IRS Transfer Pricing Guidance: Adjustments Based on Actual Results

The IRS has issued guidance endorsing a muscular approach to the application of “periodic adjustments” provisions. Those provisions authorize IRS adjustments of a taxpayer’s pricing for transfers of high-value intangibles, including platform contribution transactions, for taxable years after the year of transfer, based on the actual, realized profitability of those intangibles in those later years.[1] In General Legal Advice Memorandum 2025-001 (the “GLAM”), released January 17, 2025 and directed to the group within the IRS responsible for APAs and transfer pricing audits, the IRS asserts that the periodic adjustments rules trump the general arm’s length standard. That is, unless the taxpayer qualifies for an exception provided in the regulations, the taxpayer cannot avoid periodic adjustments by relying on the general arm's length standard or the best method rule.[2]

The GLAM reiterates the IRS’ longstanding positions that the commensurate with income (“CWI”) standard in section 482 of the Code contemplates adjustments based on actual profits or savings—information not available to the taxpayer at the time of the transaction—and that the CWI requirement is consistent with the arm’s length standard. Neither position is “news,” as such, but the GLAM’s publication delivers notice to taxpayers, including those who may previously have qualified for one of the above-referenced exceptions, that the IRS will more assertively apply the periodic adjustments rules going forward. It also strongly suggests that the next wave of high-dollar transfer pricing litigation will focus on periodic adjustments. This Alert summarizes the GLAM’s scenario-based guidance, analyzes key aspects of the IRS’s legal position, and identifies CWI “housekeeping” that a taxpayer might consider to mitigate the risk of periodic adjustments.

The GLAM

The IRS finds statutory authority for periodic adjustments in the second sentence of section 482: “In the case of any transfer (or license) of intangible property (within the meaning of section 367(d)(4)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.”[3] In 1988 the Treasury Department and the IRS conducted a “study” of the then new CWI standard at the direction of Congress and released the so-called “White Paper.” The White Paper concluded that the “commensurate with income standard is fully consistent with the arm’s length principle,”[4] thus reconciling the subsequently issued periodic adjustments regulations with the arm’s length standard. The regulations allow IRS to make periodic adjustments to prices charged for the transfer of an intangible in an agreement that lasts more than one year to ensure the consideration is commensurate with income attributable to the intangible.[5] In the case of platform contribution transactions (PCT) to a cost sharing arrangement (CSA), the regulations allow IRS to make periodic adjustments to the platform contribution payments when the platform contribution payor realizes a return ratio that is outside a defined range.[6]

In previous guidance, the IRS interpreted “income” within CWI to mean operating profits attributable to transferred intangibles that the taxpayer “would reasonably and conscientiously have projected” at the time of the transfer.[7] The GLAM characterizes this interpretation as “just one application” of the IRS’s CWI authority. Instead, “properly construed,” CWI includes “income actually received after the transfer of the intangible, as evaluated on an ongoing basis.” Thus, taxpayers are expected to set pricing ex ante not based on reasonable and conscientious projections, but rather based on perfect foresight of ex post outcomes or using a pricing mechanism that trues up pricing based on actual income.

Scenario Analysis

The GLAM illustrates this reinvigorated periodic adjustments authority through two scenarios. In the first scenario, a taxpayer licenses an intangible to a controlled party for an annual fixed royalty over a ten-year period, determining the royalty using the comparable uncontrolled transaction (“CUT”) method. As its sole comparable, the taxpayer uses an uncontrolled license of a different intangible. Although the uncontrolled transaction is similar to the taxpayer’s transaction, the license agreements impose different use limitations, and the GLAM describes the circumstances of the two licenses as “different.” Six years into the license agreement, the licensed intangible has proven substantially more profitable than anticipated, presumably yielding results outside the arithmetic range prescribed in the regulations. The IRS examines the taxpayer’s taxable years 6 and 7 and makes periodic adjustments based on actual profits.[8]

According to the GLAM, the taxpayer cannot successfully rebut the adjustments on the premise that it complied with the best method rule when it initially determined the royalty because the taxpayer does not satisfy any of the exceptions under Treasury Regulation 1.482-4(f)(2)(ii). In particular, the taxpayer’s CUT method involved intangible property that was not the same as the intangible property in the controlled transaction, and the circumstances of the transfers were not substantially the same. Additionally, the controlled license agreement did not limit the use of the intangible property in the same way as the uncontrolled transaction.

In the second scenario, a taxpayer has entered into a CSA to which it makes a PCT of resources, capabilities, rights, or intangible property reasonably anticipated to contribute to the intangible development activity.[9] The taxpayer uses the income method to price its PCT payments.[10] Six years into the CSA, the contributed and cost shared intangibles have produced profits significantly exceeding the taxpayer's original projections. The IRS examines taxpayer’s taxable years 6 and 7 and makes periodic adjustments.[11] As in the first scenario, the taxpayer does not satisfy any of the applicable exceptions that would have prevented the IRS from making an adjustment.[12] In particular, the GLAM recites that the taxpayer does not qualify for the “extraordinary events” exception, which requires events beyond the taxpayer’s control that could not have been reasonably anticipated.

