Announcement 2004-26
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Internal Revenue Bulletin:
2004-15
April 12, 2004
Announcement 2004-26
Announcement and Report Concerning Advance Pricing Agreements
March 30, 2004
This Announcement is issued pursuant to § 521(b) of Pub. L. 106-170, the Ticket to Work and Work Incentives Improvement Act of 1999, which requires the Secretary of the Treasury to report annually to the public concerning Advance Pricing Agreements (APAs) and the APA Program. The first report covered calendar years 1991 through 1999. Subsequent reports covered calendar years 2000, 2001, and 2002. This fifth report describes the experience, structure and activities of the APA Program during calendar year 2003. It does not provide guidance regarding the application of the arm’s length standard.
Matthew W. Frank Director, Advance Pricing Agreement Program
Background
Internal Revenue Code (IRC) § 482 provides that the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among two or more commonly controlled businesses if necessary to reflect clearly the income of such businesses. Under the regulations, the standard to be applied in determining the true taxable income of a controlled business is that of a business dealing at arm’s length with an unrelated business. The arm’s length standard also has been adopted by the international community and is incorporated into the transfer pricing guidelines issued by the Organization for Economic Cooperation and Development (OECD). OECD, TRANSFER PRICING GUIDELINES FOR MULTINATIONAL ENTERPRISES AND TAX ADMINISTRATORS (1995). Transfer pricing issues by their nature are highly factual and have traditionally been one of the largest issues identified by the IRS in its audits of multinational corporations. The APA Program is designed to resolve actual or potential transfer pricing disputes in a principled, cooperative manner, as an alternative to the traditional examination process. An APA is a binding contract between the IRS and a taxpayer by which the IRS agrees not to seek a transfer pricing adjustment under IRC § 482 for a covered transaction if the taxpayer files its tax return for a covered year consistent with the agreed transfer pricing method (TPM). In 2003, the IRS and taxpayers executed 58 APAs and amended 4 APAs.
Since 1991, with the issuance of Rev. Proc. 91-22, 1991-1 C.B. 526, the IRS has offered taxpayers through the APA Program the opportunity to reach an agreement in advance of filing a tax return on the appropriate TPM to be applied to related party transactions. In 1996, the IRS issued internal procedures for processing APA requests. Chief Counsel Directives Manual (CCDM), ¶¶ 42.10.10 - 42.10.16 (November 15, 1996). Also in 1996, the IRS updated Rev. Proc. 91-22 with the release of Rev. Proc. 96-53, 1996-2 C.B. 375. The APA Program continues to operate under the provisions of Rev. Proc. 96-53, which provides taxpayers with instructions of how to apply for an APA, and what to expect in the processing of the case. In addition, in 1998, the IRS published Notice 98-65, 1998-2 C.B. 803, which set forth streamlined APA procedures for Small Business Taxpayers (SBTs). That Notice also expanded the availability of the lowest APA user fee in an effort to attract taxpayers who may not have the resources to do the sophisticated economic studies normally required in APA submissions.
Advance Pricing Agreements
An APA generally combines an agreement between a taxpayer and the IRS on an appropriate TPM for the transactions at issue (Covered Transactions) with an agreement between the U.S. and one or more foreign tax authorities (under the authority of the mutual agreement process of our income tax treaties) that the TPM is correct. With such a “bilateral” APA, the taxpayer ordinarily is assured that the income associated with the Covered Transactions will not be subject to double taxation by the IRS and the foreign tax authority. It is the policy of the United States, as reflected in § 7 of Rev. Proc. 96-53 to encourage taxpayers that enter the APA program to seek bilateral or multilateral APAs when competent authority procedures are available with respect to the foreign country or countries involved. However, the IRS may execute an APA with a taxpayer without reaching a competent authority agreement (a “unilateral” APA).
A unilateral APA is an agreement between a taxpayer and the IRS establishing an approved TPM for U.S. tax purposes. A unilateral APA binds the taxpayer and the IRS, but obviously does not prevent foreign tax administrations from taking different positions on the appropriate TPM for a transaction. As stated in Rev. Proc. 96-53, should a transaction covered by a unilateral APA be subject to double taxation as the result of an adjustment by a foreign tax administration, the taxpayer may seek relief by requesting that the U.S. Competent Authority consider initiating a mutual agreement proceeding, provided there is an applicable income tax treaty in force with the other country.
