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Advance pricing agreements: practical issues to consider in determining whether to pursue one.

In March, the Internal Revenue Service published Rev. Proc. [91-22,.sup.1+] which sets forth the procedures for taxpayers to follow in applying for an Advance Pricing Agreement. The revenue procedure is a substantial improvement over the earlier draft version, which had been distributed informally to a limited group of practitioners and taxpayers for comments, and had subsequently been published in the press. [2] This article focuses not so much on the provisions of the revenue procedure but rather on practical issues that taxpayers should consider when thinking about whether to pursue an Advance Pricing Agreement.

Apportionment Methodology

Rev. Proc. 91-22 expressly provides that taxpayers may apply for an APA using one of the three traditional pricing methodologies0--comparable uncontrolled price, resale price, or cost-plus--or a fourth methodology. Although any of the three traditional methods or a fourth method theoretically ought to produce the same result when applied to the same set of facts, any taxpayer that has attempted to apply different methodologies can readily attest to the fact that consistency of results is rarely the case. To take a simple example, suppose that a foreign-controlled U.S. company acts as a super-distributor of high-tech electronics products manufactured by its foreign parent company. [3] A review of publicly available data reveals that large distributors of these types of electronics products generally earn gross margins of 17 to 20 percent with operating profits before taxes and interest of 3 to 5 percent. Suppose also that the comany has used a transfer pricing methodology whereby the parent company transfers product manufactured by it to the subsidiary at its production cost-plus 5 percent. Using the cost-plus 5-percent method, the U.S. taxpayer has generally earned gross margins of approximately 10 to 12 percent and has earned net operating profits before taxes and interest ranging from 2 to break even. A review of the available U.S. data on manufacturers of similar high-tech electronics components reveals that cost-plus 5 percent is on the low range of profits earned by manufacturers of similar products. There is no publicly available data on what manufacturers of similar products earned in the parent company's country of manufacture.

An initial question to consider is what the U.S. company's risk might be on IRS examination. Under the current regulations, the priority of methods for the pricing of tangible property would apply. Since there was no comparable uncontrolled price in the stated facts, the IRS would look to the method that has second priority, the resale price method. Assuming that on audit an agent would use the resale price method, the question arises how the agent would apply the method. Under the traditional view of resale price method, the agent would reduce the taxpayer's cost of goods sold so that the gross margin was adjusted to the comparable range of 17 to 20 percent, or to a specific number within that range. Under a revised view of the resale price method that agents have recently been using in inbound cases, the agent might look to the net operating profit before tax of the potentially comparable companies and adjust the taxpayer's gross margin upward to produce the same net profit margin. [4] Under the current priority of methods, the agents would not take into account the fact that the parent company has an apparently reasonable cost-plus methodology, since this method has a lower priority that the resale price method. Nor would the agents necessarily consider information on fourth methods, such as the Berry ratio, or return on assets methods, that might show that the reason for the U.S. taxpayer's lower gross margins and lower net profitability is that it performs fewer functions and incurs fewer expenses than the large public distributors to which it is being compared.

One of the advantages of the APA process is that the taxpayer is apparently not limited to the current priority of methods or to a traditional application of those methods. In the foregoing example, it is clear that the transfer pricing methodology was not set in an abusive manner, since the cost-plus was well within the range of reason and below that of any potential comparables. Yet that approach reached a result that may not be acceptable to the IRS. If the goal of the APA process is to reach a "reasonable" result, then the example just given is probably a good one for consideration of an APA, since the taxpayer might face an uncertain result, or an unfavorable one, upon examination.

