Strategic choices for transfer-pricing controversies.

Few tax topics combine as many strategic options with as little substantive law as transfer pricing. The inescapable need to set prices for goods and services transferred between related entities and the huge amounts involved make this a fertile source for tax disputes. Yet the substantive issues involved are so contourless (and at the same time so sophisticated) that they are difficult for taxpayers and the Internal Revenue Service (IRS) to manage. Transfer-pricing audits are becoming legendary for their length, depth, cost, and risk; cases are often settled for large sums simply to avoid the burden of protracted controversy.

Section 482 of the Internal Revenue Code is the source of the IRS's authority to wring tax dollars out of transfer pricing. Section 482 authorizes the IRS to allocate gross income and deductions between commonly controlled entities in order to prevent evasion of taxes or clearly reflect income. For this purpose the regulations utilize the standard of an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer and specify rules for its application to various categories of transactions.(1*) Recently proposed regulations(2) would reconfigure the substantive rules to focus on the operating income of uncontrolled taxpayers with comparable operations (the "comparable profit interval") and to take into account the 1986 amendment to section 482 that requires the transferor's income from transferred intangible property to be "commensurate with the income" attributable to the intangible. These concepts make transfer-pricing analysis the haunt of economists and the subject of endless debate on "correct" transfer pricing as both a legal and economic matter.

This article focuses on nonsubstantive aspects of transfer-pricing cases - the strategic and tactical opportunities that line the path. Transfer-pricing controversies present a wide spectrum of choices. With choices, of course, comes the need for decisions - choosing the correct path at each fork in the road.

Use of Decision-Tree Methodology

The choices presented to taxpayers in transfer-pricing cases are particularly susceptible to analysis by "decision tree" methodology. A "decision tree" is a diagrammatic presentation of options and possible, but uncertain, events, along with their benefits or costs - as a handy mechanism for roughly evaluating and comparing the probable outcomes of various courses of action. By superimposing probability estimates and applying a prescribed methodology, the "best" route can be identified.(3) The methodology involves the dissection of a complex series of choices ("acts") and chances ("events") to enable the analyst to focus on smaller, more manageable pieces of the overall picture. Properly used, decision trees, can simplify both explanations and decision-making. When combined with simple computer analysis, it becomes easy to vary critical numbers (the amount of a settlement offer, for example, or the likelihood that the IRS will accept it) and observe the differences in results.

Decision trees are a tool, not an answer. They are heavily influenced by the assumptions used and the probability factors placed on each step. Noneconomic factors, such as "political" or personnel considerations, cannot readily be taken into account. Thus, although mathematical techniques permit sophisticated use of elaborate decision trees, it is often beet to use a simple, less accurate, construct and emphasize that it is not precise.

There are three basic steps in creating a decision tree:

1. Analyze and divide the options and potential events

into separate parts, using a pattern of forked lines.

Each fork (either an "act" or an "event") must represent

mutually exclusive and collectively exhaustive

possibilities, and the order of the steps must

reflect real-world sequences. The diagram can be

simplified to highlight or narrow issues.

2. Calculate the ultimate cost or benefit of each end

point. In transfer-pricing cases, the pertinent calculation

is the resultant tax deficiency (refund)

plus related costs. If timing considerations and

differences are significant, present-value calculations

should be used, including tax-effected interest.

Either incremental or total costs can be used.

3. Estimate the probability of specific events occurring

at each event fork where the options are beyond

the taxpayer's control (e.g., the likelihood that

the IRS will either accept or, conversely, reject a

particular settlement offer).

Working backward, the analyst can then compute the various probabilities and costs and, by choosing the lowest cost option at each action fork, design the best route through the complex array. Examples of the use of decision trees in transfer-pricing analysis are sprinkled throughout the following discussion of strategic issues.

End Points: Why Do Taxpayers Care?

