PRIVILEGED AND CONFIDENTIAL — ATTORNEY WORK PRODUCT SUBJECT TO ATTORNEY-CLIENT PRIVILEGE
CALDERWOOD & HARKNESS LLP 1735 Market Street, Suite 3100 Philadelphia, PA 19103
MEMORANDUM
To: Sylvia Hartwell, Billing Partner, Tax Department
From: Leonard Cross, Responsible Partner, Tax Department
Date: December 5, 2023
Re: Hazards of Litigation Analysis — Penterra Pharmaceuticals Corp. IRS Transfer Pricing Examination (TY 2017–2020)
Matter No.: 1018-00009
Privileged and Confidential — Prepared in Anticipation of Litigation
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I. Purpose and Scope
The purpose of this memorandum is to assess the litigation hazards that Penterra Pharmaceuticals Corp. ("PPC" or the "Company") would face if the Internal Revenue Service's proposed transfer pricing adjustments are not resolved at IRS Appeals and the case proceeds to the United States Tax Court. This analysis has been prepared in connection with the development of PPC's Appeals strategy following the issuance of the Notice of Proposed Adjustment ("NOPA") on October 12, 2023, and the 30-Day Letter on November 8, 2023. The Formal Protest is currently being finalized by this firm for filing by the December 22, 2023 deadline.
This analysis covers all four tax years under examination: TY 2017, TY 2018, TY 2019, and TY 2020. The IRS's proposed adjustments across these four years total a net amount of $380.4 million, broken down as follows:
• CSA Cost-Sharing Adjustments: $235.01 million
• Royalty Rate Adjustments: $188.04 million
• Correlative Offset: ($42.65 million)
• Net Proposed Adjustment: $380.4 million
In addition, the IRS has proposed a penalty under IRC § 6662(e) for substantial valuation misstatement in the amount of approximately $15.98 million, calculated as 20% of the underpayment of tax attributable to the full $380.4 million adjustment at the 21% corporate tax rate.
This memorandum assigns probability-weighted assessments to each IRS position and models potential Tax Court outcomes across a range of scenarios. The purpose of this modeling is to inform PPC's settlement posture at IRS Appeals and to provide the analytical framework for the Settlement Authority Memorandum that will be prepared separately for distribution to the client's decision-makers. The probability-weighted analysis contained herein reflects our professional judgment based on our review of the applicable law, regulations, and case authority; the factual record developed during the examination; the economic analyses performed by Whitmore Valuation Group; and our experience with similar transfer pricing disputes at both the Appeals and Tax Court levels.
This memorandum is intended exclusively for internal use by Calderwood & Harkness LLP in furtherance of the attorney-client relationship with PPC and is protected by the attorney-client privilege and the attorney work product doctrine. It should not be shared with the client or any third party without further review and preparation of a separate Settlement Authority Memorandum suitable for client distribution.
II. Executive Summary of Litigation Hazard Assessment
Overall Assessment
PPC's transfer pricing positions are well-supported by contemporaneous documentation, robust economic analysis, and a strong factual record of operational substance at Penterra Biopharma Ireland Ltd. ("PBI"). The IRS would face significant hazards in sustaining the full proposed adjustments at trial. Based on our analysis of the individual issues and their interrelationships, we conclude that the probability-weighted outcome in Tax Court would result in the IRS sustaining only approximately 10–20% of its proposed adjustments.
Issue-by-Issue Summary
CSA Cost-Sharing Issue ($235.01M proposed adjustment). The IRS faces moderate-to-high litigation hazards on this issue. We estimate the probability of the IRS fully prevailing—that is, sustaining the entire $235.01 million adjustment—at approximately 10–15%. The probability of partial IRS success, in which the Tax Court would sustain approximately 15–25% of the proposed CSA adjustment, is estimated at 35–45%. The IRS's central theory—that the alleged PCT undervaluation infects the ongoing cost-sharing ratios—is analytically problematic and lacks direct regulatory support. PPC's RAB methodology was prepared contemporaneously and is supported by WVG's independent benchmarking analysis.
Royalty Rate Issue ($188.04M proposed adjustment). The IRS faces high litigation hazards on this issue. The probability of the IRS fully prevailing—sustaining an 11.0% royalty rate—is estimated at only 5–10%. The probability of partial IRS success, sustaining approximately 10–20% of the proposed royalty adjustment, is estimated at 25–35%. PPC's 4.5% royalty rate falls almost exactly at the median of WVG's 14-CUT comparable set (IQR of 3.1%–6.8%), and the IRS's proposed rate of 11.0% appears to reflect cherry-picked comparables with materially different risk profiles and product lifecycles.
Economic Substance Challenge. The IRS faces very high litigation hazards on this issue. The probability of the IRS prevailing on its full recharacterization theory—that PBI lacked sufficient economic substance and should be disregarded—is estimated at less than 10%. PBI's 185 employees, €47.2 million in cumulative regulatory expenditures, 42 Dublin board meetings, and independent commercial operations across 68 country markets present a factual record that is far more robust than the "bare shell" entities typically targeted by economic substance challenges.
Penalty Issue ($15.98M proposed). PPC has a strong reasonable-cause defense under IRC § 6662(e)(3)(B). PPC maintained contemporaneous transfer pricing documentation for all four years, prepared by Crestfield & Associates, and the Company's transfer pricing positions are supported by well-reasoned economic analyses. We estimate the probability of full penalty abatement at 75–85%.
Recommended Settlement Posture
Based on the probability-weighted analysis, we recommend a settlement target range at IRS Appeals of 10–15% of the $380.4 million proposed adjustment, which corresponds to a total adjustment of approximately $38.0 million to $57.1 million, with full penalty abatement. This settlement range is consistent with, or slightly better than, the expected probability-weighted Tax Court outcome, and would avoid the substantial additional costs, delays, and uncertainties associated with Tax Court litigation. A detailed discussion of the recommended Appeals posture is set forth in Section XI below.
III. Background
A. PPC's IP Structure and Intercompany Arrangements
PBI Formation and the Cost-Sharing Arrangement
Penterra Biopharma Ireland Ltd. ("PBI") was incorporated on March 15, 2012, under the laws of Ireland, with its registered office and principal place of business in Dublin. Effective July 1, 2012, PPC and PBI entered into a Qualified Cost Sharing Arrangement ("CSA") under Treas. Reg. § 1.482-7. Under the CSA, PBI acquired the rights to develop and exploit PPC's pharmaceutical intellectual property portfolio for territories outside the Americas (the "non-Americas territory") in exchange for (i) a platform contribution transaction ("PCT") payment and (ii) ongoing cost-sharing contributions proportional to the reasonably anticipated benefits ("RAB") that each party expected to derive from the intangible development activities being co-funded under the CSA.
