Lessons in Avoiding Transfer Pricing Penalties: DHL Corp.
Advance preparation is the key to avoiding stiff transfer pricing penalties.
In 1990, Congress increased the penalties levied on underpayments of tax that are attributable to large transfer-pricing adjustments from 20% to 40%.(1) In a recent memorandum decision, which considered challenges by the Internal Revenue Service (the "Service") to the transfer- pricing positions taken by a major courier and package delivery business, the Tax Court upheld the Service's imposition of these penalties for the first time.(2) As commentators anticipated,(3) the reasonableness of the taxpayer's transfer-pricing positions, as well as the reasonableness of the taxpayer's reliance on contemporaneous third-party support for those positions, figured prominently in the decision. The taxable years involved in this case were 1990 through 1992; thus, underpayments occurring in any of those years would have been subject to the new, higher penalties.
The worldwide courier and package delivery business of the DHL network, which had originally been operated by DHL Corporation ("DHL"), a California corporation, was split along geographic lines in the early 1970's to comply with certification requirements of the U.S. Civil Aeronautics Board. Following the split, DHL continued to operate the U.S. courier and package delivery business, while the foreign business was operated by Document Handling Limited, International ("DHLI"), a Hong Kong sister corporation of DHL.(4)
Under the restructured arrangement, DHL serviced (1) shipments wholly within the United States, (2) the U.S. portion of inbound and outbound shipments (i.e., shipments originating in a foreign country and bound for the United States, and shipments originating in the United States and bound for a foreign destination), and (3) transfer shipments (i.e., shipments from one foreign location to another foreign location that passed through the United States). For its part, DHLI serviced (1) shipments between two foreign locations and (2) the foreign portion of inbound and outbound shipments (i.e., shipments originating in the United States and bound for a foreign destination, and shipments originating in a foreign country and bound for the United States).
Until 1987, the entity to whom a customer submitted a package collected, and generally retained, the entire fee -- even if the other entity actually delivered the package. Thus, neither DHL nor DHLI was compensated for the services it performed for the other on inbound and outbound shipments, and DHL was not compensated for servicing transfer shipments for DHLI. Beginning in 1987, however, DHL and DHLI implemented an imbalance-fee system similar to that commonly used by the postal authorities, and DHLI began to pay DHL a transfer fee to compensate it for the services it performed in connection with transfer shipments. The imbalance fee was determined by netting inbound and outbound shipments and applying a cost-plus-2% formula to the difference. The transfer fee also was determined on the basis of cost plus 2%.(5) This formula for calculating the imbalance and transfer fees remained the same throughout the taxable years at issue.
Despite the geographic division of DHL's business to accommodate the certification requirements of the U.S. Civil Aeronautics Board, the Tax Court found that the "worldwide air express service operated by DHL and DHLI was generally represented as, and perceived to be, a single worldwide delivery system."(6) In this regard, the entire DHL network used the same DHL trademark, which DHL had registered in the United States in 1977, but had licensed to DHLI on a royalty-free basis since 1974.(7)
In the mid-1980's, DHL attempted to expand its presence in the U.S. overnight delivery market. This attempt was unsuccessful, and DHL consequently suffered losses from 1983 through 1988. In 1986, DHL retained Bain & Co., Inc. ("Bain") to advise it on how to return its business to profitability. As a result of recommendations made by Bain, DHL changed its business strategy and began looking for a merger candidate.
Following a failed attempt to merge with UPS, DHL and DHLI began negotiations with a group of foreign investors that included Japan Air Lines, Nissho Iwai, and Lufthansa. In 1990, the foreign investors acquired a 2.5% interest in DHL, a 12.5% interest in DHLI, and an option to purchase an additional 45% interest in DHLI. This option was exercised in 1992, and it brought the new investors' collective ownership of DHLI to 57.5%.
As a part of the negotiated transactions, DHL also granted DHLI an option in 1990 to purchase the DHL trademark. Upon the sale of the trademark, DHL was to retain the right to use the mark without the payment of royalties for a period of 15 years; after the expiration of the royalty-free period, DHL was to pay a royalty of .75% of gross sales for its use of the mark. DHLI's option to purchase the trademark was exercisable only after the foreign investors exercised their option to acquire the additional 45% interest in DHLI. In fact, one month after the foreign investors exercised their option, DHLI exercised its option to purchase the DHL trademark.
During the protracted negotiations, the foreign investors initially agreed to place a value of $50 million(8) on the trademark as a means of infusing capital into DHL. The agreed value of the trademark was later reduced to $20 million, however, for "tax and other purposes."(9) After an agreement was reached on the value to be placed on the trademark, Bain was retained to value the trademark, and ultimately provided a comfort letter confirming the $20 million valuation. A draft letter indicating Bain's ability to "provide some comfort on the [valuation] issue"(10) was furnished only two days after Bain began its analysis of the trademark's value.
