INSIGHT: Global Transfer Pricing Trends Continue to Drive Interest in U.S.-Japan APAs

The Internal Revenue Service established its advance pricing agreement (APA) program in 1991 to prospectively negotiate transfer pricing issues with taxpayers and other tax authorities. Japan-based multinational corporations (MNCs) are well-represented in the IRS inventory of bilateral APAs. IRS statistics for 2013-2019 show that approximately 50% of all U.S. APA cases concluded are bilateral U.S.-Japan APAs.

Companies seek APAs for the certainty available through the APA process. That certainty encompasses freedom from penalty exposure, freedom from double tax and adjustment, no Customs correction, and no uncertain tax position for financial and tax reporting and no reputation risk. Further, most companies anticipate that the long-term costs of an APA will be lower than the cost of transfer pricing compliance and defense.

Recent global tax and other financial developments continue to heighten global transfer pricing uncertainty, thus increasing the attractiveness of the certainty available through APAs. This article will detail the recent global events that contribute to that uncertainty, with a focus on the impact specific to Japan-based MNCs.

GLOBAL DEVELOPMENTS THAT INCREASE TRANSFER PRICING UNCERTAINTY

Increased Global Transfer Pricing Enforcement and Reporting Requirements

Each year, more countries initiate active transfer pricing enforcement, leading to increased transfer pricing disputes. According to Organization for Economic Cooperation and Development (OECD) statistics, the global inventories of disputes between treaty partners, largely composed of transfer pricing issues, have more than doubled in seven years, from 3,328 cases in 2010 to 6,605 cases in 2018. The IRS currently has several transfer pricing cases under the jurisdiction of the U.S. Tax Court, and the IRS has publicly advocated for continued examination and litigation of transfer pricing issues.

In 2015, the OECD released its Base Erosion and Profit-Shifting (BEPS) project report, which encourages restrictions on the ability of MNCs to artificially shift income to lower-tax locations. BEPS Actions 8-10 attempt to align income with value creation, and Action 13 addresses documentation and country-by-country reporting (CbCR) requirements in a manner that will increase taxpayer compliance effort. In particular, the additional CbCR reporting requirements are expected to further increase the number of transfer pricing disputes between treaty countries.

Many Japan-based MNCs adopted global transfer pricing policies when BEPS-based rules were introduced by the Japanese government. Since those global transfer pricing policies are primarily designed to address the Japanese BEPS requirements, difficulties have arisen when Japan-based MNCs’ U.S. subsidiaries rely not on APAs but on the U.S. transfer pricing documentation. The global transfer pricing polices often emphasize the arm’s-length nature of intercompany agreements before the transactions, while U.S. transfer regulations test the arm’s-length results of those transactions.

U.S. Tax Reform

The U.S. signed Public Law 115-97 into law in 2017, which introduced several new international tax provisions, which involve transfer pricing: a slight modification to Section 482, a base erosion and anti-abuse tax (BEAT), a modified definition of intangibles under Section 936, the global intangible low tax income (GILTI), foreign derived intangible income (FDII) in Section 250, and interest expense limitations defined in Section 163(j). BEAT, GILTI and FDII, in particular, represent new tax regimes that rely upon transfer pricing determinations.

Tariffs

Beginning in 2018, the U.S. imposed substantial tariffs on imports of aluminum and steel (25% and 10%, respectively) and up to 25% tariffs on goods manufactured in China. These significant new tariffs threaten an immediate, material impact on the transfer pricing results of Japan-based MNCs that employ China manufacturing in the supply chain for goods sold in the U.S. 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 producing results below the arm’s-length range and requiring transfer pricing adjustments. Unfortunately, no guidance regarding the treatment of tariffs in transfer pricing has been received from the tax authorities involved in the transactions.

Tax Challenges of Digitalization

The OECD is currently coordinating a debate about the tax challenges posed by digitalization. Internet-based business models allow large MNCs to engage in transactions with consumers in a “market” country without triggering the traditional taxing nexus in that market country. Market countries object to the ability of highly profitable MNCs to avoid taxing jurisdiction in those market countries.

In early 2019, the OECD proposed expanding the taxing jurisdiction for market countries and imposing a formulary allocation of deemed residual profits to include an allocation to those market countries. No consensus has been achieved by the end of 2019, and a number of market countries have been unwilling to wait for a consensus resolution. In March 2019, France enacted a 3% digital services tax (DST) on gross revenues from digital advertising and data-driven revenue earned in France; a growing number of countries, including Turkey and the U.K., have enacted or are considering similar DST regimes.