When a unilateral APA involves taxpayers operating in a country that is a treaty partner, information relevant to the APA (including a copy of the APA and APA annual reports) may be provided to the treaty partner under normal rules and principles governing the exchange of information under income tax treaties.
The APA Program
An IRS team headed by an APA team leader is responsible for the consideration of each APA. As of December 31, 2003, the APA program had 18 team leaders. The team leader is responsible for organizing the IRS APA team. The IRS APA team arranges meetings with the taxpayer, secures whatever information is necessary from the taxpayer to analyze the taxpayer’s related party transactions and the available facts under the arm’s length standard of IRC § 482 and the regulations thereunder (Treas. Reg.), and leads the discussions with the taxpayer.
The APA team generally includes an economist, an international examiner, LMSB field counsel, and, in a bilateral case, a U.S. Competent Authority analyst who leads the discussions with the treaty partner. The economist may be from the APA Program or the IRS field organization. As of December 31, 2003, the APA Program had 7 economists. The APA team may also include an LMSB International Technical Advisor, other LMSB exam personnel, and an Appeals officer.
The APA Process
The APA process is voluntary. Taxpayers submit an application for an APA, together with a user fee as set forth in Rev. Proc. 96-53. The APA process can be broken into five phases: (1) application; (2) due diligence; (3) analysis; (4) discussion and agreement; and (5) drafting, review, and execution.
(1) 'Application'
In many APA cases, the taxpayer’s application is preceded by a pre-file conference with the APA staff in which the taxpayer can solicit the informal views of the APA Program. Pre-file conferences can occur on an anonymous basis, although a taxpayer must disclose its identity when it applies for an APA. Taxpayers must file the appropriate user fee on or before the due date of the tax return for the first taxable year that the taxpayer proposes to be covered by the APA. Many taxpayers file a user fee first and then follow up with a full application later. The procedures for pre-file conferences, user fees, and applications can be found in Rev. Proc. 96-53.
The APA application can be a relatively modest document for a small business taxpayer. Notice 98-65 describes the special APA procedures for small businesses. For most taxpayers, however, the APA application is a substantial document filling several binders. The APA Program makes every effort to reach agreement on the basis of the information provided in the taxpayer’s application.
The application is assigned to an APA team leader who is responsible for the case. The APA team leader’s first responsibility is to organize the APA team. This involves contacting the appropriate LMSB International Territory Manager to secure the assignment of an international examiner to the APA case and the LMSB Counsel’s office to secure a field counsel lawyer. In a bilateral case, the U.S. Competent Authority will assign a U.S. Competent Authority analyst to the team. In a large APA case, the international examiner may invite his or her manager and other LMSB personnel familiar with the taxpayer to join the team. When the APA may affect taxable years in Appeals, the appropriate appellate conferee will be invited to join the team. In all cases, the team leader contacts the Manager, LMSB International Technical Advisors, to determine whether to include a technical advisor on the team. The IRS APA team will generally include a technical advisor if the APA request concerns cost-sharing, intangibles or services. The APA team leader then distributes copies of the APA application to all team members and sets up an opening conference with the taxpayer. The APA office strives to hold this opening conference within 45 days of the assignment of the case to a team leader. At the opening conference, the APA team leader proposes a case plan designed to complete the recommended U.S. negotiating position for a bilateral APA within 9 months from the date the full application was filed and to complete a unilateral APA within 12 months from the application date. In 2003, the median for completing negotiating positions was 15.2 months (average 15.3), and the median for completing unilateral APAs was 9.2 months (average 20.0).
(2) 'Due Diligence'
The APA team must satisfy itself that the relevant facts submitted by the taxpayer are complete and accurate. This due diligence aspect of the APA is vital to the process. It is because of this due diligence that the IRS can reach advance agreements with taxpayers in the highly factual setting of transfer pricing. Due diligence can proceed in a number of ways. Typically, the taxpayer and the APA team will agree to dates for future meetings during the opening conference. In advance of the opening conference, the APA team leader will submit a list of questions to the taxpayer for discussion. The opening conference may result in a second set of questions. These questions are developed by the APA team and provided to the taxpayer through the APA team leader. It is important to note that this due diligence is not an audit and is focused on the transfer pricing issues associated with the transactions in the taxpayer’s application, or such other transactions that the taxpayer and the IRS may agree to add.
