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June 1992

Advance pricing agreements: advantageous or not?

by Feinschreiber, Robert

    Abstract- Internal Revenue Code Section 482 allows taxpayers to secure advance IRS approval of intercompany pricing policies. The provisions of Section 482, under Revised Procedure 91-22, specify that US corporations with foreign afilliates are given the authority, together with the IRS, to formulate an advance pricing agreement (APA) for international transactions. The APA functions as a joint taxpayer-Office of the Associate Chief Counsel agreement that specifies a pricing procedure. Pricing sources, under the APA, need to be classified as either independent transactions, comparable transaction or similar transactions. The APA is implemented through a pre-filing conference request containing both general and detailed information on the selected techinque for transfer pricing. Taxpayers are required to inform the IRS of the use of a selected technique.

Taxpayers can now secure an advance IRS approval of their intercompany pricing policies in conjunction with IRC Sec. 482 provisions. This procedure has become imperative as a result of the issuance of proposed transfer pricing regulations on January 27, 1992. Otherwise, such more extensive provisions might be applicable as a result of these regulations,

Rev. Proc. 91-22 authorizes the taxpayer and the IRS to write an advance pricing agreement that would affect a U.S. corporation and one or more of its foreign affiliates. This pricing procedure applies only to international intercompany transactions and would determine intercompany transfer pricing and resulting inventory costs.

The advance pricing agreement (APA) is an agreement between a taxpayer and the Office of the Associate Chief Counsel (International). This agreement encompasses the parameters of prospective transactions and a transfer pricing methodology, and it is designed to sharply limit the audit risks emanating from these transactions. Without such an agreement, the IRS has a freer hand to challenge intercompany pricing and to attribute more taxable income to activities in the U.S, This transfer pricing "methodology" is much more than a "method," and encompasses the science or techniques of method selection that would apply in particular instances.


At first reading, the process appears deceptively simple:

* A taxpayer suggests its pricing proposal to the IRS;

* The IRS reviews and accepts this pricing proposal, or suggests modification; and

* The parties execute the pricing agreement.

However, obstacles and stumbling blocks to the formation of an agreement arise when a taxpayer has provided data that it believes demonstrates that the proposed transfer pricing methodology produces arm's-length results, but the taxpayer's methodology itself turns out to be unacceptable to the IRS. A prefiling conference can be used to eliminate these obstacles in many situations.

The Chief Counsel's Office evaluates the pricing proposal by analyzing both data submitted by the taxpayer and extrinsic data that the IRS deems relevant. IRS can challenge the data, question the methodology, or disagree with the taxpayer's arm's-length assessment. Partial or complete revision of data could be required, forcing the taxpayer to reformulate its pricing policies. Structuring the written agreement could become tedious, even if the taxpayer and IRS agree in concept to the pricing proposal.

Basic Principles

Acceptable transfer pricing methodologies must generally be in accord with Sec. 482 and the methods specifically described in the regulations. Acceptable methods for pricing sales transactions are the comparable uncontrolled price method, the resale price method, and the cost-plus method, Imperfections in the last two of these methods have led commentators to criticize the revenue procedure as too narrow, causing this otherwise forward-looking procedure to be enmeshed in obsolescent regulations.

Alternative pricing methods receive only fourth-rate status in Rev. Proc. 9122. The profit-split method appearing in recent court cases and discussed in Reg. Sec. 1.6038A is considered an alternative pricing method. Rev. Proc. 91-22 permits such a fourth method approach only if the taxpayer shows "why none of the first three methods specified in the regulations is applicable or practical,"a standard that limits the use of the profitsplit alternative.

The 1992 proposed transfer pricing regulations provide for substantiation of pricing using the "commensurate with income" concept, but do not directly affect Rev. Proc. 91-22 procedures.

Criteria for a Transfer Pricing Methodology

The IRS evaluates the acceptability of a transfer pricing methodology suggested by the taxpayer using three principal criteria. The methodology must be:

* Consistent with the arm's-length standard;

* Supported by available and reliable data; and

* Efficiently administrable.

