INSIGHT: Seriously Considering an Advance Pricing Agreement

The global exposure to transfer pricing disputes continues to escalate. Transfer pricing exposure has recently increased due to new reporting requirements stemming from the Organization for Economic Coordination and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) report, U.S. tax reform legislation, increased information sharing between governments, and recent OECD discussions of the tax challenges in the digitalization of the global economy.

Advance pricing agreements (APAs) are a way for multinational enterprises to achieve certainty and avoid transfer pricing exposure. However, the pursuit of an APA is a voluntary undertaking that requires a substantial user fee and significant taxpayer effort and expense. Therefore, the decision to pursue an APA should not be made lightly, but instead in a clinical fashion with the best information available.

This paper sets out a diagnostic framework for taxpayers to determine whether an APA would be the best way to resolve their transfer pricing issues. The framework identifies the benefits of certainty associated with APAs, discusses the cost/benefit analysis, and sets out the taxpayer-specific factors that influence the decision to seek an APA. The paper will also evaluate the impact of recent enforcement and APA process changes on the decision.

FACTORS TO CONSIDER

The Benefits of Certainty

Most taxpayers seeking an APA are interested in some form of certainty—freedom from penalty exposure, freedom from double tax and adjustment, no Customs correction, and no uncertain tax position for financial and tax reporting. Having such certainty generally enables taxpayers to focus their resources and attention on their business instead of potential tax audits and adjustments. It is hard to knock certainty, but the value of specific types of certainty differs substantially by taxpayer.

Freedom From Tax Code Section 6662 Penalties

U.S. taxpayers often spend substantial amounts of money producing annual transfer pricing documentation for penalty protection in the U.S. Local filing requirements in various countries add to the expense. After the taxpayer and the Internal Revenue Service negotiate an APA, the taxpayer is only required to prepare documentation to demonstrate compliance with the APA. Thus, an APA eliminates the need to annually update the comparable company information used in 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 term. Taxpayers previously covered by an APA can rely for penalty purposes on the agreed APA methodology for a few years afterward.

Freedom From Double Tax and Transfer Pricing Adjustment

Taxpayers generally experience inconsistent interpretation and enforcement of transfer pricing rules from country to country, with the attendant risks of adjustment and the possibility of double tax if the other country involved does not agree. This exposure can be prospectively eliminated by negotiating a bilateral APA; as long as the taxpayer complies with the APA, no examination in either country would produce an adjustment.

No Additional Customs Exposure

Customs duties are assessed based upon the “dutiable value” of imported goods at the date of importation. Although Customs rules contain several different valuation methodologies, many companies use “transaction value” to value imported goods between related parties, which relies on the transfer price developed for tax purposes. In this situation, a downward adjustment in the price of products sold to a related party will increase the buyer’s profit and decrease the buyer’s potential duties in the importing country. An upward adjustment in the product price will decrease the buyer’s profit and increase the buyer’s potential duties in the importing country.

U.S. importers need to be aware of Customs issues created by transfer pricing adjustments mandated by tax authorities, including the necessity to report certain changes in values to Customs and the possibility of paying additional duties plus interest. By avoiding transfer pricing adjustments, an APA can also eliminate the need for the administrative burden of correcting the Customs valuation.

No Uncertain Tax Position

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

Reputation Risk

Beginning in2010, multinational companies began to face the possibility that their international tax structures, and in particular their transfer pricing practices, could have a detrimental impact on their global reputation. A survey conducted in 2011 found that multinational companies faced an unprecedented level of scrutiny around the reporting of their tax practices by advocacy groups and the media, which sometimes led to a diminution in brand and shareholder value, even when the reports were inaccurate or misleading.

An APA can be an effective tool to minimize reputational risk associated with transfer pricing. Governments treat APAs as highly confidential, so the likelihood of public disclosure is small. Even if the transactions were disclosed, an APA would provide a government imprimatur on the transactions, suggesting that the taxpayer’s transfer pricing practices are in compliance with international norms.

The Business Decision: Cost-Benefit Analysis

For all the benefits of certainty achieved by an APA, most companies make the decision to pursue an APA based upon an expectation that the long-term costs of an APA will be lower than the cost of compliance and transfer pricing defense. In most cases, that calculation holds.

