Advance pricing agreements: practical issues to consider in determining whether to pursue one.

• Author: Patton, Michael F.

In March, the Internal Revenue Service published Rev. Proc. [91-22,.sup.1+] which sets forth the procedures for taxpayers to follow in applying for an Advance Pricing Agreement. The revenue procedure is a substantial improvement over the earlier draft version, which had been distributed informally to a limited group of practitioners and taxpayers for comments, and had subsequently been published in the press. [2] This article focuses not so much on the provisions of the revenue procedure but rather on practical issues that taxpayers should consider when thinking about whether to pursue an Advance Pricing Agreement.

Apportionment Methodology

Rev. Proc. 91-22 expressly provides that taxpayers may apply for an APA using one of the three traditional pricing methodologies0--comparable uncontrolled price, resale price, or cost-plus--or a fourth methodology. Although any of the three traditional methods or a fourth method theoretically ought to produce the same result when applied to the same set of facts, any taxpayer that has attempted to apply different methodologies can readily attest to the fact that consistency of results is rarely the case. To take a simple example, suppose that a foreign-controlled U.S. company acts as a super-distributor of high-tech electronics products manufactured by its foreign parent company. [3] A review of publicly available data reveals that large distributors of these types of electronics products generally earn gross margins of 17 to 20 percent with operating profits before taxes and interest of 3 to 5 percent. Suppose also that the comany has used a transfer pricing methodology whereby the parent company transfers product manufactured by it to the subsidiary at its production cost-plus 5 percent. Using the cost-plus 5-percent method, the U.S. taxpayer has generally earned gross margins of approximately 10 to 12 percent and has earned net operating profits before taxes and interest ranging from 2 to break even. A review of the available U.S. data on manufacturers of similar high-tech electronics components reveals that cost-plus 5 percent is on the low range of profits earned by manufacturers of similar products. There is no publicly available data on what manufacturers of similar products earned in the parent company's country of manufacture.

An initial question to consider is what the U.S. company's risk might be on IRS examination. Under the current regulations, the priority of methods for the pricing of tangible property would apply. Since there was no comparable uncontrolled price in the stated facts, the IRS would look to the method that has second priority, the resale price method. Assuming that on audit an agent would use the resale price method, the question arises how the agent would apply the method. Under the traditional view of resale price method, the agent would reduce the taxpayer's cost of goods sold so that the gross margin was adjusted to the comparable range of 17 to 20 percent, or to a specific number within that range. Under a revised view of the resale price method that agents have recently been using in inbound cases, the agent might look to the net operating profit before tax of the potentially comparable companies and adjust the taxpayer's gross margin upward to produce the same net profit margin. [4] Under the current priority of methods, the agents would not take into account the fact that the parent company has an apparently reasonable cost-plus methodology, since this method has a lower priority that the resale price method. Nor would the agents necessarily consider information on fourth methods, such as the Berry ratio, or return on assets methods, that might show that the reason for the U.S. taxpayer's lower gross margins and lower net profitability is that it performs fewer functions and incurs fewer expenses than the large public distributors to which it is being compared.

One of the advantages of the APA process is that the taxpayer is apparently not limited to the current priority of methods or to a traditional application of those methods. In the foregoing example, it is clear that the transfer pricing methodology was not set in an abusive manner, since the cost-plus was well within the range of reason and below that of any potential comparables. Yet that approach reached a result that may not be acceptable to the IRS. If the goal of the APA process is to reach a "reasonable" result, then the example just given is probably a good one for consideration of an APA, since the taxpayer might face an uncertain result, or an unfavorable one, upon examination.

This example also raises the issue whether a taxpayer should focus on pure methodology or on bottom-line results. If the taxpayer is considering applying for an APA, should the taxpayer attempt to focus on the gross margin of the U.S. taxpayer, the U.S. taxpayer's net operating profit before taxes, or the foreign parent company's cost-plus? In the case of both a gross margin methodology or a cost-plus methodology, the taxpayer might not get ultimate certainty even if an APA were granted. This is because either the IRS or the foreign tax authorities could question the amount of below-the-line expenses in applying the resale price method, or might question the costs of the foreign manufacturer in applying the cost-plus methodology. On the one hand, focusing upon the net operating profit before taxes and interest would give the U.S. taxpayer greater certainty of result and freedom from adjustment. On the other hand, the foreign jurisdiction might object to guaranteeing the profit of the U.S. subsidiary. In this context, if a guarantee of profit is essentially being made, should not the profit be lower to reflect the lack of risk on the part of the U.S. subsidiary?

Dealing With Open Years

Once a taxpayer gets over the initial hurdle of deciding what methodology it should use, an additional question that must be raised is what effect this methodology will have on open years, if it is not the methodology that is currently being employed by the taxpayer. This is an extremely significant issue for taxpayers that are recognizing that their past methodology has been improper. It is an issue that exists whether taxpayers are seeking an APA or merely engaging in self-examination as a result of increased IRS and foreign tax authority scrutiny of cross-border transfer pricing. Outside the context of an APA...