Resolving transfer-pricing disputes through the revised competent authority process.
This stepped-up attempt to identify related-party transactions that are not conducted at arm's length under section 482 of the Internal Revenue Code and comparable foreign statutes has spawned a significant increase in the number and magnitude of examination adjustments to intercompany transactions -- adjustments that create unique complications owing to the two-sided nature of the transaction. In these situations, unlike a solely domestic audit adjustment that has no effect on any taxpayer other than the one under examination, an adjustment made in one country often requires a reciprocal opposite adjustment to the related party located in the country on the other side of the transaction. Otherwise, the multinational group may be subject to double taxation on the same income.
Under the terms of most tax treaties entered into by the United States, a mechanism exists to relieve this international double taxation. Under these treaties, each treaty country designates a representative, called the Competent Authority (CA), to assist taxpayers in resolving disputes between taxing jurisdictions. Recently, the IRS issued guidance that revamped the procedures and requirements for using the competent authority process. Because an understanding of the process is essential for those who encounter transfer-pricing and other cross-border intercompany tax disputes, this article explains the IRS's recent guidance and discusses the requirements for using the competent authority process to mitigate double taxation.
Double-taxation cases addressed by the CA can be categorized into two general groups:
* Allocation cases. In these cases, international intercompany and intracompany allocations are made by the IRS or by the revenue authorities of a U.S. income tax treaty partner. These cases typically involve such issues as adjustments to intercompany pricing, royalty rates, interest, management fees, business expense and gross revenue allocation adjustments.
* Nonallocation cases. These situations arise from unauthorized or discriminatory taxation by either treaty partner. These cases generally involve interpretation of treaties, for example, source of income, exempt income, reduced treaty rates, nondiscrimination, residence, and permanent establishment.
Allocation cases represent the vast majority of double-taxation occurrences. A typical example might be the hypothetical case of Global, a U.S. corporation that provides knowhow and use of its corporate name to its foreign subsidiary in exchange for a five-percent royalty. In a subsequent examination initiated by the foreign revenue authorities, the foreign country contests the rate paid as excessive and reduces the rate from five percent to four. Under this scenario, Global has already recognized the five-percent royalty as income on its U.S. tax return for the year under foreign examination. Because the subsidiary's deduction has been reduced by the foreign jurisdiction, the amount that Global is required to recognize as income should be reduced commensurately. If not, Global worldwide suffers potential double taxation on the royalty rate differential.
THE COMPETENT AUTHORITY PROCESS
Purpose of the Competent Authority
Within nearly all income tax treaties, a mechanism is available to address double-taxation problems. Under these treaties, the taxpayer -- whether corporate or non-corporate, citizen or resident -- may apply to the CA for assistance under the Mutual Agreement Procedure (MAP) article of the applicable tax treaty. Competent authority relief is only available if a tax treaty is in place that contains a MAP article.
The IRS's Assistant Commissioner (International) located in Washington acts as the U.S. CA. Other treaty countries designate their own competent authority representative. The CA serves to assist taxpayers and to protect government interests in matters relating to international double taxation. The principal role of the CA is to act as the official liaison with his or her counterpart overseas. As such, the CA is responsible for administratively interpreting and applying the tax treaties and to attempt to determine the proper allocation of income between multijurisdictional taxpayers. (1) As a result, the competent authority process essentially serves as a diplomatic forum to resolve disputes arising from the application of a tax treaty.
Competent Authority Involvement
If a taxpayers suffers double taxation, it may solicit competent authority assistance. In these situations, the U.S. CA in many respects acts as the taxpayer's advocate and is not bound by determinations made during th examination that gave rise to the adjustment. There is no guarantee, however, that the CA will find the case suitable for a competent authority proceeding. Upon submission of the request, the case is assigned to a competent authority analyst. Based on the facts provided by the taxpayer and other information supplied by the IRS or the foreign taxing authority, the analyst will evaluate the merits of the issue in light of applicable domestic and foreign law to determine if the CA will proceed. In addition, the CA may contact the examining agents to obtain background information.
The CA will prepare a position paper and contact the foreign CA. The next step depends on the complexity of the issues. An early agreement could be reached, though it is more likely that negotiations, offers and counter-offers, as well as one or more face-to-face meetings, will occur before an agreement to lessen or eliminate double taxation is reached. Ordinarily, the taxpayer's role in this part of the competent authority process is passive.