(3) 'Analysis'
A significant part of the analytical work associated with an APA is done typically by the APA or IRS field economist assigned to the case. The analysis may result in the need for additional information. Once the IRS APA team has completed its due diligence and analysis, it begins negotiations with the taxpayer over the various aspects of the APA including the selection of comparable transactions, asset intensity and other adjustments, the TPM, which transactions to cover, the appropriate critical assumptions, the APA term, and other key issues. The APA team leader will discuss particularly difficult issues with his or her managers, but generally the APA team leader is empowered to negotiate the APA.
(4) 'Discussion and Agreement'
This phase differs for bilateral and unilateral cases. In a bilateral case, the discussions proceed in two parts and involve two IRS offices — the APA Program and the U.S. Competent Authority. In the first part, the APA team will attempt to reach a consensus with the taxpayer regarding the recommended position that the U.S. Competent Authority should take in negotiations with its treaty partner. This recommended U.S. negotiating position is a paper drafted by the APA team leader and signed by the APA Director that provides the APA Program’s view of the best TPM for the covered transaction, taking into account IRC § 482 and the regulations thereunder, the relevant tax treaty, and the U.S. Competent Authority’s experience with the treaty partner.
The experience of the APA office and the U.S. Competent Authority is that APA negotiations are likely to proceed more rapidly with a foreign competent authority if the U.S. negotiating position is fully supported by the taxpayer. Consequently, the APA Office works together with the taxpayer in developing the recommended U.S. negotiating position. On occasion, the APA team will agree to disagree with a taxpayer. In these cases, the APA office will send a recommended U.S. negotiating position to the U.S. Competent Authority that includes elements with which the taxpayer does not agree. This disagreement is noted in the paper. The APA team leader also solicits the views of the field members of the APA team, and, in the vast majority of APA cases, the international examiner, LMSB field counsel, and other IRS field team members concur in the position prepared by the APA team leader.
Once the APA Program completes the recommended U.S. negotiating position, the APA process shifts from the APA Program to the U.S. Competent Authority. The U.S. Competent Authority analyst assigned to the APA takes the recommended U.S. negotiating position and prepares the final U.S. negotiating position, which is then transmitted to the foreign competent authority. The negotiations with the foreign competent authority are conducted by the U.S. Competent Authority analyst, most often in face-to-face negotiating sessions conducted periodically throughout the year. At the request of the U.S. Competent Authority analyst, the APA team leader may continue to assist the negotiations.
In unilateral APA cases, the discussions proceed solely between the APA Program and the taxpayer. In a unilateral case, the taxpayer and the APA Program must reach agreement to conclude an APA. Like the bilateral cases, the APA team leader almost always will achieve a consensus with the IRS field personnel assigned to the APA team regarding the final APA. The APA Program has a procedure in which the IRS field personnel are solicited formally for their concurrence in the final APA. This concurrence, or any items in disagreement, is noted in a cover memorandum prepared by the APA team leader that accompanies the final APA sent forward for review and execution.
(5) 'Drafting, Review, and Execution'
Once the IRS and the taxpayer reach agreement, the drafting of the final APA generally takes little time because the APA Program has developed standard language that is incorporated into every APA. The current version of this language is found in Attachment A. APAs are reviewed by the Branch Chief and the APA Director. In addition, the team leader prepares a summary memorandum for the Associate Chief Counsel (International) (ACC(I)). On March 1, 2001, the ACC(I) delegated to the APA Director the authority to execute APAs on behalf of the IRS. See Chief Counsel Notice CC-2001-016. The APA is executed for the taxpayer by an appropriate corporate officer.
Model APA at Attachment A [§ 521(b)(2)(B)]
Attachment A contains the current version of the model APA language. As part of its continuing effort to improve its work product, the APA Program has revised the model language to reflect the program’s collective experience with substantive and drafting issues.
The Current APA Office Structure, Composition,
and Operation In 2003, the APA Office consisted of four branches with Branches 1 and 3 staffed with APA team leaders and Branch 2 staffed with economists and a paralegal. Branch 4, the APA West Coast branch, is headquartered in Laguna Niguel, California, with an additional office in San Francisco, and is presently staffed with both team leaders and an economist.
Overall, the APA staff increased from 34 to 36. The APA Program hired a new APA Director and a new team leader. In addition, one team leader transferred to the APA Office from another Chief Counsel function, and one team leader transferred from the APA Office to another Chief Counsel function. The number of APA team leaders increased from 17 to 18, while the number of economists remained constant at 7.