Commonly controlled parties in different countries must price intercompany transactions, and those prices will directly affect their relative taxable incomes. The ultimate economic consequences - the end points of the decision tree - will also depend on:

* relative tax rates of the different jurisdictions;

* differing tax rules of the jurisdictions (e.g., relating

to net operating loss and foreign tax credit

carryovers, deductibility of research expenses, or

timing rules for deductions);

* limitations on foreign tax credits;

* tax withholding rules and rates for payments

abroad;

* state and local tax rates and rules;

* cash flow needs and relative interest rates;

* substantive tax rules relating to transfer pricing;

* applicability of income tax treaties and techniques

for avoiding double taxation; and

* nontax considerations such as currency controls,

legal restrictions on repatriation, and customs duties.

Because of the sales volume involved, the consequences of a small change in transfer prices can be dramatic. In addition, special 20- and 40- percent penalties apply to transfer-pricing adjustments under section 6662(e) of the Code, and costly "hot" interest of five points above the federal short-term rate may apply under section 6621(c). Significant out-of-pocket and personnel costs are also entailed in a transfer-pricing investigation and controversy.

Decision Point - How To Avoid the Problem

Transfer-pricing controversies are not inevitable. There are several ways to forestall or minimize audit controversies. Taxpayers must evaluate whether the benefit of enhanced certainty justifies the costs - including the relative cost/benefit of the pricing methodology utilized in the avoidance technique.

Advance Pricing Agreement 

Rev. Proc. 91-22(4) offers the unique tool of an "advance pricing agreement\" (APA) with the IRS for prospectively establishing a transfer-pricing method for the taxpayer's particular facts and circumstances. Obtaining an APA involves significant analysis and documentation by the taxpayer, as well as extended discussion with a team of IRS professionals. Outside economic assistance is often helpful in preparing the taxpayer's analysis, but the retention of an independent expert to opine on the proposed methodology, as authorized under Rev. Proc. 91-22, has seldom been required. Involvement of U.S. and foreign competent authorities to obtain a bilateral agreement is highly desirable. Turnaround time for an APA is currently a year or more; it is hard to predict whether this period will decrease (because of IRS experience with APAs in general or with those in the taxpayer's industry) or increase because of the volume of requests).

Key considerations in determining whether the APA option is advantageous include:(5)

* Have other companies in the taxpayer's industry

sought APAs? If so, the IRS may already be knowledgeable

edgeable about the industry, which could accelerate

the process, or already committed to an approach,

which is disadvantageous to the taxpayer.

This issue is underscored by the IRS's plan to publish

"guidelines" for APAs in specific industries once

it has handled enough requests in an industry to

ensure that the identity of specific companies can

be obscured. The taxpayer's factual situation, audit

history, and preferred pricing method, as well

as its resources and time pressures, will help determine

where (and whether) it wants to get in line

for an APA.

* What is the taxpayer's audit status? Taxpayers

with active and contentious audits may be reluctant

to consider an APA because of the potential

effect on the earlier years(6) or, conversely, may want

to try a new face or approach for resolving past and

future controversies. The APA process may sometimes

be used, with the taxpayer's consent, to resolve

prior years' transfer-pricing issues under examination.

Given the IRS's commitment to the

APA process and its desire to encourage utilization,

"roll-backward" may well be more of an opportunity

than a risk. In a similar vein, good audit

strategy involves analyzing the effect of a particular

resolution on subsequent years; although "roll-forward"

of one cycle's results is by no means automatic

or required, it is certainly a practical consideration

to minimize audit effort by all parties.

Packaging audit experience with the APA process

is a nimble way to ensure this result.

* What pricing methodology is likely to be agreed

upon? APAs are most amenable to formalistic approaches,

whose suitability to the taxpayer's business

and business plans must be evaluated. A

method's vulnerability to business changes, as well

as the ability to identify "critical assumptions" that

will trigger adjustments or termination of the

agreement, must be studied. Most important, the

taxpayer must compare the likely results of the

probable APA methodology with those of the taxpayer's

current method and its possible revision on

audit.