Although resolution of an issue through the competent authority procedures usually results in full or partial relief, the full range of outcomes include:
* the affiliate in the other jurisdiction securing a corresponding offsetting adjustment with respect to the same tax period (correlative adjustment);
* the jurisdiction proposing the adjustment withdrawing its adjustment (unilateral withdrawal);
* a mutually satisfactory combination of the above is achieved; or
* competent authority assistance is denied or is not achieved.
RECENT IRS GUIDANCE
How to Invoke Competent Authority
In March 1991, the IRS released new procedural rules that apply to taxpayers seeking U.S. competent authority assistance. Rev. Proc. 91-23, 1991-11 I.R.B. 18, supplants two earlier revenue procedures. (2) The result of a recent study into the workings of the competent authority process, the new revenue procedure provides a more complete and understandable body of guidance. It also imposes stricter requirements for those who seek competent authority assistance, and gives the IRS substantially more muscle to protect U.S. interests.
What is Included in a Competent Authority Request?
Like its predecessors, Rev. Proc. 91-23 separates competent authority requests into two components, foreign- and U.S.-initiated adjustments. The revenue procedure provides different filing requirements for each, though many requirements are similar. For either type of adjustment the request must contain information and statements that are listed in sections 4 and 5 of the revenue procedure, most of which involve background information relating to the nature of the adjustment.
Under the new rules, there is more interplay between the taxpayer and the CA during the process. For example, a U.S. taxpayer that invokes the competent authority procedures has an increased responsibility to keep the CA apprised of developments and changes with respect to the information or documentation it supplied.
If a foreign tax treaty partner adjusts (or proposes to adjust) the taxable income of a U.S. taxpayer (or its foreign affiliate) and the effect is to subject a U.S. taxpayer to double taxation, the U.S. taxpayer cna invoke competent authority in an attempt to mitigate the double taxation. Under Rev. Proc. 91-23, the written request for competent authority consideration must be filed by the U.S. taxpayer as soon as practical after the treaty country's position on the adjustment has been sufficiently developed to permit consideration, whether or not the adjustment has been formally proposed. This represents a change from the prior rule, which had required that the taxpayer submit the request within 90 days from the date the adjustment was proposed in the foreign taxing jurisdiction. (3)
Where the MAP article of the applicable treaty allows waiver of internal procedural barriers and the U.S. taxpayer's statute of limitations has expired for the year under foreign examination, a waiver of the statute may be permitted in order to afford the taxpayer a credit or refund of U.S. taxes. Such a waiver is not guaranteed under the new revenue procedure, however, and may depend on the treaty partner's willingness to grant waivers in statute-barred situations in similar circumstances. On the other hand, if the opportuniy had existed for the U.S. taxpayer to extend the statute of limitations and the taxpayer did not do so, the new rules provide that competent authority relief may be denied. Therefore, where U.S. taxpayers have foreign affiliates that are parties to a foreign examination that may produce double taxation, the U.S. taxpayer should be kept apprised of developments in the foreign examination, especially where the U.S. statute of limitations is in danger of expiring.
For foreign-initiated adjustments, a U.S. taxpayer's competent authority request must be accompanied by an amended return for the years in question. This amended return is important for two reasons: it shows the effect of the foreign adjustment on the U.S. taxpayer, and it serves as a claim for refund that insulates the U.S. taxpayer from the running of the statute of limitations. An amended return filed under Rev. Proc. 91-23, however, only allows the granting of a credit or a refund agreed to by the U.S. and foreign CAs or unilaterally allowed by the U.S. CA. It does not grant the taxpayer the right to invoke section 482 to achieve a more favorable allocation of income or deductions which could result in a tax credit or refund. In addition, the amended return, which need not be filed with the IRS Service Center as would normally be the case, must be limited to the matter under competent authority consideration.
As with adjustments initiated by other treaty partners, avoiding procedural barriers plays an important part in a successful competent authority proceeding arising from an IRS-initiated adjustment. In these cases, the taxpayer should take immediate steps to protect against the statute of limitations' expiring in the foreign country. If such steps are not taken and the tax treaty does not provide for a waiver of procedural barriers, the taxpayer will likely find competent authority relief unavailable.