Section 482 of the Code grants the Service broad authority to "allocate income among commonly controlled corporations to prevent the artificial shifting of net incomes of controlled taxpayers and to place them on a parity with uncontrolled, unrelated taxpayers."(11) The Tax Court determined that, for the purposes of Section 482, DHL and DHLI were under common control during the taxable years at issue (1990 through 1992), despite the creeping acquisition by the foreign investors that resulted in their obtaining a controlling (57.5%) interest in DHLI. After confirming the existence of common control, the court considered the propriety of the pricing adjustments proposed by the Service to (1) the value of the DHL trademark,(12) (2) the royalty-free license of the DHL trademark to DHLI, and (3) the imbalance and transfer fees.(13)
Valuation of the DHL Trademark
With respect to the value of the DHL trademark, DHL contended that the $20 million value set in connection with the acquisition by the foreign investors (and confirmed by Bain) was determinative, but that, in any event, the $50 million value originally placed on the trademark by the foreign investors represented a maximum value. The Service contended, however, that the trademark had a value of $300 million. After reviewing expert testimony proffered by DHL and by the Service, the court ultimately determined that the value of the trademark was $100 million.(14)
In valuing the trademark, the court rejected DHL's contention that, for the purposes of the section 482 regulations, DHLI was the "developer" of the DHL trademark outside the United States and that, therefore, the value of that portion of the trademark should not be allocated to DHL under Section 482. Under the Section 482 regulations (as in effect during the taxable years at issue), the identity of the developer of a trademark was determined not on the basis of legal ownership of the trademark, but on the basis of which member of the group bore the largest share of the direct and indirect costs of development, as well as the risks associated with development.(15) DHL thus argued that DHLI was the developer of the trademark outside the United States because it "spent substantially more on advertising than DHL."(16) For example, from 1982 through 1992, DHL spent approximately $150 million on advertising, publicity, and promotion within the United States, while DHLI spent approximately $380 million on advertising, publicity, and promotion outside the United States. The court rejected this argument on the ground that DHL had not carried its burden of showing that DHLI was the developer of the trademark outside the United States, because DHL had not shown that "DHLI expended any more than an arm's-length amount in connection with a licensee's use, development, enhancement, or maintenance of the trademark."(17)
The court also rejected the Service's application of the so-called Alstores doctrine to the valuation of the DHL trademark. In Alstores,(18) the court determined that a rent-free lease of property back to the seller constituted additional consideration for the sale of the property, where the property had initially been offered for sale at $1 million but was ultimately sold for $750,000 plus the rent-free leaseback. The court rejected the application of Alstores to the valuation of the DHL trademark on the ground that a Section 482 adjustment had been made to DHL's income to reflect the full fair market value of the trademark and, therefore, "the factual predicate for additional value [did] not exist."(19)
During the pre-option-exercise period, DHLI had a royalty-free licence of the DHL trademark.(20) The court determined that a royalty would have been charged during those years between unrelated parties for the use of the DHL trademark at a rate of .75%. Note that the royalty rate that the court found appropriate was exactly the same as the rate set by DHL, DHLI, and the foreign investors to be paid by DHL after the expiration of the royalty-free 15-year period following DHLI's purchase of the trademark.
Imbalance and Transfer Fees
With respect to the imbalance and transfer fees, the court found that the manner in which these fees were calculated generally was proper because it was patterned "after that used in the postal community."(21) Nevertheless, the court found that the amount of the markup used by DHL and DHLI was insufficient, and that an arm's-length markup would be 4%, not 2%.(22)
DHL's Conduct During the Litigation
DHL's conduct throughout the Tax Court discovery and litigation process seemed to colour the court's view, and clearly affected certain portions of its decision. In fact, at one point, the court observed that
throughout the pretrial and trial portions of these cases, the parties were contentious and intractable... . [The Service's] third-party summonses seeking information about [DHL] remained in litigation in other courts. In the proceedings before this Court, the parties' representatives gave no ground on any point, causing, in some instances, the unnecessary protraction of the trial and parts of the pretrial portion of these cases... . The production of documents and responses to interrogatories by [DHL] lingered beyond the commencement of the trial and necessitated certain procedural adjustments to accommodate generally dilatory compliance by [DHL] and the untimely receipt of information by [the Service].(23)
The Tax Court imposed accuracy-related penalties on some, but not all, of the foregoing transfer-pricing adjustments.