As of December 31, 2003, the APA staff was as follows:
| Director’s
Office1 Director 1 Special Counse l to the Director 1 Secretary to the Director | |||
|---|---|---|---|
| Branch 1 | Branch 2 | Branch 3 | Branch 4 |
| 1 Branch Chief | 1 Branch Chief | 1 Branch Chief | 1 Branch Chief |
| 1 Secretary | 1 Paralegal | 1 Secretary | 1 Secretary |
| 8 Team Leaders | 6 Economists | 8 Team Leaders | 2 Team Leaders |
| 1 Economist | |||
'APA Training'
In 2003, the APA Office continued to emphasize training as a high priority. Training sessions regarded APA-related current developments, new APA office practices and procedures, and international tax law issues. The APA New Hire Training materials were updated, as necessary, throughout the year. The updated materials are available to the public through the APA internet site on the IRS Digital Daily (www.irs.gov). These materials do not constitute guidance on the application of the arm’s length standard.
APA Program Statistical Data [§ 521(b)(2)(C)
and (E)] The statistical information required under § 521(b)(2)(C) is contained in Tables 1 and 9 below; the information required under § 521(b)(2)(E) is contained in Tables 2 and 3 below:
TABLE 1: APA APPLICATIONS, EXECUTED APAs, AND
PENDING APAs1
| Unilateral | Bilateral | Multilateral | Year Total | Cumulative Total | |||
|---|---|---|---|---|---|---|---|
| APA applications filed during year 2003 | 44 | 46 | 90 | 766 | |||
| APAs executed | |||||||
| • Year 2003 | 21 | 37 | 58 | 492 | |||
| • 1991-2002 | 206 | 221 | 7 | 434 | |||
| APA renewals executed during year 2003 | 8 | 9 | 17 | 108 | |||
| Revised or Amended APAs executed during
year 2003 | 3 | 1 | 4 | 25 | |||
| Pending requests for APAs | 67 | 162 | 229 | ||||
| • Pending Requests for new APAs | 46 | 109 | 155 | ||||
| • Pending requests for renewal APAs | 21 | 53 | 74 | ||||
| APAs canceled or revoked | 0 | 0 | 0 | 5 | |||
| APAs withdrawn | 2 | 1 | 3 | 83 | |||
TABLE 2: MONTHS TO COMPLETE APAs2
| Months
to Complete Advance Pricing Agreements in Year 2003 | |||||
|---|---|---|---|---|---|
| Combined Unilateral, Bilateral, Multilateral:
Average | 33.7 | ||||
| Combined Unilateral, Bilateral, Multilateral:
Median | 32.0 | ||||
| Unilateral
New | Unilateral
Renewal | Unilateral
Combined | |||
| Average | 22.3 | Average | 16.2 | Average | 20.0 |
| Median | 8.5 | Median | 9.8 | Median | 9.2 |
| Bilateral/Multilateral
New | Bilateral/Multilateral
Renewal | Bilateral/Multilateral
Combined | |||
| Average | 41.2 | Average | 42.3 | Average | 41.5 |
| Median | 35.4 | Median | 50.2 | Median | 39.4 |
TABLE 3: APA COMPLETION TIME - MONTHS PER APA
| Months | Number of APAs | Months | Number of APAs | Months | Number of APAs | Months | Number of APAs |
|---|---|---|---|---|---|---|---|
| 1 | 0 | 26 | 0 | 51 | 3 | 76 | 0 |
| 2 | 0 | 27 | 1 | 52 | 2 | 77 | 0 |
| 3 | 0 | 28 | 1 | 53 | 1 | 78 | 1 |
| 4 | 0 | 29 | 0 | 54 | 0 | 79 | 0 |
| 5 | 1 | 30 | 1 | 55 | 2 | 80 | 0 |
| 6 | 2 | 31 | 3 | 56 | 0 | 81 | 0 |
| 7 | 5 | 32 | 0 | 57 | 0 | 82 | 0 |
| 8 | 1 | 33 | 1 | 58 | 0 | 83 | 0 |
| 9 | 2 | 34 | 3 | 59 | 1 | 84 | 0 |
| 10 | 4 | 35 | 1 | 60 | 1 | 85 | 0 |
| 11 | 0 | 36 | 1 | 61 | 0 | 86 | 0 |
| 12 | 0 | 37 | 1 | 62 | 0 | 87 | 0 |
| 13 | 1 | 38 | 0 | 63 | 0 | 88 | 0 |
| 14 | 0 | 39 | 1 | 64 | 1 | 89 | 0 |
| 15 | 1 | 40 | 2 | 65 | 0 | 90 | 0 |
| 16 | 1 | 41 | 0 | 66 | 0 | 91 | 0 |
| 17 | 0 | 42 | 1 | 67 | 0 | 92 | 1 |