A number of administrative requirements apply to competent authority requests arising from U.S. adjustments. For example, in addition to filing the request with the U.S. CA, the taxpayer must file a copy with the IRS office where the taxpayer's case is pending. The filing of amended returns also may be necessary. Unlike the situation with foreign-initiated adjustments, however, such filings are not mandatory in all circumstances; rather, amended returns need only be filed where a reduction in the taxpayer's U.S. tax may result from a correlative adjustment by the treaty country.
Where the incidence of double taxation is small, the taxpayer may request competent authority assistance through use of an abbreviated and simplified filing procedure which is described in section 10 of Rev. Proc. 91-23. To take advantage of this procedure, the proposed adjustment for corportaions must not be greater than $100,000, and the tax attributable to the adjustment may be no more than $25,000. In the case of individuals, the adjustment and the tax may be no more than $50,000 and $10,000, respectively.
EFFECT OF COMPETENT AUTHORITY ON
OTHER DISPUTE RESOLUTION OPTIONS
Rev. Proc. 91-23 requires that taxpayers coordinate their competent authority request with their other options, such as Appeals or litigation. The new rules are intended to preclude taxpayers from shopping for a resolution in one of these forums and then moving on to the next forum to see if the deal can be sweetened. Rev. Proc. 91-23 gives the Ca the last say in whether the taxpayer can pursue these other options after conclusion of a competent authority proceeding.
Coordination with Appeals
If a taxpayer wishes to pursue an adjustment with the Appeals office of the IRS, the taxpayer must generally do so before soliciting competent authority relief. Once the taxpayer has exhausted its appeals rights, it may request competent authority consideration and it will not be permitted to return later to Appeals unless the CA approves.
If the taxpayer proceeds directly to competent authority without pursuing the matter in Appeals, the CA may require the taxpayer, as a precondition for competent authority assistance, to waive the opportunity to take the case to appeals. Therefore, taxpayers with unagreed cases must assess the chances of a successful resolution in Appeals before submitting the competent authority request.
Coordination with Litigation
Unless the IRS Chief Counsel consents, the U.S. CA will not accept any request for assistance in cases that either are under litigation or have been designated for litigation. This consent requirement represents an expansion of the previous rule, which potentially limited a taxpayer's right to competent authority relief where cases were docketed in court. In the case of U.S.-initiated adjustments, if a competent authority request is filed after the matter has been designated for litigation or while a suit is pending, the taxpayer must file a copy of the competent authority request with the IRS Chief Counsel (International) along with background information pertaining to the judicial proceedings. (4)
COMPETENT AUTHORITY NECESSARY TO
ENSURE FOREIGN TAX CREDIT AND TAX-FREE
One of the most compelling reasons for pursuing competent authority relief relates to the ability of a U.S. taxpayer to ensure that it can take a foreign tax credit for foreign taxes paid where there have been intercompany adjustments. The IRS's concern in this regard is that, following a U.S. adjustment increasing U.S. income, U.S. taxpayers may continue to claim a foreign tax credit for the higher foreign taxes paid by the foreign affiliate, rather than claiming a foreign refund for what should be a decreased foreign tax, either directly or through the competent authority mechanism. Treas. Reg. [section] 1.901-2(e) addresses this situation by providing that such foreign taxes may not be "creditable" for foreign tax credit purposes unless attempts are made to secure the foreign refund.
Rev. Proc. 91-23 confirms that a taxpayer must pursue the foreign refund claim, including competent authority relief, before the taxes can be considered eligible for a foreign tax credit. Moreover, the revenue procedure contains the additional warning that seeking competent authority relief does not in and of itself establish that the taxpayer has exhausted all effective and practical remedies to reduce its foreign tax liability. In addition, Rev. Proc. 91-24, 1991-11 I.R.B. 26, which may issued simultaneously with Rev. Proc. 91-23, imposes restrictions on a U.S. taxpayer's ability to receive tax-free repatriation of funds resulting from intercompany pricing or allocation adjustments. Under the new rules, earnings repatriation under the favorable rules of Rev Proc. 65-17, 1965-1 C.B. 833, will be only available if a competent authority request has been submitted. This change will substantially increase the number of cases submitted for competent authority consideration.