Valuation of DHL Trademark
The court upheld the Service's assertion of the 40% penalty on the adjustment to the value of the DHL trademark on the ground that the price set by DHL constituted a "gross valuation misstatement." In the context of a transfer-pricing adjustment, a gross valuation misstatement occurs when the price charged for property is 400% or more, or 25% or less, than the amount determined under Section 482 to be the correct amount.(24) As discussed above, DHL had taken the position in its return that the trademark had a value of $20 million, while the court found that the appropriate value under Section 482 was $100 million. Since the price set by DHL was only 20% of the price set by the court, DHL clearly met the 25% or less standard for a gross valuation misstatement.
The only means DHL had to avoid imposition of the penalty was a showing that it (1) had reasonable cause for the underpayment of tax and (2) had acted in good faith.(25) To show that it had reasonable cause and had acted in good faith, DHL argued that it had reasonably relied on the $20 million appraisal provided by Bain, especially given Bain's background in working with DHL in the past and its expertise in performing appraisals.
The court rejected this argument for a number of reasons. First, the court found that DHL, DHLI, and the foreign investors had not respected the value of individual assets during their negotiations, but instead had worked to fix the value of the trademark "within the context of a fixed offer price from the foreign investors."(26) In this regard, the foreign investors had initially placed a $50 million value on the trademark, not because they believed that figure to be the actual fair market value of the trademark, but rather as a means of infusing capital into DHL. DHL's representative later reduced the value of the trademark to $20 million for "tax and other purposes."(27) The court also noted that the shareholders of DHL had at one point made a counteroffer of $100 million for the trademark. The court then concluded its summary of the pertinent facts by stating that, "[after all of that maneuvering, Bain was given the job of valuing the trademark and supported the $20 million figure."(28) The court further mentioned that, although the Bain appraisal was in the record and DHL offered the testimony of other experts to support the appraisal, Bain itself was not offered as an expert at trial to testify in support of its appraisal.
In light of these facts, the court held that DHL had not reasonably relied on the Bain appraisal in valuing the trademark. The court found it "difficult to believe that Bain independently reached the same $20 million figure as the parties and/or their representative had already devised,"(29) and expressed its dismay at the fact that "parties can find experts who will advance and support values that favor the position of the person or entity that hired them."(30)
In obiter, the court gave the following advice to taxpayers wishing to rely on appraisals in transfer-pricing cases:
If the parties to the transaction had given the valuation to an independent valuation entity before any values being placed on the trademark by the parties and/or not advised the evaluator of a value, it might have been reasonable for [the taxpayer] to rely on such an appraisal.(31)
The court also imposed a 20% penalty on the failure of DHLI to pay DHL a royalty for the use of the trademark while it was owned by DHL. The ground for imposing this penalty remains unclear. In its discussion of the accuracy-related penalty, the court mentioned both negligence and substantial understatement of tax as possible grounds, but did not specify which ground(s) applied. The court refused to excuse imposition of the 20% penalty on the basis of the reasonable cause exception, described above, because it found that DHL's "royalty-free reporting position was not reasonable."(32)
Imbalance and Transfer Fees
The court declined to impose any penalty on the adjustment to the imbalance and transfer fees, because DHL had used "an arm's-length approach in computing the amounts paid for those items."(33) The court also noted that "the only difference between [DHL's] reporting position and [the Service's] trial position [was] the 2% differential in the markup, which represented a relatively small difference."(34)
The Tax Court's decision in DHL Corp. provides taxpayers with some common sense guidance on avoiding transfer-pricing penalties.
First, to the extent that a taxpayer can demonstrate that it relied on an arm's-length standard used by unrelated persons in the same or a similar industry, no penalty should be imposed on a transfer-pricing adjustment if the taxpayer simply erred somewhat in setting the exact price, because the method for setting the price was reasonable. Of course, this may not conform to the requirements of the Section 6662 regulations, which were promulgated in 1996 (well after the taxable years at issue in this case), and which require an effort to use the "best method" for pricing intercompany transactions.(35)
Second, to the extent that a taxpayer wishes to rely on a contemporaneous appraisal in establishing the value of property sold by one affiliate to another, the taxpayer should retain a completely independent appraiser, and should rely on that appraiser to set the fair market value of the property. The taxpayer should avoid any appearance of collusion or impropriety by not retaining its regular accounting firm or an appraisal firm with which it has a long history of dealings, and the taxpayer should not determine a value itself and then seek out an appraiser to confirm that value. If the taxpayer has, for some reason, already placed a value on the property, great pains should be taken to ensure (and document) that the independent appraiser had not been informed of that value before completing its appraisal report.
Finally, a taxpayer involved in a transfer-pricing case (or any other case, for that matter) should temper its conduct before the court with a large dose of restraint, or risk having the court perceive it as "contentious and intractable."(36) As was well demonstrated in DHL Corp., these qualities serve only to antagonize the court, and have the potential adversely to affect the court's decision.