| 18 | 1 | 43 | 0 | 68 | 0 | 93 | 0 |
| 19 | 1 | 44 | 0 | 69 | 0 | 94 | 1 |
| 20 | 0 | 45 | 1 | 70 | 0 | 95 | 0 |
| 21 | 1 | 46 | 0 | 71 | 0 | 96 | 0 |
| 22 | 1 | 47 | 1 | 72 | 0 | 97 | 0 |
| 23 | 0 | 48 | 0 | 73 | 0 | 98 | 1 |
| 24 | 0 | 49 | 0 | 74 | 0 | 99 | 0 |
| 25 | 1 | 50 | 1 | 75 | 0 | 100 | 0 |
TABLE 4: RECOMMENDED NEGOTIATING POSITIONS'
| Recommended Negotiating Positions Completed in Year 2003 | 19 |
TABLE 5: MONTHS TO COMPLETE RECOMMENDED NEGOTIATING
POSITIONS
| New | Renewal | Combined | |||
| Average | 14.5 | Average | 15.3 | Average | 15.3 |
| Median | 15.2 | Median | 13.1 | Median | 15.2 |
TABLE 6: RECOMMENDED NEGOTIATING POSITIONS COMPLETION
TIME - MONTHS PER APA
| Months | Number of APAs | Months | Number of APAs | Months | Number of APAs | Months | Number of APAs |
|---|---|---|---|---|---|---|---|
| 1 | 0 | 11 | 1 | 21 | 0 | 31 | 0 |
| 2 | 0 | 12 | 0 | 22 | 1 | 32 | 0 |
| 3 | 0 | 13 | 2 | 23 | 0 | 33 | 0 |
| 4 | 0 | 14 | 1 | 24 | 2 | 34 | 0 |
| 5 | 1 | 15 | 3 | 25 | 0 | 35 | 0 |
| 6 | 2 | 16 | 0 | 26 | 1 | 36 | 0 |
| 7 | 1 | 17 | 1 | 27 | 1 | 37 | 0 |
| 8 | 0 | 18 | 0 | 28 | 0 | 38 | 0 |
| 9 | 1 | 19 | 1 | 29 | 0 | 39 | 0 |
| 10 | 0 | 20 | 0 | 30 | 0 | 40 | 0 |
TABLE 7: SMALL BUSINESS TAXPAYER APAs3
| Small Business Taxpayer APAs Completed in Year
2003 | 12 |
|---|---|
| Renewals | 8 |
| New | 4 |
| Unilateral | 8 |
| Bilateral | 4 |
TABLE 8: MONTHS TO COMPLETE SMALL BUSINESS TAXPAYER
APAs
| Months
to Complete Small Business Taxpayer APAs in Year 2003 | |||||
|---|---|---|---|---|---|
| New | Renewal | Combined | |||
| Average | 12.5 | Average | 13.8 | Average | 13.0 |
| Median | 11.5 | Median | 11.9 | Median | 11.5 |
TABLE 9: INDUSTRIES COVERED4
| Industry Involved - NAICS Codes | Number |
|---|---|
| Electronic equipment, appliance and component manufacturing - 335 | 7-9 |
| Wholesale trade, nondurable goods - 422 | 4-6 |
| Chemical manufacturing - 325 | 4-6 |
| Wholesale trade, durable goods - 421 | 4-6 |
| Credit intermediation and related activities - 522 | 4-6 |
| Computer and electronic product manufacturing - 334 | 4-6 |
| Machinery manufacturing - 333 | 1-3 |
| Broadcasting and telecommunications - 513 | 1-3 |
| Information service and data processing services - 514 | 1-3 |
| Securities, commodity contracts and other intermediary and related
activities - 523 | 1-3 |
| Oil and gas extraction - 212 | 1-3 |
| Motor vehicle and parts dealers - 441 | 1-3 |
| Food manufacturing - 311 | 1-3 |
| Apparel manufacturing - 315 | 1-3 |
| Beverage and tobacco manufacturing - 312 | 1-3 |
| Fabricated metal manufacturing - 332 | 1-3 |
| Transportation equipment manufacturing - 336 | 1-3 |
| Miscellaneous manufacturing - 339 | 1-3 |
| Sporting goods, hobby, book and music stores - 451 | 1-3 |
| Air transportation - 481 | 1-3 |
| Accommodation - 721 | 1-3 |
| Food services and drinking places - 722 | 1-3 |
Trades or Businesses[§ 521(b)(2)(D)(i)]
The nature of the relationships between the related organizations, trades, or businesses covered by APAs executed in 2003 is set forth in Table 10 below:
TABLE 10: NATURE OF RELATIONSHIPS BETWEEN RELATED
ENTITIES
| Relationship | Number of APAs |
|---|---|
| Foreign Parent - U.S. Subsidiary (-ies) | 31 |
| U.S. Parent - Foreign Subsidiary (-ies) | 23 |
| Foreign Company and U.S. branch(es) | 4 |
Covered Transactions [§ 521(b)(2)(D)(ii)]
The controlled transactions covered by APAs executed in 2003 are set forth in Table 11 and Table 12 below:
TABLE 11: TYPES OF COVERED TRANSACTIONS
| Transaction Type | Number |
|---|---|
| Sale of tangible property into the U.S. | 23 |
| Performance of services by Non-U.S. entity | 16 |
| Performance of services by U.S. entity | 12 |
| Sale of tangible property from the U.S. | 9 |
| Use of intangible property by U.S. entity | 7 |
| Use of intangible property by Non-U.S. entity | 6 |
| Financial products - Non-U.S. parent | 2 |
| Financial products - U.S. branch of foreign company | 2 |
| Other | 11 |
TABLE 12: TYPES OF SERVICES INCLUDED IN COVERED
TRANSACTIONS
| Intercompany Services Involved
in the Covered Transactions | Number |
|---|---|
| Administrative | 10 |
| Accounting | 9 |
| Marketing | 9 |
| Distribution | 9 |
| Manufacturing services | 8 |
| Management | 7 |
| Research and development | 7 |
| Legal | 6 |
| Technical support services | 6 |
| Product support | 5 |
| Logistical support | 5 |
| Headquarters costs | 4 |
| Communication service | 3 |
| Contract research & development | 3 |
| Billing services | 3 |
| Purchasing | 3 |
| License administration services | 2 |
| Assembly | 2 |
Business Functions Performed and Risks Assumed
[§ 521(b)(2)(D)(ii)] The general descriptions of the business functions performed and risks assumed by the organizations, trades, or businesses whose results are tested in the covered transactions in the APAs executed in 2003 are set forth in Tables 13 and 14 below:
TABLE 13: FUNCTIONS PERFORMED BY THE TESTED PARTY
| Functions Performed | Number |
|---|---|
| Manufacturing | 33 |
| Distribution functions | 28 |
| Marketing functions | 23 |
| Transportation and warehousing | 12 |
| Managerial, legal, accounting, finance, personnel, and other support
services | 11 |
| Research and development | 10 |
| Product assembly and/or packaging | 9 |
| Trading and risk management of financial products | 7 |
| Purchasing and materials management | 7 |
| Product design and engineering | 6 |
| Licensing of intangibles | 6 |
| Technical training and tech support for sales staff (including sub-distributors) | 5 |
| Product testing and quality control | 4 |
| Process engineering | 3 |
| Telecom services | 2 |
TABLE 14: RISKS ASSUMED BY THE TESTED PARTY
| Risks Assumed | Number |
|---|---|
| General business risks (e.g., related to ownership
of PP&E) | 57 |
| Market risks, including fluctuations in costs, demand, pricing, &
inventory | 52 |
| Credit and collection risks | 37 |
| Financial risks, including interest rates & currency | 31 |
| Product liability risks | 22 |
| R&D risks | 21 |
'Discussion'
The vast majority of APAs have covered transactions that involve numerous business functions and risks. For instance, with respect to functions, companies that manufacture products have typically conducted research and development, engaged in product design and engineering, manufactured the product, marketed and distributed the product, and performed support functions such as legal, finance, and human resources services. Regarding risks, companies have been subject to market risks, R&D risks, financial risks, credit and collection risks, product liability risks, and general business risks. In the APA evaluation process a significant amount of time and effort is devoted to understanding how the functions and risks are allocated amongst the controlled group of companies that are party to the covered transactions.