The U.S. has threatened a retaliatory tariff of up to 100% on approximately $2.8 billion of French products including wine, cheese, and handbags. Similar retaliatory tariffs are being considered by the U.S. Trade Representative regarding all similar DSTs. A global consensus is unlikely in the near future, especially now that negotiations are delayed due to impact of the Covid-19 pandemic, thus raising the likelihood of further DSTs and retaliatory tariffs, plus heightened scrutiny of marketing intangibles in all countries. Each of these DSTs and tariffs is relatively new, and questions exist regarding the proper transfer pricing treatment of these costs can be expected to trigger transfer pricing disputes.

Economic Impact of Covid-19

The Covid-19 pandemic continues to rage globally, inflicting great personal suffering. In addition to the health impact, this pandemic has spawned a recession that has wreaked havoc on global businesses in ways not seen before. The pandemic recession is operational, rather than just economic. Companies have experienced labor outages from infected workers and government stay-at-home orders, and supply chain disruptions have produced steep sales declines.

In the midst of this chaos, transfer pricing professionals must consider whether to re-evaluate transfer prices in light of altered market equivalent prices, determine whether intercompany contracts are still valid, interpret force majeure clauses (or lack thereof), and prepare for tax audits and income adjustments.

The pandemic recession raises two critical APA questions—

(1) Would an APA, either original or renewal, be an advisable way to manage the transfer pricing uncertainty created by the pandemic recession?

(2) Absent specific language in an existing APA, does the general critical assumption in all APAs dictate an outcome?

Facing great uncertainty regarding the application of transfer pricing in the midst of the pandemic recession, taxpayers are, nonetheless, expected to correctly price intercompany transactions. The APA process allows taxpayers to share that burden real-time with the affected governments, and effectively conveys “clean hands” status to the taxpayer requesting an APA. The arm’s-length may be just as difficult to determine, but the taxpayer no longer carries that burden alone.

In some ways, the interpretation of the “critical assumption” language in an existing APA may be less satisfactory than negotiating a new APA. The critical assumption clause of an APA serves the same purpose as a force majeure clause—to excuse taxpayer adherence to the results dictated under the APA in limited, designated circumstances. One general-purpose critical assumption in most APAs employs the following language:

The business activities, functions performed, risks assumed, assets employed, and financial and tax accounting methods and classifications [and methods of estimation] of Taxpayer in relation to the Covered Transactions will remain materially the same as described or used in Taxpayer’s APA Request. A mere change in business results will not be a material change (emphasis added).

In the aftermath of recent recessions (e.g., 2008-2009), the application of this general critical assumption has been discussed with the IRS in numerous APAs, in an attempt to excuse non-conforming taxpayer results. However, the authors are aware of few modifications allowed pursuant to this critical assumption. It is hoped that the severity of the pandemic recession, coupled with the physical disruptions to the functions and risks of the involved businesses would justify reevaluation of the negotiated APA terms. It is also worth noting that in conjunction with the operational impact of the pandemic, additional complications such as impairment of fixed assets are likely to arise and need to be addressed.

Japan’s National Tax Agency (NTA) has shown a willingness to renegotiate APAs in cases where the critical assumptions are no longer valid. Covid-19 pandemic is generally considered to generate such a circumstance. As a result, it is fully expected that the NTA and the IRS will jointly consider revising the existing APAs to account for the impact of Covid-19 on the agreed-upon transfer pricing method.

To facilitate the process, taxpayers need to prepare the information and materials that demonstrate and support a finding that the critical assumption is no longer valid—the duration of their business lockdown, the duration of no purchase order from the customers, the expected timeline of their business normalization. the estimated revenue loss, the expenses incurred to retain employees and to minimize Covid-19 infection, their industry specific conditions, and their competitors’ responses to the Covid-19 pandemic. The more information taxpayers gather and submit to the NTA and IRS, the faster the NTA and IRS will negotiate and resolve any consideration of critical assumptions.

In particular, it is important to demonstrate that the adjusted profitability by excluding the numerical impact of the pandemic factors will fall within the APA profitability range.

