Small and medium enterprises should consider making advance pricing agreements.

• Author: Collins, James G.

Small and medium-size enterprises (SMEs) comprise some 97% of all U.S. exporters. They produce almost a third of all goods and services exported, as measured by value (Office of Trade and Industry Information, International Trade Administration, U.S. Department of Commerce (2008), available at http://tinyurl.com/3xr49al). In 2008, export revenues for SMEs were nearly $360 billion.

In what has become a global economy, SMEs compete globally not only to make sales but to employ labor, consume raw materials, and obtain low-cost capital. SMEs have looked overseas for one or more of these business resources for generations and have incorporated affiliates where they can be most efficiently obtained. But whenever companies have crossed borders and dealt with controlled affiliates, tax collectors have followed. And foremost among tax collectors' concerns is the matter of intercompany pricing--i.e., assuring that prices charged among related corporations are at arm's length.

This item acquaints readers with the procedures that SMEs can use to obtain advance pricing agreements (APAs) with the IRS so they can minimize their exposure to intercompany pricing adjustments on audit. As used here, and as limited by the IRS, SMEs are those with less than $200 million in gross sales or entities with covered transactions with an aggregate value of less than $50 million, and $10 million or less annually of covered transactions involving intangible property (Rev. Proc. 2006-9). These limits are set for all entities owned or controlled directly or indirectly by the same interests controlling the taxpayer seeking the ruling (Rev. Proc. 2006-9, [section]4.12(6)).

Why Should SMEs Consider APAs?

Arm's-length pricing (ALP) of transactions between controlled affiliates is a statutory prerequisite for proper tax compliance in the United States. A failure to comply can result in a penalty of 20% or even 40% of the tax in the United States (Sec. 6662). Virtually all the major U.S. trading partners have their own provisions for managing intercompany pricing for their own jurisdictions, and most belong to multinational associations of tax administrators who are attempting to unify intercompany pricing regimes. The IRS already works with its counterparts in foreign jurisdictions with which the United States has tax treaties to assure a proper allocation of income and expenses across foreign borders.

The IRS recently announced its intention to develop a protocol for "joint" tax audits with other foreign jurisdictions so that intercompany pricing between related affiliates will become even more transparent and seamless (see remarks of IRS Commissioner Douglas Schulman before the OECD Business and Industry Advisory Committee, June 8, 2010, available at http://tinyurl.com/2bcey2x). Finally, the IRS has recently taken significant steps to strengthen its transfer pricing specialty practice, hiring the greatest number of economists in IRS history, identifying agents with an aptitude for the area, and institutionalizing the IRS knowledge base in the field (see Ossi and Shepherd, "The IRS's Renewed Emphasis on Transfer Pricing," J. Corp. Tax'n 3 (July-August 2010)).

There are six pricing methods. The comparable uncontrolled price method, the resale price method, the cost-plus method, the comparable profits method, and the profits split method are used primarily for tangible property. Comparable uncontrolled transactions, the profits split method, and the comparable profits method are used for intangible property. The IRS also allows an undefined "other reasonable method." A full discussion of these methods is beyond the scope of this item. Because the IRS has not adopted a comprehensive procedure to address SME ALP intangibles pricing and cost-sharing arrangements, those aspects of ALP are also not addressed here. (The closest the IRS comes to discussing intangibles and cost-sharing arrangements for SMEs is to say that they will be considered on a case-by-case basis (Rev. Proc. 2006-9, [section]9.01).)

An APA is an agreement between a taxpayer and the IRS to determine the best transfer pricing method (TPM) of controlled transactions under Sec. 482. Generally the agreement describes the controlled transaction, the APA term, assumptions, records that must be maintained, and reporting responsibilities. But APAs can also "provide a process whereby the Service and taxpayers may resolve other issues arising ... under income tax treaties, the Code or the ... regulations for which transfer pricing principles are relevant" (Rev. Proc. 2008-31). Thus, according to the IRS, the APA process can help resolve whether income is effectively connected to a U.S. trade or business and determine amounts of income derived from sources partly within and partly outside the United States (Rev. Proc. 2008-31). These additional aspects of APAs can be particularly helpful when a company is...