Advance pricing agreements - a strategic tool in global transfer pricing management.

• Author: Canale, David J.

Introduction

The Internal Revenue Service's Advance Pricing Agreement (APA) Program was established in March 1991 to avoid transfer pricing disputes by entering into prospective agreements with taxpayers regarding their transfer pricing. In the 17 years of its existence, the APA Program has completed nearly 800 APAs and has evolved into the forum of choice for the most challenging transfer pricing issues. (1) The IRS completed 81 APAs during 2007, (2) and had an inventory of 249 APAs pending at various stages of development as of December 31, 2007. (3) Based on numerous public comments by taxpayers, practitioners, and tax officials from other countries, the APA process has been generally effective. (4)

Historically, taxpayers have chosen to pursue APAs to avoid transfer pricing uncertainty and freedom from exposure to double tax and penalties. More recently, U.S.-based multinational corporations have been motivated to pursue APAs to achieve certainty for financial reporting purposes. Further, greatly increased global enforcement efforts have encouraged both U.S.-based and non-U.S. based MNCs to pursue APAs to avoid examinations, or develop a representative arm's-length outcome on a fact pattern repeated in other countries (e.g., negotiate a bilateral APA for the MNC's distribution transactions that are similarly structured in other countries). The increase in demand for APAs is also reflected in the increased number of countries that have established APA programs--34 at current count. (5)

This article presents a comprehensive review of all aspects of the IRS APA process. Section II describes APAs and the IRS APA Program. Section III discusses taxpayer motivation to seek an APA. Section IV provides a detailed explanation of the IRS APA process, from considering whether to pursue an APA through APA renewal, including the roles of the participants.

APAs and the APA Program

1. APAs Generally

   APAs are intended to resolve transfer pricing issues before they arise. An APA is an agreement between a taxpayer and the IRS in advance of the taxpayer transactions, in which the parties set forth the best transfer pricing method (TPM) to use for purposes of calculating and allocating the taxable income which arises as a result of the specified transactions. APAs help ensure that the taxpayer satisfies the requirements of section 482 of the Internal Revenue Code. Among other things, the APA formalizes an agreement to the facts surrounding the transactions to which it will apply, the TPM, the taxable years to which the APA will apply, and an arm's-length range of results.

2. Unilateral/Bilateral APAs

   APAs may involve agreements with one or more foreign competent authorities under applicable income tax treaties. Such APAs are referred to as "bilateral" or "multilateral," as opposed to "unilateral" APAs that involve agreement only between the IRS and the taxpayer. Initially, only 50 percent of all APAs were bilateral; current statistics indicate that bilateral APA requests constitute more than 84 percent of the APA inventory. (6)

   When mutual agreement procedures are available with respect to the foreign countries involved, the taxpayer must show sufficient justification for seeking a unilateral APA. (7) Although a unilateral APA with the United States may provide protection from U.S.-initiated adjustments and penalties, it provides no protection from foreign-initiated adjustments. The bilateral approach creates efficiency by involving both competent authorities in the negotiation from the outset. By working simultaneously with both tax authorities, taxpayers can remain involved in the process and assist the governments to reach an appropriate solution to the taxpayer's transfer pricing issues.

3. Rollback to Resolve Prior Tax Years

   A"rollback" (i.e., application of the TPM developed in an APA to prior tax years not covered by the APA) is an effective means of addressing unresolved tax issues. It is IRS policy that, whenever feasible, the TPM used in the APA should be used to resolve transfer pricing issues for prior taxable years. (8) The IRS deems rollback appropriate where the business and economic conditions in the rollback years are consistent with those of the APA years. Rollback contemplates application of the TPM, comparable selection criteria, and financial adjustments to the rollback years, but not necessarily the application of the arm's-length range developed in the APA. The taxpayer may request a rollback at any time before completion of APA negotiations. Even without a taxpayer request, the IRS may determine that the approach agreed to in an APA should be applied to prior years. (9)

   In seeking a bilateral APA, the taxpayer can resolve its open transfer pricing issues with all countries involved in a transaction. The IRS will consider a taxpayer rollback request of a bilateral APA to years under examination, as a request for accelerated competent authority assistance. (10) It will treat a rollback request of a bilateral APA to years before Appeals as a request for simultaneous Appeals competent authority consideration. (11) In either circumstance, the taxpayer resolves all of its transfer pricing issues in one forum on an accelerated basis.