* Will competent authority be involved? A bilateral or

multilateral approach may influence the methodology

choice because of the "traditionalism" or lack of

experience of foreign tax authorities. The perfect

case for an APA is one where the pertinent jurisdictions

have similar tax rates and rules so that the

taxpayer is a mere stakeholder and can let the tax

authorities sort out the issue as they see fit.

Advance Pricing Study and Planning

Economic consultants are readily engaged to study a business and recommend one or more transfer-pricing methods designed to minimize audit risk. These studies often involve sophisticated economic and statistical analysis, the intricacy depending both on the taxpayer's request (and budget) and the peculiarities of a particular industry. Although studies provide no guarantee against audit problems, they do reflect a professional's best effort to steer through the imprecise boundaries of section 482. Studies are particularly valuable if reliable "comparable" transactions or public companies can be found and analyzed. On the other hand, care must be taken to avoid any obvious result "pull." Conscientious pricing studies can position the taxpayer close to the mark and evidence its good faith attempt to comply with the law.(7)

In selecting a consultant, the taxpayer should look for transfer-pricing audit (or trial) experience, pertinent analytical skills, and familiarity with the particular industry, along with reputation, efficiency, and cost factors. Industry experience may be a two-edged sword, especially if an analytic posture has developed that affects different members differently (or sidesteps potential creativity) or there is a competitive concern about consistency of position or confidential information.

A critical element in advance pricing studies is the sensitivity of the information developed. Economic analysis - including the roads not taken - is subject to ready discovery by the IRS unless protected by the attorney-client privilege or work-product doctrine. Meaningful involvement of legal counsel may be necessary to maintain confidentiality of the analysis.

Finally, note that use of outside consultants is not essential. Similar results, lacking only the stamp of "independence," may be achieved by internal analysis and planning, if adequate resources and skills are available. The objective is to develop an economically sound and well-documented transfer - pricing method by means of a thorough process involving review of intragroup dealings and analysis of external comparative material.

Cost-Sharing Agreements

The handling of intangible property is a particularly problematic and elusive aspect of transfer pricing. One related party using intangibles owned by another must pay an arm,s length, commensurate-with-income royalty to the latter, yet the valuation of intangibles and identification of "comparable" transactions are quite difficult. The "developer/assister" rules of the section 482 regulations(8) require a complex overlay of payments for royalties, services, equipment, and financing when integrated research operations are involved.

The section 482 regulations allow taxpayers to minimize audit risk by entering into "cost-sharing agreements" (CSAs) for the development of intangibles.(9) By agreeing to share the costs of developing the intangibles in a specific fashion, the parties to a CSA become co-owners of the intangibles, each entitled to the income generated by its own use of the property without any obligation to pay royalties for such use. Although some audit activity may revolve around the requirement that costs be shared in proportion to benefits including the commensurate-with-income rule), the issue is relatively amenable to formalistic analysis. Practical questions may arise about the proper scope of the CSA, and some often-important vestigial royalty determinations are presented with respect to buy-ins and buy-outs. Nevertheless, the recently proposed regulations(10) reflect a heroic effort to make CSAs accessible and, assuming a modest amount of further tinkering, appear to have largely succeeded.

CSAs should be seriously considered by any taxpayer with significant intangibles, particularly taxpayers in relatively mature industries who perform incremental research on many products and models in a number of locations. CSAs work best if the jurisdictions involved have relatively comparable tax rates. Otherwise, the tradeoff for the relative certainty of a CSA is the spreading of income and deductions among the parties, making it more difficult to concentrate deductions in high-tax jurisdictions and income in lower-tax jurisdictions.

Section 6038A District Director Agreements

Section 6038A of the Code is the newest bane of transfer-pricing audits. The provision gives the IRS virtually limitless authority to obtain documentation and information in the hands of foreign related parties or to penalize the failure to comply. Taxpayer outrage at this provision is divided between those concerned merely with the administrative burden to maintain, produce, and translate a kitchen-sinkful of documents (and to explain the requirements to foreign affiliates), and those more concerned with what that information might disclose. Some also worry about retaliation by foreign governments.

