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Rev. proc. 91-22: advance pricing agreements.

On April 2, 1993, Tax Executives Institute filed the following comments with the Internal Revenue Service on Rev. Proc. 9122, which sets forth the procedure for obtaining an advance pricing agreement (APA) with respect to section 482 transfer pricing issues. The comments took the form of a letter from TEl President Bob Periman to Regina Deanehan, Assistant Commissioner (International), and Robert E. Culbertson, Associate Chief Counsel (International), and was prepared in response to an IRS request for TEI's comments on the revenue procedure and its recommendations in light of the operation of the APA program over the last two years. The Institute's comments were prepared under the aegis of its International Tax Committee, whose chair is Lisa Norton of Ingersoll-Rand Company. Philip J. Bergquist of Apple Computer Co. contributed materially to the preparation of the Institute's comments.

On March 1, 1991, the Internal Revenue Service issued Rev. Proc. 9122, 1991-1 C.B. 534, outlining the procedure for obtaining an advance pricing agreement (APA) with respect to section 482 transfer pricing issues. This letter responds to your request for TEI's comments on the revenue procedure and our recommendations in light of the operation of the APA program over the past two years.


TEl commends the IRS for adopting such an innovative procedure for resolving transfer pricing issues. It is our understanding that since Rev. Proc. 91-22 was issued in 1991, more than 50 taxpayers have applied for APAs with respect to operations in 16 foreign countries and Puerto Rico. We believe that the number of pending applications evidences an increasing acceptance by taxpayers--and U.S. treaty partners--of the viability of the APA process. Although the recent proposed section 482 regulations accord taxpayers more flexibility in setting transfer prices, the regulations also introduce more uncertainty in ascertaining whether a particular price will be deemed to satisfy section 482. For many taxpayers, obtaining an APA will doubtlessly reduce that uncertainty, especially with respect to the section 482 regulations. TEl was an early supporter of the APA process, and we continue to believe that the use of the procedure may enhance compliance with section 482, avoid audit disputes, and serve as an effective complement to any generally applicable safe harbors.(1)

A key element of the APA procedure is the ability to obtain a ruling in advance of the years to be covered, thereby placing both taxpayers and the IRS on an equal footing in assessing historical information and projecting the appropriate level at which the various critical assumptions should be set. Although we believe that this feature is critical to the success of the APA process, we do not believe the IRS should foreclose the possibility that the parties may agree to apply the APA retroactively. If the proposed pricing methodology has been used in prior years with respect to the same parties and transactions and the critical assumptions have not changed, common sense dictates that the finding of reasonableness should be given substantial weight in respect of those earlier years.

With respect to the renewal of the APA, we concur with the IRS's approach of "looking back" to contrast actual results with the targeted ranges as a tool in establishing new critical assumptions. New data relating to a taxpayer's company or industry may suggest the rate at which renewal should occur; reviewing historical results is precisely the procedure many taxpayers perform to establish future transfer prices and is therefore an appropriate practice to follow for the APA purposes.

Another important aspect of an APA is its bilateral nature. Negotiating with foreign jurisdictions on an acceptable range of results and establishing critical assumptions make the APA process an advantageous tool for many taxpayers to reduce--or eliminate--future pricing controversies. As the IRS knows well, however, in certain jurisdictions it is difficult to reach a bilateral agreement. Rev. Proc. 91-22 provides that the Chief Counsel may issue a unilateral APA in such circumstances where the taxpayer shows "good and sufficient" reasons. We encourage the IRS to remain open to providing the taxpayer with a unilateral APA. Taxpayers with extensive operations throughout the world may simply not want to incur the expense of negotiating an APA with every country. For example, a company operating in 25 countries may wish to negotiate a unilateral APA with the IRS and go through competent authority only if an issue arises subsequently. Although the effect of unilateral agreements is unclear, the use of a unilateral APA would still provide the taxpayer with a modicum of certainty within the United States.