PCT Payment. The PCT payment was structured as a lump-sum payment of $312 million, paid by PBI to PPC on July 1, 2012. This payment compensated PPC for PBI's buy-in to the pre-existing intangible development activity pool, including the then-existing pipeline of pharmaceutical compounds and related know-how. PPC's contemporaneous valuation of the PCT, prepared by Crestfield & Associates, employed an income-method/Discounted cash flow ("DCF") analysis and concluded that $312 million fell within the arm's-length range for the buy-in rights. Whitmore Valuation Group subsequently confirmed this conclusion under its own independent DCF analysis, as discussed further in Section III.C below.
Cost-Sharing Ratios (TY 2017–2020)
Under the CSA, each party's share of the intangible development costs was determined annually based on the ratio of each party's reasonably anticipated benefits from the exploitation of the co-funded intangibles to the total RAB of all participants. The RAB ratios were calculated based on projected revenue splits between the Americas territory (PPC's territory) and the non-Americas territory (PBI's territory). During the examination years, PBI's cost-sharing percentages and the resulting cost-sharing contributions were as follows:
The gradual increase in PBI's cost-sharing percentage over the four-year period reflected the growing share of non-Americas revenue in PPC's global pharmaceutical portfolio, driven by expansion into additional non-Americas markets and increasing penetration in existing markets.
Legacy IP Royalty Arrangement
Separately from the CSA (which governs cost-shared intangibles developed after the July 1, 2012 effective date), PBI licensed certain pre-2012 legacy pharmaceutical compounds from PPC under an intercompany licensing agreement. The license covered the right to manufacture, market, and sell these legacy compounds in the non-Americas territory, subject to a royalty rate of 4.5% of net sales. The legacy compounds were mature products that were generally in the declining phase of their product lifecycle. Net sales and royalties for the examination years were as follows:
The declining trajectory of legacy compound sales is noteworthy and relevant to the royalty rate analysis discussed in Section V below, as it reflects the mature, declining-lifecycle nature of these products—a characteristic that is typically associated with lower royalty rates in comparable uncontrolled licensing transactions.
PBI Operations and Substance
PBI maintained substantial operational presence and performed meaningful functions in Ireland and throughout the non-Americas territory during the examination years. Key indicators of PBI's operational substance include the following:
Personnel. PBI's workforce grew from 52 employees at its inception in 2012 to 185 employees by the end of 2020. PBI's staff included dedicated teams for regulatory affairs, medical affairs, commercial strategy, and supply chain management. The growth in personnel reflected PBI's expanding role in the non-Americas market and its increasing responsibility for regulatory submissions, pricing decisions, distribution partner management, and market access across its territory.
Management. PBI was led by Managing Director Aidan Naughton, who was based full-time in Dublin and exercised day-to-day management authority over PBI's operations. Naughton reported to PBI's board of directors and had decision-making authority over key commercial and operational matters, including pricing, market entry strategy, regulatory submission priorities, and distribution partner selection.
Board Governance. During the four-year examination period (TY 2017–2020), PBI's board of directors held 42 meetings in Dublin, consisting of quarterly scheduled meetings and additional special sessions as needed. Board meeting minutes, which have been produced to the IRS in response to IDR No. 14, document substantive decision-making on topics including product pricing across individual country markets, regulatory submission strategy, capital expenditures on regulatory dossiers, selection and management of distribution partners, supply chain optimization, and market entry and withdrawal decisions.
Office Presence. PBI maintained approximately 18,000 square feet of office space at Sandyford Business Park in Dublin, Ireland. The office housed PBI's management team, regulatory affairs staff, commercial strategy personnel, and support functions.
Regulatory Expenditures. During TY 2017–2020, PBI incurred cumulative regulatory expenditures of approximately €47.2 million in connection with regulatory submissions, marketing authorization applications, post-marketing commitments, and pharmacovigilance activities across 68 country markets in its territory. These expenditures reflect PBI's substantive role in the protection and exploitation of the pharmaceutical IP portfolio in the non-Americas territory.
Independent Pricing. PBI made independent pricing decisions across the 68 non-Americas markets in its territory. Pricing was determined based on local market conditions, reimbursement frameworks, competitive dynamics, and regulatory requirements in each country. PBI's pricing function was staffed by a dedicated team of pricing and market access specialists based in Dublin.
Banking and Treasury. PBI maintained independent treasury operations with Glenmore Bank Ireland plc, including its own bank accounts, cash management functions, and intercompany settlement processes.
Intermediate Holding Entity — PHL
Penterra Holdings Luxembourg S.à r.l. ("PHL") served as an intermediate holding entity in the corporate structure. PHL was disregarded for U.S. federal income tax purposes and is not a party to the CSA or the legacy IP license. PHL's existence is noted for completeness but does not bear directly on the transfer pricing issues under examination.
Contract Manufacturing — PMI
Penterra Manufacturing Ireland Ltd. ("PMI") served as a contract manufacturer for PBI under a cost-plus arrangement at cost + 8%. PMI employed approximately 620 employees at its manufacturing facility in Ireland and produced pharmaceutical products for distribution in PBI's non-Americas territory. The cost + 8% markup was established based on a benchmarking study prepared by Crestfield & Associates and is not at issue in this examination.
Key Products. PPC's pharmaceutical portfolio included three significant product franchises during the examination years:
• Veritaxol (oncology): Global net sales of $3.12 billion in 2020, of which $1.34 billion was attributable to the non-Americas territory.
• Imvara (immunology): Global net sales of $1.87 billion in 2020, of which $0.79 billion was attributable to the non-Americas territory.
• Cerulon (rare disease): Global net sales of $0.62 billion in 2020, of which $0.28 billion was attributable to the non-Americas territory.
Veritaxol and Imvara were developed under the CSA as cost-shared intangibles, while certain legacy compounds predating the CSA were licensed under the separate royalty arrangement described above.