Here too the IRS offers an advance agreement with the District (a "district director's agreement" or DDA) to specify and limit the documentation to be maintained by a particular corporate group. Rev. Proc. 91-38, 1991-2 C.B. 692, details the requirements for a DDA. To date, however, the IRS has not entered into any individual DDAs, despite the passage of more than a year since the final section 6038A regulations were promulgated. This can be traced in part to the Field's reluctance to go forward without particularized guidance from the National Office(11) and, in larger part, to the difficulties of assessing taxpayer records and the IRS's need for such records under ill-defined substantive transfer-pricing rules. A DDA would seem easiest to work out after an in-depth audit or as part of an APA.

Factors to consider in evaluating the advisability of a DDA include:

* existing record maintenance policies of foreign related

parties;

* sensitivity of foreign related parties to disclosure

of records to the IRS;

* complexity and size of the business;

* number of countries and languages involved;

* audit history with respect to document production

and, particularly, development and acceptance of a

transfer-pricing methodology; and

* relative U.S. and foreign profits (and their

documentation), the key focus of the current section

6038A regulations (prior to the recently proposed

revisions to the section 482 regulations).

Rev. Proc. 91-38 also poses the possibility of "model" DDAs for particular industries, subject to modification for facts and circumstances of particular members. At least one such model is under consideration at the present time.

Decision-Tree Illustration

The foregoing audit-amelioration approaches can be evaluated with the decision-tree methodology. A simple example posing the option of using a CSA instead of the developer/assister rules is set forth in Figure 1.

The example in Figure 1 assumes that the U.S. tax rate exceeds the foreign tax rates, that most research activity takes place in the United States, and that a CSA would save taxes overall (110-115) compared with an unfavorable application of the developer/assister rules on audit (120-150, depending on support by an advance study). As applied by the taxpayer, however, the developer/assister rules are relatively favorable (70). The chances of a meaningful audit occurring (indicated in parentheses) are estimated at 20 percent if a CSA is used and 90 percent otherwise.

The decision tree indicates that a CSA is preferable, although not by a wide margin.(12) (One moves from right to left, multiplying end points by probabilities and aggregating the results for events, and choosing the lowest cost fork for acts.) The tree also suggests that if the taxpayer should for some reason decide not to enter into a CSA, the advance pricing study route is likely to work out better than seeking an APA or doing nothing.

Decision Point - What to Do When

the Auditors Come?

If advance planning or advance agreements have not been undertaken (or do not suffice) to keep the IRS at bay, a transfer-pricing audit may well occur. Many of the choices then presented are common to any tax audit - administrative or judicial forum, cooperative or adversarial approach, settlement strategies - but have special nuances in the international context. Issues uniquely applicable to transfer-pricing cases also arise, such as the involvement of competent authority and potential diplomatic and political considerations. Moreover, the involvement of foreign parties who are unfamiliar with the U.S. system or reflect particular national temperaments or preferences can affect the direction selected.

Taxpayer Attitude

A constant undercurrent in any audit is the taxpayer's basic attitude - i.e., whether the taxpayer is cooperative or adversarial. Although taxpayers and advisers may have different philosophies, cooperativeness (combined with a reputation for integrity, usually goes a long way). Adversarial attitudes tend to be self-fulfilling, often on an unfortunately permanent basis - and transfer pricing is the archetypal recurring issue. An adversarial stance may eliminate opportunities for creative resolution of cases and productive long-term relationships with the IRS. There are, nevertheless, isolated situations where audit history or peculiar circumstances make a more defensive strategy entirely appropriate.

Creative approaches to help shape the audit favorably include providing helpful information relatively quickly and suggesting affirmative approaches to shortcut burdensome and potentially useless (or troublesome) avenues of inquiry. For example, the taxpayer can offer a detailed report and section 482 analysis of a line of business, rather than waiting for the IRS to dig through reams of documents and develop its own, potentially more problematic, theory. A taxpayer who has good communications and relationships with the IRS team can suggest the use of sample documentation and can maintain the focus on those document requests likely to advance the audit.

