from the actions of two or more taxpayers acting in concert or with a common goal or purpose.
[vii] By definition, wouldn’t any transaction with an unrelated person should be conducted at arm’s length? Think back on the definition of fair market value: the price that a service or a property would sell for on the open market. It is the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts.
[viii] “Transaction” means any sale, assignment, lease, license, loan, advance, contribution, or any other transfer of any interest in or a right to use any property (whether tangible or intangible, real or personal) or money, however such transaction is effected, and whether or not the terms of such transaction are formally documented. It also includes the performance of any services for the benefit of, or on behalf of, another taxpayer.
[ix] 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.
The regulations promulgated under IRC Sec. 482 provide specific methods to be used to evaluate whether or not transactions between or among members of the controlled group satisfy the arm’s length standard, and if they do not, to determine the arm’s length result. Reg. Sec. 1.482-1(b)(2).
[x] The method or methods most appropriate to the calculation of arm’s length results for controlled transactions must be selected, and different methods may be applied to interrelated transactions if such transactions are most reliably evaluated on a separate basis.
The arm’s length result of a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable measure of an arm’s length result.
When the IRS makes an allocation under IRC Sec. 482, appropriate correlative allocations will also be made with respect to any other member of the group affected by the allocation. For example, if the IRS makes an allocation of income, the agency will not only increase the income of one member of the group but correspondingly decrease the income of the other member.
[xi] 3M Company v. Comm’r, No. 23-3772 (— F.4th —-, 2025).
[xii] No similar prohibition applied to unrelated companies.
[xiii] Reg. Sec. 1.482-1(h)(2).
[xiv] Corp also argued that the IRS did not follow the Administrative Procedure Act (“APA”) when it adopted the blocked-income regulation – Reg. Sec. 1.482-1(h)(2) – that purportedly authorized it to do so.
[xv] According to the IRS’s blocked income regulations, foreign legal restrictions will be considered only if, and so long as, the following conditions are met:
(A) The restrictions are publicly promulgated, generally applicable to all similarly situated persons (both controlled and uncontrolled), and not imposed as part of a commercial transaction between the taxpayer and the foreign sovereign;
(B) The taxpayer (or other member of the controlled group with respect to which the restrictions apply) has exhausted all remedies prescribed by foreign law or practice for obtaining a waiver of such restrictions (other than remedies that would have a negligible prospect of success if pursued);
(C) The restrictions expressly prevented the payment or receipt, in any form, of part or all of the arm’s length amount that would otherwise be required under IRC Sec. 482; and
(D) The related parties subject to the restriction did not engage in any arrangement with controlled or uncontrolled parties that had the effect of circumventing the restriction and have not otherwise violated the restriction in any material respect.
[xvi] Reg. Sec. 1.482-1(h)(2).
[xvii] According to the Tax Court, the parties stipulated there was no evidence that these legal restrictions affected “an uncontrolled taxpayer under comparable circumstances for a comparable period of time” within the meaning of the regulation. In any case, Corp did not elect the deferred income method described in Reg. Sec. 1.482-1(h)(2)(iv).
[xviii] 160 T.C. No. 3 (2023).
[xix] Citing the Supreme Court’s decision in Loper Bright Enterprises v. Raimondo, 603 U.S. 369, 400 (2024).
[xx] The relevant statutory language – IRC Sec. 482 – provides as follows:
In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses. In the case of any transfer (or license) of intangible property …, the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.
[xxi] Reg. Sec. 1.482-1(b)(1). However, the Court noted, “The problem, of course, is that reallocation can also be arbitrary because it answers a hypothetical question: what would two unrelated and independent entities have done?”
[xxii] According to the Court, if dominion or control is the dividing line for purposes of applying the reallocation rule with respect to income, and if income attribution requires the taxpayer to be an entity that “could have received” such income, then the source of the restriction on payment – be it domestic or foreign (as in the present case) – was irrelevant. A foreign restriction can deprive a U.S. company of control over potential income just as effectively as a federal one.
[xxiii] The Court noted that, for the IRS, it was of no help in reallocating royalties that foreign law blocked Sub from paying.
[xxiv] Reg. Sec. 1.482-1(h)(2).
[xxv] Reg. Sec. 1.482-1(h)(2)(ii)(A)–(C).
[xxvi] The Court “firmly” disagreed with any suggestion by the IRS that Corp had a duty to “purposely evade” the foreign law.
[xxvii] Let’s ignore the high-tax exception for now. IRC Sec. 954(b)(4).
[xxviii] Rev. Proc. 99-32.