B. The IRS Examination and Proposed Adjustments
Examination Overview. The IRS initiated its examination of PPC's transfer pricing positions on May 16, 2022, under Examination Team designation LB&I-NE-TP-2022-00641. The examination team was led by Supervisory Revenue Agent Gerald Meskill and included Lead Revenue Agent Patricia Dunleavy, IRS Economist Dr. Alan Washburne, and IRS Chief Counsel attorneys Franklin Rosario (Attorney-Advisor) and Donna Hirabayashi (Senior Counsel). The involvement of Chief Counsel attorneys from the outset of the examination signals that the IRS views this case as a significant matter with potential for litigation.
Over the course of the examination, the IRS issued 47 Information Document Requests ("IDRs") between June 2022 and September 2023, covering the full range of PPC's intercompany transactions, PBI's functional profile and operational substance, the CSA terms and execution, the PCT valuation methodology, the legacy IP licensing arrangement, and PPC's contemporaneous transfer pricing documentation.
The NOPA and 30-Day Letter
On October 12, 2023, the IRS issued the NOPA covering all four examination years. The NOPA was followed by the 30-Day Letter on November 8, 2023. The IRS asserted four principal positions in the NOPA:
1. PCT Undervaluation. The IRS valued the PCT at $852 million, compared to PPC's $312 million, and used this purported undervaluation as a basis for recharacterizing the ongoing CSA ratios and royalty rates. The IRS's valuation was prepared by Dr. Washburne using a DCF methodology with a weighted-average cost of capital ("WACC") of 7.2%, compared to PPC's 9.8% WACC.
2. CSA Cost-Sharing Ratio Increase. The IRS proposed increasing PBI's cost-sharing percentage by 8–12 percentage points for each examination year, based on revised RAB calculations incorporating the IRS's higher PCT valuation and different revenue projections.
3. Royalty Rate Increase. The IRS proposed increasing the legacy IP royalty rate from 4.5% to 11.0% of net sales, based on a narrow selection of CUT data from third-party pharmaceutical licensing agreements.
4. Economic Substance Challenge. The IRS asserted that PBI lacked sufficient economic substance to justify its role as IP owner and CSA participant, arguing that key DEMPE functions (Development, Enhancement, Maintenance, Protection, and Exploitation) remained in the United States at PPC.
Detailed Proposed Adjustments
The IRS's proposed adjustments are summarized in the following table:
Proposed Penalty. The IRS proposed the 20% substantial valuation misstatement penalty under IRC § 6662(e) on the full $380.4 million adjustment, resulting in a proposed penalty of approximately $15.98 million (calculated as $380.4M × 21% × 20%, using the post-TCJA corporate rate as an approximation). The IRS reserved but did not assert the 40% gross valuation misstatement penalty under IRC § 6662(h), which would apply if the transfer pricing misstatement exceeded 400% of the correct amount. While the IRS's decision not to assert the 40% penalty is somewhat favorable, the reservation leaves open the possibility that the IRS could escalate to the higher penalty at Appeals or in Tax Court litigation.
C. PPC's Defense — Summary of Key Analyses
Contemporaneous Transfer Pricing Documentation
PPC maintained contemporaneous transfer pricing documentation for all four examination years, prepared by Crestfield & Associates ("Crestfield") under the supervision of Susan Lam, Transfer Pricing Partner, and Martin Ogilvy, Engagement Partner. The documentation was prepared in accordance with the requirements of Treas. Reg. § 1.482-7 (for the CSA) and Treas. Reg. § 1.482-4 (for the legacy IP license) and addressed the selection and application of the best method, the identification and analysis of comparable transactions, the documentation of the relevant functional analysis, and the establishment of arm's-length ranges for both the cost-sharing ratios and the royalty rate. The contemporaneous documentation is a critical component of PPC's reasonable-cause and penalty-protection defense under IRC § 6662(e)(3)(B).
Whitmore Valuation Group Engagement
Following the commencement of the IRS examination, Calderwood & Harkness retained Whitmore Valuation Group ("WVG") to perform independent economic analyses in support of PPC's defense. WVG was retained under a Kovel arrangement pursuant to a Kovel letter dated June 20, 2022, reference 1018-00009-KV, signed by the undersigned. Under this arrangement, WVG's work product is protected by the attorney-client privilege and work product doctrine as communications made at the direction of counsel in anticipation of litigation. The WVG engagement team was led by Dr. Helena Vasquez and Dr. Rohan Chakrabarti, both of whom are recognized experts in pharmaceutical industry transfer pricing and valuation.
WVG performed three principal analyses:
CUT Analysis (Royalty Rate). WVG identified 14 comparable uncontrolled pharmaceutical license agreements through a comprehensive search of publicly available databases, including Vireo Health IT, Sundial Health IT, and SEC filings. After applying comparability screens for therapeutic area, compound stage, territory scope, and risk allocation, the 14 agreements yielded an interquartile range ("IQR") of royalty rates of 3.1% to 6.8%, with a median of 4.4%. PPC's 4.5% royalty rate falls almost exactly at the median of this distribution and comfortably within the IQR, supporting the conclusion that the 4.5% rate reflects an arm's-length result.
CPM/TNMM Analysis (CSA). WVG conducted a comparable profits method ("CPM") / transactional net margin method ("TNMM") analysis using a set of 22 comparable distributors and IP-holding companies to test whether PBI's operating margins were consistent with arm's-length results. PBI's operating margins fell within the IQR of the comparable set in all four examination years, confirming that PBI's profitability was consistent with the functions performed, assets used, and risks assumed by comparable independent enterprises.
Income Method/DCF Analysis (PCT). WVG performed an independent DCF valuation of the PCT buy-in using a WACC of 9.8%, which was derived from a comparable company beta analysis and risk premium data appropriate for the pharmaceutical industry. WVG's DCF analysis yielded an arm's-length range for the PCT payment of $278 million to $361 million. PPC's actual PCT payment of $312 million falls within this range, supporting the conclusion that the PCT was priced at arm's length. By contrast, the IRS's WACC of 7.2% is significantly below the industry-appropriate range, which typically falls between 9% and 11% for pharmaceutical companies of PPC's risk profile.
Calderwood & Harkness Functional Analysis
In addition to the economic analyses performed by WVG, Calderwood & Harkness conducted a comprehensive functional analysis of PBI's operations, functions, assets, and risks. This analysis included 12 key employee interviews conducted by associates Jonathan Simmons and Priya Nazari in Dublin over the course of three trips during the examination period. The interviews covered PBI's regulatory affairs team, commercial strategy group, medical affairs department, supply chain management function, and senior management, including Managing Director Aidan Naughton.