TRENDS WITHIN THE APA PROCESS

APA Renewals

In the nearly 30 years the IRS has been negotiating APAs, 763 (42%) of the total APAs to date have been renewals of previously agreed APAs. In the last five years, renewal APAs constituted 57% of APAs concluded. The motivation for a renewal APA is similar to the motivation for the initial APA. However, companies with an initial APA generally expect that the increased familiarity with the APA process and lower user fees ($62,000 for a renewal APA compared to $113,500 for an initial APA) for renewals will result in a renewal APA more quickly and efficiently than the initial APA process. The efficiency gained in the renewal APA process has been widely recognized by Japan-based MNCs as many of them are known to renew their APA consistently.

U.S. APA Process Changes and User Fees

Revenue Procedure 2015-41 updated IRS guidance on requesting and obtaining APAs. Generally, Rev. Proc. 2015-41 limits taxpayer flexibility regarding the scope of APA coverage, requires more up-front provision of information, and increases the APA user fee. Under Rev. Proc. 2015-41, the taxpayer may be required to expand its APA request to cover interrelated issues in the same years, covered issues, or interrelated issues in other years. Taxpayers in the APA process are also required to extend the statute of limitations on prior tax years. Rev. Proc. 2015-41 requires the taxpayer to submit a proposed draft APA; this requirement may add additional taxpayer effort to the APA process, but it is intended to expedite the drafting of the APA document.

Two APA requirements have changed after Rev. Proc. 2015-41: (1) user fees have increased to $113,500 for an initial APA, and (2) the proposed draft APA template has been updated and extended.

Standardization Efforts

Relying upon nearly 30 years of experience with the APA process, the Advance Pricing and Mutual Agreement Program (APMA) is attempting to streamline the APA process wherever possible. The front-loaded information requirements in Rev. Proc. 2015-41 are intended to reduce the overall time and effort in the APA process. Taxpayers that believe that their circumstances warrant an “abbreviated” APA filing can present their case to APMA personnel. Another effort to streamline the APA process is exploration of the use of “reference sets”—standardized sets of comparables encountered by taxpayers, governments, and representatives on multiple occasions. Although no formal proposal has been developed, the APMA program has been actively exploring this approach with taxpayers and treaty partners. The APMA program has already proposed two distribution reference sets (durable goods, non-durable goods). The use of reference sets is seen as a promising way to improve efficiency, but concerns have been raised regarding the appropriateness of individual comparable sets and the need for appropriate adjustments.

The authors believe that more can be done for the reference sets to achieve both the efficiency improvements of the APA process and the enhanced flexibility to address the specifics of individual taxpayers.

Increased Use of Benchmark APAs

From the early days of the APA program, a small group of MNCs 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 MNC can 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. This benchmark approach has been desirable, because those large MNCs 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 CbCR, many more companies have found benchmark APAs to be useful. The anticipated increase in transfer pricing examinations and potential double tax following the adoption of CbCR has subjected more 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.

Marketing Intangibles

Marketing intangibles, especially in the context of the automotive industry, have been a difficult issue for the U.S. and Japan to resolve in APAs. Recently, the IRS unveiled its Functional Cost Diagnostic Method (FCDM) approach, a profit-split approach that differentiates between routine and non-routine costs. Taxpayers with certain types of issues are required to present FCDM information to the IRS to facilitate the IRS understanding of intangibles development. On a separate front, the OECD discussions about tax challenges of digitalization have heightened global interest in the ownership and value of marketing intangibles in global transactions between related parties. Together, these two trends make it likely that Japan–U.S. transactions that involve valuable marketing intangibles represent great transfer pricing uncertainty.

CONCLUSION

A large number of Japan-based MNCs have relied upon APAs to achieve freedom from penalty exposure, double tax and adjustment, to avoid Customs correction and uncertain tax position reporting, and to prevent reputation risk. Global changes to transfer pricing enforcement, combined with the unprecedented event of Covid-19, strongly encourage Japan-based MNCs to reevaluate and reposition their APAs. U.S. tax reform, tariffs, digitization of businesses, marketing intangibles, and an increased use of the reference sets by the IRS points to both challenges and rewards of APAs.

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

Author Information

Steven C. Wrappe is the National Technical Leader of Transfer Pricing in Grant Thornton’s Washington National Tax Office and an adjunct professor at New York University School of Law; Harumi Yamada is a Director, Transfer Pricing in Tokyo; and Shinichi Tsutsui is Director, Transfer Pricing in Washington, DC and Transfer Pricing Leader in the Japanese Business Group.