INSIGHT: Seriously, Should I Renew My Advance Pricing Agreement?

The Internal Revenue Service has been negotiating advance pricing agreements (APAs) for nearly 30 years. During that time, the IRS has concluded 1,940 APAs, 763 (42%) of which have been renewals of previously agreed APAs. During the most recent five years, renewal APAs constituted 57% of the APAs concluded.

Statistics alone would indicate a high likelihood of renewal. However, with a user fee for APA renewals of $62,000, concerns about high professional fees, substantial efforts required of company personnel, and an average of 32 months to complete a unilateral renewal APA and 38 months to conclude a bilateral renewal APA (compared to an average of 34 months to complete a new unilateral APA and 47 months to complete a new bilateral APA), APA renewal decisions can be expected receive substantial corporate scrutiny. This article sets forth a straightforward process to for a taxpayer to evaluate the anticipated benefits of an APA renewal. In many respects, the APA renewal decision should be similar to the decision process regarding the initial APA—evaluate the benefits of certainty associated with an APA, consider cost/benefit analysis, and address any taxpayer-specific factors that influence the decision to seek an APA. However, the taxpayer’s expectations for the renewal APA should take into account the potential that the renewal APA could provide increased benefits and be negotiated more efficiently than the original APA. The additional benefits and efficiencies stem from three main factors:

(1) changes in the tax, business, and APA environment since the initial APA;

(2) the availability of streamlined processes for renewals under Revenue Procedure 2015-41; and

(3) the experience of the parties (taxpayer, advisors, and governments) based on the prior APA. In many cases, having taxpayer and advisor personnel from the prior APA can provide a historical perspective that is useful in negotiating the APA.

In other cases, new taxpayer and advisor personnel can provide even more value by offering a fresh look and new approach to the transactions under the changing environments.

FACTORS CONSIDERED IN THE INITIAL APA

Benefits of Certainty

Taxpayers seeking an APA are interested in various forms of certainty, enabling taxpayers to focus their resources and attention on their business instead of potential tax audits and adjustments. The value of the different types of certainty differ from taxpayer of taxpayer. The benefits of certainty can easily be affected by changes to global transfer pricing enforcement; taxpayer and governmental experience gained in the initial APA is not likely to affect the value of certainty.

Freedom from Section 6662 Penalties (and documentation)

After concluding an APA, the taxpayer’s compliance with the APA assures that covered transactions are considered arm’s-length, freeing the taxpayer from exposure to 20% and 40% penalties and the need to prepare transfer pricing documentation. The taxpayer is required only to prepare documentation to demonstrate compliance with the APA, which in most cases is a very straightforward process.

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. As long as the taxpayer complies with the APA, no examination in either country would produce an adjustment.

No Additional Customs Exposure

Customs assesses duties based upon the “dutiable value” of imported goods at the date of importation. Customs rules contain a number of different valuation methodologies, but many companies use “transaction value” to value imported goods between related parties, which relies on the transfer price developed for tax purposes. Thus, an adjustment in the transfer price between related parties would necessitate a change to the customs filing. By avoiding transfer pricing adjustments, an APA also eliminates exposure to a customs issue and the need to file correcting the customs valuation.

No Uncertain Tax Position

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 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 eliminating the need for UTP reporting.

Reputation Risk

In certain cases, publicity regarding the transfer pricing practices of multinational companies has had a detrimental impact on those companies’ global reputations. An APA can be an effective tool to minimize reputational risk associated with transfer pricing. Governments treat APAs as highly confidential; even if the transactions were disclosed, an APA would suggest that the taxpayer’s transfer pricing practices comply with international norms.

Cost-Benefit Analysis

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. The APA process is designed to be more focused and take less time than a transfer pricing examination and dispute resolution efforts. Rev. Proc. 2015-41 requires taxpayers to front-load information in the APA request to expedite the APA process and save both the IRS and the taxpayer time and effort.

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.

Cost-benefit analysis: Exam/Appeals, Original APA, Renewal APA

Similarly, most companies with an initial APA expect that the increased familiarity with the APA process and lower user fees for renewals will result in a renewal APA more quickly and efficiently than the initial APA process. Taxpayer’s expectations for the renewal APA are likely to be strongly influenced by experiences gained during the initial APA.

Taxpayer-Specific Factors

The ease with which a company can pursue an APA and the benefit that company can achieve through the APA process are influenced by a number of taxpayer-specific factors. Some of these factors could have changed since the initial APA and could impact the decision whether to renew the APA.

