Transfer pricing has long been the most significant area of tax risk for most multinational companies. Those risks will likely increase in coming years due to several factors, including the recent transfer pricing guidelines under the OECD’s Base Erosion and Profit Shifting (BEPS) project (including country-by-country reporting), enhanced global enforcement, U.S. tax reform, digital services taxes, tariffs, and the Covid-19 pandemic.
Small and mid-sized taxpayers are not immune to such pressures. Even if a taxpayer does not meet the revenue threshold for country-by-country reporting (currently at approximately $850 million), the pandemic, BEPS, tax reform, and tariffs can still affect their international tax structures and transfer pricing. Moreover, relatively small transactions are frequently the target of Internal Revenue Service or foreign country audits. Adjustments applied to intercompany transactions of only a few million dollars can have a disproportionate impact on small and mid-sized taxpayers compared to large taxpayers. Even a relatively modest adjustment can require significant cost and resource burdens for audit defense, administrative appeals, mutual agreement procedure filings, and revisions to federal, state, and foreign tax returns.
The IRS started the Advance Pricing Agreement (APA) Program in 1991 as an alternative dispute resolution forum to resolve transfer pricing issues prospectively. The program changed its name to the Advance Pricing Mutual Agreement (APMA) Program in 2012 following the consolidation of the APA program with the IRS competent authority. The program has had provisions for small case APAs from the mid-1990s intended to attract small and mid-sized taxpayers to the APA program by making the cost and effort of pursuing an APA commensurate with the dollar value of the proposed covered issues; those provisions are discussed in detail below. The world has changed a lot since the mid-90s, and current global tax and business conditions have created far more compelling reasons for small and mid-sized taxpayers to pursue an APA, including protecting the integrity of international tax and transfer pricing structures in a cost-efficient manner.
This article first sets out the definition of and requirements for a small-case APA under current IRS revenue procedures, then discusses the specific provisions applicable to those APAs, and finally sets out the key cost and operational considerations for small and mid-sized taxpayers with respect to APAs in the current global tax and business environment.
What is a Small Case APA?
Revenue Procedure 2015-41 contains four criteria that must be satisfied to qualify for small case APA treatment. First, the taxpayer’s consolidated gross income in each of the three most recent back years must be less than $500 million. Second, the aggregate value of the proposed covered issue(s) cannot be expected to exceed $50 million in any proposed APA year. Third, the aggregate value of any transfer of rights in, or rights to use, intangibles is not expected to exceed $10 million in any proposed APA year. Fourth, the proposed covered issue does not involve intangible property arising from, or otherwise related to, an intangible development arrangement cannot qualify for small case APA treatment.
The current user fee for a small case APA is currently $54,000, compared to $113,500 for a non-small case APA.
Provisions Applicable to Small Case APAs
The APA program first formalized special provisions for small and mid-sized taxpayers in 1998. In Notice 98-65, the program set out procedures to reduce compliance burdens and costs in an effort to make APAs more accessible to those taxpayers. The program published statistics on small case APAs in annual statutory reports for the years 2000 through 2011. Based on those statistics, the provisions had a significant impact on the desirability of small case APAs and the efficiency with which they were completed. In 2000, the APA program completed 63 APAs, 10 of which were small case APAs (16% of total completions). The median completion time for new small case APA requests was 7.5 months, and the median completion time for renewal small case APAs was 6.5 months. Through 2011, the number of small case APAs completed each year was generally in the low to mid-double digits, with a high of 20 completed in 2006 (approximately 25% of the 82 total APAs completed in that year). In most years, the program completed more unilateral than bilateral small case APAs, with the exception of 2008, when 11 out of 15 small case APAs completed were bilateral.
The desirability of small case APAs, and the efficiency with which they were completed, are attributable to the two main factors set out in the 1998 Notice and in the subsequent APA revenue procedures, including Rev. Proc. 2015-41: decreased costs and reduced compliance burdens during the APA process.
Reduced User Fees and Other Costs: Under Rev. Proc. 96-53, which was in effect when Notice 98-65 was published, the user fee for small case APAs was $5,000, compared to $25,000 for larger taxpayers. The current APA user fee for small case APAs is $54,000, which is less than half of the $113,500 user fee for a non-small case APA. Other costs, including professional fees and employee time, are required to prepare the APA request and negotiate the APA with the tax authorities. As discussed immediately below, the APA program has taken steps to reduce the costs associated with those steps by decreasing the amount of documentation and analyses required for small case APAs.