   Motivation to Seek an APA

   The IRS established the APA process as a common-sense alternative to prolonged, expensive litigation, previously seen as the primary method for resolving transfer pricing disputes. The APA process provides a number of substantial benefits to taxpayers.

1. Certainty

   The most important benefit provided by the APA process is certainty of tax treatment. This certainty extends to:

   * Freedom from U.S. penalty;

   * Freedom from U.S. adjustment;

   * Adequacy of U.S. documentation;

   * Freedom from double tax; Freedom from a finding of "material weakness" in internal controls; and

   * Freedom from an uncertain tax provision.

   The costs of transfer pricing uncertainty have risen dramatically in recent years. As transfer pricing examination activity in the United States has increased, the likelihood of a sustained adjustment and penalty have increased. The same is now true in other countries. Furthermore, Sarbanes-Oxley (12) and FIN 48 (13) compliance has created financial reporting exposure if the tax reporting for transfer pricing issues is not reliable. In combination, these developments have substantially increased the value of the certainty obtainable through the APA process.

   In the APA process, the taxpayer and the IRS agree upon facts, the TPM, and an arm's-length range of results. If the taxpayer complies with the terms and conditions of the APA, the IRS will regard the results of the taxpayer's TPM as satisfying the arm's-length standard. (14) Further, any examination of transactions covered by the APA is limited to establishing the taxpayer's compliance with the APA. (15) Therefore, compliance with an APA protects taxpayers from transfer pricing adjustments and penalties.

   An APA also addresses a taxpayer's uncertainty regarding transfer pricing recordkeeping. (16) Without an APA, a taxpayer may feel compelled to retain documentation that analyzes all possible TPMs to be certain of compliance with recordkeeping requirements and establish that its pricing approach complies with the arm's-length standard and best method rule, no matter which method the IRS may seek to impose. After the taxpayer and the IRS sign an APA, the taxpayer may realize immediate recordkeeping reductions because it is only required to support the TPM agreed to in the APA.

   Another area of uncertainty that can be addressed through the APA process is the taxpayer's exposure to inconsistent treatment in other countries and the attendant risk of double taxation. (17) This certainty can only be provided through a bilateral APA. Therefore, it is not surprising that more than half of the completed APAs have been bilateral agreements and 84 percent of all pending APAs are bilateral in approach. (18)

2. Taxpayer Involvement in Competent Authority Negotiations

   All U.S. income tax treaties contain a Mutual Agreement Provision (MAP) sometimes referred to as the "competent authority process" that encourages negotiations between the competent authorities to resolve disputes arising under the treaty, including transfer pricing disputes. (19) Taxpayers facing a proposed IRS transfer pricing adjustment may seek competent authority assistance to eliminate double taxation arising from a transfer pricing adjustment in a country that maintains an income tax treaty with the United States. (20) The MAP, essentially a government-to-government negotiation, provides the taxpayer with only a limited opportunity to present its views to the competent authorities.

   In contrast, a bilateral APA allows taxpayers to actively participate in the development of the U.S. negotiating position. Even though the taxpayer is not present during the actual negotiations between the U.S. and foreign competent authorities, taxpayers remain in contact with both for purposes of assisting in the factual development of the case and providing the taxpayer's viewpoint regarding the TPMs and adjustments discussed.

   The bilateral negotiation of an APA often takes less time than the MAP resolution of double tax cases for a number of reasons. First, in most countries, APA cases may be scheduled for negotiation without adherence to the quarterly or semiannual schedule for double tax cases. Second, the taxpayer prepares a well-documented APA request that includes nearly all information necessary to negotiate the case to its bilateral conclusion. Taxpayer involvement helps eliminate factual questions and misunderstandings. Third, the prospective nature of the APA case means that neither country will be required to give up revenue already received from the taxpayer. Thus, neither country is required to back away from adjustments its examiners spent substantial time and money to develop, except in the case where the taxpayer requests rollback of...