A taxpayer involved in a transfer-pricing audit that follows the advice of the court in DHL Corp. should find itself in a significantly better position than DHL did when it comes time to defend itself against stiff transfer-pricing penalties, which, as DHL found, can reach 40%, even before the imposition of interest.(37)
1. A 20% accuracy-related penalty is imposed on the portion of an underpayment of income tax that is attributable to one or more of the following: (1) negligence or disregard of rules or regulations, (2) a substantial understatement of tax, or (3) a substantial valuation misstatement (which includes certain transfer-pricing adjustments). Search7RH 6662(b). If a substantial valuation misstatement exceeds certain thresholds (described in the text below), the substantial valuation misstatement is transformed into a gross valuation misstatement, and the amount of the accuracy-related penalty is correspondingly increased from 20% to 40%. Search7RH 6662(h).
2. 76 T.C.M. 1122 (1998).
3. See, for example, Sandra K. Miller, "Penalty for Valuation Misstatements May Apply to Transfer Pricing" (May/June 1992), 3 The Journal of International Taxation 25-29; and Mike McIntyre, "Good Faith, Reasonable Cause, and the U.S. Penalty for Transfer Pricing Abuses" 3 Tax Notes International 493-97.
4. The case did not address, nor was it concerned with, the tax consequences of this split.
5. These 2 percent markups were not applied in 1987, but were applied in 1988 and each subsequent year.
6. Supra footnote 2, at 1126.
7. DHL raised an issue concerning the ownership of the DHL trademark, because DHLI had, contrary to the direction of DHL and its general counsel, registered the trademark in the name of DHLI in a number of countries (other than the United States) beginning in 1983.
8. All dollar amounts are in U.S. dollars.
9. Supra footnote 2 at 1169.
10. Ibid., at 1137.
11. Ibid., at 1142
12. The court disregarded the fact that the foreign investors had acquired a controlling interest in DHLI prior to its exercise of the option to purchase the DHL trademark, on the grounds that (1) the option was granted at the time that the requisite control existed and (2) the acquisition by the foreign investors of a controlling interest in DHLI was part of a preconceived plan of which the granting of the option to purchase the trademark was part.
13. The court also considered, and rejected, the Service's attempt to allocate to DHL a portion of the fees paid to DHLI by the local operating companies and independent agents that DHLI had established or hired to perform services in foreign countries.
14. The value of the trademark was actually set at $150 million, but was reduced by the court to $100 million to reflect certain questions concerning the ownership of the trademark. See footnote 7, supra.
15. Treas. Reg. Search7RH 1.482-2A(d)(1)(ii)(c). The current Section 482 regulations are configured somewhat differently than the former regulations. See Treas. Reg. Search7RH 1.482-4(f)(3).
16. Supra footnote 2, at 1158.
17. Ibid., at 1159. This concept appears in the current Section 482 regulations. See Treas. Reg. Search7RHSearch7RH 1.482-4(f)(3)(iii) & (iv), Exs. 2 & 3 (the so-called cheese examples).
18. Alstores Realty Corp. v. Commissioner, 46 T.C. 363 (1966), acq., 1967-2 C.B. 1.
19. Supra footnote 2, at 1160. If the full fair market value was determined without regard to the below-market (that is, royalty-free) use of the trademark for 15 years, query whether DHL would have been entitled to deductions in future years if DHL and DHLI had remained commonly controlled. Furthermore, if, as discussed in the text below, a 0.75% royalty rate was the arm's-length rate, query whether the royalty-free period did not affect the purchase price.
20. DHLI did not purchase the DHL trademark until September 1992, which was near the very end of the taxable years at issue; thus, the royalty-free licence discussed in the text above is the licence from DHL to DHLI that existed from 1974 until September 1992 (when DHLI exercised its purchase option).
21. Supra footnote 2, at 1163.
22. The court also applied the imbalance and transfer fees, with the 4% markup that it deemed to be arm's length, to taxable years prior to the taxable years at issue (1990-1992) in order to adjust the net operating losses that had been incurred in those years because those losses had been carried forward to the taxable years at issue.
23. Supra footnote 2, at 1143.
24. Sections 6662(e)(1)(B)(i) and 6662(h).
25. Section 6664(c).
26. Supra footnote 2, at 1169.
29. Ibid., at 1169, footnote 29.
30. Ibid., at 1169.
32. Ibid., at 1170.
34. Ibid. Depending on the focus, this could be less than a 2% adjustment (to the total price) or a 100% adjustment (to the profit element).
35. See Treas. Reg. Search7RH 1.6662-6(d)(2)(ii).
36. Supra footnote 2, at 1143.
37. Interest runs not only on the additional tax, but also on the penalties and interest. See sections 6622 and 6665(a)(2).