INSIGHT: Advance Pricing Agreements—Looking for Transfer Pricing Certainty in Uncertain Times

Transfer pricing is frequently a contentious and controversial issue. Traditional Internal Revenue Service enforcement has historically polarized the positions of the IRS and taxpayers, creating an unhealthy environment for reaching agreement on the arm’s-length character of related party transactions. The addition of another interested government into the negotiations exponentially complicates the process. Therefore, the IRS developed the advance pricing agreement (APA) process and other techniques to promote voluntary compliance and reduce the administrative burden on taxpayers and the IRS.

An APA is a prospective agreement between a taxpayer and the IRS (and possibly other governments) on transfer pricing issues. Intended as a mutually cooperative, problem-solving alternative to the regular transfer pricing enforcement process, the desirability of an APA is affected by a taxpayer’s assessment of its global transfer pricing exposure, the certainty derived though the APA process, and the cost and effort of seeking an APA.

Recent changes to the APA process are intended to reduce the cost and effort associated with APAs while continuing to offer certainty with regard to transfer pricing issues. Although a recent increase in APA user fees may run counter to that effort, APAs are often the most efficient and cost-effective way for taxpayers to manage their global transfer pricing risks, especially in this era of transfer pricing and commercial uncertainty.

The success of the IRS APA program continues in the current environment. The APA program has received over 2,500 taxpayer submissions and completed over 1,800 APAs since its founding in 1991. The APA program received a record 203 APA filings in 2018, nearly double the APA filings in 2017. The increase is partially attributable to taxpayers wanting to file before APA user fees rose, but it is also driven by the significant change in the global transfer pricing and international tax landscape.

RECENT CHANGES HAVE INCREASED GLOBAL TRANSFER PRICING EXPOSURE

In recent years, several countries have enhanced their transfer pricing enforcement. In some cases, the increased enforcement derives from the recognition that transfer pricing issues can generate significant tax revenues. In other cases, the increased enforcement stems from uneven application of the Organization for Economic Cooperation and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) reports, which changed certain rules regarding the recognition of transactions, the treatment of intangibles, and global reporting requirements. Additional recent changes affecting U.S. multinationals include tax reform, which motivated many taxpayers to rethink their global tax structures, and substantial new tariffs, which created uncertainty regarding traditional value chains and the locus of production.

Increased Global Transfer Pricing Enforcement

Each year, more countries initiate active transfer pricing enforcement. Moreover, several countries that have historically committed significant resources to transfer pricing have recently reaffirmed their commitment to examine transfer pricing issues, particularly in the U.S., Western Europe, the Asia Pacific region, Mexico, and Canada. Both trends have led to an increase in the number of transfer pricing disputes. The global inventory of disputes between treaty partners, largely composed of transfer pricing issues, was approximately 6,831 at the beginning of 2018, up from 4,073 cases in 2012. This heightened global exposure to transfer pricing examinations and disputes increases the anticipated costs and efforts of the regular transfer pricing enforcement process, which generally includes audit, some form of appeals, and potentially litigation.

U.S. Transfer Pricing Enforcement

In recent years, the IRS has more actively pursued transfer pricing issues in examination and beyond. An IRS memorandum stated that the International Business Compliance and Transfer Pricing units of its Large Business & International (LB&I) division had 1,060 cases under examination as of Dec. 31, 2013, involving between $90 billion and $194 billion of estimated potential adjustments. Although LB&I has not released more recent statistics, the IRS has stated on multiple occasions that transfer pricing makes up the vast majority of international examination issues.

To address the inventory of transfer pricing issues, LB&I released several directives on Jan. 12, 2018, that modify IRS exam and Advance Pricing and Mutual Agreement (APMA) procedures and further explain existing rules. Touching on transfer pricing information document requests (IDRs), penalties, cost-sharing arrangements (CSAs), and best method selection, these directives have important implications for transfer pricing planning and controversy management.

The directives generally set out (i) a requirement that IRS Transfer Pricing Operations management approve any change to a taxpayer’s transfer pricing method proposed by IRS Exam or by APA personnel; (ii) guidance for IRS Exam personnel in imposing transfer pricing penalties, including in instances in which taxpayers have transfer pricing documentation on hand, but the documentation is inadequate; (iii) guidance on the circumstances under which IRS Exam personnel may not need to follow established IRS practice on issuing formal IDRs; and (iv) a hiatus on IRS Exam positions regarding which reasonably anticipated benefit share should be used when calculating the value of acquisition platform contribution transactions in cost sharing arrangements until the IRS has developed a formal position on that issue.

In addition, the IRS currently has more than 20 transfer pricing cases under the jurisdiction of the U.S. Tax Court, and the current IRS commissioner has stated publicly that he believes the IRS should continue “pushing” the field on transfer pricing and bringing transfer pricing cases. This increased exposure to U.S. transfer pricing examination and disputes raises the anticipated taxpayer cost and effort associated with transfer pricing compliance and defense, renders the outcome of those disputes less certain, and makes the selection of an APA all the more desirable.

