IT-APAs: harmonizing inconsistent transfer pricing rules in income tax - customs - VAT.

• Author: Ainsworth, Richard T.
• Position: Information technology advanced pricing agreements, value added tax

INTRODUCTION

In most jurisdictions there are three separate spheres of transfer pricing analysis--income tax, customs, and VAT. Although they share policy objectives and terminology, and frequently borrow methodologies from one another, these domestic transfer pricing systems are not in harmony.

Businesses find this lack of harmony costly and problematical, but also a planning opportunity. The door is open for arbitrage. Related parties play a three-dimensional game of chess with tax authorities whenever they structure cross-border transactions. Deft taxpayer planning through this complex maze of rules often leaves the treasury with a three-way transfer pricing problem, pitting uncoordinated, sometimes uncooperative revenue authorities against one another--the treasury, it seems, can be hoisted on its own petard. (1)

What if the transfer pricing rules within a jurisdiction were harmonized?

The World Customs Organization (WCO) and the Organization of Economic Cooperation and Development (OECD) are considering this question. It would ease domestic compliance if only one set of transfer pricing rules applied regardless of the tax involved. However, to avoid double taxation (or double non-taxation) the domestic rules also need to be harmonized internationally (among jurisdictions).

Therefore, a more accurate statement of the question considered by the WCO and OECD is: What if transfer pricing rules were harmonized within and between jurisdictions (vertical and horizontal harmonization)?

Through a series of conferences, the WCO and OECD have embarked on a broad-ranging assessment of current transfer pricing regimes to see whether a harmonized pricing methodology can be forged. As expected, the jointly sponsored First and Second Conferences on Transfer Pricing and Customs Valuation (May 3-4, 2006 (2) and May 22-23, 2007 (3)) concluded that more consideration is needed, that harmonization will require adjustment on all sides, (4) and that pilot projects or case studies in harmonization need to be identified. (5) The first WCO/OECD conference focused on income tax and customs harmonization; the second conference extended the inquiry to VAT.

This article synthesizes the range of transfer pricing regimes currently in use and argues that an affirmative answer to the WCO/OECD's harmonization question can only be realized through technology. (6) Inherent differences embedded in the annual income tax are nearly impossible to harmonize with transaction taxes like customs and VAT if what is envisioned is a single, monolithic transfer pricing standard. If instead one imagines a standard that employs flexible, integrated rules, where separately harmonized (vertical and horizontal) elements are brought together in a certified automated system, then a harmonized transfer pricing standard can be realized.

The direct harmonization of income tax and customs rules is a nearly impossible task. The income tax quest for true taxable income through transfer pricing fundamentally conflicts with the customs use of transfer pricing to determine substitute values. Thus, harmonization is only possible through the use of a permitted customs exception, a delay in customs valuation for certified systems that accurately ties later-in-time (income) valuations to the present transaction value.

This article argues that the keys to successful harmonization can be found in the assurances of certified automated systems. The operation of these systems tips the balance in favor of linking domestic transfer pricing rules in income tax, customs, and VAT. A five-way negotiation is envisioned to establish these linkages. Income tax, customs, and VAT administrations will need to negotiate with business groups and software providers.

Developing countries need to remember that most multinational corporations already have fully automated tax compliance systems in place that determine all tax compliance measures. By aligning transfer pricing rules, governments will be indirectly aligning these pre-existing automated systems. But alignment alone is not what businesses want in this exchange. The true simplicity and the bottom-line efficiency benefits that come from a harmonized transfer pricing regime flow from the certified use of these systems. Thus, this proposal is not one that requires a government investment in technology. It is one that requires an investment in the capacity to certify technology. Businesses want to know and governments need to be assured that the automated systems that determine compliance are doing the calculations, making the adjustments, filing returns, and making payments correctly.