In sum, the Institute believes that the APA can further the goals of Compliance 2000 and, concomitantly, be a useful tool in the IRS's enforcement efforts, providing certainty for both taxpayers and the government alike. In these comments, we suggest additional ways for fine tuning the process and increasing both its efficiency and overall acceptance within the taxpayer community.

The Anticipated Range of Results

Section 3 of Rev. Proc. 91-22 sets out the principles of the APA process. Section 3.02 provides that the agreed upon transfer pricing methodology must be consistent with the arm'slength standard, be supported by available and reliable data, and be efficiently administrable. The procedure further provides that the methodology chosen "should produce, with as little adjustment as possible, an anticipated range of arm's length results that clearly reflect income."

The recently proposed section 482 regulations also anticipate that a taxpayer's results will generally fall within a range of prices; if the taxpayer's results fall outside that range, an allocation may be made to bring the results within the range, generally to the midpoint. The APA process adopts this approach.

In some circumstances, the adjustable range may actually need to be expanded. In an industry that is changing rapidly, for example, a taxpayer's ability to adopt a methodology whereby the actual results fall within a narrow range may be limited. Although an APA for a taxpayer in such an industry may arguably not be appropriate, we believe that these taxpayers should have the opportunity to utilize the APA process. Often, the uncertainties within a given industry will be temporary and the APA process should remain flexible enough to deal with such situations.

TEl understands that some foreign jurisdictions have argued for an elimination of the adjustable range, suggesting that once the target point has been established, all actual results should be adjusted to that point. Early in the APA process, the IRS seemed to vacillate between targeting actual results for a particular entity and targeting the methodology to be used. We believe that the APA procedure--and the transfer pricing regulations-- should focus on the end result, not on the methodology. Section 482 is a results-oriented statute. As long as the proper result is reached (i.e., an arm'slength, third-party price), the method for obtaining that result is--and should be--immaterial.

Submission of Data

Sections 5.03, 5.04, and 5.05 of the revenue procedure prescribe general guidelines for the type of data to be submitted with the APA request. In what is an improvement over the initial draft of the APA procedure, Rev. Proc. 91-22 does not require the submission of certain information; rather, it suggests the type of data that "may be appropriate" to establish the arm's-length basis of the proposed pricing methodology.

TEl is pleased that taxpayers' initial fears about the volume of information that may be required to obtain an APA have not been realized. Anecdotal reports about the APA process suggest that the amount of data necessary to complete the APA has been reasonable. We encourage the IRS to continue streamlining its review of a taxpayer's functions. Because the APA procedure requires the taxpayer to provide all material facts, the taxpayer carries the burden throughout the Alga process. As such, the IRS should be comfortable in assuming that the taxpayer will provide the data required to execute the APA.

Critical Assumptions

Section 5.07 of the procedure requires the taxpayer to describe a proposed set of "critical assumptions," which are defined as "objective business and economic criteria that are fundamental to the operation of the taxpayer's proposed [transfer pricing methodology]." A critical assumption is any fact about the taxpayer, a third party, or an industry that would significantly affect the substantive terms of the APA if it changed.

Because critical assumptions are so vital in ensuring the validity of the APA, TEI believes the number of critical assumptions should be kept to a minimum. The critical assumptions should essentially ensure that the particular functions of the entity or set of transactions remain relatively consistent over the years covered.

We recommend that--consistent with the temporary section 482 regulations-the IRS should continue its policy of establishing only one "target" of results to be incorporated into a critical assumption. Whether that target is a gross margin or operating profit-or something else--can be left to negotiations between the particular parties and foreign jurisdictions involved. Dealing with multiple targets as critical assumptions, however, may engender problems in administering the APA. For example, if an APA specifies a gross margin target of 20 percent and an operating profit target of 5 percent, it is unclear what actions a taxpayer should take if it achieves the operating profit target but misses the gross margin target. Clearly, any adjustment to the gross margin would affect the operating income, possibly necessitating a second adjustment. Such "chain-reaction" adjustments should be avoided.