Risk Tolerance of Company Management

The risk tolerance of the company’s management figures heavily in the decision to pursue an APA. Without some risk of a transfer pricing examination and dispute, company management would generally not incur the cost and effort of the APA process. Further, given the level of taxpayer cooperation required in 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.

“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

After nearly 30 years of operation, the IRS APMA Program has significant experience with nearly every industry. Experience is especially heavy in particular industries, including automotive, pharmaceutical, and electronics, where companies are encouraged by the inherent size, global exposure and transfer pricing uncertainty to seek an APA; videogame and other entertainment industries, where bilateral issues often play a role, especially with Japan; and retail, where companies are often encouraged by the relatively high levels of experience of the IRS APMA program and other tax authorities with the industry and its issues.

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 Issue

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.

Experience from Initial APA

Assuming taxpayer personnel had not changed from the prior APA, the experience gained during the prior APA process could help drive the renewal APA to its conclusion in a more effective manner. Taxpayer personnel will have gained an understanding of the APA timeline and the transfer pricing issues, which should lead to a more focused and efficient process.

RENEWING THE APA

In addition to the desire for certainty and taxpayer-specific factors discussed above, there are two additional reasons why taxpayers should renew their APAs. First, the U.S. and global tax, transfer pricing, and business environments have changed dramatically since many taxpayers first negotiated an APA. Those changes make the certainty associated with an APA even more desirable than previously. For many taxpayers, the changes can also lead to significant tax planning opportunities. Second, the IRS APMA Program has special provisions specifically designed for renewal APAs. Those provisions are intended to make the renewal process more efficient and less costly but are often neglected in the preparation and negotiation of a renewal APA.

The Heightened Need for Certainty

As stated, recent changes to the U.S. and global tax, transfer pricing, and business environments have increased the need for transfer pricing certainty. For many taxpayers, the changes will give rise to the need to reevaluate their transfer pricing and reach a prospective agreement that will take into account potential further shifts in the global environment. For some other taxpayers, the changes will create tax planning opportunities.

Global Changes

Countries continue to escalate transfer pricing enforcement. 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 6,575 cases in 2018. This increased exposure to transfer pricing disputes makes APAs more attractive.

The Organization for Economic Development and Cooperation’s (OECD’s) Base Erosion and Profit Shifting (BEPS) Final Reports, issued in 2015, encourage 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 reporting (CbCR) reporting requirements, are likely to 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.

A further OECD initiative that could create additional and significant transfer pricing uncertainty relates to the tax challenges posed by digitalization of the global economy. Internet-based business models allow large multinational corporations (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. A number of market countries have been unwilling to wait for a consensus resolution; France enacted a 3% digital services tax (DST) on gross revenues from digital advertising and data-driven revenue earned in France; other countries have begun to enact 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. A global consensus appears unlikely in the near future, thus raising the likelihood of further digital services taxes and retaliatory tariffs, plus heightened scrutiny of marketing intangibles in all countries. These DSTs and tariffs are relatively new, and questions exists regarding the proper treatment of these costs in transfer piecing analysis can be expected to trigger transfer pricing disputes.

The risk of a transfer pricing audit and the associated uncertainty have long existed. The uncertainty associated with potential changes in how multinational companies will be taxed is new. One of the most effective tools against both types of uncertainty is an APA. As discussed, a key reason many taxpayers incur the cost and expend the effort of pursuing an APA is to avoid transfer pricing examinations and disputes. A key reason many taxpayers decline to pursue a renewal APA is they believe that risk has been reduced by virtue of the fact that they have a government agreement blessing their transfer pricing. Even if the APA is no longer in force, and assuming no changes in underlying facts or in the transfer pricing itself, many taxpayers try to rely on the prior APA terms to persuade tax authorities that the transfer pricing complies with the arm’s-length standard.

In fact, the persuasive impact of an expired APA is very limited in an audit situation. Tax authorities may dig deep into the facts to determine whether there have been any changes that would compel an adjustment to the transfer pricing. In addition, the 2015 OECD BEPS final reports, and the upcoming changes to taxing jurisdiction rights, have created, and will continue to create, additional uncertainty. Finally, a bilateral agreement between tax authorities should not be assumed to reflect satisfaction on the part of the involved audit teams or even the competent authorities themselves. Competent authority agreements are the result of compromise, and some members of the team, including especially those involved primarily in the examination process, may have strong reservations about the final agreement. They may relish the opportunity to review the transactions again in audit.

