In November, the IRS Office of Chief Counsel issued a generic legal advice memorandum (“GLAM”) AM-2022-006, entitled “Realistic Alternatives and Tax Considerations in Applying Sections 482 and 367(d).” As the title suggests, GLAM analyzes the principle of realistic alternatives, which was codified in section 482 of the Tax Cuts and Jobs Act (Pub. L. No. 115-97).
The principle of realistic alternatives is, of course, not new and has been part of the Section 482 regulations since 1993. See Tres. Reg. § 1.482-1(d)(3)(iv); 58 federal. Reg. 5253, 5266, 5275 (January 21, 1993). But realistic alternative regulatory arrangements lacked practical substantive guidance. Thus, the GLAM provides new insight into how the IRS currently believes the principle of realistic alternatives should be applied. In summary, the GLAM applies the concepts of the Discounted Cash Flow Valuation Method of Corporate Finance (“DCF”) to make realistic alternative comparisons.
The Scenarios
GLAM introduces three interchangeable scenarios involving 1) patent licensing of its CFC by a US parent company, 2) patent contribution to a Section 351 settlement, or 3) formation of a cost sharing agreement with its CFC to further develop the patent and share usage rights. GLAM at 3–4.
To analyze these scenarios, GLAM concludes that the determining factor is whether the “expected after-tax present value income” from entry into each proposed scenario is greater than the “expected after-tax present value income” that the US parent company could have achieved by retaining its rights to the patent. GLAM 6 to 7. The GLAM explains that “present value” is calculated by applying a “risk-adjusted discount rate to reliable projections of results” where the “risk-adjusted discount rate incorporates adjustments for all risks associated with an uncertain future income stream”. See GLAM at 2, fn. 3.
GLAM then proposed a risk-adjusted present value for each scenario and found that only scenarios that generate a present value greater than the expected present value of patent rights retention satisfy the recently codified realistic alternatives requirement. GLAM at 6. In addition, to analyze the third scenario related to cost sharing agreements, GLAM also compared the present value of this scenario with that associated with licensing the patent to its CFC. GLAM from 9 to 10.
While relying on the present value and risk-adjusted discount rate concepts often associated with DCF analyzes is not new to the IRS, See, for example Amazon.Com, Inc. v. comm, 148 TC 108 (2017), it is surprising that GLAM assumes without explanation that there is no other consideration. Indeed, the GLAM simply concludes without pertinent citation that:
“The Commissioner will consider that the uncontrolled parties to a transaction seek to maximize their after-tax profit, which represents the economic return of the transaction. Thus, for example, the price the assignor receives for the sale of an asset must be sufficient to provide the assignor income with an after-tax present value at least equal to the after-tax present value the assignor would have realized had it not the property had been transferred.
GLAM at 6.
For the first two scenarios, GLAM indicates at best atmospheric claims in Section 482 regulations regarding the use of unspecified methods to support its claim. id. at 5; Tres. Reg. § 1.482-4(d)(1) (use of an unspecified method to evaluate the transfer of intangible property); Tres. Reg. § 1.482-3(e) (use of an unspecified method to evaluate the transfer of tangible assets); Tres. Reg. § 1.482-9(h) (use of an unspecified method to evaluate the transfer of services). For the third scenario, GLAM cites Treas. Reg. § 1.482-7(g)(2)(iii), which discusses the analysis of realistic alternatives before entering into a cost-sharing arrangement along lines similar to those used in the GLAM. But the application of this concept to transfer pricing transactions outside cost-sharing agreements is quite an interpretative stretch.
Conclusion
The recent GLAM shows that the IRS interpreted the realistic alternatives requirement as being almost entirely dependent on DCF concepts with respect to the risk-adjusted present value of future cash flows associated with transactions. For now, it is arguable that this could be seen as a sort of safe haven for realistic alternative analyses, because GLAM’s unique application of these concepts to transfer price transactions beyond cost-sharing agreements lacks a concrete statutory and regulatory support. However, GLAM may be relevant to determining whether a budget buffer is needed when implementing a cost sharing or other IP transaction.
