One of the more interesting aspects of the Tax Court’s recent decision in the Amazon transfer pricing case was its treatment of reasonable alternatives.  The IRS argued that the US taxpayer had the “reasonable alternative” of not entering the cost sharing agreement (“CSA”) and that therefore the buy-in payment should reflect the present value of the profits that it would have earned, had it retained ownership of the intangible property contributed to the CSA.  The Tax Court rejected this argument on two grounds:

  1. “it proves too much” – as any taxpayer entering a CSA has the option of not doing so, requiring the same economic outcome under a CSA as would exist absent the CSA would, in effect, make the regulation meaningless; and
  2. The IRS needs to respect the business arrangements established by the taxpayer provided they have substance, which also implies the need to respect the economic consequences of these business arrangements.

The Tax Court has also placed little if any weight on the concept of reasonable alternatives in the past – In Bausch & Lomb, for example, the Tax Court ruled that Bausch & Lomb’s US affiliate was free to pay a price of $7.50 per lens even though it could produce that same lens for approximately $2.00.   (There was a royalty payment that narrowed, but which did not eliminate, this gap.)

However, the concept of reasonable alternatives remains alive and well despite the Tax Court decision.  The Tax Court decision in Amazon was based on the regulations that existed in 2005, and these regulations have been changed.  One of the more significant regulatory changes was to introduce a new method – the income method – that is explicitly based on the concept of reasonable alternatives, in that it is based on the difference between the present value of profits under cost sharing and under the “reasonable alternative” of not cost sharing.  Similarly, various European tax authorities have used the concept of reasonable alternatives to support exit charges based on the profits that a legal entity would have expected to earn, had it stayed in business.

The interest of tax authorities in using the concept of reasonable alternatives is understandable – they want to prevent taxpayers from undermining their tax base by opting for business arrangements that lead to lower taxable income.  Moreover, as an economist, it is of course hard to say that reasonable alternatives should be ignored – in some applications the use of the term reasonable alternatives may be simply a different way of saying that opportunity costs matter.

That said, the potential definition of what is or is not a “reasonable alternative” can be highly subjective, and some interpretations of the concept may undermine the traditional deference given to the business arrangements established by the taxpayer.  Prices at arm’s length are highly dependent upon the details of the business arrangements governing the transaction at issue:  who is at risk if the price of raw materials increases; are prices set on a spot basis or fixed for several years; what is the nature of the specific property that is being transferred, and if the transfer is for an intangible, which party is responsible for funding any ongoing investments needed to maintain the value of that intangible; what are each party’s rights to terminate the business arrangement, and will a payment be needed in the event of termination?  Given that prices depend upon the detailed nature of business arrangements, the question arises as to whether transfer prices should reflect the business arrangements established by the taxpayer, or whether they should reflect the impact of the taxpayer’s “reasonable alternative” of entering a more favorable arrangement.

Using financial investments as a simple example, an investor can choose to make a risk-free investment that will generate an expected return of 2% per year, or an at-risk investment of 8% per year.   Both investments may be equally arm’s length, but the second will clearly provide a higher level of expected taxable income than the first.  Standard transfer pricing theory provides that taxpayers have the option of choosing between the two investments, that tax authorities should respect this decision, and that once this is done the arm’s length pricing (interest rate) should be based on arm’s length benchmarks with the same risk profile as the controlled transaction.  The economic consequences of the taxpayer’s decision are therefore respected.

However, it is certainly possible to argue that some investment decisions are ones that would be avoided by a rationale investor.  In such cases, can a tax authority use the concept of reasonable alternatives to challenge whether the selection of a specific investment is arm’s length?  Given the option of investing in a diversified portfolio that gives an expected return of say 8%, would a rationale investor ever choose to invest exclusively in very low risk instruments that only pay 2%?  Conversely, would a rationale investor ever choose to invest exclusively in a single high risk junk bond that pays 20%, but has a high risk of default and no diversification?

I choose the interest rate example above largely because it gives a relatively simple and clear delineation of the issue.  However, the question of when and how the concept of reasonable alternatives comes into play quickly becomes much more complex – is an exit charge needed when a business is closed; do the interest rates specified in a 10-year loan have to be re-priced when interest rates change; are “reasonable alternatives” based on the expected profits of the business as a whole, or should they reflect the value of the specific intangibles that are transferred?

The Tax Court’s decision regarding reasonable alternatives in the Amazon case was based on bright lines:  the taxpayer set up specific business arrangements; if those business arrangements have substance the IRS needs to respect them; the evaluation of whether or not prices are arm’s length therefore has to respect the business arrangements put in place by the taxpayer and does not have to take into account other options that might have been available.  While I am not a lawyer and make no predictions as to how courts may interpret current regulations, I do believe that there is a strong push on the part of the IRS and many other tax authorities to move beyond this simple paradigm, and to challenge arrangements that they view as artificially distorting prices.  Given this, taxpayers ought to be aware of possible tax authority challenges to business arrangements based on the theory that better options are available, which implies that there is a need to show that the arrangements that are in place are rationale, even given such other options.

As always, the opinions expressed above are mine, and do not reflect those of Economic Partners.

The increased focus on reasonable alternatives is only one way in which tax authorities are changing their interpretation of the arm’s length standard.  I discuss some of these changes in more detail in a series of blogs on the Evolution of the Arm’s Length Standard:

Evolution of the Arm’s Length Standard: Introduction

Evolution of the Arm’s Length Standard: Part 2 – Entering a Market Through Sales v Investment

Evolution of the Arm’s Length Standard: Part 3 – The Introduction of Profit-Based Methods

Evolution of the Arm’s Length Standard: Part 4 – Reasonable Alternatives

Evolution of the Arm’s Length Standard: Part 5 – An Increasing Focus on the Location of Decision-Makers