BEPS Changes

In 2015, the OECD released its BEPS report encouraging some additional rigor to transfer pricing rules and compliance. The OECD has acknowledged that the BEPS-related changes to transfer pricing, especially the country-by-country (CbyC) reporting requirements, are likely to further increase the number of transfer pricing disputes. CbyC reports were exchanged between tax authorities during the second half of 2018, and tax auditors will decide which companies to examine based on potential risk indicators, including disparities between profits and functions. Moreover, certain provisions in the BEPS report have created additional transfer pricing controversy on inherently contentious issues. For example, the OECD’s revised transfer pricing report includes provisions that allow tax authorities to recharacterize transactions they believe lack “commercial rationality” and to allocate intangible income based on a potentially subjective determination of the degree to which entities exercise decision-making authority and control over certain types of risks.

Taxpayers and countries alike have expressed concern regarding the ability of governments to keep up with BEPS-created transfer pricing disputes. In fact, the transfer pricing principles set out in the BEPS reports have been unevenly applied in practice and have already created a significant amount of controversy. The controversy comes with a cost for both taxpayers and governments in the resources they need to expend to resolve transfer pricing issues on a bilateral basis.

U.S. Tax Reform

Although very little of U.S. tax reform legislation (U.S. tax reform) enacted in December 2017 directly changes transfer pricing rules, transfer pricing will be important to determining the amount of income under the new tax regimes created by the legislation. In addition to the reduction of the corporate federal tax rate from 35 percent to 21 percent, U.S. tax reform creates a base erosion and anti-abuse tax (BEAT) under tax code Section 59A, modifies the definition of intangibles under Section 936, modifies Section 482, and introduces the global intangible low tax income (GILTI) defined in Section 951A, foreign derived intangible income (FDII) defined in Section 250, and interest expense limitations defined in Section 163(j). Taken together, these changes create multiple competing tax regimes, each of which relies on income characterization and allocation to determine the tax outcome. Due the importance of transfer pricing decisions in the allocation of income under these new tax regimes, the costs and efforts of transfer pricing compliance are expected to increase because of U.S. tax reform.

New U.S. Tariffs

Significant new tariffs enacted by the U.S. and any retaliatory tariffs enacted by other countries threaten to have an immediate, material impact on the transfer pricing results of multinational companies. Because of a lack of recent experience with trade wars involving significantly high tariffs, few companies are prepared to deal effectively with the transfer pricing implications, which could be substantial. Moreover, the governments affected by the tariffs have so far not provided guidance on how to treat tariffs in transfer pricing analyses.

A tariff, also referred to as a customs “duty,” is a tax on a particular class of imported goods. Tariffs are levied at the time of import and are paid by the “importer of record.” The tariff rate varies depending on the product classification, pursuant to the Harmonized Tariff System of the U.S. (HTSUS) and by its country of origin. Companies will typically account for the tariff costs as part of the imported product’s inventoriable cost in cost of goods sold (COGS).

In 2018, President Trump imposed a 25 percent steel and a 10 percent aluminum tariff on products imported into the U.S. under Section 232 of Trade Expansion Act of 1962. The U.S. Trade Representative (USTR) imposed an additional tariff of 25 percent on certain imports of goods with a Chinese country of origin. To the extent that related party importers cannot raise prices to pass the impact of the tariffs on to customers, the tariffs will have a direct negative impact on the profitability of the importer, potentially causing results outside the arm’s-length range and requiring transfer pricing adjustments.

Overall Increase In Transfer Pricing Uncertainty

The anticipated cost and effort required for global transfer pricing compliance and defense are substantially increased by enhanced, and sometimes aggressive, global transfer pricing enforcement as well as incremental reporting suggested in the OECD BEPS project and now required by several countries. U.S. tax reform and tariffs create additional uncertainty surrounding transfer pricing outcomes. Taken together, the global changes to regular transfer pricing enforcement greatly increase the value of the certainty that can be achieved with an APA.

ADVANTAGES OF AN APA

Freedom From Substantial Understatement Penalty

After the taxpayer and the IRS negotiate an APA, the taxpayer is only required to create documentation sufficient to demonstrate compliance with the APA. Thus, an APA eliminates the need to update annually the comparable company information used in preparing the taxpayer’s transfer pricing documentation. Taxpayers that have requested, but not yet executed, an APA generally do not prepare documentation for the proposed APA period. According to Section 3.07 of Revenue Procedure 2015-41, the submission of a complete APA request, updated and supplemented in accordance with APA procedures, “will be a factor taken into account in determining whether the taxpayer has met the documentation requirements of Treas. Reg. § 1.6662-6(d)(2)(iii) for the proposed APA years.” Taxpayers that were previously covered by an APA can rely for penalty purposes on the agreed APA methodology for a few years afterward.