In its APA submission, the taxpayer must provide a functional analysis. The functional analysis identifies the economic activities performed, the assets employed, the economic costs incurred, and the risks assumed by each of the controlled parties. The importance of the functional analysis derives from the fact that economic theory posits that there is a positive relationship between risk and expected return and that different functions provide different value and have different opportunity costs associated with them. It is important that the functional analysis go beyond simply categorizing the tested party as, say, a distributor. It should provide more specific information since, in the example of distributors, not all distributors undertake similar functions and risks.
Thus, the functional analysis is critical in determining the TPM (including the selection of comparables). Although functional comparability is an essential factor in evaluating the reliability of the TPM (including the selection of comparables), the APA evaluation process also involves consideration of economic conditions such as the economic condition of the particular industry.
In evaluating the functional analysis, the APA program considers contractual terms between the controlled parties and the consistency of the conduct of the parties with respect to the allocation of risk. In accord with the section 482 regulations, the APA program also gives consideration to the ability of controlled parties to fund losses that might be expected to occur as the result of the assumption of risk. Another relevant factor considered in evaluating the functional analysis is the extent to which each controlled party exercises managerial or operational control over the business activities that directly influence the amount of income or loss realized. The section 482 regulations posit that parties at arm’s length will ordinarily bear a greater share of those risks over which they have relatively more control.
Related Organizations, Trades, or Businesses
Whose Prices or Results are Tested to Determine Compliance with APA Transfer Pricing Methods [§ 521(b)(2)(D)(iii)] >The related organizations, trades, or businesses whose prices or results are tested to determine compliance with TPMs prescribed in APAs executed in 2003 are set forth in Table 15 below:
TABLE 15: RELATED ORGANIZATIONS, TRADES, OR BUSINESSES
WHOSE PRICES OR RESULTS ARE TESTED5
| Type of Organization | Number |
|---|---|
| U.S. distributor | 20 |
| Multiple tested parties | 16 |
| U.S. provider of services | 11 |
| Non-U.S. provider of services | 9 |
| Non-U.S. manufacturer | 8 |
| U.S. manufacturer | 7 |
| U.S. licensor of intangible property | 4 |
| Non-U.S. distributor | 4 |
| U.S. dealer in financial products | 3 |
| Non-U.S. dealer in financial products | 2 |
| Other | 4 |
Transfer Pricing Methods and the Circumstances
Leading to the Use of Those Methods [§ 521(b)(2)(D)(iv)] The TPMs used in APAs executed in 2003 are set forth in Tables 16-20 below:
TABLE 16: TRANSFER PRICING METHODS USED FOR TRANSFERS
OF TANGIBLE AND INTANGIBLE PROPERTY6
| TPM Used | Number |
|---|---|
| CPM: PLI is operating margin | 9 |
| CPM: PLI is markup on total costs | 7 |
| Unspecified method | 6 |
| CUT (intangibles only) | 4 |
| CPM: PLI is gross margin | 3 |
| CPM: PLI is return on assets or capital employed | 3 |
| CPM: PLI is Berry ratio | 3 |
| CPM: PLI is other PLI | 3 |
| Resale Price Method (tangibles only) | 3 |
| Other profit split | 3 |
| Residual profit split | 2 |
| CUP (tangibles only) - not based on published market data | 2 |
| Cost Plus Method (tangibles only) | 2 |
| Other | 2 |
TABLE 17: TRANSFER PRICING METHODS USED FOR SERVICES
| TPM Used | Number |
|---|---|
| Cost plus a markup | 12 |
| CPM: PLI is markup on total costs | 7 |
| Cost with no markup | 5 |
| CPM: PLI is Berry ratio | 3 |
| Other | 3 |
TABLE 18: TRANSFER PRICING METHODS USED FOR FINANCIAL
PRODUCTS
| TPM Used | Number |
|---|---|
| Interbranch allocation (using indirect evidence of CUPs) | 3 |
| Profit split | 2 |
'Discussion'
The TPMs used in APAs completed during 2003 were based on the section 482 regulations. Under Treas. Reg. § 1.482-3, the arm’s length amount for controlled transfers of tangible property may be determined using the Comparable Uncontrolled Price (CUP) method, the Resale Price Method, the Cost Plus Method, the Comparable Profits Method (CPM), or the Profit Split method. Under Treas. Reg. § 1.482-4, the arm’s length amount for controlled transfers of intangible property may be determined using the Comparable Uncontrolled Transaction (CUT) method, CPM, or the Profit Split Method. An “Unspecified Method” may be used for both tangible and intangible property if it provides a more reliable result than the enumerated methods under the best method rule of Treas. Reg. § 1.482-1(c). For transfers involving the provision of services, Treas. Reg. § 1.482-2(b) provides that services performed for the benefit of another member of a controlled group should bear an arm’s length charge, either deemed to be equal to the cost of providing the services (when non-integral, see Treas. Reg. § 1.482-2(b)(3)) or which should be an amount that would have been charged between independent parties.