The functional analysis documented PBI's substantive decision-making authority, risk management capabilities, and control over the commercialization of PPC's pharmaceutical products in the non-Americas territory. Key findings included: PBI's independent pricing decisions across 68 country markets; PBI's €47.2 million in cumulative regulatory expenditures on regulatory submissions, marketing authorization applications, and pharmacovigilance activities; PBI's capital expenditures on regulatory dossiers and post-marketing commitments; and PBI's independent selection and management of distribution partners across its territory.
IV. Hazard Analysis — Issue 1: CSA Cost-Sharing Ratio Adjustments ($235.01M)
A. IRS Position
The IRS proposes increasing PBI's cost-sharing percentage by 8 to 12 percentage points across each of the four examination years, which would result in additional cost-sharing payments from PBI to PPC totaling $235.01 million. The IRS's proposed percentages and resulting adjustments are as follows:
The IRS's position rests on two interrelated arguments. First, the IRS contends that PPC's projections of reasonably anticipated benefits understated the value of U.S.-source contributions to the intangible development activities, resulting in an allocation that shifted too much value to PBI's territory. Second, and more fundamentally, the IRS argues that the original PCT was undervalued—the IRS values it at $852 million versus PPC's $312 million—and that this undervaluation "infected" the ongoing RAB calculations by understating the baseline from which PBI's cost-sharing ratios were derived.
IRS economist Dr. Alan Washburne prepared the analysis underlying the proposed CSA adjustments. Dr. Washburne's analysis used different revenue projections than those employed by PPC in its contemporaneous RAB calculations and asserted that the original PCT undervaluation required a cascading adjustment to the ongoing cost-sharing ratios. The implicit theory is that because PBI obtained IP rights at below the arm's-length price, PBI's ongoing cost-sharing contributions must be increased to compensate PPC for the value that was purportedly undertransferred at the time of the PCT.
B. PPC's Position and Strengths
PPC's defense on the CSA cost-sharing issue rests on several strong foundations, each of which presents significant litigation hazards for the IRS.
Regulatory Compliance. PPC's RAB methodology followed the requirements of Treas. Reg. § 1.482-7(e), which provides that cost-sharing ratios under a qualified CSA are to be based on the reasonably anticipated benefits that each participant expects to derive from the intangible development activities. PPC calculated its RAB ratios based on projected revenue splits between the Americas and non-Americas territories, using contemporaneous revenue projections that were reasonable at the time of execution. This methodology is squarely within the framework contemplated by the regulations.
Reasonableness of Projections. PPC's revenue projections were prepared contemporaneously with the execution of the CSA and with each annual update to the cost-sharing ratios. The projections were developed by PPC's internal forecasting team in consultation with Crestfield & Associates and reflected management's best estimates of future revenues at the time. Actual results generally tracked the projections, with some modest deviations discussed below in Section IV.D. The consistency between projections and actual results supports the conclusion that the projections were reasonable when made and were not artificially depressed to shift costs to PBI.
WVG CPM/TNMM Confirmation. WVG's CPM/TNMM analysis of 22 comparable distributors and IP-holding companies confirms that PBI's operating margins fell within the arm's-length IQR in all four examination years. This independent benchmarking analysis provides a second avenue of support for the cost-sharing ratios: even if the Tax Court were to question the specific RAB projections, the fact that PBI's overall profitability is consistent with arm's-length results suggests that the cost-sharing ratios are not materially mispriced.
PCT Valuation Support. WVG's independent DCF analysis of the PCT payment, using a WACC of 9.8%, establishes an arm's-length range of $278 million to $361 million. PPC's actual PCT payment of $312 million falls within this range. This analysis directly undermines the IRS's foundational assertion that the PCT was undervalued by $540 million ($852M minus $312M), which in turn undermines the IRS's cascading adjustment theory.
Analytical Separation of PCT and Ongoing CSA. The IRS's approach of using the alleged PCT undervaluation to infect the post-2012 cost-sharing ratios is analytically problematic. Under the regulations, the PCT and the ongoing cost-sharing contributions are evaluated under separate regulatory provisions. The PCT payment is governed by Treas. Reg. § 1.482-7(g), which addresses the valuation of platform contributions, while the ongoing cost-sharing ratios are governed by Treas. Reg. § 1.482-7(d), which addresses the determination of cost-sharing contributions based on RAB. These are distinct analytical exercises, and the IRS's theory of cascading infection conflates two separate regulatory frameworks in a manner that lacks direct regulatory support.
discount Rate Dispute. The WACC dispute is one of the most significant analytical disagreements between PPC and the IRS. The IRS's use of a 7.2% WACC is significantly below the range typically observed for pharmaceutical companies. Industry-standard WACCs for pharmaceutical companies of PPC's size and risk profile generally fall in the range of 9% to 11%, reflecting the inherent risk of drug development and commercialization. WVG's 9.8% WACC is well-supported by comparable company beta analysis, equity risk premium data from published sources (including Westmark Consulting Group and Damodaran), and a debt-to-equity structure appropriate for a pharmaceutical company. The IRS's 7.2% rate appears to understate the risk premium and overstate the present value of future cash flows, which mechanically inflates the PCT valuation and cascades into the proposed CSA adjustments.
Harborview Corporation Precedent. The Tax Court's decision in Harborview Corporation, Inc. v. Commissioner, 154 T.C. 138 (2020), is instructive. In Harborview Corporation, the Tax Court engaged in a detailed review of comparability under the CUT method and rejected both the IRS's and the taxpayer's proposed transfer pricing methodologies, ultimately developing its own analysis based on the factual record. While Harborview Corporation involved a royalty rate rather than a CSA cost-sharing ratio, the case illustrates the Tax Court's willingness to scrutinize the IRS's methodology and reject it where the IRS fails to demonstrate adequate comparability. The IRS's approach here—simply shifting cost-sharing ratios by 8 to 12 percentage points without providing a robust comparable-based justification or an alternative methodology—is vulnerable to the same type of critique.
C. Litigation Hazards — IRS
The IRS faces several significant litigation hazards on the CSA cost-sharing issue:
Burden of Proof. Under IRC § 482, the IRS bears the initial burden of demonstrating that the taxpayer's method does not reflect arm's-length results. Only after the IRS has made this threshold showing does the burden shift to the taxpayer to demonstrate that its method is the best method. Given the strength of PPC's contemporaneous documentation and WVG's confirmatory analysis, the IRS will face a significant challenge in meeting its initial burden.