General Comparison

The APA process is designed to be more focused and take less time than a transfer pricing examination and dispute resolution efforts. Revenue Procedure 2015-41 requires taxpayers to front-load information in the APA request that could be expected to be requested during the APA process. The front-loading of the information is expected to expedite the APA process and save both the IRS and the taxpayer time and effort during the due diligence phase—especially compared to the regular transfer pricing enforcement process, which often involves an audit and an appeals process followed by mutual agreement proceedings (MAP) in competent authority.

Even with procedures intended to add efficiency to the APA process, pursuing an APA can be expensive, and most companies attempt to estimate the cost and effort of pursuing an APA against the risk adjusted cost and effort of the regular transfer pricing enforcement defense. From this perspective, a taxpayer that does not expect to be examined could not justify pursuing an APA. To the extent a taxpayer believes itself to be at risk of an examination, the benefits of an APA are readily apparent when the cost and effort of the regular transfer pricing compliance exceed the cost and effort of an APA, including the APA user fee. Moreover, any tax authority adjustment can also carry the additional cost of penalties and interest as well as amended federal and state tax returns and Customs filings. Eliminating the need for annual transfer pricing documentation and FIN48 analyses can also save taxpayers significant sums of money.

Any benefit achieved by an APA can be enhanced by rollback, renewal, or the opportunity to use the APA analysis or outcome to address similar transfer pricing issues in another country or countries.

Rollback to Resolve Prior Years

Although APAs are intended to provide prospective resolution of transfer pricing issues, a rollback of the transfer pricing methodology (TPM) developed in an APA to open tax years not included in the APA term can be an effective way to address unresolved transfer pricing issues. This approach can add substantially to the attractiveness of an APA solution. However, except in unusual circumstances, IRS Advance Pricing and Mutual Agreement (APMA) program will not agree to cover a closed filed year with a rollback of a unilateral APA request.

APA Renewal

A taxpayer may request a renewal APA using updated information. The user fee for a straightforward renewal is $62,000 rather than $113,500 for an initial APA, and taxpayers may request an abbreviated APA request for a renewal. If the intercompany transactions, functions, and risks remain the same, a renewal APA should take less time and require fewer resources than the original APA. However, the APMA program may scrutinize the renewal request if the taxpayer’s results during the term of the original APA were to fall consistently at the edge of the agreed upon arm’s-length range.

Affirmative Use of APAs

Since the early days of APAs, a small group of large taxpayers 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 agreement 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 country-by-country reporting (CbCR), many more companies will likely find benchmark APAs to be a desirable option. The anticipated increase in transfer pricing examinations and potential double tax following the adoption of CbCR 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.

Taxpayer-Specific Factors

The ease with which a company can pursue an APA and the overall benefit that company can achieve through the APA process are influenced by several taxpayer-specific factors.

Risk Tolerance of Company Management

The risk tolerance of the company’s management strongly affects the decision whether to pursue an APA. Without some risk of a transfer pricing examination and dispute, company management would generally not embrace the cost and effort of the APA process. Further, given the cooperative nature of the APA process and the information requirements, companies with arguably aggressive transfer pricing positions should likely avoid the APA process. The APA process works best with taxpayers that have taken more “middle of the road” positions but still value the benefit of certainty around those positions. Some have pointed to these factors to explain the prominence of Japan-based MNEs in the APA process.

“Examination fatigue” is a common driver for a company’s decision to pursue an APA. The company may have experienced multiple examination cycles in either or both countries without the development of any principle to guide its transfer pricing determinations. The taxpayer may be looking for a fresh perspective from the government and an approved approach regarding the transfer pricing issue going forward. Although the examination team will be involved in an APA, jurisdiction for the issue rests with the APMA program.

Company’s Industry

The industry in which the company operates usually has some impact upon the decision whether to pursue an APA. Some industries, notably the automotive and pharmaceutical industries, are encouraged by the inherent size, global exposure, and uncertainty of transfer pricing outcomes to seek the certainty of an APA. Other industries (e.g., electronics) are encouraged by the relatively high levels of experience of the IRS APMA program and other tax authorities with the industry and its issues. Industries where the governments have little or no APA experience may be less inviting, since the initial APA in an industry may require more taxpayer time and effort to complete.

