There appears to be a potential developing issue within the IRS relating to companies with transfer pricing agreements with foreign parents. The argument in its most simple form is that transferring intellectual property rights to a foreign parent runs afoul of the ‘Funded Research’ exclusion in §41(d)(4)(H) because the U.S. subsidiary does not retain “substantial rights.”
Company A is a multinational foreign parent corporation incorporated in country “F1.” Company B is a multinational foreign holding company incorporated in country “F2.” Company A owns 100% of Company B stock. Neither Company A nor Company B have any U.S. operations, and neither of them are subject to U.S. tax. Company A has a multitude of subsidiaries, one of which, Company C, is located within the U.S..
Company C is a domestic U.S. company, which files a U.S. tax return, and pays U.S. tax. Company C is a wholly owned (100%) subsidiary of Company B. Company C is a chemical company which earns profits through the sale of new high-value chemicals. It has U.S. research operations, and employs numerous chemists and other technical personnel to develop new technologies and processes. For such efforts, Company C will often file for patent protection on its improvements, and for those which it does not, it relies on trade secret. Both patented and trade secret research are hereafter referred to as “intellectual property rights.”
Company C intellectual property rights are often utilized by all Company A entities through a series of assignments and transfer agreements which tend to push decision making and research rights up to the foreign parents, then down to all relevant subsidiaries. Most commonly, Company C transfers, or ‘sells’ its intellectual property rights to Company B in Country F2, in return for a sum sufficient to fund the research team. Company B then re-sells this to Company A through another transfer pricing agreement in Country F1, where it is incorporated into the Company A global structure, and depending on the value of the intellectual property rights, will be utilized in many other nations.
In this process, Company A selects the offerings that will be supplied by region, including the U.S., and then orders production of those products accordingly. Based on the Company A plan, Company C will then start to import and/or produce these materials for distribution or sale. The structure of this plan follows the same transfer pricing chain, in particular where Company C pays Company B for the right to use any and all technologies (via licenses), who will then have an independent agreement with Company A for regional licenses.
Company C has no substantial barriers to utilization other than possible ‘funding’ under §41(d)(4)(H), and would like to take a research credit for U.S. technical efforts. The research it conducts qualifies under the §41(d)(1) ‘four-part’ test, and is not otherwise excluded.
Does the relationship with the foreign parent Company B and/or subsequent transaction with Company A restrict credit utilization through the “Funded” exclusion in §41(d)(4)(H)?
No. It appears that the transfers of ownership within the controlled group is disregarded for purposes of the §41(d)(4)(H) funded research exclusion.
There appears to be a potential developing issue within the IRS relating to companies with transfer pricing agreements with foreign parents. The argument in its most simple form is that transferring intellectual property rights to a foreign parent runs afoul of the ‘Funded Research’ exclusion in §41(d)(4)(H) because the U.S. subsidiary does not retain “substantial rights.” The issue is that there appears to be little justification for this position from the IRS side – it appears in fact to be a misapplication of authority.
Private Letter Ruling 8643006, (July 23, 1986), appears to be a decision on exactly these grounds, where the IRS challenged a taxpayer using this theory. In that instance, the facts were very similar to those listed above, where there was a foreign parent who was assigned the IP rights, and a domestic U.S. subsidiary was qualifying the research activities which created them. The issue is that the decision is fairly old (now 25 years), and there have been several additions to the law since the R&D credit was listed under §44F (now §41), along with some notable modifications.
After an evaluation, the perspective still appears to be valid. The foundation of the decision was based on the effects of §1563, which is the section that defines the term “controlled group” for income tax purposes. Within that section, subsection §1563(a) generally supplies the definition of “controlled group,” §1563(b) supplies the definition of “component member” and “excluded member,” and §1563(c-f) define what ownership rights are required to trigger these effects, and other special rules. It would appear that §41 deals exclusively with §1563(a), and it so happens that this subsection is not affected by foreign IP ownership within the controlled group.
To detail this issue, we begin with the ‘definition’ portion in §1563(a), where it would appear that there is little doubt that the companies here are ‘control group members’:
(1) Parent-subsidiary controlled group
One or more chains of corporations connected through stock ownership with a common parent corporation if—
(A) stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote or at least 80 percent of the total value of shares of all classes of stock of each of the corporations…
As can be seen with our facts, the ownership chain from A to B and B to C is 100%, so this argument is simple, even without the lower thresholds in §41(f)(5)(A); the entities are in a Parent-subsidiary controlled group, the ownership requirement is met, and the fact that they are foreign does not change this.
We then continue to the ‘component / excluded’ definition of subsection §1563(b), things become more interesting. This language says as follows:
(b) Component member …
(2) Excluded members
A corporation which is a member of a controlled group of corporations on December 31 of any taxable year shall be treated as an excluded member of such group for the taxable year including such December 31 if such corporation—…
(C) is a foreign corporation subject to tax under section 881 for such taxable year,…
This apparent exclusion also lines up tightly with our facts, and would appear to pretty clearly say that Company A and B are “excluded members,” though it is not immediately clear what that means. If the term “excluded member” means that they are not technically part of a controlled group, then the research is likely funded, if not, then it is very possible that the assignment is disregarded, and the company can internally assign the IP to any control group member, excluded or not, without ramifications. To find this out, we have to have a more complete understanding of the entire sub-part, particularly as to how it interacts with §1561.
