Advance Pricing Agreements: An Alternative Practical Strategy
What factors should you consider before attempting this tactic?
November 29, 2007
by Mary Bernard, CPA/MST
Prior to March 1991, there was no formal mechanism for a taxpayer and the IRS to agree in advance on a transfer pricing methodology. Why? The IRS simply refused to issue advance rulings on this issue. Earlier that year, Apple Computer Corporation announced that it had received the first advance ruling on transfer pricing, which resulted in the issuance of Revenue Procedure 91-22 that established the Advance Pricing Agreement process. Under this process, a taxpayer could request prior approval of its transfer pricing methodology. Revenue Procedure 2006-9 later superseded the earlier Revenue Procedure and updated the process.
The Advance Pricing Agreement (APA) binds the taxpayer to a transfer pricing methodology that the IRS agrees not to challenge. This is provided that all terms of the agreement are followed. Upon audit, the IRS will not challenge whether transactions between the taxpayer and the related party have been conducted at arm’s length. The agreement may be made with only the taxpayer, or with a related party and/or with foreign tax authorities.
The primary advantage of an APA is the approval of the transfer pricing methodology (TPM), which can be not only a traditional methodology, such as compensable profits method or resale price method, but also any other method described in the regulations, a combination of methods or a formulary method.
The advance acceptance affords the taxpayer the knowledge that no adjustment will result if the agreement is followed. It spares the taxpayer the ordeal of a detailed audit to verify the appropriateness of the TPM used in transactions.
Factors to Consider
The taxpayer is assured of the outcome of examination of the TPM in advance. No surprises or challenges will arise if the agreement is followed. The scope of certainty includes: tax treatment of covered transactions as to amount and characterization, avoidance of time-consuming U.S. or foreign tax audits, elimination of potential penalties for substantial tax understatement and a limitation of record-keeping requirements.
In the course of the request for APA, full disclosure of factual information is required. For some taxpayers, this is a huge hurdle regarding protecting privacy and corporate secrets. The amount of disclosure necessary may require more than usually needed to request a private letter ruling, but less than normally provided in the course of an audit of a TPM. Also of concern is what happens if no agreement can be reached. Will the information disclosed be used against the taxpayer? How does an application for APA affect open years?
Choosing the appropriate TPM involves a number of factors: ease of administration, degree of certainty sought, availability of internal data to support the TPM, the amount and sensitivity of data to be provided, whether changes in accounting systems are needed, and tax results generated, to name a few. One TPM may not work best for all transactions. Flexibility in the design of a TPM is an advantage in those instances.
In addition to the user fee of $50,000 for an initial APA (subsequent renewals cost $35,000), there are other direct costs such as professional fees and expert opinions. The cost of staff time to produce the required documentation should also be considered. In many cases of large multinational entities, the benefits will far outweigh the costs. A small business with income of less than $200 million may request an APA with a reduced user fee of $22,500 if the request involves tangible property or services of a total annual value of $50 million or less, or payments for intangible property which do not exceed $10 million. Indirect costs include the potential exposure of tax in open years and the additional cost of recordkeeping and potential new accounting systems to comply with the burden. The total costs will vary depending on the number of entities covered, the corporate structure of the entity, the variety of covered related party transactions, the availability of data, and the expert analysis required.
- Other Factors
The taxpayer may have pending litigation with the IRS or others that may be adversely affected by the disclosures of an APA. This could include tax litigation on this or other issues in earlier years, customs litigation involving products subject to the APA or trade litigation. The litigation could also involve foreign tax authorities. The validity of the TPM may be useful when dealing with foreign authorities that questions the methods used. This “stamp of approval” provided by the IRS can be advantageous as a negotiating tool in contracts. The values approved in the APA can also be useful in establishing dutiable values for customs.
The APA is usually effective for five years, with an expedited renewal process available. Under certain circumstances, the APA can be applied to all open years even though the agreement is prospective.
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Mary F. Bernard, CPA/MST is a Tax Principal and Director of State and Local Tax Services at Kahn, Litwin, Renza & Co., Ltd. in Providence, RI. She has over 20 years of experience with national and local accounting firms working with a variety of individual, partnership and corporate clients, with particular focus on corporate multi-state tax issues. She has also provided advisory and compliance services to our extensive nonprofit clients. Bernard is a member of the AICPA, the Massachusetts Society of CPAs and serves as President-elect of the board of directors for the Rhode Island Society of CPAs.