Neither scenario provides especially useful guidance to IRS examiners or taxpayers because the facts are slanted. In the first scenario, the taxpayer’s ex ante methodology exhibits obvious flaws: the taxpayer’s supposed CUT involves a different intangible with different profit potential licensed under different conditions. Although the “best method” rule may, in practice, function as a “least-worst method” rule, it is unclear from the GLAM that a discounted cash flow approach would not have yielded a more reliable result than the selected CUT on an ex ante basis. In the second scenario, the GLAM implies that the taxpayer could have (and should have) anticipated the results that ultimately ensued but does not directly elaborate on why no exception to periodic adjustments applies.

Questionable Legal Positions

The GLAM’s core position is that a taxpayer may not overcome periodic adjustments with the argument that such adjustments conflict with the general arm's length standard. Yet it also doubles down on the IRS’ historic view that periodic adjustments result in a truer expression of the arm’s length standard than arm’s length methods relying solely on ex-ante information. The GLAM thus both asserts that periodic adjustments trump the arm’s length standard, and that they are fully consistent with it, relying on a construction of the applicable Treasury Regulations that arguably lacks internal consistency and undermining the force of its core argument.

Also, the GLAM says nothing about situations where profits are less than anticipated in the taxpayer’s pricing. In other guidance, the IRS has opined that periodic adjustments is a one-way street.[13] Taxpayers are not permitted to make downward adjustments based on actual profitability, except on an original return.[14] The collective IRS guidance thus can only be construed as heads the IRS wins, tails the taxpayer loses, which, because it applies prospectively, is inherently inconsistent with the arm’s length standard.

But even if taxpayers were free to adjust down their US profits based on periodic adjustments (or an implementing provision in an inter-company agreement), such an approach would leave the parties to the transaction in the same risk-adjusted profits positions in which they started. Why transfer intangibles at all if the associated economic risks do not transfer with them? The IRS position thus achieves the opposite of its “realistic alternatives” approach made applicable to transfers of intangibles by the third sentence of section 482 – taxpayers must ignore the realistic alternatives to the transaction in favor of one that shifts no risk-adjusted profits at all. Every transfer of intangibles thus becomes a mere financing transaction.

A second element of the GLAM similarly seems ripe for controversy. At the conclusion of both scenarios, the GLAM alludes to an extraordinary feature of the regulations’ periodic adjustments rules. Specifically, the IRS can make adjustments to an open tax year that address deficiencies in prior tax years so that the entire transaction reflects the CWI standard regardless of whether those prior tax years are closed.[15] That is, the adjustment in Year 7 may be computed with reference to actual profits not only in Year 7, but also in Years 1-6—even if Years 1-6 have been audited and closed without adjustments, and even if the limitations period on assessment is closed for one or more of those years. The IRS first asserted this authority to, in effect, disregard the statute of limitations when determining periodic adjustments in the White Paper, but it has never expressly articulated the statutory basis for its position.[16] Post-Loper Bright, that omission heightens the risk of a regulatory challenge.[17]

Indeed, as other commentators have observed, there are good arguments why this aspect of the regulations may be ultra vires.[18] Unlike the CWI language that was added to Code section 367(d), the text of section 482 does not expressly contemplate that income arising in years preceding the year under audit be taken into account in IRS adjustments. Nothing in section 482 explicitly or implicitly overrules the normal statute of limitations on assessment.

By maintaining these inconsistencies, the IRS in fact tees up arguments for taxpayers who seek to challenge the IRS’ exercise of periodic adjustments authority in litigation. But regardless of the merits of these positions, it is clear the IRS will hold to them during examination and potentially during any subsequent dispute.

Good CWI Housekeeping

The GLAM highlights the importance of CWI housekeeping. Intangibles transfers may not simply be priced and forgotten. Realized profitability and its implications vis-à-vis the original pricing methodology must be monitored—apparently, indefinitely, given that the IRS can always disagree as to a taxpayer’s satisfaction of the temporal exceptions to periodic adjustments prescribed in the regulations. Taxpayers desiring to avoid or mitigate the effects of the periodic adjustments rules should review their pricing methods, projections, and profits connected with intangibles transfers, including in PCTs, annually.

If a taxpayer discovers that it has experienced returns or cost savings significantly above (or, for an inbound transfer, below) what was anticipated at the time of the original transaction or PCT, it should assess its eligibility for an exception to the periodic adjustments rules with experienced counsel. If a transaction appears to fall outside the other exceptions, the taxpayer should evaluate the potential applicability of the “extraordinary events” exception and, if feasible, develop robust substantiation for this exception that can be used on audit—and in court.

Although the periodic adjustments rules in principle are relevant to all transfers of intangible property, the scenarios in the GLAM suggest that good CWI housekeeping is most relevant for U.S. licensors and taxpayers who have executed PCTs in recent years. Taxpayers who repatriated their intangibles to the United States after the TCJA should also take note. The GLAM reveals a current focus of IRS audit efforts as well as its litigating position and the theory behind it. Taxpayers at risk of periodic adjustments should marshal their facts and prepare to argue the law.

If you have questions concerning this Alert, or would like more information, please contact the Caplin & Drysdale attorneys below. James Whippo, an International Tax Extern at Caplin & Drysdale, assisted with this Alert.