Reduced Compliance Burdens
Notice 98-65 contained several provisions intended to simplify and reduce the cost of the APA process for small business transactions. Those provisions included analyzing the proposed covered transactions at an early stage of the process, if possible in the prefiling stage; eliminating specific elements otherwise required in the APA submission; holding meetings at locations convenient to the taxpayers; assisting with the comparables selection process; and, for unilateral APAs requests, having the taxpayer submit a proposed draft APA to expedite completion. Most of those provisions were included in the APA revenue procedures following the Notice.
Like Notice 98-65 and prior APA revenue procedures, Rev. Proc. 2015-41 contains several provisions intended to increase the efficiency with which small case APAs are completed by reducing certain compliance burdens. Those provisions include:
- No Required Pre-filing Meeting or Memoranda: The APMA program requires pre-filing meetings for many types of issues and taxpayers. Even where the meetings are not required, the APMA program generally encourages them, particularly when the APA transaction involves novel issues or significant dollar amounts. Pre-filing meetings generally require extensive preparation and costs. Under Rev. Proc. 2015-41, the pre-filing requirements applicable to non-small case APAs do not apply to small case APAs. Instead, a taxpayer that files a small case APA request may submit the user fee together with a complete APA request. Alternatively, prior to those filings, taxpayers may contact APMA to discuss filing an abbreviated APA request (defined below) or to discuss any other procedural or substantive issue. Rev. Proc. 2015-41 encourages informal consultations between taxpayers and APMA personnel for such issues.
- Abbreviated APA Requests: Rev. Proc. 2015-41 defines an “abbreviated APA request” as an APA request in which information, documents, or content required for a complete APA request has been truncated or omitted, as per explicit authorization from APMA. The revenue procedure makes clear that abbreviated APA requests may be available for cases that qualify for the small case user fee. Approval of the abbreviated APA request, and the exact contents of the abbreviated request, are based on consultation with the taxpayer. Under the revenue procedure, abbreviated APA requests may also be available for non-small case APAs, depending on the facts and circumstances.
- IRS Assistance: A key element in Notice 98-65 for facilitating the APA process was having the APA team provide assistance with comparables selection and adjustments. Although that assistance is not formalized in Rev. Proc. 2015-41, in certain circumstances APMA personnel generally have significant experience regarding the comparables that are used for particular transactions and can often provide assistance in economic analysis generally. In certain situations, APMA has experimented with the use of “reference sets” of comparables to limit the time and effort in the development of arm’s-length ranges.
The net effect of these provisions is, in most cases, increased efficiency, a speedier path to resolution and reduced costs.
Small Case APAs—Now More than Ever
Despite the reduced costs and increased efficiencies associated with small case APAs, the APA program has historically been the province of large taxpayers. There are several reasons. Large taxpayers are more likely to have the resources to spend on the strategic benefit of a voluntary program. They are also more likely to have the types of complicated intercompany transactions that are best resolved through the APA process. In addition, large taxpayers often engage in similar transactions with multiple affiliates. Pursuing a bilateral APA with one of those affiliates can provide the taxpayers with persuasive authority for the arm’s-length pricing of similar transactions in other jurisdictions.
In the current global tax and business environment, limited resources and relatively straightforward intercompany transactions are no longer reasons to rule out an APA. In fact, as discussed below, limited resources have become one of the most compelling reasons small taxpayers should consider pursuing an APA. In addition, in the current global business and tax environment, transactions that at one time may have seemed relatively straightforward and risk-free can now present significant tax and operational challenges as a result of the functional changes imposed by Covid. This consideration makes an APA all the more compelling for small and mid-sized taxpayers, whose intercompany transactions may be limited in number and often subject to tax authority scrutiny.
Cost and Resource Considerations: Even a modest transfer pricing adjustment can have a disproportionately large impact on a small or mid-sized taxpayer. Such taxpayers often do not have the resources to defend adequately against an adjustment from the audit stage to full resolution, which can take years to complete. Resources are required not just for audit defense, administrative appeals, and MAP filings, but also for amended federal, state, and foreign returns for multiple years. Instead of focusing on operating and growing the business, executives have to spend time and resources on difficult and drawn-out tax matters.
