Yesterday, the Tax Court decided The Coca-Cola Company v. Commissioner, 155 T.C. ___, No. 10 (2020), GS here, a transfer pricing company case in which the IRS seems to have substantially prevailed. Transfer pricing cases are fact intensive cases. However, in this discussion, I won’t wander through the morass of facts but rather deal with burden of proof issues that, although presented in a fact setting, can be considered at a conceptual level independent of the facts of the case. However, I do ask that readers keep in mind that transfer pricing cases are, at bottom, simply valuation cases.
I recently wrote an article on burden of proof in tax cases. John A. Townsend, Burden of Proof in Tax Cases: Valuation and Ranges—An Update, 73 Tax Lawyer 389 (2020), here. In that article, I discussed the seminal case of Helvering v. Taylor, 293 U.S. 507 (1935), see discussion beginning on p. 411, here. In that case in summary and without nuance, the Court held that in a deficiency case in the Tax Court, once the taxpayer shows the deficiency is “arbitrary and excessive,” the IRS bears the burden of persuasion (risk of nonpersuasion) to show that the taxpayer has a deficiency. Three nuance points: (i) I address in the article (p. 397 n. 28, here) that “arbitrary and excessive,” although stated in the conjunctive is really disjunctive; (ii) if the issue involves a deduction turning upon valuation, the taxpayer will bear the burden of persuasion with respect to value to support the deduction; and (iii) the burden of persuasion is often called the risk of nonpersuasion which is more descriptive of how the burden of persuasion performs, but I used the term burden of persuasion here.
I illustrate the key concept of the article in a simple example. Assume that the taxpayer receives property in a service income transaction. Taxpayer reports $40 income on his tax return based on valuing the property at that amount. The IRS determines a deficiency of tax by valuing the property at $100. The parties litigate in the Tax Court. The Tax Court cannot find a finite value by a preponderance of the evidence but can find a range where the low end of the range is the lowest value proved by a preponderance of the evidence and the high end of the range is the highest value proved by a preponderance of the evidence. Let’s say that range is from $70 to $80. (This range may also be called the range of equipoise where the Court (or other trier of fact) is in equipoise as to the valuation based on the preponderance of the evidence standard.)
In the example, Helvering v. Taylor, 293 U.S. 507 (1935) requires that the value be determined at $70 because the taxpayer has shown the deficiency determination excessive because of the excessive valuation. The IRS thus bears the burden of persuasion as to an amount that would produce some deficiency amount. In the example, the evidence proves by a preponderance a value of at least $70 and the Tax Court should determine the deficiency accordingly.
Now, I said that transfer pricing under § 482 is just a valuation issue. Does the foregoing Helvering v. Taylor-based analysis apply to transfer pricing valuations? In my article, I identified some authority that suggested that perhaps it might not because of the discretion allowed the IRS in § 482. (See Article, beginning at the bottom of p. 417, here.) In Coca-Cola, Judge Lauber (beginning on p. 86, here) makes the following key points:
1. As interpreted, the IRS’s § 482 allocation will be set aside only if the taxpayer shows it to be “arbitrary, capricious, and unreasonable,” which is an abuse of discretion standard.
2. Whether the IRS abused its discretion generally turns upon questions of fact.
3. If the record does not support the allocation, the IRS abused its discretion. Does that mean that, if the evidence shows that the allocation is excessive but arguably not arbitrary, it will be sustained? The abuse of discretion might suggest that but I don’t think it does.
Let’s go back to the same example but in a transfer pricing context with the same state of the evidence at the conclusion of trial: (i) IRS deficiency determination of $100, and (ii) evidence showing a range of $70 to $80. What does the Court do? Here are the choices among the possible values for the § 482:
1. $40 as originally reported by the taxpayer
2. $70 the low end of the range of values based on a preponderance of the evidence
3. $75 the mid-point in the range (split the baby)
4. $80 the high end of the range
5. $100
I don’t know except that I can eliminate 1 and 5. I think I can eliminate 3 because that is arbitrary. In the Helvering v. Taylor model, 2 would be the choice. But, if § 482 is different, then 4 must be the choice because it could be argued that, within the range of equipoise, the taxpayer has not shown that the IRS abused its discretion conferred by § 482.
If readers have ideas, please weigh in by comment or email to me.