Hindsight Problem. The IRS's revenue projections underlying the proposed RAB adjustment appear to rely on hindsight—that is, actual results—rather than reasonable ex ante projections. This approach is disfavored under the regulations, which specifically require that RAB calculations be based on "reasonably anticipated" benefits, not actual outcomes. See Treas. Reg. § 1.482-7(e)(2)(ii). If the Tax Court finds that the IRS's projections impermissibly incorporate hindsight, the IRS's proposed adjustment would be significantly undermined.
Novel Cascading Theory. The IRS's linkage of the alleged PCT undervaluation to the ongoing CSA ratios is a novel theory that lacks direct regulatory support. No provision of the regulations expressly contemplates adjusting cost-sharing ratios based on an alleged undervaluation of a prior PCT payment. The Tax Court may reject this cascading adjustment as exceeding the IRS's authority under the regulatory framework or as conflating two analytically distinct inquiries.
Aggressive Revenue Assumptions. Dr. Washburne's analysis uses aggressive revenue growth assumptions for non-Americas markets that are inconsistent with actual market performance during the examination years. While the use of actual results to test projections is one thing, projecting future revenues at rates that exceed both the taxpayer's contemporaneous projections and the actual outcomes is analytically suspect and would be subject to significant challenge at trial.
Absence of Alternative Method. The IRS did not propose an alternative cost-sharing methodology. Rather, it simply increased PBI's percentages by 8 to 12 percentage points based on its own revised RAB calculations. This "adjustment without alternative method" approach is vulnerable under the best method rule set forth in Treas. Reg. § 1.482-1(c), which requires the IRS to establish that its proposed result reflects the best method application. The IRS's failure to identify and apply a specific alternative method—and instead simply adjusting the taxpayer's percentages upward—weakens the analytical foundation of its position.
D. Litigation Hazards — PPC
While PPC's position on the CSA issue is strong, it is not without risk. PPC faces the following litigation hazards:
Deviation from Projections. PPC's RAB projections, while reasonable at the time they were prepared, showed some deviation from actual results. In particular, actual non-Americas revenue somewhat exceeded PPC's projections in TY 2019 and TY 2020, primarily due to faster-than-anticipated uptake of Veritaxol in certain European and Asian markets. While regulatory law is clear that RAB calculations should be based on ex ante projections rather than actual results, the Tax Court may view these deviations as evidence that the projections were somewhat conservative with respect to non-Americas revenue, giving the IRS some factual basis to argue for a modest upward adjustment to the cost-sharing ratios.
Increasing PBI Percentage. PBI's cost-sharing percentage increased from 38.2% in 2017 to 42.7% in 2020. While this increase was consistent with the contemporaneous projections (which anticipated growing non-Americas market share), the trajectory could draw scrutiny from the Tax Court as to whether the increasing percentage was genuinely based on ex ante projections or was adjusted in hindsight to reflect actual performance. PPC will need to demonstrate through the contemporaneous documentation that the trajectory was embedded in the original projections and updated consistently with the CSA's terms.
Judicial Scrutiny of IP-Holding Structures. Some courts have been receptive to IRS arguments that IP-holding structures in low-tax jurisdictions warrant heightened scrutiny of CSA arrangements and transfer pricing positions generally. While this sentiment is not a legal standard, it can influence the Tax Court's overall assessment of the transaction and the credibility of the taxpayer's positions. PPC's strong factual record of PBI substance mitigates this risk, but it does not eliminate it entirely.
E. Probability Assessment — CSA Issue
Based on the foregoing analysis, we assign the following probability estimates to the range of potential Tax Court outcomes on the CSA cost-sharing issue:
Expected value of IRS adjustment on CSA issue: approximately $30 million to $50 million (roughly 13–21% of the proposed $235.01 million adjustment).
The expected value reflects a scenario in which the Tax Court is most likely to make a modest adjustment to PPC's cost-sharing ratios—perhaps 2 to 4 percentage points rather than the IRS's proposed 8 to 12 percentage points—based on a finding that PPC's RAB projections were somewhat conservative for the non-Americas territory in the later examination years. However, the Tax Court is unlikely to adopt the IRS's cascading PCT theory or its full proposed adjustment.
V. Hazard Analysis — Issue 2: Royalty Rate Adjustment ($188.04M)
A. IRS Position
The IRS proposes increasing the royalty rate on legacy IP from 4.5% to 11.0% of net sales for PBI's non-Americas territory. This increase would result in additional royalty payments from PBI to PPC totaling $188.04 million across the four examination years, as follows:
The IRS's proposed 11.0% royalty rate is based on CUT data from third-party pharmaceutical licensing agreements. The IRS selected a small number of CUTs—our review indicates that the NOPA references approximately five or six agreements—with royalty rates clustered at or above 10%, which the IRS asserts are more comparable to PPC's legacy pharmaceutical compounds than the broader set identified by PPC and WVG. The IRS's position emphasizes the high value and commercial success of PPC's legacy compounds and contends that the 4.5% rate fails to reflect the full value of the underlying IP.
B. PPC's Position and Strengths
PPC's defense on the royalty rate issue is particularly strong and presents the most significant litigation hazards for the IRS.
WVG's Broader and More Defensible CUT Set. WVG identified 14 comparable uncontrolled pharmaceutical license agreements through a comprehensive search methodology, as described in Section III.C above. This is a substantially broader and more defensible set than the IRS's narrow selection of five or six agreements. The breadth of WVG's comparable set enhances its statistical reliability and reduces the risk of selection bias, both of which are important factors in Tax Court CUT analysis.
PPC's Rate Within the IQR. The IQR of WVG's 14-CUT set ranges from 3.1% to 6.8%, with a median of 4.4%. PPC's 4.5% royalty rate falls almost exactly at the median and comfortably within the IQR. Under Treas. Reg. § 1.482-1(e)(2)(iii)(B), where the taxpayer's result falls within the arm's-length range established by the best method, no adjustment is warranted. PPC's 4.5% rate is as close to the statistical center of the arm's-length range as one could reasonably expect, which is a powerful defense against the IRS's proposed adjustment.