APA Term

Section 5.09 of Rev. Proc. 91-22 provides that the taxpayer should suggest an initial term for the APA. The procedure suggests that the typical APA could take effect at the beginning of the tax year during which it was suggested or signed, and have a term for three years. TEl encourages the IRS to remain flexible concerning the term of the APA and not lock itself into a hard-and-fast rule. Because of the fact-bound nature of the APA, there should be no "general rule" for the APA's duration; rather, the term should be subject to negotiations between the taxpayer and the IRS.

We believe that the term for which an APA will be applicable should take into account not only the particular taxpayer and industry involved, but also the foreign jurisdiction that may be involved in any bilateral negotiations and the period of time it will take to conclude those negotiations. An APA may typically take 12-18 months to consummate; if it covers the term during which the APA was negotiated, then the taxpayer may be left with only 18 months under which to operate before beginning the renewal process. The protections built into the procedure--such as the requirements for an annual report and notification of changes in critical assumptions-- provide adequate safeguards for the IRS and the taxpayer in terms of both compliance with the APA and unforeseen future events. If the IRS feels compelled to have a "normal" term for an APA, we suggest that the APA term be extended to, say, five years, or at least permit the taxpayer to "tack" the processing time onto the three-year term.

Where the industry itself is changing rapidly, an APA term of less than three years may be appropriate. Moreover, if the renewal process itself is expedited, there may be benefits in having an APA term of, say, two years, when the process permits the taxpayer to "roll over" the critical assumptions set forth in the initial APA. Renewing the APA should be as administratively straightforward as possible.

IRS Field Audit

Section 6.02 of the procedure provides that the Chief Counsel will coordinate the evaluation of the request with the appropriate district director. Section 6.03 provides that the Chief Counsel, in coordination with the district director, will evaluate the taxpayer's APA request by discussing it with the taxpayer, verifying the data supplied, and requesting additional information, if necessary. Section 10.03 provides that the district director may require the taxpayer to establish that (i) it has complied with the terms of the APA; (ii) the material representations in the APA and the annual reports remain valid; (iii) the supporting data and computations used in applying the methodology were correct; (iv) the critical assumptions remain valid; and (v) the taxpayer has consistently applied the methodology and the critical assumptions.

The initial draft of the APA procedure gave the IRS field office "primary" responsibility for the timely evaluation and verification of the taxpayer's proposal. TEl objected to this provision, averring that the intimate involvement of the field office was unwarranted and would only serve to prolong the process. Rev. Proc. 91-22 takes a more pragmatic approach to the involvement of the IRS field office, but the role of the district office remains unclear.

Given the taxpayer's obligation under the APA procedure to supply all material facts relating to its transfer pricing policies, the IRS should avoid extensively "auditing" the information or interviewing corporate personnel to confirm the accuracy of the submitted information. We suggest that the National Office coordinate with the field office in each case to limit the scope of field examination to that which is necessary to ascertain that the taxpayer's critical assumptions are sound. Factors that could be considered in determining the scope of field review could include the proposed pricing range and the degree to which accounting judgments underlie the taxpayer's critical assumptions. By adopting a practical and flexible approach, the IRS should be able to protect its interest in accuracy while encouraging efficiency and freeing up IRS resources for other APAs or projects. In contrast, a "full-scale" audit of the information before the APA is granted will increase the time frame for negotiating an APA and burden both taxpayers and the IRS field office. Moreover, an audit of the taxpayer's future methodology may impede the current ongoing examination of the taxpayer's tax returns.

At a minimum, the IRS should not require an audit of the taxpayer's pricing methodology both before and after the APA is granted. Such a procedure undermines the APA's purpose of reducing audit disputes and administrative costs. We also note that whether an "audit" or a "review" is performed by the district office, taxpayers should generally not be required to extend the statute of limitations. APA review activities and ongoing audit activities should be conducted in such a way--by separate teams, if necessary--to allow both to be concluded in an independent and timely fashion.