That is why a rough alignment of transfer pricing regimes is not the end of the story. The real benefits of harmonization are delivered through an Information Technology Advanced Pricing Agreement (IT-APA). An IT-APA, like a traditional APA, is a voluntary, taxpayer-initiated agreement, but in this instance it is an integrated software program that is at the core of the agreement, not just accounting procedures and agreed pricing formulas. The software program can be either proprietary or a third-party system.

Reaching an IT-APA agreement is in essence the certification of the software. Certification means the determination by the tax administration that the software (absent fraudulent use): (a) accurately records the determination of transfer prices, (b) properly calculates VAT and customs duties based on these values, (c) automatically files all tax documentation, (d) authoritatively interfaces with financial reporting systems and the pricing elements of the income tax, and (e) adjusts all invoices, tax reports, and returns for pricing decisions made later in time. It is expected that concessions on penalties, the kinds of adjustments possible, later filing of amended returns, and even some linkages among transfer pricing regimes will only be available to businesses that enter into an IT-APA. Only these enterprises will be able to assure governments that the necessary balancing of compliance obligations (among income tax, customs, and VAT regimes) has been accomplished--short of a full-blown three-tax audit.

Taxpayers who do not secure an IT-APA will benefit from the harmonization of income tax, customs, and VAT rules, a necessary activity that prepares the way for the IT-APA. However, these taxpayers will have no assurance that their returns will be accepted as accurate on all pricing issues (immediately on filing) and will certainly encounter a more highly cross-checked and comprehensively enforced tax system when they do file.

Adopting an IT-APA will be a matter of taxpayer choice. But if the model of the American Streamlined Sales Tax (SST) (7) is considered, and if third-party certified service providers (CSPs) enter the tax compliance market as they have in the United States, then certified solutions and the IT-APA will be readily available at low cost with online access. Perhaps, as is the case in the United States, the government may pay for business adoption in certain circumstances. (8)

A Trade Barrier and the Reason for WCO/OECD Cooperation

The world's largest multinational enterprises transfer significant volumes of goods, services, and intangible property in cross-border (and domestic) related party transactions. Is the lack of vertical harmony in transfer pricing rules a trade barrier? The WCO and OECD believe it is. (9)

In the international arena, best estimates are that multinational entities are the source of 60 percent of all cross-border transactions, (10) or stated in dollar volumes, estimates are that more than one third of the value of cross-border trade is between related parties. (11) Approximately 37 percent of U.S. cross-border trade involves related parties--an aggregate figure that includes, for example, roughly 74 percent of all Japanese imports and 65 percent of total exports by U.S. multinationals. (12) Why should this amount of trade be subject to three different and frequently conflicting transfer pricing regimes?

The simple answer is that income tax, customs, and VAT authorities each demand an accurate valuation of cross-border supplies. But this answer begs the question of why these regimes should be different. The reality is (although a number of jurisdictions have managed to partially harmonize their systems (13)) that valuation results frequently differ. It is an anomaly of transfer pricing practice that even though (1) the rules between jurisdictions are reasonably harmonized within a single tax type creating horizontal harmonization, it is also true that (2) the rules within a jurisdiction are not harmonized, ruling out vertical harmonization.

The horizontal harmonization we see today is largely attributable to the specialized influence of supra-national standard setting organizations: the Organization for Economic Cooperation and Development (OECD) in income tax, (14) the World Trade Organization (WTO) in customs, (15) and various regional economic unions, like the European Union (EU) in VAT. (16) Thus, it makes sense to ask, can a coordinated effort by these organizations facilitate vertical harmonization?

B. Organization of the Text

This article proceeds in three parts. The first part describes the vertical context. It sets out problem areas that need to be addressed before full vertical harmonization can be achieved. It indicates that technology may be able to resolve these problems.

The second part is structured around the two primary questions of transfer pricing analysis: (1) Are the parties to the transaction sufficiently "related" so that their relationship could be affecting the price? (2) If so, how is the correct price to be measured? This part considers divergent answers to these questions across income tax, customs, and VAT regimes, identifies patterns where harmonization has been partially achieved, and offers suggestions for further alignment.

The second part also considers examples...