Strategic choices for transfer-pricing controversies.

• Author: Lewis, Patricia Gimbel

Few tax topics combine as many strategic options with as little substantive law as transfer pricing. The inescapable need to set prices for goods and services transferred between related entities and the huge amounts involved make this a fertile source for tax disputes. Yet the substantive issues involved are so contourless (and at the same time so sophisticated) that they are difficult for taxpayers and the Internal Revenue Service (IRS) to manage. Transfer-pricing audits are becoming legendary for their length, depth, cost, and risk; cases are often settled for large sums simply to avoid the burden of protracted controversy.

Section 482 of the Internal Revenue Code is the source of the IRS's authority to wring tax dollars out of transfer pricing. Section 482 authorizes the IRS to allocate gross income and deductions between commonly controlled entities in order to prevent evasion of taxes or clearly reflect income. For this purpose the regulations utilize the standard of an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer and specify rules for its application to various categories of transactions.(1*) Recently proposed regulations(2) would reconfigure the substantive rules to focus on the operating income of uncontrolled taxpayers with comparable operations (the "comparable profit interval") and to take into account the 1986 amendment to section 482 that requires the transferor's income from transferred intangible property to be "commensurate with the income" attributable to the intangible. These concepts make transfer-pricing analysis the haunt of economists and the subject of endless debate on "correct" transfer pricing as both a legal and economic matter.

This article focuses on nonsubstantive aspects of transfer-pricing cases - the strategic and tactical opportunities that line the path. Transfer-pricing controversies present a wide spectrum of choices. With choices, of course, comes the need for decisions - choosing the correct path at each fork in the road.

Use of Decision-Tree Methodology

The choices presented to taxpayers in transfer-pricing cases are particularly susceptible to analysis by "decision tree" methodology. A "decision tree" is a diagrammatic presentation of options and possible, but uncertain, events, along with their benefits or costs - as a handy mechanism for roughly evaluating and comparing the probable outcomes of various courses of action. By superimposing probability estimates and applying a prescribed methodology, the "best" route can be identified.(3) The methodology involves the dissection of a complex series of choices ("acts") and chances ("events") to enable the analyst to focus on smaller, more manageable pieces of the overall picture. Properly used, decision trees, can simplify both explanations and decision-making. When combined with simple computer analysis, it becomes easy to vary critical numbers (the amount of a settlement offer, for example, or the likelihood that the IRS will accept it) and observe the differences in results.

Decision trees are a tool, not an answer. They are heavily influenced by the assumptions used and the probability factors placed on each step. Noneconomic factors, such as "political" or personnel considerations, cannot readily be taken into account. Thus, although mathematical techniques permit sophisticated use of elaborate decision trees, it is often beet to use a simple, less accurate, construct and emphasize that it is not precise.

There are three basic steps in creating a decision tree:

1. Analyze and divide the options and potential events

   into separate parts, using a pattern of forked lines.

   Each fork (either an "act" or an "event") must represent

   mutually exclusive and collectively exhaustive

   possibilities, and the order of the steps must

   reflect real-world sequences. The diagram can be

   simplified to highlight or narrow issues.

2. Calculate the ultimate cost or benefit of each end

   point. In transfer-pricing cases, the pertinent calculation

   is the resultant tax deficiency (refund)

   plus related costs. If timing considerations and

   differences are significant, present-value calculations

   should be used, including tax-effected interest.

   Either incremental or total costs can be used.

3. Estimate the probability of specific events occurring

   at each event fork where the options are beyond

   the taxpayer's control (e.g., the likelihood that

   the IRS will either accept or, conversely, reject a

   particular settlement offer).

   Working backward, the analyst can then compute the various probabilities and costs and, by choosing the lowest cost option at each action fork, design the best route through the complex array. Examples of the use of decision trees in transfer-pricing analysis are sprinkled throughout the following discussion of strategic issues.

   End Points: Why Do Taxpayers Care?

   Commonly controlled parties in different countries must price intercompany transactions, and those prices will directly affect their relative taxable incomes. The ultimate economic consequences - the end points of the decision tree - will also depend on:

   * relative tax rates of the different jurisdictions;

   * differing tax rules of the jurisdictions (e.g., relating

   to net operating loss and foreign tax credit

   carryovers, deductibility of research expenses, or

   timing rules for deductions);

   * limitations on foreign tax credits;

   * tax withholding rules and rates for payments

   abroad;

   * state and local tax rates and rules;

   * cash flow needs and relative interest rates;

   * substantive tax rules relating to transfer pricing;

   * applicability of income tax treaties and techniques

   for avoiding double taxation; and

   * nontax considerations such as currency controls,

   legal restrictions on repatriation, and customs duties.

   Because of the sales volume involved, the consequences of a small change in transfer prices can be dramatic. In addition, special 20- and 40- percent penalties apply to transfer-pricing adjustments under section 6662(e) of the Code, and costly "hot" interest of five points above the federal short-term rate may apply under section 6621(c). Significant out-of-pocket and personnel costs are also entailed in a transfer-pricing investigation and controversy.

   Decision Point - How To Avoid the Problem

   Transfer-pricing controversies are not inevitable. There are several ways to forestall or minimize audit controversies. Taxpayers must evaluate whether the benefit of enhanced certainty justifies the costs - including the relative cost/benefit of the pricing methodology utilized in the avoidance technique.

   Advance Pricing Agreement

   Rev. Proc. 91-22(4) offers the unique tool of an "advance pricing agreement\" (APA) with the IRS for prospectively establishing a transfer-pricing method for the taxpayer's particular facts and circumstances. Obtaining an APA involves significant analysis and documentation by the taxpayer, as well as extended discussion with a team of IRS professionals. Outside economic assistance is often helpful in preparing the taxpayer's analysis, but the retention of an independent expert to opine on the proposed methodology, as authorized under Rev. Proc. 91-22, has seldom been required. Involvement of U.S. and foreign competent authorities to obtain a bilateral agreement is highly desirable. Turnaround time for an APA is currently a year or more; it is hard to predict whether this period will decrease (because of IRS experience with APAs in general or with those in the taxpayer's industry) or increase because of the volume of requests).

   Key considerations in determining whether the APA option is advantageous include:(5)

   * Have other companies in the taxpayer's industry

   sought APAs? If so, the IRS may already be knowledgeable

   edgeable about the industry, which could accelerate

   the process, or already committed to an approach,

   which is disadvantageous to the taxpayer.

   This issue is underscored by the IRS's plan to publish

   "guidelines" for APAs in specific industries once

   it has handled enough requests in an industry to

   ensure that the identity of specific companies can

   be obscured. The taxpayer's factual situation, audit

   history, and preferred pricing method, as well

   as its resources and time pressures, will help determine

   where (and whether) it wants to get in line

   for an APA.

   * What is the taxpayer's audit status? Taxpayers

   with active and contentious audits may be reluctant

   to consider an APA because of the potential

   effect on the earlier years(6) or, conversely, may want

   to try a new face or approach for resolving past and

   future controversies. The APA process may sometimes

   be used, with the taxpayer's consent, to resolve

   prior years' transfer-pricing issues under examination.

   Given the IRS's commitment to the

   APA process and its desire to encourage utilization,

   "roll-backward" may well be more of an opportunity

   than a risk. In a similar vein, good audit

   strategy involves analyzing the effect of a particular

   resolution on subsequent years; although "roll-forward"

   ...