This example also raises the issue whether a taxpayer should focus on pure methodology or on bottom-line results. If the taxpayer is considering applying for an APA, should the taxpayer attempt to focus on the gross margin of the U.S. taxpayer, the U.S. taxpayer's net operating profit before taxes, or the foreign parent company's cost-plus? In the case of both a gross margin methodology or a cost-plus methodology, the taxpayer might not get ultimate certainty even if an APA were granted. This is because either the IRS or the foreign tax authorities could question the amount of below-the-line expenses in applying the resale price method, or might question the costs of the foreign manufacturer in applying the cost-plus methodology. On the one hand, focusing upon the net operating profit before taxes and interest would give the U.S. taxpayer greater certainty of result and freedom from adjustment. On the other hand, the foreign jurisdiction might object to guaranteeing the profit of the U.S. subsidiary. In this context, if a guarantee of profit is essentially being made, should not the profit be lower to reflect the lack of risk on the part of the U.S. subsidiary?

Dealing With Open Years

Once a taxpayer gets over the initial hurdle of deciding what methodology it should use, an additional question that must be raised is what effect this methodology will have on open years, if it is not the methodology that is currently being employed by the taxpayer. This is an extremely significant issue for taxpayers that are recognizing that their past methodology has been improper. It is an issue that exists whether taxpayers are seeking an APA or merely engaging in self-examination as a result of increased IRS and foreign tax authority scrutiny of cross-border transfer pricing. Outside the context of an APA, many taxpayers struggle with the issue of trying to change something they know has not been properly done in the past. Does the taxpayer play audit lottery and hope that it does not get caught, or wait to deal with the issue when it has been raised on audit? Does the taxpayer change to the right methodology all at once and cross its fingers that the issue will not be picked up on audit, or does the taxpayer change gradually year by year until the proper methodology is achieved, hoping that incremental changes will not be a red flag for a transfer pricing audit?

Individual taxpayers will answer these issues in different ways outside the context of an APA. The issue, however, takes on increased importance when the taxpayer is proposing an APA, since one of the procedural requirements for obtaining an APA is to apply the method to prior years in the event that the method is not consistent with what was done in prior years. The taxpayer is thereby providing a complete audit trail for the IRS. Obviously, the easiest cases for consideration of an APA are those where the taxpayer is maintaining a consistent method, or where the method produces very small deviations from what was reported on returns in prior years. Cases where there are significant differences may not be appropriate cases for an APA.

There evidently have been cases where taxpayers that have undergone an IRS examination and that have had substantial deficiencies proposed have applied for APAs with respect to their current years. It is possible that the "reasonable methodology" agreed to in an APA may be more favorable to the taxpayer than the methodology used by examining agents, who are necessarily taking an aggressive position with the view that a substantial portion of their adjustment will be whittled down, either by Appeals or the courts. Assuming that the taxpayer finds itself in such a situation, it is reasonable to assume that the IRS would allow the taxpayer to apply the methodology agreed upon in an APA context retroactively to all open years, as long as the facts concerning the taxpayer's operations, functions, risks, etc., were the same or similar to those existing for the tax years to which an APA would apply.

Handling Factual

and Other Representations

Suppose our taxpayer in the previous example decides that it wants to apply for an APA, and that it would like to target a net operating profit before tax and interest of 2 to 4 percent. The taxpayer realizes that any factual information that it submits is the type of information that the IRS could discover, in any event, upon an audit. [5] In pursuing the APA process, however, the taxpayer will necessarily be making statements that could potentially be admissions against interest if the process fails. For example, the taxpayer would be characterizing what it thought was or was not a reasonable range of profitability for its U.S.-based activities and its foreign parent's foreign-based activities. It might also be stating that certain potentially comparable companies are, or are not, comparable to the taxpayer's situation. In the event that the process concludes without reaching agreement, the taxpayer may want to retain its flexibility to argue as strenuously as possible to sustain a return position, which argument may require the taxpayer to back away from the representations made as part of the APA process.

If the taxpayer decides that, on balance, it is better off trying to seek a negotiated settlement via an APA that would apply prospectively as well as retroactively, how does a taxpayer do so without burning its bridges in the event that the process fails? One way to do so is to have an agreement with the IRS that any factual material submitted as part of the APA process will be available to the IRS for all legitimate tax purposes, whereas nonfactual information will not be used by either party in a potential administrative proceeding or judicial proceeding. The parties could also stipulate what would be considered nonfactual matters that would not be treated as admissions in the event that an agreement is not reached on an APA or, even if agreement is reached, that would not be applied to prior years without the parties' consent.