High Comparability Standard for CUTs. Under Treas. Reg. § 1.482-4(c), the comparable uncontrolled transaction method requires a high degree of comparability between the controlled and uncontrolled transactions. PPC's selected CUTs are closely comparable in terms of therapeutic area, stage of compound development (i.e., commercialized, mature products), geographic market territory, and risk allocation between licensor and licensee. In contrast, the IRS's proposed CUTs appear to include agreements involving materially different risk profiles and transaction characteristics, as discussed below.
IRS's CUTs Are Insufficiently Comparable. Our review of the IRS's selected CUTs indicates that several of the agreements relied upon by the IRS involve early-stage compounds with higher optionality value, agreements that bundle marketing support obligations not present in the PPC-PBI arrangement, or transactions covering different therapeutic areas with different market dynamics. The inclusion of early-stage compounds in the IRS's comparable set is particularly problematic, as such compounds carry significantly higher risk and correspondingly higher royalty rates to compensate the licensor for the risk of development failure. PPC's legacy compounds, by contrast, were fully commercialized, mature products with established market positions and declining sales trajectories.
Declining Lifecycle of Legacy Compounds. The legacy compounds subject to the 4.5% royalty were mature products in the declining phase of their lifecycle, as evidenced by the decline in net sales from $814.6 million in 2017 to $624.1 million in 2020. Royalty rates for mature, declining products are typically lower than for blockbuster or growth-stage IP, because the licensor's contribution to the licensee's future profitability is diminishing as the products approach patent expiration or face increasing generic competition. This lifecycle characteristic strongly supports a royalty rate at or below the median of a well-constructed comparable set, not at the 11.0% level proposed by the IRS.
Harborview Corporation Precedent. The Tax Court's decision in Harborview Corporation is particularly instructive on the royalty rate issue. In that case, the Tax Court engaged in extensive CUT comparability analysis and rejected the IRS's proposed royalty rate where the IRS's CUTs were found to be insufficiently comparable to the controlled transaction. The court's willingness to reject the IRS's rate and engage in its own comparability analysis provides strong precedent for PPC's position that the IRS's narrow, cherry-picked CUT selection should not be adopted.
C. Litigation Hazards — IRS
The IRS faces high litigation hazards on the royalty rate issue, including the following:
Vulnerable CUT Selection. The IRS's CUT selection methodology is vulnerable to challenge on multiple grounds. The narrow sample size—five or six agreements compared to WVG's fourteen—increases the risk of selection bias and reduces the statistical reliability of the IRS's arm's-length range. Moreover, the IRS's selection criteria appear to have been designed to identify high-royalty agreements rather than the most comparable agreements, which is the standard required by the regulations.
Rate Outside IQR. The IRS's proposed 11.0% rate is significantly above the median and the 75th percentile of WVG's broader comparable set. The Tax Court has historically been skeptical of proposed rates that fall outside the arm's-length range established by a well-constructed benchmarking study, and the distance between the IRS's proposed rate and the center of WVG's range is substantial.
Failure to Account for Lifecycle. The IRS did not adequately account for the declining lifecycle of the legacy compounds in its CUT comparability analysis. By including agreements involving growth-stage and early-stage IP in its comparable set, the IRS failed to control for one of the most important comparability factors affecting royalty rates in pharmaceutical licensing transactions.
Burden of Proof. As with the CSA issue, the IRS bears the initial burden of demonstrating that PPC's 4.5% rate does not reflect arm's-length results. Given that PPC's rate falls at the median of WVG's well-constructed comparable set, the IRS will face a significant challenge in meeting this burden. The IRS will need to demonstrate not only that its own CUTs are more comparable than PPC's CUTs, but also that PPC's broader comparable set is flawed—a heavy burden in light of WVG's thorough search methodology and comparability screening process.
D. Litigation Hazards — PPC
PPC faces some litigation hazards on the royalty rate issue, though they are more modest than those faced by the IRS:
Potential for Upward Adjustment Within IQR. Some Tax Court judges have been willing to select a rate within the IQR but above the taxpayer's actual rate, particularly where the IRS demonstrates that certain of the taxpayer's CUTs require comparability adjustments. If the Tax Court determines that several of PPC's 14 CUTs require adjustments for factors such as exclusivity scope, geographic territory size, or supply chain obligations, the adjusted IQR could shift modestly upward, potentially supporting a rate in the range of 5.0% to 6.0%.
CUT Adjustability. While PPC's 4.5% rate falls at the median of the unadjusted IQR, the Tax Court could find that certain of PPC's CUTs are less comparable than others when subjected to detailed scrutiny. For example, if the Tax Court excludes two or three of the lower-royalty CUTs as insufficiently comparable, the median of the remaining set could increase modestly. PPC should be prepared to defend the comparability of each individual CUT in the WVG set, and WVG's trial testimony should address the sensitivity of the IQR to the inclusion or exclusion of specific agreements.
Modest Adjustment Risk. If the Tax Court adjusts the royalty rate modestly upward—for example, to 5.5% or 6.0%—PPC would face a real, though relatively small, adjustment on the royalty issue. However, the dollar impact of such an adjustment would be modest in absolute terms, particularly given the declining sales trajectory of the legacy compounds.
Double-Edged Nature of Declining Sales. The declining sales trajectory of the legacy compounds, while supporting a lower royalty rate as a matter of economic analysis, also reduces the absolute dollar impact of any rate adjustment. This means that even if the Tax Court adjusts the rate upward, the resulting additional royalties would be smaller in later years due to the declining revenue base. While this is a favorable dynamic from a total dollar perspective, it also means that the IRS could argue that the declining revenue trajectory is already reflected in the year-over-year numbers and should not be a basis for reducing the royalty rate below what would otherwise be appropriate for the compounds' commercial value.
E. Probability Assessment — Royalty Issue
Based on the foregoing analysis, we assign the following probability estimates to the range of potential Tax Court outcomes on the royalty rate issue:
Expected value of IRS adjustment on royalty issue: approximately $15 million to $35 million (roughly 8–19% of the proposed $188.04 million adjustment).
The expected value reflects a scenario in which the Tax Court is most likely to either sustain PPC's 4.5% rate or adjust it modestly upward to a rate in the range of 5.0% to 6.0%, based on comparability refinements within WVG's comparable set. The IRS's proposed 11.0% rate is very unlikely to be sustained, and even a partial IRS success would likely result in a rate well below the IRS's position.
