Commensurate With Income: IRS Nonenforcement Has Cost $1 Trillion

Abstract

This paper summarizes and updates research that began in 2020 and was subsequently published in the online tax journal Tax Notes, comprising studies of the compliance posture of six major U.S. corporations with the “Commensurate with Income” (CWI) statute of the U.S. tax code. This law, enacted by Congress in 1986, applies to transfers of intellectual property (IP) by U.S. corporations to their foreign affiliates and allows the IRS to make “periodic adjustments” that increase U.S. income in years after the transfer. These “periodic adjustments” can be triggered because the original transfer price was too low or because the income recorded by the foreign transferee in years following the transfer was too high.

The CWI statute was implemented into the cost sharing regulations via a “periodic adjustments” mechanism in 2009, which allows the IRS to increase the U.S. taxable income of the U.S. cost sharing participant related to an IP transfer via a cost sharing arrangement if the foreign transferee’s profits from using the IP exceed a limitation established by the regulation. This limitation is roughly that the foreign transferee’s cumulative return on the sum of its payments for transferred IP, certain other contributions, and its allocable share of cost-shared research and development expenses does not exceed 150%.

These six studies found that each of these major U.S. corporate taxpayers had cost sharing arrangements that violated the cost sharing periodic adjustments regulation, and cumulatively could owe as much $500 billion in taxes, penalties and interest to the U.S. Treasury. Yet by all accounts the IRS has never enforced this regulation.

This paper investigates possible reasons for this apparent IRS non-enforcement, and also reviews recent developments in a United States Tax Court case involving Facebook, one of the six U.S. corporations profiled in this research. In that case, Facebook submitted its internal periodic adjustments calculations to the court, possibly as a direct result of our 2020 published research. This court submission enabled a comparison between our published estimates of the Facebook’s periodic adjustments based on book financial reporting, and Facebook’s own internal calculations using its proprietary tax accounting information. The estimated results accurately predicted the actual results. If the estimated results for the other five U.S. corporations are equally as accurate, the estimated $500 billion in amounts owed to the Treasury for the six indicated violations could mean that as much as a trillion dollars could be owed by the larger population of what appear to be widespread violations by possibly dozens or even hundreds of corporate taxpayers.

The paper importantly proposes actions the Treasury and IRS could take now to begin to enforce this existing tax law, and to improve tax administration in general. One important step is the modification and updating of Counsel Advice Memorandum 2007-007, which provides examination guidance related to periodic adjustments, but which clearly conflicts with the cost sharing periodic adjustment regulations that were issued in 2009 several years after the 2007 publication of this guidance.

Keywords: Transfer Pricing, Auditing, Forensic Economics, Tax Compliance and Tax Enforcement, Periodic Adjustments, Section 482, International Taxation, CSA, Cost Sharing Agreements

JEL Classification: F23, H21, H25, H26, H32, H83, K34, M42, E62