The IRS’s recent advice memorandum on periodic adjustments suggests that the agency may belatedly start using a decades-old, hitherto ignored, transfer pricing enforcement mechanism.
Before AM 2025-001’s release, any acknowledgment of periodic adjustments in an IRS chief counsel advice memorandum would have been an important development. The only other IRS advice memorandum to address the topic in any meaningful way was AM 2007-07, which essentially renounced the agency’s authority to make ex post periodic adjustments to licenses, transfers, and other contributions of intangible property. But AM 2025-001 did far more than simply acknowledge the existence of periodic adjustments. The memorandum reclaims what AM 2007-07 renounced: the retrospective adjustment authority that section 482 confers on the IRS.
In response to Congress’s codification of the commensurate with income standard in 1986, the final section 482 regulations issued in 1994 (T.D. 8552) introduced the periodic adjustment rules applicable to most controlled intangible transfers.
Unless an exception applies, reg. section 1.482-4(f)(2) allows the IRS to adjust the transferor’s income when the transferee’s actual returns deviate by more than 20 percent from its ex ante projected returns. The 2009 (T.D. 9441) temporary and 2011 (T.D. 9568) final cost-sharing regulations added a separate periodic adjustment mechanism under reg. section 1.482-7(i)(6) for platform contribution transaction (PCT) payees. If the returns on a PCT payer’s total investment in cost-shared intangible development falls outside the applicable range and no exception applies, the PCT payee may be subject to a periodic adjustment.
These provisions have gone largely, if not entirely, unenforced. This largely reflects the common perception that they conflict with the arm’s-length standard, which is the foundation for the section 482 regulatory regime and U.S. bilateral treaties. The IRS has thus relied almost entirely on the ex ante pricing methods available under the regulations in its enforcement efforts.
The memorandum answers two related questions about these long-ignored provisions. The first, addressed in the memorandum’s Taxpayer 1 example, is whether a controlled licensee or transferee of intangibles can avoid a periodic adjustment by showing that it properly applied the comparable uncontrolled transaction method at the time of the transaction. The other, addressed in the Taxpayer 2 example, was whether a PCT payee may be subject to a periodic adjustment if its upfront application of the income method was consistent with its ex ante income projections. The broader question underlying both scenarios was whether a taxpayer’s upfront compliance with the general provisions of reg. section 1.482-1, including reg. section 1.482-1(c)’s best method rule, prevents the IRS from later making a periodic adjustment based on ex post returns.
AM 2025-001’s answer is that comparables and profit projections available ex ante cannot defeat a periodic adjustment unless they establish that one of the enumerated exceptions in reg. section 1.482-4(f)(2)(ii) or 1.482-7(i)(6)(vi) applies. If ex post returns fall outside the prescribed range and no enumerated exception applies, then compliance with reg. section 1.482-1(c)’s best method rule cannot shield a taxpayer from a periodic adjustment.
A Capacious Standard
To reach its conclusion, AM 2025-001 had to distance itself from the position endorsed in AM 2007-07. The meaning of the word income in the phrase “commensurate with the income attributable to the intangible,” part of the sentence added to section 482 by the Tax Reform Act of 1986 (TRA), figured prominently in both memorandums. However, the two advice memorandums read the same word to mean two different things. AM 2007-07 argued that the term refers to “the operating profits attributable to the intangible the taxpayer would reasonably and conscientiously have projected at the time it entered into the controlled transaction” (emphasis added).
The purpose of the TRA amendment and the periodic adjustment provisions according to the 2007 memorandum was to address information asymmetries that hinder the IRS’s ability to challenge taxpayers’ profit projections. In other words, the retrospective adjustment mechanism contemplated by Congress in 1986 is just an enforcement tool to ensure reliable ex ante pricing. As the 2007 memorandum explained:
“The IRS coming to examine a transaction only after-the-fact is inherently at a disadvantage in assessing whether the pricing was supported by such upfront reasonable and conscientious evaluation of projected operating profits attributable to the transferred intangible. Therefore, the IRS, in its discretion, provisionally may treat actual profits as evidence of projected profits and make periodic adjustments as if such results were projected at the time of the controlled intangible transfer. [Emphasis added.]”
The IRS endorsed this interpretation, which built on some of the less convincing conclusions set out in Treasury’s 1988 white paper (Notice 88-123, 1988-2 C.B. 458), in an effort to thwart claims that the commensurate with income standard gives taxpayers the right to make self-serving retrospective adjustments.