Competent Authority Negotiations

Section 7 of the procedure provides guidance on the consideration of the APA request under the competent authority process. Although the procedure requires the taxpayer to cooperate with the U.S. competent authority, there is no provision for the active participation of the taxpayer in the procedure.

It is our understanding that taxpayers to date have not been included in the negotiations between the U.S. and foreign competent authorities. Although we recognize (and generally lament) that taxpayers are not usually included in competent authority negotiations, we urge the IRS to consider permitting such participation, perhaps initially on an experimental or limited basis. While the APA request will contain a general summary of the facts relating to the transfer pricing issues, the taxpayer is still the party in the best position to know the facts relating to the particular entities or transactions to be covered. The increased communications that will flow from such involvement will expedite the entire process.

Such a procedure would also be consistent with the policy underlying the APA process--to reach a three-party agreement concerning transfer prices. Limiting the negotiations to the competent authorities--with the final result being communicated to the taxpayer on essentially a "take it or leave it" basis--seems inappropriate and inefficient. Taxpayers should be involved in the negotiations to ensure that no issues are left unresolved.

Confidentiality of Data Submitted

Section 11 of the procedure provides that information submitted with respect to the APA request is subject to the confidentiality requirements of section 6103 of the Code or under the terms and conditions of an income tax convention.

Shortly after the issuance of Rev. Proc. 91-22, some commentators suggested that information submitted as part of the APA process is subject to disclosure under the Freedom of Information Act (FOIA). While the IRS has routinely dismissed this position, TEI remains convinced that the law is unclear and that the possibility of disclosure may deter taxpayers from entering the APA process. We therefore urge the IRS to affirm that the APA information is exempt from disclosure as taxpayer-identifying information.

The need for confidentiality, however, should not discourage the IRS from releasing "conceptual guidance" on the process. As the APA process gains support, any generic or recurring themes that may arise from the process could assist the taxpayer community at large.

Expedited APA Process

As the IRS gains more experience with the APA process, a marked improvement in its efficiency in reviewing the APA submission and reaching a preliminary conclusion should occur. We suspect, however, that smaller taxpayers continue to find the APA process daunting. For this reason, we urge the IRS to consider developing an expedited process for smaller taxpayers, based upon the dollar volume of the entities (i.e., gross sales or assets) or transactions covered by the APA. Such an expedited process might require:

* Reduced information about the

company's history.

* Reduced information about

functions or activities not di-

rectly relevant to the APA sub-

mission. For example, an APA

addressing distribution activi-

ties should not require exten-

sive information about a tax-

payer's manufacturing or R&D


* Reduced comparables research.

Taxpayers should not be re-

quired to perform extensive

comparability studies. Consid-

eration should be given to per-

mitting taxpayers to use indus-

try statistics, adapted to the

taxpayer's particular situation.

* Reduced analysis. Taxpayers

should not have to review their

proposal in relation to all of the

various "tests" for reasonable-

ness. Thus, if a taxpayer sug-

gests using comparables, an ex-

tensive return-on-investment

or return-on-assets analysis

should not be required.


Tax Executives Institute appreciates this opportunity to present our current views on Rev. Proc. 91-22, relating to the issuance of advance pricing agreements. If you have any questions, please do not hesitate to call Lisa Norton, chair of TEI's International Tax Committee, at (201) 573-3200 or Mary L. Fahey of the Institute's professional staff at (202) 638-5601.

(1) Although the Institute believes that APAs should be made nmre generally available to--and more easily obtainable by--taxpayers, we would be less than candid if we did not express some reservations about the deployment of IRS resources. TEI recently responded to an IRS request for comments on the possibility of extending the APA approach to the resolution of domestic issues. Some of our members have questioned whether the IRS has the resources available in either the field or the National Office to issue domestic APAs without depleting the resources devoted to other areas. As the current APA and the domestic APA process goes forward, the IRS must take steps to ensure that other functions are not impeded by, for example, transferring greater responsibility for APAs to field personnel.
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Publication:Tax Executive
Date:May 1, 1993
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