Covid-19

Covid-19 has created an unanticipated disruption in supply chains, workplace locations, revenues, research activities, executive management activities, interest rates, intangible values, and other aspects of a multinational corporation’s operations, with a direct impact on their transfer pricing. Many taxpayers are struggling to determine whether and how to adjust their transfer pricing policies to respond to the pandemic’s impact. One of the concerns relates not just to managing the transfer pricing in the present in an effort to survive as a going concern, but to the potential for controversy in the future resulting from a deviation in established policies and agreements.

Under crisis conditions, the last thing a taxpayer may want to consider is renegotiating an agreement made with a tax authority. However, having the opportunity to do so and to reach an agreement upfront with the tax authorities will, in most cases, be far preferable to having to justify any changes in transfer policy long after the triggering event. Covid-19 is likely not the final pandemic, and climate change may cause similar disruptions. An APA agreement containing critical assumptions and adjustment mechanisms that are triggered during such disruptions provides an additional layer of certainty in an environment likely prone to further change. The impact of the 2008 financial crisis on APAs in effect during that period provides a framework for how the IRS APMA Program and other tax authorities may treat such disruptions; advice from practitioners who renegotiated APA terms during the financial crisis can be invaluable. However, due to operational disruptions in addition to economic hardship, this recession offers a greater likelihood of renegotiated APAs.

U.S. Tax Reform

Although U.S. tax reform (Tax Reform) legislation enacted in December 2017 changes the treatment of most intercompany transactions in only minor ways, transfer pricing is important to determining income under the new tax regimes created by the legislation. Tax Reform creates a base erosion and anti-abuse tax (BEAT), modifies the definition of intangibles under tax code Section 936, and introduces the global intangible low tax income (GILTI), foreign derived intangible income (FDII), and interest expense limitations defined in Section 163(j). In addition, as stated above, Tax Reform significantly reduced the statutory corporate income tax rate in the U.S.

The changes are currently affecting how taxpayers approach renewal APA requests. Even if underlying facts have not changed between prior and renewal APAs, taxpayer goals sometimes do. For example, since Tax Reform, many taxpayers have examined how they might restructure operations to take advantage of the reduced U.S. statutory corporate tax rate. A taxpayer may also be able to achieve that goal through a renewal APA, in some cases with respect to bilateral APAs with terms that may seem overly generous to the treaty partner. A renewal APA may be the most effective way to reset those terms in a principled fashion.

Streamlined Renewal Requests under Rev. Proc. 2015-41

Rev. Proc. 2015-41 formally updated IRS guidance on requesting and obtaining APAs. On the one hand, the revenue procedure contains provisions that, to some extent, may limit taxpayer flexibility regarding the scope of APA coverage and require more up-front provision of information. 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, and extend the statute of limitations on prior tax years. Further, APMA recently developed 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.

However, for many renewal APA requests, those changes will not apply. Specifically, Rev. Proc. 2015-41 contains provisions allowing taxpayers to streamline the renewal process. First, in most instances, a formal prefiling meeting will not be required, which eliminates a significant amount of upfront effort and cost required to draft a prefiling memorandum and to prepare for and attend the prefiling conference itself. Second, provided there are no material changes between the prior APA and the renewal APA, the IRS will typically allow taxpayers to file an abbreviated APA request. An abbreviated APA request is an APA request in which information, documents or content required for a complete APA request has been truncated or omitted, saving significant time and resources.

Rev. Proc. 2015-41 does not contain specific guidance on what should be included in an abbreviated APA request. The actual contents and scope of analysis are subject to negotiation with the APMA Program. Taxpayers and advisors with significant APA experience would need to assess the materials that should be included in the APA request based on the facts of the case and the complexity of the transactions to negotiate the content and scope effectively.

CONCLUSION

For some taxpayers, renewing an APA does not require a significant amount of reflection. The benefits of certainty and the cost savings associated with having an APA in force on a continuous basis exceed the risks and costs of not having an APA. For other taxpayers, the issue is not as obvious. They may begin to regard continued renewals as providing diminishing returns with respect to cost and risk management and may decline to pursue the renewal.

Regardless of which category a taxpayer falls into, a renewal APA, properly prepared and negotiated, can provide significant advantages in the current tax, transfer pricing, and business environment. Certainty is arguably more important now than ever before. The number of disputes continues to increase globally, the nature of the disputes will continue to evolve, and business disruptions will continue to challenge established transfer pricing policies. Moreover, recent changes in domestic legislation have created conditions for renewals on a potentially more favorable basis than previously. A renewal APA need not be a routine exercise that taxpayers simply have to endure to obtain certainty. The renewal can instead be a robust process that provides taxpayers with significant benefits in highly uncertain times.

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; Matthew Kramer is Transfer Pricing Managing Director for the West Region, based in San Francisco.