VI. Hazard Analysis — Issue 3: Economic Substance Challenge
A. IRS Position
The IRS asserted that PBI lacked sufficient economic substance to justify its role as IP owner and CSA participant. The IRS's position is grounded in the DEMPE framework—Development, Enhancement, Maintenance, Protection, and Exploitation—and argues that the key DEMPE functions remained in the United States at PPC throughout the examination period. Under the IRS's theory, PBI was essentially a shell holding entity that did not exercise meaningful control over the intellectual property or the commercial exploitation of PPC's products in the non-Americas territory.
If this position were sustained, it would support a recharacterization of PBI's income as attributable to PPC, which would magnify both the CSA and royalty adjustments by eliminating PBI's entitlement to residual profit from the non-Americas exploitation of the IP portfolio. The economic substance challenge thus serves as a backstop theory that would significantly increase PPC's exposure if sustained, while also providing the IRS with additional leverage at Appeals.
B. PPC's Position and Strengths — Economic Substance Evidence
PPC's factual record on the economic substance issue is exceptionally strong. PBI's operational profile during the examination years far exceeds the level of substance that would be necessary to withstand an economic substance challenge, and the evidence comprehensively documents PBI's control over the key DEMPE functions for the non-Americas territory.
Personnel. PBI employed 185 people by the end of 2020, having grown from 52 employees at inception in 2012. The workforce included dedicated teams for regulatory affairs, medical affairs, commercial strategy, and supply chain management. This level of staffing is well beyond what would be expected of a mere holding company or conduit entity and reflects a genuine, functioning business operation.
Managing Director. PBI's Managing Director, Aidan Naughton, was based full-time in Dublin and exercised day-to-day management authority over PBI's operations. Naughton made or approved key operational and commercial decisions, reported to PBI's board of directors, and was responsible for the overall performance of PBI's non-Americas business. His role is documented through employment records, decision memoranda, and the 12 key employee interviews conducted by C&H.
Board Governance. During TY 2017–2020, PBI's board of directors held 42 meetings in Dublin, consisting of quarterly scheduled meetings and additional special sessions convened as needed to address significant business matters. The board meetings were attended by a majority of directors physically present in Dublin (with occasional participation by telephone for directors traveling), and the minutes document substantive decision-making on pricing, market entry, regulatory submissions, capital expenditures, distribution partner selection, and strategic planning. The 42 board meetings represent an average of more than 10 meetings per year—a frequency that exceeds the governance practices of many independent companies and strongly supports the conclusion that PBI's board exercised genuine oversight and control.
Office Presence. PBI maintained approximately 18,000 square feet of office space at Sandyford Business Park, Dublin, Ireland. The office served as PBI's headquarters and housed its management, regulatory, commercial, and support teams.
Regulatory Expenditures. PBI incurred cumulative regulatory expenditures of approximately €47.2 million during TY 2017–2020 in connection with regulatory submissions, marketing authorization applications, post-marketing commitments, and pharmacovigilance activities across 68 country markets. These expenditures represent PBI's performance of the "Protection" and "Maintenance" elements of the DEMPE framework, as well as significant aspects of "Exploitation."
Independent Pricing. PBI made independent pricing decisions across its 68 non-Americas markets, based on local market conditions, reimbursement frameworks, competitive dynamics, and regulatory requirements. PBI's pricing function was staffed by a dedicated team of pricing and market access specialists. The independence of PBI's pricing decisions is one of the strongest indicators of PBI's control over the "Exploitation" element of the DEMPE framework.
Banking and Treasury. PBI maintained independent treasury operations with Glenmore Bank Ireland plc, including its own bank accounts, cash management functions, and intercompany settlement processes. PBI managed its own working capital and made independent decisions regarding the timing and method of intercompany payments.
Contract Manufacturing. PBI managed its own manufacturing supply chain through PMI (cost + 8%) and other third-party manufacturers, making independent decisions regarding manufacturing volumes, quality control, supply logistics, and distribution channel management.
Key Employee Interviews. Calderwood & Harkness associates Jonathan Simmons and Priya Nazari conducted 12 key employee interviews in Dublin during the examination period, documenting the substantive functional contributions of PBI's personnel across regulatory affairs, commercial strategy, medical affairs, supply chain management, and senior management. The interview memoranda, maintained in the privilege file, provide detailed evidence of PBI's decision-making authority and functional capabilities.
Comprehensive Functional Analysis. C&H's functional analysis comprehensively documented PBI's control over DEMPE functions for non-Americas exploitation, including PBI's role in enhancement (through localized formulation and packaging development), maintenance (through pharmacovigilance and quality assurance), protection (through regulatory filings and trademark enforcement), and exploitation (through independent pricing, distribution partner management, and market access activities).
C. Litigation Hazards — IRS
The IRS faces very high litigation hazards on the economic substance issue:
Robust Operational Substance. PBI's operational substance is significantly more robust than the "bare shell" entities typically targeted by economic substance challenges. The IRS's economic substance argument is designed for cases involving entities with minimal or no employees, no physical presence, and no genuine decision-making authority. PBI, with 185 employees, €47.2 million in regulatory expenditures, and independent decision-making across 68 markets, presents a factual record that is far removed from the "bare shell" paradigm.
Board Meeting Documentation. The 42 Dublin board meetings with documented substantive decisions are powerful evidence of genuine governance and control. The frequency, location, and content of these meetings directly rebut the IRS's assertion that PBI was a mere conduit for PPC's operations.
Tax Court Standards. The Tax Court has generally required the IRS to demonstrate that the foreign entity is a mere conduit or lacks any meaningful economic activity in order to sustain an economic substance challenge. See, e.g., Compaq Computer Corp. v. Commissioner, 277 F.3d 778 (5th Cir. 2001); Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006). PBI's profile is far from the standard the IRS would need to establish.
OECD DEMPE Framework. The OECD Transfer Pricing Guidelines (2017 and 2022 editions), Chapter VI, establish the DEMPE framework as the analytical tool for determining the allocation of residual profit among related entities. While the OECD Guidelines are not binding on U.S. courts, they are persuasive authority and are frequently cited by the Tax Court. The Guidelines support the conclusion that an entity such as PBI, which performs and controls key exploitation, maintenance, and protection functions and assumes associated risks, is entitled to residual profit commensurate with its functional contributions.