Pre-Filing Conferences

Rev. Proc. 91-22 encourages taxpayers to use pre-filing conferences to clarify issues. One of the issues that could be clarified in a pre-filing conference is establishing ground rules to identify and handle factual matters, as well as nonfactual matters.

The pre-filing conference can be an extremely valuable opportunity for the taxpayer to explore the possibility of an APA without becoming so committed to the process that it suffers actual or perceived harm in the event that an agreement is not reached. One issue that the taxpayer might explore at a pre-filing conference is whether its case is the type that the IRS would consider for an APA. For example, the IRS has indicated publicly that it is primarily interested in pursuing APAs involving countries with which the United States has a bilateral income tax convention and that have expressed interest in the APA process. A taxpayer at a pre-filing conference could ascertain from the IRS whether the other country that it would propose for inclusion in an APA is receptive to the process, and whether, if not, the IRS would be willing to entertain a unilateral APA. The taxpayer might also explore with the IRS the methodology that it proposes to employ, especially if a fourth method-type of methodology would be proposed.

Other issues that a taxpayer might explore include whether other taxpayers in its industry or similar industries have applied for APAs, and what methodologies the IRS has found appropriate in those cases. The extent of data, documents, or analysis to be supplied by the taxpayer; the need for an independent economics, or other type of, expert, the prospects for a Competent Authority consideration, and IRS timing for handling the APA could also be discussed. The foregoing list does not exhaust the possibilities of subjects that could be covered by a pre-filing conference. Indeed, any issue potentially relevant to the taxpayer's application should be an appropriate subject for discussion in a pre-filing conference.

Confidentiality of Data

Submitted by the Taxpayer

Many taxpayers have expressed concern that information submitted to the IRS as part of an APA is particularly sensitive information that should not be disclosed to the public. For example, taxpayers might be required to submit business plans describing a new product marketing strategy before the product has been announced to the market and competitors are aware of the product. Revenue and cost projections may also be particularly sensitive data that a taxpayer would not want disclosed to its competitors. The IRS has taken the position than any information submitted as part of the APA process is taxpayer return information, protected by section 6103 of the Internal Revenue Code and, thus, not subject to being turned over in response to a Freedom of Information Act suit.

There certainly is a strong argument that could be made for this position, especially since the IRS district office will be involved in verifying any information submitted. The taxpayer will also be submitting prior years' tax returns and other information that relates to its potential audit history with the IRS. On the other hand, since there currently is no express statutory provision dealing with material submitted as part of an APA process, there is some room for doubt about the IRS's position. As a practical matter, taxpayers may wish to provide in any agreement reached with the IRS, that should any information become subject to turnover pursuant to a Freedom of Information Act suit, the taxpayer will be allowed to redact any identifying information prior to the time that the information is turned over to the court or the plaintiff in such a suit.

Dealing with IRS Field Agents

Rev. Proc. 91-22 provides that information submitted as part of the APA process will be verified by field agents following initial review by the National Office. One concern that many taxpayers have is how this verification process will be handled by the field agents. Will the agents be content to examine or ask additional questions concerning the information submitted by the taxpayer, or will the agents commence a full-blown audit, looking for additional issues? These issues become more acute if the taxpayer has an examination pending for earlier years, or is involved in controversy with regard to earlier years.

Since the APA process is a voluntary one initiated by the taxpayer, the taxpayer should have some ability to limit the agents' inquiries to issues that are relevant to the taxpayer's submission, and to verifying the information submitted by the taxpayer. If the taxpayer believes that the agents' inquiries are going too far, the taxpayer can always seek guidance from the National Office or, potentially, withdraw its application for an APA and adopt a defensive mode. Obviously, a taxpayer that is in this position may wish that it had never started the APA process, especially if the taxpayer had not been recently subject to audit. Fortunately, it has been the author's experience that agents in this position, whether IRS agents or foreign revenue agents, have not used an APA request as an open invitation to an unlimited audit of the taxpayer's transactions. Nor has an APA request triggered a retaliatory type of audit for open years that would not otherwise have been subject to audit. Thus, although it involves a leap of faith, one has to assume that the IRS is interested in pursuing APAs as a program, and that any actions (such as aggressive use of audits following application for an APA) that would be viewed by taxpayers as detriments to the APA process would not be undertaken without good cause.

