IRS Not Required, as a Matter of Law, to Adjust Each Subsidiary's Income or Break Down Adjustment in Detail in Making §482 Adjustment

The question of how much detail the IRS must provide in making an adjustment under IRC §482 was the issue decided by the Tax Court in the case of Guidant, LLC v. Commissioner, 146 TC No. 5.

IRC §482 is meant to deal with cases where taxpayers may be tempted to use transactions between related entities to manipulate a tax result by having the transactions take place under terms that are markedly different than would result from a true arms-length transaction between unrelated parties.

The section is relatively short, providing:

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 (within the meaning of section 936(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.

In the case at hand a group of U.S. corporations filing a consolidated return entered into various transactions with foreign affiliates.  The IRS sought to adjust the prices at which items were transferred in these transactions under IRC §482.

The IRS did not determine the effect on each subsidiary, instead determining adjustments only to consolidated taxable income, making all adjustments to the group’s parent.  As well, the IRS did not determine how much of the adjustment related to tangibles, intangibles and services, again simply arriving at an adjustment amount.

The taxpayer complained that this lack of specificity meant that the adjustments were arbitrary, capricious and unreasonable as a matter of law because the IRS “did not determine the "true separate taxable income" of each controlled taxpayer within the meaning of sec. 1.482-1(f)(1)(iv), Income Tax Regs.” and the IRS “did not make specific adjustments with respect to each transaction involving an intangible, a purchase and sale of property, or a provision of services.”

It is important to note that the taxpayer was arguing at this point that the case could be ended without looking any further at the IRS’s adjustments—that any IRS adjustments under IRC §482 that failed to give these details would automatically be deficient.  Unfortunately for the taxpayer, the Tax Court did not agree.

The taxpayers made two arguments.  As the Court summarized the first:

As petitioners see it, section 482 and the applicable regulations require that the Commissioner, contemporaneously with making a section 482 adjustment in the setting of a consolidated return, determine the “true separate taxable income” (within the meaning of section 1.482-1(f)(1)(iv), Income Tax Regs.) of each controlled taxpayer joining in that return. Petitioners note that respondent applied his section 482 adjustments solely to Guidant Corp. and observe that Guidant Corp. did not participate in most of the adjusted transactions. Respondent agrees that Guidant Corp. did not participate in most of the adjusted transactions but counters that the Commissioner need not determine each controlled taxpayer’s true STI whenever the Commissioner makes a section 482 adjustment in the setting of a consolidated return. Respondent asserts that, in such a setting, the Commissioner must determine the affiliated group’s true CTI and that the Commissioner will determine each controlled taxpayer’s true STI only to the extent that doing so will not interfere with the Commissioner’s reliably determining taxable income from the controlled transactions underlying the section 482 adjustments.

With regard to this argument, the Court found that the key issue is whether a proper consolidated taxable income (CTI) is produced, with separate taxable income (STI) being calculated only if necessary to obtain a proper CTI.  The Court reasoned:

Bearing the principles of the consolidated return regime in mind, we read section 1.482-1(f)(1)(iv), Income Tax Regs., to require the Commissioner to determine both CTI and STI when making a section 482 adjustment with respect to income reported on a consolidated return, but also giving the Commissioner a certain latitude to decide when the determination of STI becomes necessary. The primary objective of section 482, as we discern from our reading of that section, is to prevent a distortion of income or an evasion of tax on account of controlled transactions that distort the taxable base. As we see it, the Commissioner’s main responsibility under the regulation, when read in the light of the statute to which it relates, is to make sure that the section 482 adjustments serve the purposes of the consolidated return regime discussed above, i.e., reflect the consolidated group’s true net income clearly and prevent an avoidance of such tax liability. See Atl. City Elec. Co. v. Commissioner, 288 U.S. at 154; Gen. Motors Corp. v. Commissioner, 112 T.C. at 303.

Note that the Court did not find, in this case, that the IRS’s positon was reasonable, merely that it could be and that this was a matter to be decided at trial, and thus was not suitable for summary judgment.

The second objection the taxpayers had, and which they argued rendered the IRS’s adjustments invalid as a matter of law, was summarized by the Court as follows:

Petitioners argue secondarily that respondent abused his discretion because he failed to make a section 482 adjustment with respect to each transaction involving an intangibles license, a purchase and sale of tangible property, or a provision of services. Instead, petitioners assert, respondent’s adjustments were inappropriately made through a combined groupwide analysis on the basis of multiple types of controlled transactions among multiple corporations. Respondent counters as to petitioners’ secondary argument that the Commissioner may aggregate transactions of different types for purposes of effecting a reliable section 482 adjustment.

The Court also declined to find that this automatically rendered the IRS adjustment invalid.  The opinion continues:

We disagree. The regulations let the Commissioner aggregate separate transactions involving tangibles, intangibles, or services when doing so provides the best means of determining the true taxable income of a controlled taxpayer. See, e.g., sec. 1.482-1(b)(2)(ii), (f)(2)(i), Income Tax Regs. While it is true that section 1.482-1(b)(2)(ii), Income Tax Regs., indicates generally that an arm’s-length result may be calculated by separately applying one or more methods in the case of interrelated transactions, e.g., ones involving services and the transfer of property, the section then goes on by way of a reference to section 1.482-1(f)(2)(i), Income Tax Regs., to clarify that an aggregation of these transactions may sometimes be more appropriate.