A subset of the attitude issue involves extensions of the statute of limitations. The traditional approach has been to readily accede to IRS requests, and to grant open-ended extensions (Form 872A) when requested. The hostility likely to be engendered by imposing time pressures on the IRS - as well as the "boxcar" numbers (in section 482 cases, more like freight trains) that can result - argue strongly against recalcitrance. Taxpayers hampered by very old open years may legitimately take a more resistant stance, particularly if the statute of limitations in foreign countries as modified by treaty provisions) is not parallel. Generally, however, use of the statute of limitations to cut off extensive fact-finding or even fishing expeditions by the IRS is history, because of the new designated summons procedure under Code section 6503(k).

On balance, it is almost always best to strive for a good working relationship with the IRS audit team. Frequent meetings and prompt and appropriate responses to document requests, with an objective of progressively working through issues, are advisable.

Involvement of Outside Experts: Accountants,

Consultants and Attorneys

At some point in most section 482 audits, detailed analysis of transfer-pricing results is needed. Taxpayers can conduct internal analysis or bring in outside consultants early on, or wait until the IRS has developed its theory. This choice may be influenced by whether the IRS has itself involved an economist from its recently increased in-house staff.

Many large companies work primarily with their outside accounting firm in the early stages of a transfer-pricing audit. This is understandable because of the accountants' familiarity with the company's business, books and records, and pricing methodologies, as well as their experience with transfer-pricing audits and economic expertise.

No legal protection normally attaches, however, to communications between taxpayers and accountants or other economic consultants. Thus, all documents provided to the firm for review and all analysis that it prepares are readily discoverable by the IRS. The potential roadmap and exposure of weaknesses that might result are a major risk. At a minimum, this concern is detrimental to the open and constructive communications needed to facilitate the analysis. Foreign companies are often especially sensitive about confidentiality.

In view of this concern, taxpayers may choose to involve outside counsel relatively early in the audit process in order to trigger the attorney-client privilege and work-product protection. If accountants or other consultants are also involved, the lawyers' involvement cannot be token. Under Kovel,(13) communications must genuinely be made to obtain legal advice from the attorneys and the attorneys cannot be a mere conduit for accountants' services or advice. Inside counsel with appropriate expertise can be utilized for the same purpose. The difficulty of keeping their various hats separate, however, may make this option less reliable.

In evaluating the use of outside experts, the taxpayer must estimate whether the outcome is likely to be sufficiently improved to justify the additional cost. Consultants are often needed in transfer-pricing cases, however, simply to enable the taxpayer to handle the case, regardless of cost. Moreover, the cost of expert assistance usually pales in comparison with the tax dollars at stake.

A decision tree set forth in Figure 2 illustrates the cost/ benefit analysis and consequences of alternative taxpayer approaches to handling an audit. Although the calculations involved in this example reflect a number of uncertain events as well as choices (eg., forum, settlement opportunities, timing), the format has been collapsed for simplification. The two factors highlighted are the outcome and the time involved: the adversarial approach is estimated generally to produce better results if consultants are involved but to take longer and cost more. This model is obviously quite sensitive to predictions of the result of various approaches.

Decision Point - Negotiation/Settlement

Strategies

Some points from a panoply of options and tactical considerations in settling a transfer-pricing case:

* Effect on future audits must be considered because

of the potential ease of roll-forward. The

risk of an adverse roll-forward may be overrated,

however, given the pace of developments in section

482 substantive law and changes in business conditions.

* Creative approaches should be tried (e.g., simple

versus weighted averages in evaluating comparables,

or "smoothing" between years).

* Use of graphics can accelerate the understanding

of complex concepts and data.

* Acceptability of methodologies to the competent

authorities must be taken into account.

* Industry audit experience and approach are pertinent.

* Costs and time entailed must be estimated, including

the intangible corporate price of extended investigation

and controversy.

