In January, the IRS issued a generic legal advice memo on periodic adjustments and the arm’s length standard. Although the “GLAM” states that it merely “clarifies” and “updates” a prior memo, it contains insights into the IRS’s aggressive thinking on this topic. And the very fact that the IRS issued the memo now suggests that disputes over periodic adjustments are heating up in audits and litigation.
Background. The new memo “addresses the relationship” between “the general arm’s length standard” and “the specific periodic adjustments rules” in the section 482 regulations. Since 1986, the second sentence of section 482 has required the income from the transfer of intangible property to “be commensurate with the income attributable to the intangible.” The agency takes the position that this statutory language authorizes the IRS (and only the IRS) to adjust the income of a transferor of IP based on the actual income earned by the transferee. The agency views these “periodic adjustments” as a necessary palliative when considering IP with a high—but uncertain—profit potential.
Legal & Practical Insights. Even though the memo does not seem at first blush to contain much new information—which is perhaps why it has attracted little press coverage—it does reveal several insights into the IRS’s current thinking on this topic.
Ex Post Information. If the IRS considers after-the-fact profit information, must it do so to determine what profits the taxpayer should have projected at the time it transferred the IP—i.e., as a means to an end of an analysis that is still theoretically ex ante in nature? Or does the “commensurate with the income” language in section 482 authorize the IRS to treat after-the-fact profit information as determinative in its own right? These questions have long been the subject of debate, and the new GLAM seems to argue for an interpretation closer to the latter view. In the prior memo from 2007, the IRS characterized periodic adjustments as a means of using ex post results as presumptive evidence of what should have been projected ex ante. In footnote 9, the GLAM acknowledges the view taken in the 2007 memo but “clarifies that, as a matter of the IRS’s authority, when no enumerated exception applies, the arm’s length price determined by the periodic adjustment rules is not merely presumptive evidence but is determinative.” The GLAM further states that the commensurate with income standard authorizes the IRS to determine arm’s length results “by reference to ex-post information rather than ex-ante information, except insofar as ex-ante information is relevant to the limited exceptions in those provisions.” This in turn could be read to suggest that the IRS now believes an ex post approach is an arm’s length approach in its own right—part of what the GLAM calls a “capacious” arm’s length standard.
Untethered Periodic Adjustments. Based on a debatable construction of regulatory language, the GLAM concludes that Treas. Reg. § 1.482-4(a) and Treas. Reg. § 1.482-4(f)(2) show that periodic adjustments are afforded special treatment. Id. In particular, the GLAM concludes that the statement in Treas. Reg. § 1.482-4(f)(2) that “[a]djustments made pursuant to this paragraph (f)(2) shall be consistent with the arm’s length standard and the provisions of § 1.482-1,” is not an additional hurdle that periodic adjustments must satisfy. Instead, it is an announcement that all periodic adjustments made pursuant to Treas. Reg. § 1.482-4(f)(2) are inherently consistent with the arm’s length standard, the best method rule, and all other provisions of Treas. Reg. § 1.482-1. Id.
Relationship to OECD Transfer Pricing Guidelines. The GLAM indicates that the IRS is actively thinking about the relationship between the periodic-adjustment regime and the OECD’s analogous hard to value intangibles (“HTVI”) guidance that was introduced into the OECD Transfer Pricing Guidelines in 2018. In footnote 13, the GLAM discusses the IRS’s view that the regulations’ exception for results that are not reasonably anticipated is consistent with an analogous exception in the HTVI guidance. And, in footnote 45, the IRS acknowledges that in the competent authority process, negotiations should take into account both the periodic adjustment rules and the HTVI guidance, and the footnote reaffirms the IRS’s view that the periodic adjustment rules “are consistent with the principles of the U.S.’s treaty obligations.” But the GLAM does not fully come to terms with potential big-picture differences in scope between the periodic adjustment rules and HTVI, the latter of which is expressly limited to “hard to value intangibles” for which (i) there are no reliable comparables and (ii) either the projections or valuation assumptions are highly uncertain at the time of the transactions. OECD Transfer Pricing Guidelines, ¶6.189 (2022) (cited without detailed discussion in footnote 45 of the GLAM). Given this limited scope, it is unclear whether the facts of the two examples that the IRS considers in the GLAM—one of which involved the comparable uncontrolled transaction (“CUT”) method and the second of which involved an income method based on ex ante projections—would fall within the HTVI guidance at all.
Practical Insight: The IRS seems to think it should be making periodic adjustments more than it has in the past. In the prior memo from 2007, the IRS suggested that it would “exercise restraint in making periodic adjustments” and would “decline to make a periodic adjustment” when the taxpayer used a “conscientious upfront valuation.” But language about restraint is notably absent in the GLAM, which, as noted, indicates that periodic adjustments are “determinative” and supersede other generally applicable guidance. On this more practical point, the GLAM itself is anecdotal evidence that the IRS is already considering more periodic adjustments at the audit level. The IRS released the GLAM as “generic legal advice.” According to prior IRS guidance, generic legal advice “should rarely be needed on an issue that is not yet under examination by the Service.” Indeed, the IRS’s current internal manual counsels that these types of memos are useful “where a common set of material facts applies to a significant number of taxpayers.” Taxpayers in IP-heavy industries would be well advised to brush up on the periodic adjustment rules in the section 482 regulations.
Parting Thoughts. Interpreting IRS legal memos like this GLAM has always been somewhat an exercise in Kremlinology: Important signals are often hiding in plain sight. Although the agency’s internal guidance says that “this type of legal advice does not set out official rulings or positions of the Service and may not be referenced in other documents as precedent,” taxpayers do look to it for guidance on the IRS’s thinking, which is why this advice “is intended to be released to the public in its entirety.” Given the longstanding debate over the proper interpretation of the “commensurate with the income” language in section 482, the agency should consider whether this kind of informal policymaking through generic internal advice is really the best way to address this issue. In any event, taxpayers can reduce the risk of aggressive assertions of periodic adjustments through robust ex ante valuations and contemporaneous documentation, which despite the GLAM’s new emphasis on after-the-fact results, will likely still provide the best line of defense. Some additional risk mitigation measures that taxpayers could consider would be to document the applicability of exceptions to the periodic adjustment rules, conduct a risk assessment under the OECD’s HTVI guidance (which applies in the competent authority context), and consider advance pricing agreements for IP-related transactions in appropriate cases.