JAT Comments (Added 11/21/20 1:30pm):
I thought I would add some further discussion that might offer more nuance, although I think what I add here is implicit in the main blog entry above:
1. Judge Lauber’s outline discussion titled Burden of Proof is fairly standard. See p. 85, here. The next outline section titled “Standard of Review” is the part that bears on the discussion in the blog above. See p. 86 ff, here. Judge Lauber’s brief discussion of the statutory case interpretive history of § 482 is good background. I point out the following key excerpt (pp. 92-93, here):
If the taxpayer demonstrates that the Commissioner's allocation is arbitrary, capricious, or unreasonable, but fails to prove an alternative allocation that meets the arm's-length standard, the Court, using its best judgment, "must determine from the record the proper allocation of income." Sundstrand Corp. v. Commissioner, 96 T.C. 226, 354 (1991); see Hosp. Corp. of Am. & Subs. v. Commissioner, 81 T.C. 520, 596-597, 601 (1983); Nat Harrison Assocs., Inc. v. Commissioner, 42 T.C. 601, 617-618 (1964) (determining a proper allocation "without the benefit of any presumptions" after finding the Commissioner's allocation unreasonable). We may make partial allocations to the extent "the evidence shows that neither side is correct." Eli Lilly & Co. v. Commissioner, 856 F.2d 855, 860 (7th Cir. 1988), rev'g in part on other grounds 84 T.C. 996 (1985); see Amazon.com, Inc., 148 T.C. at 163-214 (making partial allocations with respect to buy-in payment for taxpayer's website technology, marketing intangibles, and customer information).
There are echoes of Helvering v. Taylor in this excerpt, although not cited. In Helvering v. Taylor, certainly as interpreted, the taxpayer bears the initial burden of persuasion to show that the IRS deficiency determination is excessive because of an excessive valuation. Thereafter the burden of persuasion (think risk of nonpersuasion) is on the IRS to justify a deficiency so that the Court can enter a decision document. If the quality of the evidence is such that the Court can determine a finite value (rarely in complex valuation cases such as this), then it so determines. If however, the Court can only find a range (more likely in complex valuations, including transfer pricing valuations), then the Court will do so based at the end of the range favoring the party not bearing the burden of persuasion. At least that is my interpretation of Helvering v. Taylor and ranges of valuation in my article linked above.
2. The point of this blog that a similar analysis could apply to transfer pricing valuations, which to repeat are just valuations. For example, Judge Lauber concludes (p. 110, here):
The arm's-length compensation for the totality of the services performed by the supply points would thus seem to be somewhere between 6% and 8.5% above their costs. But the profits the supply points enjoyed vastly exceeded that range. One needs no more than a back-of-the-envelope calculation to make this clear.
Although Judge Lauber does not specifically state that the range thus proffered is based on a preponderance of the evidence and equipoise within in the range, but I infer that this is what the excerpt means.
Then Judge Lauber concludes (p.146, here):
In sum, we conclude that the Commissioner did not abuse his discretion in reallocating income from the supply points to petitioner by use of the bottler CPM. Petitioner has not carried its "burden of showing that such determination was purely arbitrary." Asiatic Petroleum Co., 31 B.T.A. at 1158. And because "there is substantial evidence supporting the determination, it must be affirmed." Marc's Big Boy-Prospect, Inc., 52 T.C. at 1092. We will accordingly sustain the reallocations of income determined in the notice of deficiency, subject to the adjustments noted in the preceding pages and to our holdings elsewhere in this Opinion. We are hopeful that the parties can work out the granular-level calculations in their Rule 155 computations. To the extent they are unable to do so they may seek further guidance from the Court.
In broad overview, it seems, Judge Lauber did exactly what Helvering v. Taylor requires – tested the original valuation for excessiveness and then determined some adjustments to make the valuation non-excessive. The only question that I am not sure of is how he determined who on the items of adjustment prevails in a state of equipoise. I think from the wording of the opinion on quick overview, Judge Lauber imposed the burden of persuasion on the taxpayer as to those items, requiring that the IRS only support its allocation with "substantial evidence" which is usually used to mean include a preponderance but may mean something substantiality less than a preponderance, i.e., persuasive evidence is certainly substantial but substantial evidence may not be persuasive. (Cf., "substantial authority" for penalty purposes as something less than more likely than not, the traditional formulation for testing evidence as to persuasiveness.) If I am right about that, then the question I ask at the end of the blog above should be answered $80, for within the range of equipoise, surely the IRS allocation has substantial authority.
JAT Further Comment (Added 11/25/20 at 11:00 am):
3. The importance of ranges cannot be overstated in complex valuation cases because of the difficulty of determining value to a finite point. That was the principal point of my article linked above. With appropriately calibrated ranges (either as to the overall value or components in reaching overall value), the allocation of the burden of persuasion will determine the outcome. Accordingly, the parties -- particularly the party with the burden of persuasion -- should strive to constrict the range. In a well-tried case, the evidence was almost surely constrict but not eliminate the range of valuation. For an example of this phenomenon where one party did not strive to constrict the range, see my discussion in the article (at pp. 425-427, here) of Judge Posner’s opinion in Kohler v. United States, 468 F.3d 1032 (7th Cir. 2006). (Kohler, was just overreach by the Government where, as I say in the article, the pig got slaughtered.)
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