Perhaps the IRS believed that preventing taxpayer-initiated retrospective adjustments was more important than preserving an enforcement mechanism it had no intention of using. Whatever the IRS’s calculations may have been in 2007, the agency clearly went rogue in its legal reasoning. The memorandum’s claim that Congress codified the commensurate with income standard to help the IRS challenge unreliable ex ante profit projections is implausible and unsubstantiated.
Disingenuous operating profit projections couldn’t have been a widespread concern under a regulatory scheme that, at least as courts interpreted it, almost always required comparables-based methods. Profit projections took on major importance only after the commensurate with income amendment had already been enacted and income-based methods found their way into the regulations. As the contemporaneous legislative history attests, Congress’s real intent was for ex post returns to supplant comparables as the principal point of reference for controlled intangible transfers. After noting the committee’s concern that judicial precedent “may unduly emphasize the concept of comparables,” the House Ways and Means report on the TRA (H. Rep. 99-841) confirmed the ex post orientation of the amendment:
“It will not be sufficient to consider only the evidence of value at the time of the transfer. Adjustments will be required when there are major variations in the annual amounts of revenue attributable to the intangible.”
The IRS said nothing of consequence about transactional comparables or methods that rely on them in AM 2007-07, suggesting that the agency was confident in its ability to use methods based on ex ante profit projections. That assumption appears to have been misplaced. Since the memorandum’s release nearly 18 years ago, the IRS has lost in Veritas Software Corp. v. Commissioner, 133 T.C. 297 (2009), and Amazon.com v. Commissioner, 148 T.C. No. 8 (2017), aff’d, 934 F.3d 976 (9th Cir. 2019), and it may lose in Facebook Inc. v. Commissioner, No. 21959-16.
In the meantime, whatever it may have done to stop taxpayer-initiated adjustments, AM 2007-07 eventually became a net liability for the IRS. The 2007 memorandum argued that an ex ante orientation ultimately comes from the statutory text, not just from the regulations that implement it or the IRS’s enforcement discretion. Especially after Loper Bright Enterprises v. Raimondo, 603 U.S. 369 (2024), this interpretation would imply that the IRS has minimal statutory authority to use ex post returns to make a section 482 adjustment. At least one taxpayer has opportunistically seized on this in litigation.
Against this backdrop, the IRS’s recent decision to “clarify” AM 2007-07 by repudiating its flawed statutory construction is a welcome development. AM 2025-001 acknowledges Congress’s intent to prioritize ex post profitability when pricing controlled intangible transfers, and it rejects the strained statutory interpretation endorsed in 2007:
“The term “income” in the phrase “commensurate with the income attributable to the intangible” in section 482 is properly construed, consistent with its plain meaning and the legislative history of the section, to include income actually received after the transfer of an intangible, as evaluated on an ongoing basis. The sentence lacks any temporal limitation and refers to the “[attribution]” of income, which can be done most accurately as that income arises. [Emphasis added.]”
Based on this revised statutory construction and a review of pre-TRA case law, AM 2025-001 concludes that section 482 “permits a capacious [arm’s-length standard] that extends to adjustments based on actual profits.”
Regulatory Conflict
By abandoning AM 2007-07’s faulty interpretation of the word income in the phrase “commensurate with the income,” AM 2025-001 recognizes the IRS’s statutory authority to enforce an ex post periodic adjustment mechanism. However, Treasury and the IRS theoretically could have restricted their otherwise capacious authority to define the arm’s-length standard through the regulations.
The question is whether the more general regulatory provisions concerning the arm’s-length standard and methods, including the best method rule under reg. section 1.482-1(c), take precedence over the periodic adjustment rules in reg. sections 1.482-4(f)(2) and 1.482-7(i)(6). If so, as some taxpayers have claimed in litigation, selecting and reliably applying the best method upfront could shield a taxpayer from any periodic adjustment.
Reg. section 1.482-1(b)(1) generally provides that “the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer.” Because rational parties dealing at arm’s length generally do not compensate each other for unexpected variations in profitability, a truly retrospective adjustment mechanism is difficult to reconcile with older and more restrictive interpretations of the arm’s-length standard. Those who persist in claiming that, despite all statutory and regulatory evidence to the contrary, transactional comparables-based methods are inherently favored would argue that properly applying the CUT method can override a periodic adjustment. Taxpayers can defeat a periodic adjustment by showing that they properly applied the CUT method. Even those who recognize the limitations that make transactional methods unsuitable for most controlled intangible transfers often argue, as the IRS did in AM 2007-07, that income-based methods should apply solely on an ex ante basis.