Involved Countries

The involved countries, and the negotiating relationship between those countries, can sometimes affect the decision whether to pursue an APA. Unless a treaty exists, no bilateral APA is possible. A lack of negotiating experience between the affected countries may indicate that the APA process might take longer than an APA between more experienced countries. Further, the depth of core negotiating relationships and frequency of interaction contribute to overall negotiating efficiency.

Type of Issues

The type of transfer pricing issue can affect the decision whether to pursue an APA and whether the APA is best dealt with bilaterally or unilaterally. Some issues, like royalty determinations, may be inherently difficult to resolve without a bilateral negotiation. A bilateral APA may be the most effective way to eliminate the exposure to a transfer pricing examination in either country. In other circumstances, the issues and likely outcome of an APA for U.S. distribution may be relatively straightforward, but the time and cost of negotiating a bilateral APA may still be cost effective because of a desire for additional certainty.

Impact of Recent Changes

The utility of APAs as an alternative dispute resolution procedure is affected by changes in the global transfer pricing enforcement environment, changes in substantive international tax rules, and changes in the APA program and process.

Changes to Global Transfer Pricing Enforcement

Each year, more countries initiate transfer pricing enforcement, increasing the number of transfer pricing disputes. The global inventories of disputes between treaty partners—mostly transfer pricing issues—have more than doubled in seven years, from 3,328 cases in 2010 to 6,605 cases in 2018. This increased global exposure to transfer pricing examinations and disputes increases the anticipated costs and efforts of the regular transfer pricing enforcement process.

In 2015, the OECD released its BEPS report, encouraging additional rigor to transfer pricing rules and compliance. The OECD has acknowledged that the BEPS-related changes to transfer pricing, especially the CbCR requirements, will further increase the number of transfer pricing disputes. This increased global exposure to transfer pricing disputes substantially increases the costs and efforts of regular transfer pricing compliance and the anticipated costs and efforts of the enforcement process.

U.S. Tax Reform

Although 2017 U.S. tax reform legislation (U.S. tax reform) changed little of the 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 reducing the corporate tax rate from 35 to 21%, U.S. Tax Reform enacted a base erosion and anti-abuse tax (BEAT) under Section 59A, modified the definition of intangibles under Section 936, modified Section 482, and introduced 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). 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 has increased by U.S. tax reform.

Changes to U.S. APA Program and Process

In 2012, the APA program moved from the IRS Office of Chief Counsel to the IRS Large Busines and International division, where it merged with the competent authority function to create the APMA program. This move created case management efficiencies by allowing the same team leader to develop an APA case with the taxpayer and negotiate that case with 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.

Rev. Proc. 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, or 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.

Digital Service Taxes and Tariffs

Concerns about the tax impact of the digital economy are driving a current debate within the OECD. Internet-based business models allow large MNEs to engage in transactions with consumers in a country—the “market” country—without triggering the traditional taxing nexus in that market country. The fact that highly profitable MNEs are not subject to taxing jurisdiction in those market countries has been identified as a tax challenge that needs to be addressed.

In January 2019, the OECD proposed to expand taxing jurisdiction for market countries and impose a formulary allocation of deemed residual profits to include an allocation to those market countries. No consensus has been achieved, and a number of market countries are 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, and many other countries are expected to enact similar DSTs.

The U.S. is currently considering a tariff of up to 100% on approximately $2.8 billion of French products including wine, cheese and handbags in retaliation for the DST. The U.S. has recently imposed substantial tariffs on imports of aluminum and steel and tariffs on $350 billion of goods manufactured in China; China has responded with retaliatory tariffs on U.S. goods.

Each of these excise taxes and tariffs are relatively new, and questions exists regarding the proper treatment of these costs in transfer pricing analysis.

CONCLUSION

Transfer pricing is an inherently uncertain enterprise. Recent changes have increased the uncertainty and raised the risk of controversy worldwide. The manner in which a multinational enterprise chooses to manage that uncertainty and risk depends on several factors intrinsic and extrinsic to the enterprise. A diagnostic application of those factors to a company’s specific facts and circumstances is the best way to assess the relative advantages and disadvantages of an APA versus other potential dispute resolution mechanisms. In many cases, an APA will prove to be the most cost-effective way to achieve certainty and manage transfer pricing risk.

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 LLP’s Washington National Tax Office and an adjunct professor at New York University School of Law.

Matthew Kramer is the Transfer Pricing managing director for Grant Thornton’s West region, based in San Francisco.