* The duration and contentiousness of an audit and

concomitant IRS "investment" in the case may affect

settlement opportunities.

* Taxpayers should be cognizant of recent IRS

developments and their potential effect. For example,

IRS organizational changes (eg., the establishment

of International Field Assistance and Support

Program and the reorganization of the Coordinated

Examination Program) augur better coordination

and consistency of audits, as well as help in refining

issues and targeting enforcement; improved

training suggests faster, tougher, and less erratic

audits; additional funding as the result of congressional

attention promises more IRS economists and

international examiners as well as outside experts.

* Political considerations cannot be ignored. Transfer

pricing is currently a major political football. Taxpayers

should expect increased audit activity and

IRS persistence in this climate. Varying degrees of

sensitivity - and cooperation at the competent

authority level - between different countries must

also be taken into account.

Decision-Tree Illustration

Settlement options, in terms of amounts, methods and procedures, are particularly susceptible to decision-tree analysis. An example is set forth in Figure 3.

Once again, the options and analysis in Figure 3 have been simplified for illustrative purposes. Among the assumptions is that the level of "good" and "bad" results at Appeals increases when higher offers are rejected by the Examination Division, on the theory that the IRS consistently thinks it has a stronger case. (Alternatively, one could leave the levels alone and change the probabilities.) The litigation odds might also be adjusted on the same theory, to reflect levels of IRS conviction and energy. The potential effect on later years could be reflected if different methods were involved in the settlement offers.

On the assumptions used, the decision tree suggests making a low offer at the Examination level and moving on quickly to Appeals if it is rejected.

Decision Point - How to Wrap It Up?

Involvement of Competent Authority

As the taxpayer and the IRS converge on a settlement, consideration must be given to the procedural mechanics for closing out the case. Litigation is the ultimate option, with U.S. Tax Court the almost inevitable forum owing to the amounts involved (since the Tax Court does not require a prepayment of the disputed amount). Litigation is rarely the method of choice in transfer-pricing cases, however, owing to the cost, complexity, length and fact-intensive nature of the dispute. For the same reasons, the court is likely to exert great pressure on the parties to settle prior to trial. Although this alone could be the objective where particularly recalcitrant IRS representatives are involved, choosing litigation for this reason is a decidedly risky course. Foreign companies are particularly leery of litigation.

Cases settled at the Examination level are normally resolved by executing Form 870, and those at Appeals with Form 870AD. As a practical matter, this ends IRS interest in the case, although definitive resolution can only be obtained with a formal closing agreement under section 7121. The IRS is generally reluctant to use closing agreements because of the extra levels of review involved.

Taxpayers, particularly foreign-owned companies less familiar with IRS practice, may nevertheless prefer a closing agreement because of its enhanced certainty. Although a closing agreement can be set aside by competent authority, this is unlikely to occur to the taxpayer's disadvantage. More problematically, a closing agreement can reduce the U.S. competent authority's incentive to press the taxpayer's case in negotiations with the foreign competent authority, since the taxpayer has already agreed to pay the U.S.-determined deficiency. An alternative is to agree to pay up to the amount of the proposed deficiency if compotent authority relief is granted, bearing in mind that if the competent authority process fails, an increased adjustment by the Examination Division (if the case did not go through Appeals) is possible.

The involvement of competent authority is the peculiar feature, and obvious complication, of transfer-pricing cases.(14) In a sense, the competent authority context narrows the procedural options, since Rev. Proc. 91-23, 1991-1 C.B. 534, generally requires taxpayers to take unagreed cases to Appeals before seeking competent authority assistance. Cases may be accepted by competent authority earlier in the government's discretion, eg., where the disagreement is limited to either the amount or the methodology. In such a case, however, the U.S. competent authority may condition acceptance on the taxpayer's agreeing to waive future review by Appeals if the case is not resolved by the competent authorities. Moreover, the Examination Division may write up the case (in a Form 5701 or 30-day letter) at a relatively high level in anticipation of compromise at the competent authority negotiating table; this may give some foreign taxpayers pause and could be a problem if the case is not resolved at competent authority.