Dealing with Foreign Revenue Authorities

The discussion to this point has primarily concerned the IRS and the application of Rev. Proc. 91-22. What about dealing with the foreign revenue authorities as part of the APA process? An initial question arises concerning the timing of contacting foreign revenue authorities. Should the IRS be contacted first, or should the foreign tax authority be contacted first? To some extent, the answer depends upon the ultimate residence of the multinational taxpaying group as well as the state of sophistication of the home country tax authorities. A taxpayer may also wish to consider where it has the larger potential exposure in the event that its proposed APA will involve a change in method from that currently being used. Thus, a Japanese-controlled corporation that believes it may have substantial potential U.S. income tax liability may wish to contact the IRS before contacting the NTA, unless it had some strong indications from the NTA that the NTA would favorably and expeditiously consider its proposal. [6]

Whether the taxpayer chooses to approach the IRS or the foreign tax authority first, it would be prudent for the taxpayer to commence discussions with the tax authority not contacted first shortly after discussions begin with the first to be contacted. It is theoretically possible that the taxpayer could negotiate solely with the IRS, leaving the IRS to negotiate on its behalf with the foreign tax authorities. Such an approach, however, would not seem prudent unless the taxpayer were wholly indifferent to the result that might be achieved as a result of the negotiation process. More likely, the taxpayer would want to negotiate with each set of tax authorities separately, recognizing that each one will arrive at a position that it feels represents a reasonable result, taking into account its own revenue interests. Assuming that the gap between the positions were not too wide, the Competent Authorities could then negotiate an agreeable settlement, subject to input from the taxpayers. Unfortunately, the Competent Authority process has not been one where taxpayers have traditionally been allowed to participate actively. Inasmuch as an APA is proposed voluntarily by the taxpayer and is based on the record created by the taxpayer (rather than by a thorough audit), the taxpayer ought to be allowed to have a stronger participatory role in Competent Authority negotiations over an APA process. For example, a taxpayer would be present during Competent Authority discussions of the facts of its particular case, since it would presumably be better informed about those facts than either of the tax authorities. The tax authorities could then deliberate among themselves concerning the proper resolution of the issues that would be recommended for Competent Authority agreement. Such a procedure might represent a good compromise to assure that an accurate factual record is made to support the proposal, while ensuring the confidentiality of the Competent Authority process.

Issues that a taxpayer might want to discuss with foreign tax authorities considering an Advance Pricing Agreement include the procedures that the foreign tax authorities will follow in handling the agreement. For example, would the foreign tax authorities follow Rev. Proc. 91-22 as a guideline? If so, this would help simplify issues such as the amount of supporting data on independent transactions, comparable transactions, competitor data, etc., that might need to be submitted by the taxpayer. The taxpayer may also wish to pursue the same issues with the foreign tax authorities that it raised with the IRS at pre-filing conferences. In particular, the taxpayer might want to confirm the legal effect of an APA under foreign law, as well as the legal status of information submitted as part of the APA process. On this last point, the taxpayer would want to ensure that any information submitted was treated as confidential tax-related information, that potential trade secrets were protected, and that nonfactual disclosures would be treated consistently with the way they would be treated in the United States. The taxpayer might also want to explore the acceptability and process for making compensating adjustments. [7] The taxpayer should also discuss how potential field verification of information submitted would be handled, as well as the procedure for coordinating verification of information between the National Tax Office and any field auditors. Finally, the taxpayer would want to discuss with the Competent Authority the procedures for reaching a Competent Authority agreement with the IRS, including the taxpayer's involvement.

