Some folks may consider this a case about tax havens, others about how companies manipulate expenses between domestic and overseas operations. Either way, it’s a big win for the IRS.
We have to go back a little way. It seems the Tax Court (you know, one of those administrative entities that ends up deciding most of the cases in the US- faster than the courts do) rendered a decision in favor of Altera Corporation (now a subsidiary of Intel). Altera wasn’t happy with the way the IRS ruled on its expense allocations between US and foreign operations. So, they fought the IRS in Tax Court. And, the Court’s decision, 145 TC, Number 3, way back in 2015, basically invalidated Section 482 (of the tax code). Under 26CFR Section 1.482-7A(d)(2), related entities were required to share the costs of employee stock compensation (to render the arranged as qualified cost-sharing). The 15 judge panel sided with Altera that the IRS regulations were arbitrary and capricious.
Somehow, the IRS appealed to the 9th Circuit of the US. That court ruled that the IRS was neither arbitrary nor capricious and was in total compliance with the Administrative Procedure Act. Which means the IRS’ decisions are the law of the land in this case. Basically, the “arm’s length standard”, whereby internal corporate transactions must be analyzed in comparison to what independent (as opposed to wholly-owned subsidiaries) would make is the standard.
Here’s the crux of the issue. Independent companies never would consider any stock-based compensation as a cost-sharing item among two firms. So, that means that there is no “comparable” independent deals with which to compare the concept- so the IRS was free to develop its own rational split of the costs, relative to the income generated.
(We also must consider that the most “flagrant” cases that apply under Section 482 are stock-based compensation splits and the fairy-tale that intellectual property is that of the overseas subsidiary. This is how Intel and Apple have avoided their true income tax liability for decades. They are not alone- this is the tax dodge used by most technology and pharmaceutical houses- those firms that rely heavily on patent rights.
It’s also what I’ve been complaining about for decades. [Here’s but one example using Apple.] Firms claim they pay XYZ in federal income tax to their stockholders, and lower the dividend payments they make to accommodate the cash needs of these “tax payments”. But, you see these are “provisions for income taxes”- that amount doesn’t reflect how the firms manipulate their REAL books (the ones they don’t share with stockholders) to appropriate intellectual property and stock-based compensation. Then, that “tax benefit” is accounted for as a “contribution to capital”.)
It is true that US companies are allowed to shift profits to an “offshore” subsidiary to avoid taxes. They are also allowed to identify and shift the costs between such entities. But, the IRS regulations stipulate that more of the costs must be transferred to the subsidiary, and, therefore, wouldn’t be deducted under US law. This concept is called “transfer pricing”- and the IRS rarely won cases in such matters.
(Until the new tax law was enacted last year, the goal of every US company with overseas subsidiaries was to shift as much of its profits overseas and secure as many of the deductions domestically, to ensure that their taxes- which could be as high as 35% [but never were]- would be minimal. The new law, which stipulates a maximum corporate rate of 21%, provides a 13.125% rate on foreign income from goods and services using patents and other technology.)
Oh, yeah. Just like the IRS appealed the Tax Court decision, it’s possible that the US Chamber of Commerce – or Intel alone- may elect to appeal to the Supreme Court. (Amazon had filed an amicus brief to the 9th Circuit, in support of the Tax Court position.)
But, for now, the IRS interpretation is the law of the land.