AM 2025-001 appears to be the first IRS guidance to contend that purely ex post periodic adjustments are always fully consistent with the arm’s-length standard. AM 2025-001 argues that the periodic adjustment rules represent a targeted mechanism for determining an arm’s-length result, and that they operate independently and in parallel with the best method rule and other method-related provisions.
According to the memorandum, transactions that drive ex post returns above the high end of the applicable range are transfers of high-profit-potential intangibles. Because these transactions are uniquely resistant to methods that rely on comparables or ex projections, the memorandum argues, periodic adjustments based on ex post returns can provide a more reliable measure of an arm’s-length result.
Methods based solely on information available at the time of the transaction (including those that rely on comparable transactions) cannot be the most reliable measure of an arm’s-length result if they fail to account for the full value of intangibles. Comparables involving unique, high-profit-potential intangibles are extremely rare. For cases involving the transfer of high-profit-potential IP — the kind of IP that would trigger a periodic adjustment — the IRS may determine an arm’s-length result based on the contingent consideration, commensurate with the income actually realized regarding the intangible, that would be charged at arm’s length.
AM 2025-001 adds that the exceptions enumerated in reg. sections 1.482-4(f)(2)(ii) and 1.482-7(i)(6)(vi), both of which offer exceptions for variations caused by unforeseeable events, are necessary and sufficient to bring periodic adjustments fully in line with the arm’s-length standard.
Therefore, the memorandum’s position is that, for the relatively narrow subset of transactions to which they apply, periodic adjustments more reliably produce an arm’s-length result than do the general regulatory provisions that govern methods. The memorandum also argues that the text and mechanics of the regulatory scheme indicate that periodic adjustments operate outside the ambit of reg. section 1.482-1(c)’s best method rule but nonetheless produce results compliant with reg. section 1.482-1.
However, the specific means by which AM 2025-001 tries to reconcile periodic adjustments with the arm’s-length standard isn’t really what distinguishes it from earlier Treasury and IRS guidance. The significance of AM 2025-001 lies in its acknowledgment of the awkward reality that periodic adjustments could produce results that conflict with the general principles defining the arm’s-length standard under reg. section 1.482-1.
In the event of any such conflict, the memorandum argues, the periodic adjustment rules in reg. sections 1.482-4(f)(2) and 1.482-7(i)(6) must prevail in the event of a conflict with reg. section 1.482-1(c)’s best method rule or any of the other general provisions of reg. section 1.482-1. The specific controls the general, the memorandum argues, and subordinating periodic adjustments to reg. section 1.482-1(c)’s best method rule would render them inert:
“A taxpayer’s focus solely on comparables or other ex-ante information, while ignoring actual profit performance, would be contrary to the statute, would disregard the legislative intent, and would impermissibly make surplusage of the exceptions in Treas. Reg. [sections] 1.482-4(f)(2)(ii) and 1.482-7(i)(6)(vi) and, in the case of Treas. Reg. [section] 1.482-4(f)(2)(ii), of the provisions withdrawing those exceptions when actual profits fall outside of the prescribed range.”
It follows that taxpayers cannot avoid an otherwise justified periodic adjustment by showing that they selected the best method under reg. section 1.482-1(c) and applied it reliably. According to AM 2025-001, the only way to avoid a periodic adjustment based on ex ante information is by fulfilling the conditions for an enumerated exception under reg. sections 1.482-4(f)(2)(ii) and 1.482-7(i)(6)(vi). Otherwise, AM 2007-07’s claims to the contrary, the “arm’s length price determined by the periodic adjustment rules is not merely presumptive evidence but is determinative.”
Same Difference?
The takeaway from AM 2025-001 is that the only limits on the IRS’s authority to use ex post returns as the basis for a periodic adjustment are the exceptions provided under reg. sections 1.482-4(f)(2) and 1.482-7(i)(6). The analysis thus begins with ex post returns, and ex ante reliability only becomes relevant if an exception recognizes it as such. However, as a practical matter, the enumerated exceptions do account for comparables and ex ante projections.