Defining Critical Assumptions

Rev. Proc. 91-22 states that a taxpayer should propose the critical assumptions that would govern an Advance Pricing Agreement. Critical assumptions are essentially that state of facts or business operations that both the tax authorities and the taxpayers assume will exist in order for the agreement to operate. Stated differently, the taxpayer would want to specifically define any circumstances under which it would not want to be bound by an Advance Pricing Agreement. For example, would the taxpayer want to be bound by an APA agreement that establishes a net profit range for a distribution subsidiary if the major product line that is being sold is being sold at a loss? Would the taxpayer want to continue to be bound if the distribution subsidiary subsequently engaged in both distribution and manufacture? These and other issues are the types of issues that ought to be defined in advance as critical assumptions under which the agreement would cease to operate or the parties would agree to discuss renegotiating the agreement.

Why Not Do an APA?

Probably the largest hurdle that a taxpayer considering an APA has to leap is whether to make a voluntary disclosure of information that could potentially result in a deficiency for open years. Notwithstanding the previous discussion of how to lessen the impact of making such disclosures, the bottom line in many instances will be that the taxpayer may have to be prepared to pay a substantial deficiency for open years in order to reach an APA agreement. If the taxpayer has not been subject to audit for these open years, it would indeed take a tax director very secure in his or her job to suggest an APA in the face of such payments.

It may be easier to consider an APA when the taxpayer has already been subject to an audit and a substantial deficiency is proposed, especially if the taxpayer believes that an APA methodology may result in a smaller deficiency for the open years. A cynic might question whether it is possible to reach agreement on an APA with the same group of people who were unable to reach agreement on the deficiencies proposed for the open years. Experience, however, teaches that the IRS is not a monolithic agency, and that it is indeed possible to reach agreement on an APA after a contentious audit that produced substantial deficiencies. This is not to say that the process is an easy one, merely that it is possible under such circumstances.

Ultimately the decision to seek an APA requires a cost-benefit analysis. If the taxpayer has been aggressive in its transfer pricing, whether purposely or through neglect, the decision may be that the traditional audit lottery process is the most cost beneficial. As a compromise position, a taxpayer considering an APA may want to wait until the years with the greatest exposure close while pursuing a strategy of moderate change.

Why Do It?

Achieving certainty on what can be a major tax issue is the primary reason for seeking an APA. This assurance is heightened when a bottom-line type of approach or formulary approach is pursued as part of the APA process. Other reasons that a taxpayer might consider doing an APA include future expansion of business into what are now relatively small markets. Under such circumstances, a taxpayer may lock in a favorable profit number before the revenue in either the U.S. or foreign jurisdictions gets so large that the tax authorities look soley at the potential revenue loss. An APA might be sought as part of an overall foreign tax reduction plan. For example, a taxpayer that followed a net profit approach for a distribution subsidiary may be able to negotiate a lower net profitability than it had been reporting previously for tax purposes because of the guarantee element inherent in such a situation. If the profit were lower, the effective foreign tax rate might also be lower, thus potentially freeing up excess foreign tax credits. A taxpayer might also have issues that have been traditionally raised on audit by IRS agents and later given away by Appeals. A taxpayer might feel that such issues have only been raised as bargaining chips in the process and may wish to have them taken off the table to reduce the issues to those that are clearly legitimate areas of dispute.

Finally, those U.S. taxpayers that are foreign-controlled have to be concerned about how field agents will exercise the new authority given to IRS under section 6038A of the Code. There is clearly a congressional mandate on the IRS to raise additional revenues through transfer pricing adjustments made against foreign-controlled U.S. corporations. Given such a state of affairs, taxpayers may wish to seek the comfort of an APA rather than the uncertainties of treatment at the hands of field agents on audit. In addition, a taxpayer may be able to negotiate a record-keeping agreement as part of seeking an APA. [8]