Competent authority is viewed by many as a "black hole" into which the taxpayer's case disappears. In fact, it is often possible for the taxpayer to play a significant role in configuring the case for competent authority consideration and in facilitating the granting of relief.

The tensions in competent authority differ from those in typical domestic tax controversies. The IRS, as the U.S. competent authority, becomes the taxpayer's advocate, arguing the taxpayer's case to the foreign tax authority, so that a well-reasoned field adjustment is helpful. The taxpayer may also hope, however, for a reduction in the U.S. adjustment (e.g., because of disparities in jurisdictions' interest rules), which is more likely to occur if there are weaknesses in the IRS's analysis that the foreign competent authority can exploit. Walking this line - which affects both the approach in the taxpayer's competent authority request and the taxpayer's actions during processing - can be particularly delicate because taxpayers have no direct participatory role in the competent authority process. Much will depend on the attitude and experience of the ERS specialist assigned to the case.

Other practical issues that may arise in a competent authority proceeding include:

* Time involved. The competent authority process is

cumbersome and lengthy. A typical case takes over

two years to resolve. The IRS is making valiant 

efforts to streamline the process. As with APAs, the

increased "popularity" of competent authority owing

to the upsurge in transfer-pricing audits could

cut two ways: increased familiarity with issues and

industries could accelerate the process, but the increased

number of cases, absent sufficient additional

personnel, could slow it down. The time involved

can have a significant end-point effect if the countries

do not have comparable interest rules.

* Provision of information. Both U.S. and foreign

competent authorities may seek data from the taxpayer

and related parties to aid their analysis.

Quick and cooperative responses are advisable.

* Communications with competent authorities. U.S.

and foreign competent authorities vary in the degree

of access afforded taxpayers during the process.

In view of the government-to-government context,

it is best to express appreciation of any opportunities

offered and use chips carefully.

* Communications with client. The oddities of the

competent authority process can be difficult to explain

to clients, complicated by national administrative

and cultural differences.

* Working both sides. At some point, it may be apparent

to the taxpayer that the governments are

close to resolution. Communication of support for

the resolution is constructive and appreciated.

* Acceptability of resolution. The taxpayer is consulted

by U.S. competent authority about its willingness

to accept a proposed resolution, and the

taxpayer may withdraw from the process if the

proposal is not acceptable. U.S. competent authority,

however, can refuse to accept a case if it perceives

that the taxpayer will only be willing to

accept a competent authority agreement under conditions

that are unreasonable or prejudicial to U.S.

interests. It is possible to resolve cases as a combination

of bilateral and unilateral relief, i.e., with

the taxpayer agreeing to accept double taxation on

part of the U.S. adjustment.

The principal choice for the taxpayer is whether to seek competent authority assistance and incur the costs and time entailed, or to accept the IRS adjustment without seeking competent authority relief. The choice depends, among other things, on the amount involved, foreign tax credit and currency issues, and time and interest considerations. In the relatively rare instance where a case is not resolved at competent authority, the taxpayer returns to the standard options of Appeals, if not already utilized, or litigation - unless the former is waived in order to get into competent authority or the latter is precluded because of a closing agreement.

Finally, competent authority assistance may not always be a right of the taxpayer. This issue is currently being litigated in the Yamaha case.(15) The IRS takes the position that it may keep a case out of competent authority by "designating" it for litigation or, in docketed cases, by District Counsel's exercise of discretion. This is another reason for carefully weighing adversarial stances.

Decision Point - Repatriation Options

If a transfer-pricing case results in increased taxable income to a U.S. taxpayer, consideration must be given to possible recovery of the adjustment amounts from the related party. Absent some sort of repatriation, a U.S. subsidiary may be deemed to have made a constructive dividend to its foreign parent, subject to U.S. withholding tax, in the amount of the price adjustment, or a U.S. parent may be deemed in receipt of a constructive dividend from its foreign subsidiary.

