What's new? What's missing? The IRS updates APA procedures.

• Author: Lewis, Patricia Gimbel
• Position: Advance Pricing Agreements

In July, the Internal Revenue Service issued Rev. Proc. 2004-40, (1) the long-in-the-works update of the procedural rules for obtaining and maintaining Advance Pricing Agreements (APAs) on intercompany transfer pricing.

The APA Program was launched in 1991 (2) and refurbished in 1996. (3) With about 100 new applications submitted annually in the last few years and the increased experience of completing 500 APAs, the IRS should be in a position to refine, streamline, and, as needed, amplify the APA Program's procedural requirements. Given the concerns of both the taxpayer community and the IRS about the lengthy processing time for APAs, one would particularly hope to see procedural changes designed to expedite the process.

In fact, the revisions are mostly evolutionary, rather than innovative. (4)

* No special new steps are proposed to shorten processing time, though several aspects have that potential, e.g., increased reliance on electronic media and certain expedited renewal procedures. The APA request contents have been made more comprehensive, rather than winnowed, on the ground the additional information will eventually be needed so up-front submission will be more efficient. This is a critical bet that should be evaluated quickly.

* Features to enhance the prospectivity of APAs are stressed.

* The APA Program's direction is increasingly focused on bilateral APAs.

A recurrent theme is requiring a continuous flow of updated information to the IRS to enhance the "best"-ness of the result (and perhaps to enhance the perceived integrity of the APA Program in the face of the current Senate Finance Committee inquiry). (5)

This article explores the changes reflected in Rev. Proc. 2004-40 and the implications for the APA customer base. (6) This is not a detailed instruction booklet--after all, that is Rev. Proc. 2004-40's job--but rather a look at the effect on the social phases of APA participation. Rev. Proc. 2004-40 applies to APA requests, including renewal requests, received on or after August 18, 2004. By mutual agreement, it may also apply to any APA request pending on that date.

Shall We Dance? Scope and Emphasis of the APA Program

Although reworded and rearranged a bit, the central goals and scope of the APA Program are largely unchanged--to promptly and fairly resolve transfer pricing issues in a principled and cooperative manner on a prospective basis. References to principles of sound and efficient tax administration, along with "proper" resolution of APA requests, have been added. There are fewer references to flexibility.

Rev. Proc. 2004-40 continues to emphasize bilateral (as opposed to unilateral) APAs (7) and to favor rollback of the agreed transfer pricing methodology (TPM) to open tax years. (8) Indeed, the bilateral incentive may be boosted by a revision to the rollback policy. Specifically, Rev. Proc. 200440 retracts the rollback policy for unilateral APA requests if the rollback would reduce taxable income for a pre-APA year, citing the regulatory provision that prevents affirmative favorable use of section 482 of the Internal Revenue Code by a taxpayer other than in an original return. (9) Thus, a taxpayer seeking refunds for pre-APA years under its TPM would be well advised to undertake a bilateral APA process.

Getting to Know You: Revised Contents of the APA Request

Rev. Proc. 2004-40 first enunciates several new "general principles" for an APA submission. (10) These are significant formal changes, although reflective of existing best practices by APA Program team leaders and experienced practitioners.

* A comprehensive table of contents is required.

* Documents available in electronic format must be submitted on either a CD-ROM or a diskette, as well as on paper.

* The submission (and any supporting documenta tion) must be supplemented to correct or update all material information (a) within 30 days of an IRS request, (b) before the start of Competent Authority (CA) negotiations in the case of a bilateral or multilateral APA, and (c) prior to execution of the APA.

* As taxable years are completed while the APA is pending, the taxpayer must update its submission to show the application of the proposed TPM to its actual financial results within 120 days after the close of each year. (11)

* Justification of the user fee amount must be provided.

Additional requirements for the submission include: (12)

* SIC codes, NAICS codes, and LMSB industry designation.

* Identification of any branches or disregarded entities (indicating potential attention to related tax effects).

* Estimated dollar value of the proposed covered transactions for each year of the proposed term.

* Information regarding any commission sales income of the tested party. This requirement raises the profile of this rather controversial issue, which was discussed in a 2003 revision of the IRS's APA Program New Hire Training Manual. (13) The concern is whether commission income may distort the tested party's results from a comparability perspective. Accordingly, the APA request must include a proposal and analysis of whether it is appropriate, in the taxpayer's situation, that commission income be separately tested, excluded, or adjusted for (to account for the functional differences between commission sales and buy-sell transactions), or that the TPM be consistent with a sales function.

* Analysis of (a) relevant contractual terms, (b) relevant economic conditions, and (c) "relevant non-recognition transactions." The boundaries of (c) are unexplained and may go beyond exchanges or corporate reorganizations to matters having economic effect that are not reflected on financial statements.

* Electronically formatted financial data on the proposed comparables (and pertinent licenses or other agreements). Moreover, the taxpayer must update the comparables data, if requested, following 90 days after the close of its fiscal year.

* Information on foreign currency exchange risk (suggesting more substantive focus on this issue).

* If rollback years are under consideration by IRS Appeals, a waiver by the taxpayer of its rights, un der the ex parte communication prohibition rules, to be present during communications between the Appeals Office and the APA Team members. (14)

Revisions to the requirements for cost-sharing arrangements (CSAs) (15) reflect the IRS's increased concern with potential revenue loss from aggressive CSA structures:

* The taxpayer must include a statement that the CSA conforms with the qualification requirements of Treas. Reg. [section] 1.482-7(b). Technically, this is somewhat circular since part of the purpose of an APA is to confirm, for example, the core qualification requirement of an appropriate correlation between cost shares and anticipated benefits. Nevertheless, having the taxpayer affirm its belief seems unobjectionable, assuming this will eventually be confirmed in the APA document.

* Not surprisingly, given the recent amendments to the regulations (16) and the pending litigation, (17) taxpayers must state how stock-based compensation is treated under the CSA.

* More specific information is required on any buy-in or buy-out payment, including a complete economic analysis supporting the payment and an analysis demonstrating that the method used to value the pre-existing intangibles and calculate the payment meets the best method test.

* More detail must be shown in the seven years of gross and net profit data required (five past and two projected years).

* The submission must include evidence of compliance with the regulatory requirement to attach a statement regarding the CSA to the pertinent U.S. tax returns or Forms 5471/5472. (18)

* Favorably, somewhat less detail is required on CSA participants and contractual terms.

Interestingly, Rev. Proc. 2004-40 opens the door to a partial APA covering only the CSA or only the related buy-in transaction--if the taxpayer can satisfactorily explain why such a limited APA is consistent with the principles of the APA process. If the request is limited to the buy-in, the APA must have a critical assumption that the CSA meets the regulatory requirements.

Developing the Relationship: Differences in the Process

Currency (Temporal, not Monetary)

To date, the APA...