Freedom From Double Tax, Transfer Pricing Examinations, and Adjustments

Taxpayers generally experience inconsistent interpretation and enforcement of transfer pricing rules from country to country, with the attendant risk of double taxation. This exposure can be prospectively eliminated by negotiating a bilateral APA, which protects taxpayers from examinations (other than examinations to confirm taxpayer compliance with the APA) and adjustments on the covered transactions. Given the current transfer pricing landscape, the benefit of avoiding audits and associated double-tax exposure through negotiation of a bilateral APA may become more valuable in the post-BEPS global enforcement environment.

No Uncertain Tax Position

For tax years beginning after Jan. 1, 2010, corporations are required to report uncertain tax positions, including transfer pricing determinations, on Schedule UTP if those positions would affect U.S. federal income tax liabilities. Taxpayers have a similar financial reporting requirement under ASC 740-10 (formerly known as Financial Accounting Standards Board (FASB) Interpretation No. 48 (FIN48)). Taxpayers have been able to achieve certainty after the resolution of an APA, and some level of certainty after filing an APA request, thereby obviating UTP reporting.

Broader Influence of Benchmark APAs

Since the early days of the APA program, a small group of very large multinational companies have found it useful to negotiate a bilateral APA between two experienced treaty partners to set a benchmark for the appropriate transfer price for similar transactions with related parties in other countries. The company can then share the bilateral APA and supporting information with any new examining country to demonstrate that the likely outcome of a principled negotiation would produce no adjustment. Geographic differences aside, the attraction of a transfer price agreed between two experienced treaty partners on similar transactions is hard to deny. This “benchmark” approach has proven to be desirable because those very large companies had exposure with regard to similar transactions in multiple countries that actively pursue transfer pricing enforcement.

In the aftermath of BEPS and the implementation of CbyC reporting, many more companies will likely find benchmark APAs to be a viable option. The anticipated increase in transfer pricing examinations and potential double tax following the adoption of CbyC reporting is expected to subject many new companies to transfer pricing scrutiny in multiple jurisdictions. In this environment, a benchmark APA to address similar transactions may be desirable for many more companies. Further, the Master File requires taxpayers to report any unilateral APAs or tax rulings. Thus, tax authorities in jurisdictions with Master File requirements will be more aware of the existence of a benchmark APA.

Ability Proactively to Develop, Frame, and Negotiate an Issue

A traditional transfer pricing enforcement proceeding such as an audit typically puts the taxpayer in a defensive posture. The tax authority selects the issues to audit and develops information document requests on the basis of whatever transfer pricing reports and intercompany agreements are available. A company must often play defense against entrenched IRS positions by providing information from old files, the continued validity of which may be in doubt. Transfer pricing adjustments then put the taxpayer into a position of further attempts at resolution in competent authority or in appeals. By contrast, the APA process allows taxpayers to take a more proactive role in framing the issue, developing the supporting documentation, and engaging in effective advocacy before one or more tax authorities. The more complex and contentious the issue, the more important that upfront development, framing, and advocacy become. The BEPS provisions relating to nonrecognition of transactions and the allocation of intangible income, mentioned above, or changes to a company’s transfer pricing stemming from business restructurings, are just two examples of issues with respect to which a more proactive role is often beneficial.

Working With Experienced Transfer Pricing Professionals

Exam personnel audit a variety of issues, many of them difficult and time consuming, and they may not have sufficient expertise or resources in any single area, including transfer pricing, to develop a position in a way that even they would prefer. The lack of resources and expertise often leads to unfocused information requests, protracted audits, and conclusions that are not based on a firm factual foundation, which can create even more controversy in appeals, competent authority, and the courts. By contrast, the APMA Program focuses on one issue: transfer pricing. The expertise developed by APMA team leaders, economists, and managers with respect not just to legal and economic issues, but also to how a particular treaty partner will approach an issue, generally leads to more focused, efficient, and often creative, ways to resolve a transfer pricing case. Though not without defects, the APMA Program is generally far preferable to traditional transfer pricing enforcement techniques and forums.

RECENT CHANGES TO THE U.S. APA PROCESS

As stated, transfer pricing examinations can be time-consuming and expensive. Transfer pricing disputes involve complex factual and economic issues requiring subjective judgment. In an audit setting, tax authorities often request information that requires the taxpayer to expend significant time and money and to provide great quantities of documentation, only some of which may ultimately be relevant to the transfer pricing issues.