Under reg. sections 1.482-4(f)(2)(ii)(A) and 1.482-7(i)(6)(vi)(A)(1), the IRS may not make a periodic adjustment when the taxpayer applies the CUT method using a controlled transfer or contribution of the same intangible under the same (or substantially similar) circumstances.
And reg. sections 1.482-4(f)(2)(ii)(D) and 1.482-7(i)(6)(vi)(A)(2) both offer exceptions for variations caused by “extraordinary events” that the taxpayer could not reasonably have anticipated. If taxpayers can qualify for an enumerated exception based on transactional comparables or ex ante profitability expectations, does it really matter that periodic adjustments prevail over reg. section 1.482-1(c) and the applicable method-related provisions?
Although reg. section 1.482-1(c)’s best method rule and the enumerated exceptions impose some overlapping requirements, they differ enough that AM 2025-001’s distinction between methods and exceptions has practical significance. The CUT-based exceptions only extend to what the 1988 white paper described as “exact comparables,” which are exceedingly rare for transactions that could trigger a periodic adjustment. Taxpayers that apply the CUT method using uncontrolled transfers of comparable intangibles under comparable circumstances, including the hypothetical Taxpayer 1 in AM 2025-001, must qualify for another exception to avoid a periodic adjustment.
The distinction between the extraordinary events exceptions and the obligation to use reliable profit projections when applying projection-based methods, including the income method applied in the memorandum’s Taxpayer 2 example, could be practically significant as well. Reg. section 1.482-7(g)(2)(vi) requires that the projections used to apply a PCT method “reflect the best estimates of the items projected,” which generally should account for the “probability weighted average of possible outcomes.” This implies that the taxpayer’s projections should reflect the expected values, as defined in probability theory, for all possibilities that the taxpayer can reasonably foresee.
However, for purposes of the periodic adjustment provisions, an “extraordinary event” is an event beyond the taxpayer’s control that could not have been reasonably anticipated or foreseen. Whether a taxpayer had control over some ex post development has no bearing on the taxpayer’s best estimate of the development’s effects and probability. It follows that an event, including one that was too improbable to incorporate into the taxpayer’s ex ante projections, might not be considered extraordinary if the taxpayer had any control over the outcome.
An extraordinary event must also be one that the transacting parties could not have reasonably anticipated or foreseen. A taxpayer’s best estimate of the probability-weighted average of possible outcomes can only account for possibilities known to that taxpayer. By definition, an unanticipated or unforeseen event is one that will not and cannot be reflected in the taxpayer’s ex ante projections. AM 2025-001 confirms this in footnote 13, which explains that foreseeable events include a potential revenue increase “considered possible . . . but not considered sufficiently likely to be reflected in financial projections.”
The enumerated exceptions to periodic adjustments thus impose stricter standards than methods selected and applied according to the general best method rule. The CUT-based exception requires that the method be applied using an uncontrolled transfer of the same intangibles under the same (or substantially the same) circumstances, which immediately disqualifies most transactions priced using the CUT method. And an extraordinary event is one that the taxpayer couldn’t control or reasonably anticipate, which means that many improbable developments justifiably omitted from the taxpayer’s ex ante projections may trigger a periodic adjustment. These differences in standards will often lead to discrepancies between the results determined under the best method and the results as periodically adjusted, and when they do, periodic adjustments take priority under AM 2025-001.
AM 2025-001’s insistence that taxpayers satisfy the stricter conditions imposed by an enumerated exception, as opposed to accepting all reasonable ex ante projections, also marks a major shift in the IRS’s interpretation of its own regulations. After arguing that section 482’s commensurate with income standard refers to operating profit that taxpayers would “reasonably and conscientiously have projected” ex ante, AM 2007-07 read the same principle into the extraordinary events exception:
“Although the IRS necessarily must examine the taxpayer’s transaction after-the-fact, it should exercise its periodic adjustment authority consistent with what would have been a conscientious upfront valuation — had the taxpayer in fact made one. . . . The regulations clearly reflect the intent that the IRS exercise restraint in making periodic adjustments based only on the upfront reasonable expectations and not based on subsequent events which could not be reasonably anticipated. [Emphasis added.]”
As is clear from footnote 13 in AM 2025-001, the IRS no longer supports this interpretation of the extraordinary events exception. The footnote cites an example from the OECD transfer pricing guidelines involving a pharmaceutical company that completed clinical trials for a new drug ahead of schedule, allowing “commercialization to begin earlier than projected” (emphasis added). This implies that, under AM 2007-07, reasonable and conscientious ex ante projections would reflect the expectation that commercialization would begin later than it actually did. However, AM 2025-001 endorses the example’s conclusion that the variance from ex ante expectations doesn’t mean that “the development was unforeseeable.”