UNILATERAL RELIEF RESTRICTED
Previously, the CA was empowered to grant, and often did grant, unilateral relief where the foreign competent authority did not grant relief or where the statute of limitations had expired. For example, if the IRS increased a U.S. taxpayer's royalty rate from an overseas subsidiary but a corresponding adjustment to the subsidiary's deduction for that year was statute-barred due to the expiration of the foreign statute of limitations, the U.S. CA might have unilaterally withdrawn the U.S. adjustment to avoid double taxation.
Unfortunately, one of the stronger messages contained in Rev. Proc. 91-23 is that while the United States will attempt to solve double-taxation issues on behalf of taxpayers, the U.S. CA will now grant unilateral relief only in extraordinary cases. This development represents a reaction to the failure of other treaty partners to provide reciprocal unilateral relief over the past several years, and underscores the need for the taxpayer to verify that procedural barriers -- such as the statute of limitations -- do not bar competent authority action. Moreover, where treaty countries have been less than forthcoming in providing competent authority relief, the ability to obtain double-taxation assistance has apparently now diminished.
CONSIDERATIONS IN USING THE
COMPETENT AUTHORITY PROCESS
In theory, the competent authority process provides taxpayers with an easy way to solve transfer-pricing disputes that result in double taxation. The process, however, is not without risk. Perhaps the biggest flaw with the competent authority process is that there is no guarantee that an agreement will be reached. In addition, because of such factors as complex fact patterns, delays in the liaison process, and request backlogs, it can take several years to resolve a dispute.
The comprehensive disclosure necessary to invoke competent authority may create fears that confidentiality might be impaired, particularly where the information is shared with the foreign CA. There is also a risk that invoking the procedure will precipitate foreign audits. Finally, the procedure does not always solve colalteral problems that can arise when an agreement is reached, such as differences between the two government's policies on whether interest is paid on refunds and charged on deficiencies, exchange rate fluctuations that may have occurred since the original adjustment, and differences in tax rates between the two countries.
On the other hand, the positive aspects of the procedure will ordinarily outweigh the potential disadvantages. First, it is often the only ways to avoid double taxation when two or more treaty countries are involved. Second, litigation or an administrative resolution of transfer-pricing disputes within a single country will only eliminate double taxation where the entire adjustment is removed. Third, the competent authority process is not conducted in a public forum; compared with litigation, the relative confidentiality of competent authority may be attractive to some multinationals, particularly foreign-controlled companies. Finally, for U.S. multinationals, the potential disallowance of foreign tax credits or Rev. Proc. 65-17 adjustment acts as a strong incentive to request competent authority relief.
Recent changes made by the IRS to the U.S. competent authority procedures will increase the use of the competent authority process as a means of settling transfer-pricing and other allocation disputes that result in double taxation. Nevertheless, these new guidelines impose stricter requirements on taxpayers that invoke competent authority, allowing them less latitude than they enjoyed under the prior regime. In addition, although the new rules provide a rational, comprehensive set of rules that rectify many of the procedural shortcomings encountered under prior guidance, many of the same administrative problems that characterized the previous competent authority rules -- perhaps most important, the slow pace of the resolution process -- will most certainly linger.
Edwin Reavey is a partner in the National Tax Office of Coopers & Lybrand in Washington, D.C. He specializes in international tax issues and is responsible for representing clients of the firm in competent authority proceedings.
William Dunn is a manager in Coopers & Lybrand's National Tax Office in Washington, D.C. He specializes in competent authority as well as domestic corporate tax matters. Both have published numerous articles in various professional journals.
(1) Interpretation of treaties is performed with concurrence from the IRS Associate Chief Counsel (International).
(2) Rev. Proc. 82-29, 1982-1 C.B. 481, and Rev. Proc. 77-16, 1977-1 C.B. 573, as amplified by Rev. Proc. 79-32, 1979-1 C.B. 599.
(3) This previous 90-day rule, however, was not vigorously enforced.
(4) In Rev. Proc. 91-26, 1991-17 I.R.B. 7, the IRS made minor modifications to the rules set forth in Rev. Proc. 91-23 pertaining to the coordination of competent authority proceedings with litigation.
|Printer friendly Cite/link Email Feedback|
|Author:||Dunn, William J.|
|Date:||May 1, 1991|
|Previous Article:||Judicial deference, consolidated returns, and loss disallowance: could LDR survive a court challenge? Amending section 1502 to deal comprehensively...|
|Next Article:||Proposed accuracy-related penalty regulations.|