The anticipated range of arm's-length results must be "commensurate with income,"a 1986 statutory change. This establishment of the "pricing results" provides the IRS with the opportunity of hindsight, and IRS scrutiny will continue even though the transfer pricing methodology has been agreed upon by the taxpayer and IRS Chief Counsel. However, even though the IRS may challenge a particular result, it is precluded from revaluating the transfer pricing methodology itself. The proposed transfer pricing regulations use a comparable profit interval that is generally consistent with the APA procedures.

The pricing agreement is expected to include understandings of the relevant facts and the transfer pricing methodology that has been agreed upon. In some cases, the APA may also include pro forma projections and other expected results emanating from the selected pricing methodology to establish the agreedupon range.

Prioritizing the Pricing Data

The APA procedures require that the taxpayer categorize the source of pricing data into three groups: independent transactions, comparable transactions, and similar transactions.

Independent Transactions. Independent transactions have first priority. The revenue procedure mandates that the taxpayer secure "relevant" pricing data "to the extent possible." Regrettably, the scope of the "relevancy" standard is uncertain, but various sources should be acceptable. Further, the scope of the data-gathering activities remains undefined for purposes of the taxpayer's quest to ascertain pricing amounts. The proposed transfer pricing regulations use a matching transaction method that is analogous to the independent transaction method within the APA procedures.

Comparable Transactions. Comparable transaction information may be used as a source of pricing data if independent transactional data cannot be obtained. Under the "comparable transaction" approach, the taxpayer must identify the transactions or entities it considers to be comparable. Decisions as to the presence or absence of comparability are apparently based on exact comparability, and transactions that are less than fully comparable are relegated to the next category of transactions. The proposed transfer pricing regulations use a comparable adjustable transaction method that is somewhat analogous to the comparable transaction method within the APA procedures.

Similar Transactions. As a last resort, "similar transactions" may be used as the source of pricing data if no comparable transactions exist. The taxpayer has an opportunity to ascertain the degree of similarity to the transaction in the first instance, before IRS review of the APA proposal. If the taxpayer cannot obtain data that fit the similar transactions category, the taxpayer must then identify other transactions, and propose pricing adjustments to create parity with its own operations. The proposed transfer pricing regulations use a comparable pricing method that is roughly analogous to the similar transaction method within the APA procedures.

Other Transactions. The presence of independent, comparable, or similar transactions are not an absolute prerequisite for an APA. Taxpayers may apply for an APA without the pricing data if the taxpayer can demonstrate that the transfer price methodology is satisfactory and other requirements are met.

Pre-filing Conferences

A taxpayer may initiate the APA process by requesting a pre-filing conference. This conference is to take place with the Office of the Associate Chief Counsel (International).

More than one pre-filing conference may be requested by the taxpayer. The purpose of these conferences is to explore informally the suitability of an APA. No charge is imposed by the IRS for these conferences; the user fee applies only if the taxpayer then seeks to secure an APA.

Rev. Proc. 91-22 acknowledges that some cases are not suitable for an APA, but does not delineate the specifics of the unsuitability. Primary negative conditions for an APA include the following:

* Presence of a myriad of products, none of which predominates;

* Presence of readily established comparable uncontrolled prices; and

* Small intercompany transfers, in both absolute amount and as a percentage of revenue and income.

Not all requests for an APA will require the same level of factual disclosure and economic or legal analysis. Factors that can make the APA more complex include:

* Presence of third-party related suppliers;

* Hard-to-value intangibles; and

* Rapid changes in exchange rates.

Issues likely to be discussed at a prefiling conference are:

* Data, documentation, and analysis that may be necessary;

* Need for an independent expert;

* Suitability of the proposed transfer pricing methodology;

* Possibility of agreement with competent authorities; and

* IRS scheduling, coordination, and evaluation.