It so happens that the statutory trigger for much of the §1563 language is actually found in §1561, where the code explains the tax effect of consolidation to “component members” and “excluded members.” Generally, “component members” will have certain restrictions on deductions, and can potentially utilize consolidated accountings. That said, there is really no language that says that “excluded members” cannot be classified as “control group” companies. In point of fact, the code allows them to have the titles simultaneously, where they are referred to as “control group component members,” or “control group excluded members” in the regulations. Accordingly, it would appear that the findings of the service in Private Letter Ruling 8643006 are still accurate: so long as you are qualified under §1563(a) as a controlled group, being an excluded member under §1563(b) does not affect the argument under §41.
After a detailed evaluation of remaining authority, it would appear that this is exactly the case. While there don’t appear to be any cases directly on point for §41(d)(4)(H) and foreign parents, there are numerous Private Letter Rulings (PLRs) and Field Service Advice (FSAs) memos which discuss the matter precisely. The consensus on these is that the PLR 8643006 findings are exactly correct, and that the §1563(b) definitions only explain the ‘type’ of control group, not if the entity is one:
The term “component member,” as defined by section 1563(b), does not determine whether [*7] a corporation is a “member” of a controlled group but merely defines a particular type of member.
The failure of § 41(f)(5) to incorporate § 1563(b) in its cross-reference to § 1563(a) for the definition of a controlled group of corporations permits a foreign corporation to be treated as a member of a controlled group.
Now after reaching this conclusion, the service in Private Letter Ruling 8643006 immediately came to the further conclusion that the inter-company transaction was disregarded, as the entities were considered a “single taxpayer.” And that selfsame language still appears in the code:
(f) Special rules
For purposes of this section—
(1) Aggregation of expenditures
(A) Controlled group of corporations
In determining the amount of the credit under this section—
(i) all members of the same controlled group of corporations shall be treated as a single taxpayer, and…
This language at first seemed to be the most open to varied interpretation, as there was little support for it in the PLR itself. That said, the precise subject matter appeared in the later papers, where the foundation for the decision was much more thoroughly evaluated. In 1995 FSA Lexis 235, it would appear that the foundation for this is a series of ownership rules in Treasury Reg. §1.41-8(e), now Treas. Reg. 1.41-6(i), which says:
(i) Intra-group transactions — (1) In general. Because all members of a group under common control are treated as a single taxpayer for purposes of determining the research credit, transfers between members of the group are generally disregarded.
That paper went on to explain that because these transactions are generally disregarded, then the transactions are literally not to ‘other persons,’ as required by the §41(d)(4)(H) exclusion, that the bulk of precedence says that the exclusion would not be triggered:
To the extent that the taxpayer is being reimbursed for its research expenditures by its foreign parent, it is arguable that such research is “funded” within the meaning of section 41(d)(4)(H) and the regulations thereunder. However, as stated above, all members of a controlled group are treated as a single taxpayer [*14] for purposes of determining the amount of the research credit. I.R.C. § 41(f)(1)(A)(i). For this reason, transfers between members of a controlled group are generally disregarded. Treas. Reg. § 1.41-8(e)(1). Thus, the taxpayer’s research is not funded by any grant, contract, or otherwise by another person, notwithstanding the fact that [TEXT REDACTED] is reimbursing the taxpayer for the cost of the research. In short, the characterization of the taxpayer and [TEXT REDACTED] as a single taxpayer effectively obviates the applicability of the “funded research” rules under sections 41(d)(4)(H) and 1.41-5 because such rules apply only with respect to contracts entered into between the taxpayer performing the research and other persons.
And so, it would again appear that there is no conflict between §41(d)(4)(H) and Company A’s relationship with Company C, regardless of B or any other intermediate subsidiary. This would mean that we have substantial authority to take this incentive, as it appears that virtually all existing authority is consistent with it. The IRS’s attempt to revive this long-dead issue seems perplexing, but there appears to be no real substance to it under these facts. In all, the issue appears resolved, and it is our opinion that the incentive can be taken without conflict from §41(d)(4)(H), per the facts and discussion listed above.
Please contact Braithwaite Global Inc., directorate of Advocacy and Interpretation for any questions or concerns.
 There is no specific citation for this, though it appears to have been raised more than once to the partners of Braithwaite Global, Inc., and has definitely been an issue in the past based on the cases on point.
 In point of fact, research has not located a single source to support the IRS current position. Not even within the RCCATG, which is known as a ‘roadmap for disallowance.’
 I.R.C. §1563(a) is entitled “Controlled group of corporations,” and has four (4) types of groups; parent-subsidiary, brother-sister, ‘combined’ groups, and certain insurance groups. §1563(b) is entitled “Component member,” and defines what ‘component’ and ‘excluded’ control-group members are.
 I.R.C. §1563(a)(1)(A).
 I.R.C. §1563(b)(2)(C).
 Tax Reg. §1.1563(b)(4)(Example 3).
 1995 FSA Lexis 235.
 1994 FSA Lexis 370.
 I.R.C. §41(f)(1)(A)(i) (emphasis added).
 Treas. Reg. §1.41-6(i) (emphasis added).
 1995 FSA Lexis 235, pp 13-14 (emphasis added).