Adverse tax consequences from the repatriation can be avoided by invoking the relief provisions in Rev. Proc. 65-17, 1965-1 C.B. 833. Rev. Proc. 65-17 allows the establishment of interest-bearing accounts receivable for the price differential that can be repaid without tax consequence (other than the effect of interest). This mechanism can be useful unless foreign tax rules capture taxable exchange gain upon the loan repayment (or, conversely, especially useful if foreign exchange pin losses are involved).

Currently, Rev. Proc. 65-17 relief in a treaty-country case can only be obtained as part of a competent authority proceeding.(16) Accordingly, repatriation options must be considered as part of deciding which way to go at the competent authority fork. The competent authority involvement can be helpful; the current U.S. competent authority policy is to waive interest on the receivables as part of closing the competent authority case. The ultimate competent authority agreement, including provisions regarding repatriation, is usually reflected in a closing agreement between the IRS and the taxpayer.

Evaluation of the repatriation decision is almost entirely a mathematical exercise and involves little uncertainty. A critical parameter is the amount of current and accumulated earnings and profits. If the absence of earnings and profits eliminates constructive dividend issues, easy nontaxable capital contribution or return of capital routes will result, affected only by foreign tax and accounting considerations.

(1) Treas. Reg. [subsection] 1.482-1 to 1.482-2.

(2) 57 Fed. Reg. 3571 (January 30, 1992).

(3) Extensive discussion of decision-tree methodology can be found in R. Schlaifer, Analysis of Decisions under Uncertainty (1967) (two volumes), and other treatises.

(4) 1991-1 C.B. 526, corrected by Rev. Proc. 91-22A, 1991-1 C.B. 534.

(5) See also Patton, Advance Pricing Agreements: Practical Issues to Consider in Determining Whether to Pursue One, 43 The Tax Executive 392 (Nov.-Dec. 1991).

(6) Rev. Proc. 91-22 requires an APA request to recast the taxpayer's prior three years' tax data under the proposed methodology. Although certain constraints are placed on use of this information by the Field, the audit implications, subtle or otherwise, are real.

(7) Both IRS officials and taxpayers have suggested that the use of a pricing study or analytical methodology in planning transactions might provide a defense ("reasonable cause") against imposition of transfer-pricing penalties under Code section 6662(e). No pertinent regulations have yet been proposed.

(8) Treas. Reg. [section] 1.482-2(d)(1)(ii).

(9) Treas. Reg. [section] 1.482-2(d)(4). See Shea & Lewis, Section 482 Cost-Sharing Arrangements: An Agenda for Regulatory Guidance, 39 The Tax Executive 357 (Summer 1987).

(10) Prop. Reg. [section] 1.482-2(g).

(11) Int. Rev. Man. 42(10)6.2 (issued 8/4/92) simply contains cross-references to Rev. Proc. 91-38 and Rev. Proc. 91-22 (regarding APAs).

(12) A change in assumptions as to the likelihood of audit could make a significant difference; at 50 percent, for example, the developer/assister route would be preferable to a CSA.

(13) United States v. Kovel, 296 F.2d 918 (2d Cir. 1961).

(14) See generally Reavey & Dunn, Resolving Transfer-Pricing Disputes Through the Revised Competent Authority Process, 43 The Tax Executive 177 May-June 1991).

(15) Yamaha Motor Corp., U.S.A v. United States, 779 F. Supp. 610 (D.D.C. 1991), on appeal to D.C. Circuit.

(16) See Rev. Proc. 91-24, 1991-1 C.B. 542.

PATRICIA GIMBEL LEWIS is a member of the law firm of Caplin & Drysdale, Chartered, in Washington, D.C. She received J.D. and M.B.A. degrees (with honors) from Harvard University in 1971. Mrs. Lewis is co-hair of the Taxation Section of the District of Columbia Bar, and is an active member of the ABA Section on Taxation's Committe on Foreign Activities of U.S. Taxpayers.