The APA Request

The APA request comprises both general and specific facts to establish the appropriate transfer pricing methodologies (TPMs). The general factual materials are mandatory as part of the APA process unless otherwise agreed to in the pre-filing conference. In contrast, the specific factual materials requested in Rev. Proc. 91-22 are non- mandated, and are merely guidelines for the taxpayer. Different factual materials apply to cost sharing TPM proposals.

The general materials are to provide a concise picture of the taxpayer and its operations. They include both factual and legal items of a comprehensive nature for the purpose of substantiating the proposed TPMs. Eleven items are enumerated, and six of these may be problematical for taxpayers.

The general provisions request "representative" financial and tax data for the last three years plus other relevant data and documents in support of the proposed TPM, of which certain items are enumerated. The requirement that the data be "representative" is troublesome. If the taxpayer selects the data and documents for submission to the IRS, and the TPM is then included in the APA, the IRS could seek to revoke or cancel the APA on the basis that the financial and tax data are not "representative." On the other hand, this phrase could be leniently construed to require less than all of the data. In any event, the presence of well supported data will not have that problem.

The taxpayer must indicate the functional currency of each party and the currency in which the payment is to be made. As a result of this requirement, the taxpayer must consider changes in the inflation rates that underlie these exchange rates. Additionally, rapid changes in exchange rates might cause the functional currency to change.

The revenue procedure requires the taxpayer to describe the "significant financial accounting methods" that have "a direct bearing" on the proposed TPM. Regrettably, Rev. Proc. 91-22 did not define the "significant financial accounting methods," or the scope of the differences. Similarly, the taxpayer must explain the "significant financial and accounting differences" between U.S. and the foreign countries involved that have "a direct bearing" on the proposed TPM. Decisions as to the significance of the methods or the directness of the "bearing" on the TPM may be left to the taxpayer, at least in the first instance.

The taxpayer is required to include in the APA suitable descriptions of "any relevant" statutory provisions, tax treaties, court decisions, regulations, revenue rulings, or revenue procedures that impact the proposed TPM. The "any relevant" phrase is overly broad, and could encompass a wide variety of pricing-related materials, from the legislative background of Sec. 45 in the 1939 IRC to regulations under Sec. 6038A. Then, to complete the circle of analysis, Rev. Proc. 91-22 compels the taxpayer to discuss its influence on how the material has been developed.

Further, to add insult to injury, Rev. Proc. 91-22 expects the taxpayer to second-guess IRS positions on previous and current issues in a variety of contexts, namely examination, appeals, judicial, or competent authority levels. Rev. Proc. 91-22 also seeks an indication of resolutions to these disputes. The disclosure of positions pertaining to current tax issues is also required. In practice, much of this information can be eliminated.

Specific Factual Items

Specific factual items must be provided as part of the APA process. The facts to be provided depend on whether the APA is based upon a cost- sharing arrangement or other transfer pricing methodology. This delineation favors cost-sharing arrangements.

Seventeen specific factual items are necessary for cost sharing purposes, in contrast with seven specific factual items required for other transfer pricing methodologies. Nevertheless, the other transfer pricing methodologies are more complex. Six of the seven items require comparative data from other businesses, without giving recognition of the possible unavailability of such comparative information to the taxpayer. In contrast, no comparative data is required to establish an APA cost sharing arrangement. The Chief Counsel's office asserts that hoards of research bases are readily available.

Both cost-sharing arrangements and other transfer pricing methodologies require that the taxpayer "apply the general guidelines in the regulations under Sec. 482."

The APA standard for other transfer pricing methodologies is dependent upon the establishment of an arm's length basis, a difficult threshold to achieve. In contrast, the APA standard for cost sharing arrangements is to establish that "the proposed cost-sharing is bona fide," which appears to be a lesser threshold than the arm's-length standard. The proposed cost sharing regulations address the bona fides concept.

Establishing Critical Assumptions

The pricing agreement will be accepted unless one or more of these critical assumptions are invalidated. Selecting the critical assumptions should be done carefully; selecting a critical assumption that is too broad may invalidate the APA ab initio, but selecting a critical assumption that is too narrow may invalidate the APA because even the most minor change in the facts might be limited by the critical assumptions.