An APA provides a cost-effective alternative not just to traditional transfer pricing enforcement, but also to baseline compliance requirements. The cost of annual compliance tends to be in the six-figures for most small and mid-sized taxpayers over a period of a few years. Depending on the number of years covered in the APA, the APA user fee plus the costs of preparing and negotiating the APA submission may in several cases be only slightly higher than, and in some cases may be less than, annual compliance costs. The cost-benefit ratio is further increased if the APA is renewed. The primary/cost benefit factors of an APA are summarized below.
- Far Less Onerous Documentation Burdens: An APA obviates the need to produce annual documentation studies under Treasury Regulation Section 1.6662(d), report uncertain tax positions on Schedule UTP, and fulfill the financial reporting requirement under ASC 740-10 (formerly known as Financial Accounting Standards Board (FASB) Interpretation No. 48 (FIN48)) on the APA covered transactions. The APA can also provide more protection against substantial understatement penalties than documentation studies do. That protection can also cover years prior to the actual execution of the APA, and often a few years after expiration of the APA term.
- Protection Against Audits and Appeals: An APA provides certainty on the covered issues. An APA thus eliminates costs that might be incurred for audit defense and administrative appeals with respect to the covered issues.
- No Double Tax: Protection against audits also means freedom from the risk of double taxation on the APA covered transactions. Taxpayers with APAs thus do not need to incur resources and expenses resolving double tax issues through the mutual agreement procedures, and potentially correcting Customs valuations that arise from the adjustments.
- Coverage of a Substantial Number of Years: The cost savings from an APA can extend to a substantial number of years, including years prior to the APA term (“rollback years”).
- Lower Cost for Renewals: APAs are generally renewed at far lower cost once the original APA term expires.
- Global Benchmarking: The APA analysis or outcome might be used as a benchmark to address similar transfer pricing issues in another country or countries.
The cost savings are even greater taking into account the ability to resolve transfer pricing issues stemming from unanticipated business disruptions, as discussed below.
Transfer Pricing Certainty During Business Disruptions: The Covid-19 pandemic has created a significant amount of transfer pricing uncertainty. Factors contributing to that uncertainty include an unexpected lack of demand for products and services; supply chain disruptions from temporary or permanent manufacturing facility closures and logistics challenges; changes in management work locations; and unanticipated reductions in intangible values and interest rates, among others.
Neither the OECD Transfer Pricing Guidelines nor the regulations under tax code Section 482 address the appropriate treatment of intercompany transactions under such circumstances. Arguably, the arm’s-length principle itself should, in many circumstances, allow taxpayers to revise their transfer pricing in response to the pandemic, provided taxpayers can find evidence among unrelated parties to support those revisions. Moreover, governments have not yet provided guidance on how to treat intercompany transactions affected by the pandemic. Taxpayers are thus put in a position of hedging what they might regard as the most appropriate treatment against the likelihood of an audit and an adjustment in a few years. The more jurisdictions in which a taxpayer is active, the more exposure.
Although formal guidance is lacking, taxpayers with APAs may have access to information and paths to resolution not available to other taxpayers. The APMA program announced on May 11, 2020, that it was actively discussing substantive and procedural issues with treaty partners, including the application of transfer pricing methods in periods of economic distress and the impacts of current economic conditions on specific industries, types of taxpayers, and regions. The APMA program recently invited stakeholders wishing to discuss those general issues, as well as case-specific issues and concerns, to contact APMA.
The advantages to any taxpayer of having direct access to the APMA program to discuss the impact of the pandemic on intercompany transactions, and, through APMA, indirect access to a treaty partner’s views, are significant. The advantages can be especially consequential to small and mid-sized taxpayers, whose entire business may be wrapped up in just one or two intercompany transactions. The discussions would help provide guidance on the transfer pricing issues currently, and could prevent controversy in one or more tax jurisdictions in the future. The cost of such resolution should be minimal once an APA is in place, particularly compared to the cost of developing and documenting a resolution currently, and defending any changes to the transfer pricing at a later date.