The APA process is intended to be more focused and take less time than a transfer pricing examination and dispute resolution effort. A number of relatively recent changes to the APA process will affect taxpayer effort and cost:

The Advance Pricing and Mutual Agreement (APMA) Program

The U.S. APA program has undergone structural and staffing changes in recent years. In 2012, the APA program moved from the IRS Office of Chief Counsel to the IRS LB&I division, where it was merged with the competent authority function to create the APMA program. This move created substantial case management efficiencies by allowing the same team leader to develop an APA case with the taxpayer and negotiate that case with representatives from the treaty partner. More recently, APMA was restructured to reduce the number of APMA teams and integrate economists and non-economists on the same team. No significant difference is expected to come from this change. APMA has also experienced a recent reduction in staffing. At the end of 2016, APMA had 62 team leaders and 20 economists with direct case responsibility; at the end of 2018, APMA had 56 team leaders and 12 economists. So far, the structural changes have generally been perceived as creating efficiency and the staffing losses are not yet perceived as slowing down the APA process. The anticipated addition of several professional staff in the near-term should create additional efficiencies going forward.

Revised APA Revenue Procedure and New APA Template

Rev. Proc. 2015-41 gives relatively new guidance on requesting and obtaining APAs. Rev. Proc. 2015-41 requires taxpayers to front-load information into the APA request that could be expected to be requested during the APA process. Therefore, the ultimate effort expended by taxpayers is likely to be the same, and the front-loading of the information is expected to expedite the APA process itself. Rev. Proc. 2015-41 also imposed a requirement that the taxpayer submit a proposed draft APA. While this requirement may add additional taxpayer effort to the APA process, it is also likely to expedite the drafting of the APA document. In 2017, the IRS shared a draft APA template which has been finalized in a new final template in September 2018.

Although many aspects of Rev. Proc. 2015-41 are intended to benefit taxpayers by increasing efficiencies, the revenue procedure also includes certain provisions that may reduce a taxpayer’s ability to control certain aspects of the APA process. For example, the revenue procedure allows the APMA Program to cover “interrelated issues” and additional tax years if it considers doing so to be in the interest of principled, effective and efficient tax administration. Prior to Rev. Proc. 2015-41, taxpayers generally had discretion over the transfer pricing issues and the years covered by an APA. Unlike prior APA revenue procedures, Rev. Proc. 2015-41 also requires taxpayers to extend statutes of limitation for each proposed APA year. Under the revenue procedure, the consent may be general or restricted. Under a general consent, all issues are potentially open for examination in prior years, not just transfer pricing.

Internal APA Process Changes

Some internal APA process developments have occurred since Rev. Proc. 2015-41 that have not been addressed in formal guidance. APMA has developed an “intake process” to rank APA requests by size and level of complexity for assignment of APMA team leaders and economists. APMA has attempted to streamline the APA process and encourages “elevation” of issues that could prevent the case from moving forward. APMA has also experimented with the use of “reference sets” of comparables to limit the time and effort in the development of arm’s-length ranges. All of these internal changes are intended to improve the overall efficiency of the APA process.

These internal IRS process changes generally generate additional efficiency for the APA process, without additional taxpayer effort. However, it is conceivable that APMA-generated reference sets may differ substantially from the viewpoint of taxpayers and treaty partners, thus requiring additional effort to achieve a reasonable outcome.

User Fees

User fees for original, non-small case APAs increased from $60,000 at the beginning of 2018 to $113,500 as of Jan. 1, 2019. Taxpayers may see the upfront cost as an impediment to pursuing an APA. However, even with the increase in user fees, the cost of pursuing an APA tends to be lower than the traditional enforcement process, which involves audit and potentially appeals and competent authority.

Overall Impact of Changes to the U.S. APA Process

The recent structural changes to APMA and changes to the APA process are generally intended to make the process more efficient. Although some process requirements may front-load taxpayer efforts, the ultimate impact is intended to be positive. Some restrictions in Rev. Proc. 2015-41 and the new APA template may reduce potential benefits to taxpayers in certain circumstances. The fee changes increase the cost to taxpayers for the APA process. For most taxpayers, the recent changes to the APA process would produce an overall improvement, but increased costs and certain restrictions may negatively affect the benefits for some taxpayers.

CONCLUSION

The recent changes in transfer pricing and international tax, both domestically and internationally, have created a seemingly endless stream of novel issues that often require creative problem solving outside the confines of traditional analytical boundaries. For many taxpayers, an APA will be the most efficient, resource- and cost-effective means of resolving these issues. An APA provides taxpayers with the opportunity proactively to develop and negotiate transfer pricing issues in a forum intended to be cooperative and in which APMA personnel may develop solutions to complex problems that would not be available to Exam. The growing popularity of the APA program testifies to its continued value as a resource available to taxpayers in resolving their transfer pricing issues.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Steven C. Wrappe is the National Technical Leader of Transfer Pricing in Grant Thornton LLP’s Washington National Tax Office; Matthew Kramer is Transfer Pricing Managing Director for the West Region and is based in San Francisco.