In addition, Treas. Reg. § 1.482-2(a) provides rules concerning the proper treatment of loans or advances, and Treas. Reg. § 1.482-7 provides rules for qualified cost sharing arrangements under which the parties agree to share the costs of development of intangibles in proportion to their shares of reasonably anticipated benefits. APAs involving cost sharing arrangements generally address both the method of allocating costs among the parties as well as determining the appropriate amount of the “buy-in” payment due for the transfer of intangibles to the controlled participants.
In reviewing the TPMs applicable to transfers of tangible and intangible property reflected in Table 16, the majority of the APAs followed the specified methods. However, there are several distinguishing points that should be made. The Regulations note that for transfers of tangible property, the Comparable Uncontrolled Price (CUP) method will generally be the most direct and reliable measure of an arm’s length price for the controlled transaction if sufficiently reliable comparable transactions can be identified. Treas. Reg. § 1.482-3(b)(2)(ii)(A). It was the experience of the APA Program in 2003 that in the cases that came into the APA Program, sufficiently reliable CUP transactions were difficult to find. In APAs executed in 2003, there were two covered transactions that used the CUP method; both used internal data on transactions between the taxpayer and unrelated parties.
Similar to the CUP method, for transfers of intangible property, the CUT method will generally provide the most reliable measure of an arm’s length result if sufficiently reliable comparables may be found. Treas. Reg. § 1.482-4(c)(2)(ii). It has generally been difficult to identify external comparables, and APAs using the CUT method tend to rely on internal transactions between the taxpayer and unrelated parties. In 2003, there were four covered transactions that utilized the CUT TPM.
The Cost Plus Method (tangibles only) and Resale Price Method were applied in 2003 in two and three APAs respectively. See Treas. Reg. § 1.482-3(c), (d).
The CPM is frequently applied in APAs. This is because reliable public data on comparable business activities of independent companies may be more readily available than potential CUP data, and comparability of resources employed, functions, risks, and other relevant considerations is more likely to exist than comparability of product. The CPM also tends to be less sensitive than other methods to differences in accounting practices between the tested party and comparable companies, e.g., classification of expenses as cost of goods sold or operating expenses. Treas. Reg. § 1.482-3(c)(3)(iii)(B), and -3(d)(3)(iii)(B). In addition, the degree of functional comparability required to obtain a reliable result under the CPM is generally less than required under the Resale Price or Cost Plus methods, because differences in functions performed often are reflected in operating expenses, and thus taxpayers performing different functions may have very different gross profit margins but earn similar levels of operating profit. Treas. Reg. § 1.482-5(c)(2).
Table 16 reflects 28 uses of the CPM (with varying PLIs) in covered transactions involving tangible or intangible property. The CPM was also used in some APAs concurrently with other methods.
The CPM has proven to be versatile in part because of the various PLIs that can be used in connection with the method. Reaching agreement on the appropriate PLI has been the subject of much discussion in many of the cases, and it depends heavily on the facts and circumstances. Some APAs have called for different PLIs to apply to different parts of the covered transactions or with one PLI used as a check against the primary PLI.
The CPM also was used regularly with services as the covered transactions in APAs executed in 2003. There were a total of 10 services covered transactions using the CPM method with various PLIs according to the specific facts of the taxpayers involved. Table 17 reflects the methods used to determine the arm’s length results for APAs involving services transactions.
In 2003, there were two APAs involving tangible or intangible property that used the residual profit split,