Tax Authority Hot Spots: Taxpayers that qualify for small case APAs do not tend to have the high profile transactions or court cases that receive attention in the trade press or general news media. Nevertheless, tax authorities often target the types of transactions in which small and mid-sized taxpayers engage, in part because the routine nature and the ubiquity of those transactions make them easy targets for audit and adjustments. For example, in January 2017, the IRS announced an initial rollout of 13 “campaigns” that focus on specific tax issues that the IRS deems high-risk. Two campaigns that may directly affect small and mid-sized taxpayers are inbound distribution and captive foreign service providers. The inbound distributor campaign focuses on whether the U.S. distributor is earning too little income relative to its functions and risks. The captive foreign service provider campaign is intended to determine whether the foreign service provider is earning too much income relative to its functions and risks.
The vast majority of cases in the APMA program’s inventory involve exactly the sorts of transactions covered by those campaigns. For example, of the 120 APAs executed in 2019, 40% involved the sale of tangible property, and 41% involved the provision of services. Only 18% involved the use of intangible property, and 1% involved other types of transactions. The comparable profits method, which is the method most commonly used for routine transactions, was used in 81% of the executed cases.
One reason for the large percentage of such cases in APMA’s inventory is that, although such transactions may appear non-controversial, they can involve unique facts that increase the risk of an adjustment, or jurisdictions that have identified the transactions as high audit priority. For example, tax authorities in several jurisdictions have recently begun treating cost-plus sales and marketing service providers as non-routine entities responsible for developing local marketing intangibles; such treatment generally leads to adjustments that significantly increase the service provider’s taxable income. For many small and mid-sized taxpayers, most, if not all, of their intercompany transactions may seem routine but can be subject to audit and adjustment in one or more jurisdictions. An APA can be the best way of achieving certainty on the appropriate transfer pricing and protecting against such an adjustment.
Changes in Transfer Pricing and Business Restructurings: A change in transfer pricing is often one of the most compelling reasons to pursue an APA. The changes can arise from a recognition that the transfer pricing for a particular transaction has been incorrectly applied; from a change in facts that render the prior transfer pricing obsolete; or from a business restructuring. As a result of several external factors, not the least of which is the Covid-19 pandemic, several small and mid-sized taxpayers are in the process of making changes to their business operations, including changes to their supply chains, that will significantly impact their transfer pricing determinations. In a bilateral setting, changes in transfer pricing normally require that one of the involved countries will have reduced taxable income compared to the prior arrangement. The APMA program has significant experience with all three categories of transfer pricing changes, and has negotiated the issues extensively with its treaty partners with results appropriate to the changes in the underlying facts.
Tariffs: 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. 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.
For many taxpayers, tariffs have had the same impact that the Covid-19 pandemic has had: the results of their intercompany transactions fall outside the arm’s-length interquartile range due to circumstances beyond their control, with no government guidance on how to adjust for those circumstances. Small and mid-sized taxpayers may be disproportionately affected, since they do not have the resources or the mass to absorb the hit or to deal with it in controversy later. For such taxpayers, an APA may be the most effective means of achieving certainty on their intercompany transactions.
Conclusion
The APMA program has long had special provisions to assist small and mid-sized taxpayers resolve their transfer pricing issues. The provisions are intended to reduce the cost and increase the efficiency with which small case APAs are processed. Despite those provisions, small and mid-sized taxpayers have often been reluctant to take advantage of the strategic benefits associated with having an APA. However, the advantages to small and mid-sized taxpayers of having an APA are arguably greater now than ever before.
The likelihood of a transfer pricing adjustment is anticipated to increase in coming years due to increased global enforcement and the uncertainty stemming from the Covid-19 pandemic. Even a relatively modest transfer pricing adjustment can have a significant impact on a small to mid-sized taxpayer, requiring costs to defend against the adjustment, prepare MAP filings, and amend federal, state and foreign tax returns. Taking into account the costs saved by not having to prepare transfer pricing documentation and FIN 48 reserve positions, and the likelihood of increased enforcement and adjustments, an APA is the most effective transfer pricing risk management tool for many small and mid-sized taxpayers.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Author Information
Matthew Kramer is Transfer Pricing Managing Director for Grant Thornton’s West Region and is an adjunct professor at Golden Gate University School of Law. He is based in San Francisco. 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.
Learn more about Bloomberg Tax or Log In to keep reading:
See Breaking News in Context
From research to software to news, find what you need to stay ahead.
Already a subscriber?
Log in to keep reading or access research tools and resources.