Open Questions
AM 2025-001 is clear and unequivocal in its answer to the question directly at hand. In accordance with the legislative history and statutory text of the TRA amendment, section 482’s use of the phrase “commensurate with income attributable to the intangible” includes ex post returns. The periodic adjustment provisions that implement this statutory mandate yield an arm’s-length result for transfers and contributions of high-profit intangibles, and the defining features of these transactions cast doubt on the reliability of ex ante comparables and projection-based methods selected under reg. section 1.482-1(c). Consistent with the statute and the regulatory text, when the periodic adjustment provisions apply, they take priority over methods selected under the best method rule if results conflict.
It follows, AM 2025-001 argues, that taxpayers cannot avoid a periodic adjustment by establishing compliance with the general principles set out in reg. section 1.482-1 and the applicable method-related regulatory provisions. The only way a taxpayer may avoid an otherwise justified periodic adjustment is by qualifying for an enumerated exception, which can exclude many transactions that were priced in accordance with reg. section 1.482-1(c).
However, AM 2025-001 also raises new questions that Treasury and the IRS have never squarely addressed. It characterizes periodic adjustments as a carefully calibrated mechanism for addressing high-profit intangible transfers. It’s true that the undervaluation of highly profitable intangibles was the main concern behind the commensurate with income amendment, but the periodic adjustment rules that implement the 1986 amendment also have upper and lower bounds. How much of AM 2025-001’s analysis should extend to intangibles that turn out to be less profitable than expected?
It’s also unclear whether all the enumerated exceptions are really “necessary and sufficient,” as AM 2007-07 contends, to ensure alignment between the periodic adjustments and the arm’s-length standard. AM 2025-001 is right that, according to the statute and regulations, the periodic adjustment rules should take priority over ex ante comparables and projections.
But if that’s the case, why should the periodic adjustment regulations create a CUT-based exception that defers to transactional evidence? Even if the exception requires so-called exact comparables, which are almost never available for transfers of high-profit-potential intangibles, the exceptions are hard to square with the reasoning in AM 2025-001.
On the other hand, the comparable profits method and profit-split method typically apply to actual results. Is it really necessary or appropriate to layer another retrospective adjustment mechanism over the methods that use ex post profitability? And wouldn’t these methods be more worthy of an exception than the CUT method?
Regarding methods, AM 2025-001 challenges the reliability of ex ante projection-based methods that the IRS has doggedly fought to apply in litigation. AM 2025-001 rightly recognizes Congress’s intent to deemphasize comparables when it enacted the TRA amendment, but the memorandum groups comparables together with profit projections as suspect forms of ex ante information. Although the TRA legislative history clearly identifies ex post returns as the proper basis for adjustments, it says little about the proper role of ex ante projection-based methods. This is unsurprising because, as noted, projection-based transfer pricing methods weren’t in widespread use until well after the TRA’s enactment.
It’s perfectly reasonable for AM 2025-001 to question the reliability of ex ante projections for highly profitable intangibles, but this raises the question of why the IRS has been so firmly committed to methods that discount projected future profit. The IRS zealously defended the reliability of discounted cash flow valuations in Veritas and Amazon, and it’s currently litigating the validity of the conceptually similar income method in Facebook. The 2009 temporary and 2011 final cost-sharing regulations introduced specified methods that rely on discounted projected profit, including the income method, which the regulations address in exhaustive detail.
This suggests that, for the transactions they target, ex post periodic adjustments can yield an arm’s-length result more reliably than methods that the IRS has spent years designing and defending. If profit projections, like comparables, are just another dubious form of ex ante information, has the IRS been wasting its time and efforts? If ex post adjustments can more reliably yield an arm’s-length result whenever they apply, then it would arguably make more sense to strictly enforce periodic adjustments and allow more flexibility regarding ex ante methods.
These questions lie well beyond the scope of AM 2025-001, and it would be unreasonable to look for answers in this memorandum. For now, AM 2025-001 represents a major step toward a more faithful implementation of the IRS’s statutory mandate to enforce the commensurate with income standard. But the questions raised by the memorandum are important, and the IRS may have to address them eventually.
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