Professional Fees and Costs

Many taxpayers contemplating APAs have expressed concern about the professional fees and costs that would be involved in pursuing such an agreement. Clearly, such fees and costs are less than what is involved in a major transfer pricing litigation, or a protracted audit and Appeals proceedings. Just as clearly, the costs of seeking an APA are not insignificant. What can a company contemplating an APA do to control its costs? One strategy is to narrow the scope of a potential APA to a limited range of transactions that are significant, rather than trying to include everything. Another way is to have a clear understanding with the professional advisors as to what work will be done by the client and what work will be done by the outside advisors. The taxpayer ought to be able to gather almost all of the documentary material itself, including the accounting data, competitor analysis, and identification of potential comparables. Taxpayers generally will need some assistance with computing profits splits or product line income statements as well as other issues.

Although it involves some additional up-front expenses, a taxpayer should probably consult with an outside economist during the development stage of the APA proposal. The outside economist could identify potential comparables for the taxpayer, as well as guide the taxpayer towards an appropriate methodology. a taxpayer that has no economic input at the planning stage may discover at the end of the process that either an IRS economist or an independent economist retained by both parties has serious reservations with the methodology being proposed, in which case much of the work previously done may have been for nought. There are, of course, other ways that costs can be managed throughout the process that are really no different than managing professional fees in any large-scale engagement.


This article has attempted to summarize some of the practical issues that arise in considering or consummating APAs. Any individual taxpayer will, of course, have issues that are unique to its own situation that have not been discussed. However, the issues discussed seem to be those that arise frequently in discussions with clients, and those that have caused most serious concerns.

[1] 1991-11 I.R.B. 11.

[2] For a discussion of issues raised by the draft revenue procedure, many of which were resolved favorably for taxpayers in the final version, see Ryan & Patton, IRS Advanced Pricing Agreements: Are They a Practical Means to Resolve Potential International Transfer Pricing Disputes? 20 Tax Management International Journal 115 (March 8, 1991).

[3] A super-distributor in this context refers to a distributor that distributes to original equipment manufacturers (OEMs), as well as to traditional distributors.

[4] See Hearing on Tax Underpayments by U.S. Subsidiaries of Foreign Companies before the Oversight Sub-Committee of the Ways and Means Committee, July 10, 1990 (testimony indicating that while some foreign controlled companies have adequate gross margins, they have excessive "below the line" expenses that require adjustments to the gross margin to reach appropriate levels of net profitability).

[5] Of course, in disclosing the information voluntarily, the taxpayer forgoes the advantage of waiting for the IRS agent to ask for the information. It has also presumably sorted the information for relevance and only disclosed that information that it believes is truly relevant. An agent who may not know the taxpayer's business would presumably take a much longer time to find out what was and what was not relevant, and might miss potentially relevant information, while seeking information that ultimately proves to be less than relevant.

[6] Recent press reports have indicated that the NTA will now favorably entertain applications for APAs. This represents an apparent change in position by the NTA. Accordingly, it would appear that the IRS is more advanced in its thinking and experience in APAs than is the Japanese NTA.

[7] Compensating adjustments are specifically provided for in Rev. Proc. 91-22. They may not be recognized in a foreign jurisdiction, and therefore this point should be considered.

[8] Rev. Proc. 91-38, 1991-30 I.R.B. 16.

MICHAEL F. PATTON is a partner in Ernst & Young's International Tax Services office in Washington, D.C. and is co-chair of the firm's Transfer Pricing Task Force. He received his J.D. degree (with honors) from the University of Maryland and his LL.M. (Taxation) degree from Georgetown University Law Center. Before joining Ernst & Young, Mr. Patton worked for 15 years for the Internal Revenue Service, most recently as Chief of Branch One in the Office of the Associate Chief Counsel (International). This article is based upon discussions with clients and IRS officials concerning Advance Pricing Agreements (APAs). It does not reflect the experience of any one particular client, nor are the views expressed herein necessarily concurred in by the IRS.
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Author:Patton, Michael F.
Publication:Tax Executive
Date:Nov 1, 1991
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