Duplicative Theory. The IRS's economic substance argument is partially duplicative of its CSA and royalty arguments. To the extent the IRS contends that PBI's functions, assets, and risks do not justify the level of profit allocated to PBI, this is more properly an IRC § 482 pricing issue—which is already addressed through the CSA and royalty adjustments—rather than a threshold economic substance issue. The Tax Court may view the economic substance argument as an alternative or overlapping theory rather than an independent basis for adjustment, which would limit its practical impact.
D. Litigation Hazards — PPC
PPC faces limited but non-trivial risks on the economic substance issue:
U.S.-Based R&D Functions. PPC's U.S. operations did perform core R&D and early-stage development functions. This is the "Development" and "Enhancement" prong of the DEMPE framework, and the IRS could argue that these prongs remained substantially in the United States. However, this is precisely the function that the CSA regulations contemplate: the U.S. parent performs R&D, the foreign participant co-funds it through cost-sharing contributions, and the foreign participant controls exploitation in its territory. The existence of U.S.-based R&D is not inconsistent with PBI's economic substance; rather, it is the raison d'être of the CSA.
Profit Commensurate with Functions. There is some risk that the Tax Court could find that PBI's functions, while real, were not commensurate with the level of profit allocated to PBI under the intercompany arrangements. However, this concern is more properly an IRC § 482 pricing issue than a threshold economic substance issue. If the Tax Court believes that PBI's profit is too high relative to its functional contributions, the appropriate remedy is a pricing adjustment under the CSA or royalty provisions—not a wholesale recharacterization of PBI's income as attributable to PPC.
E. Probability Assessment — Economic Substance Issue
Based on the foregoing analysis, we assign the following probability estimates to the range of potential Tax Court outcomes on the economic substance issue:
Expected impact: The economic substance issue is unlikely to serve as an independent basis for adjustment by the Tax Court. If the IRS's economic substance argument partially succeeds—for example, if the Tax Court finds that PBI's Development or Enhancement functions were less robust than claimed—it would most likely reinforce a modest upward adjustment to the CSA ratios or royalty rate under the pricing analysis, rather than dramatically changing the expected adjustment range. In other words, the economic substance issue is more likely to serve as a factor influencing the magnitude of the CSA and royalty adjustments than as a standalone basis for recharacterization.
The very low probability of full IRS success on this issue reflects the strength of PBI's factual record and the high evidentiary standard that the Tax Court would require the IRS to satisfy in order to disregard a foreign entity with 185 employees, €47.2 million in regulatory expenditures, and documented independent decision-making authority.
VII. Hazard Analysis — Issue 4: Correlative Offset ($42.65M)
The IRS examination team allowed a correlative offset of $42.65 million in the NOPA to avoid double-counting between the CSA and royalty adjustments. This offset reflects the fact that, to the extent PBI's cost-sharing contributions are increased and its royalties are simultaneously increased, some portion of the additional amounts flowing to PPC would overlap, and the IRS reduced its total proposed adjustment accordingly.
If the case proceeds to Tax Court, the availability of correlative adjustments under Treas. Reg. § 1.482-1(g) should be preserved. The regulations provide that the IRS shall take into account the effect of any IRC § 482 allocation on other related-party transactions and make appropriate correlative adjustments to avoid double taxation or distortion.
There is a modest risk that the Tax Court might not apply the correlative offset identically to the manner in which the IRS applied it in the NOPA. Depending on how the Tax Court resolves the underlying CSA and royalty issues, the offset could be higher or lower than $42.65 million. For example, if the Tax Court sustains a smaller CSA adjustment but a larger royalty adjustment (or vice versa), the mechanical interaction between the two issues could produce a different offset amount.
Assessment: This is a derivative issue. The correlative offset will be mechanically determined based on the resolution of the CSA and royalty issues and does not present an independent litigation hazard. We do not assign a separate probability-weighted assessment to this issue, as it is subsumed within the analyses of Issues 1 and 2 above.
VIII. Hazard Analysis — Issue 5: IRC § 6662(e) Penalty ($15.98M)
A. IRS Position
The IRS proposed the 20% substantial valuation misstatement penalty under IRC § 6662(e) on the full $380.4 million adjustment. The penalty is computed as follows:
$380.4M × 21% = $79.88M (estimated underpayment of tax) $79.88M × 20% = $15.98M (rounded)
The IRS reserved but did not assert the 40% gross valuation misstatement penalty under IRC § 6662(h), which would apply if the transfer price or value claimed on PPC's return was 200% or more (or 50% or less) of the correct amount. The IRS's decision to reserve this penalty without asserting it suggests that the IRS examination team recognized the uncertainty of its position on the magnitude of the proposed adjustments, while leaving open the possibility of escalation.
B. PPC's Reasonable Cause Defense
PPC has strong grounds for penalty abatement under the reasonable cause and good faith exception set forth in IRC § 6662(e)(3)(B). This exception provides that a taxpayer shall not be subject to the transfer pricing penalty if the taxpayer (i) maintained contemporaneous documentation establishing that the taxpayer's transfer pricing methodology was reasonable and (ii) acted in reasonable cause and good faith with respect to the transfer pricing position.
PPC's reasonable cause defense rests on the following foundations:
Contemporaneous Documentation. PPC maintained contemporaneous transfer pricing documentation for all four examination years, prepared by Crestfield & Associates under the supervision of Susan Lam and Martin Ogilvy. The documentation was prepared in accordance with the requirements of Treas. Reg. § 1.6662-6(d) and IRC § 6662(e)(3)(B) and included:
(a) A description of the principal documents relied upon in establishing the transfer pricing methodology;
(b) An analysis of the functions performed, risks assumed, and resources employed by each controlled participant;
(c) A description of the method selected as the best method and the reasons for rejecting alternative methods;
(d) A description of the comparable uncontrolled transactions, comparable profits, or other benchmarking data relied upon;
(e) An explanation of the economic analysis underlying the selection of the arm's-length range; and
(f) An index of the principal and background documents.
Methodology Reasonableness. The documentation established the methodology, selected the best method, and provided contemporaneous analysis supporting both the CSA cost-sharing ratios (under Treas. Reg. § 1.482-7) and the 4.5% royalty rate (under Treas. Reg. § 1.482-4). The selected methods—RAB-based cost-sharing for the CSA and the CUT method for the royalty—are widely recognized as appropriate for these types of transactions and are among the methods specified by the regulations.
Reliance on Professional Advice. PPC retained sophisticated outside advisors for both the original transfer pricing documentation (Crestfie