Critical assumptions are defined by Rev. Proc. 91-22 as "objective business and economic criteria that are fundamental to the operation of the taxpayer's principal TPM and are further defined as "a fact... that would significantly affect the substantiation term of the APA." Changes in facts may impact on critical assumptions, whether or not these facts are under control of the taxpayer.


The APA procedure requires the taxpayer to inform the IRS as to application of the transfer pricing methodology actually selected, This information and explanation is called an "annual report," and has no relationship to a financial report. The specifics of the report should be proposed by the taxpayer as part of the APA process. The report should generally encompass the actual operations of the TPM during the year, changes in critical assumptions, and an analysis of compensating adjustments and other parameters. Requests by the taxpayer to renew, modify, or cancel the APA should be included in the annual report. This report should be filed within ninety days after the U.S. tax return is filed,

IRS reviews the annual report and responds to items indicated, but the time period for the response is not specified by Rev. Proc. 91-22. IRS can contact the taxpayer even if a response is not required to clarify or complete information contained in the report.


The initial term of the APA should be proposed by the taxpayer, and is subject to IRS approval, The initial term can extend for more than one year, and fractional-year periods are not directly precluded by Rev. Proc, 91-22. The example in the Rev. Proc. describes a three-year period, but no maximum is provided by this procedure. Shorter periods should be permissible, such as a particular sporting event or a growing season for a crop.

The starting point for the APA is not directly specified by Rev, Proc. 91-22, The phrase, advance pricing agreement, indicates that the term begins after the agreement itself, but the examples pertaining to term and timing indicate that the APA could take effect at the beginning of the tax year during which the APA is requested or signed. Although limited retroactivity is permissible, full retroactivity is sometimes provided for in the APA.

The "user fee" imposed on the taxpayer is $5,000, which applies to each APA request and to each renewal of the APA. Some taxpayers might be tempted to request a longer term for the APA to avoid periodic fees, but this approach is often misplaced because critical assumptions could become obsolete and transfer pricing methodologies disadvantageous.


Taxpayers and the IRS can go their separate ways after the APA process is commenced. Before the APA is signed, the taxpayer may withdraw the APA request or IRS can reject it. Withdrawal of the request enables the taxpayer and IRS to void any previous understandings between the parties. However, materials submitted become part of the IRS file and are not returned. This material may be used for audit purposes, and the taxpayer can not obtain a refund of the user fee.

The IRS may reject the APA request or fail to execute the APA after the request is accepted for consideration. The IRS will hold one or more conferences with the taxpayer in anticipation of a rejection. The taxpayer may obtain a return of the user fee after the conference and the rejection.

After the APA is executed, the agreement can be terminated through revocation or cancellation. An APA can be revoked in event of fraud, malfeasance, or disregard as to any of three factors: material facts set forth in the APA request, subsequent submissions including the annual report, or lack of good faith compliance with the terms and conditions of the APA. "Material facts" are defined as facts that would have resulted in a significantly different APA or no APA. This revocation may be retroactive, and both tax and interest may be imposed.

Cancellation of the APA is less severe than revocation, and applies because of a misrepresentation mistake or other similar situations. The procedure may permit the taxpayer to make corrections instead of canceling the APA, but if cancellation applies, it is retroactive only to the beginning of the year in which these situations occurred.

An APA is a binding agreement between the taxpayer and the IRS. Foreign governments are not directly a party to the agreement, but competent authority relief could apply when applicable. State taxing authorities are not directly bound by the APA, but for federal tax purposes, compliance with the APA is treated as fulfilling the arm's length standard.


The use of APAs should be carefully considered if one of these situations exists:Intangibles are an important cost component;

* Statutes of limitation in the U.S. and the foreign country are significantly different;

* Effective tax rate differentials apply between these countries;

* Intercompany transactions are significant to the company both in dollar value and as a percentage of sales; or

* Speculative or anticipatory transactions are contemplated.

The APA process can be advantageous, but also is costly. It is hoped that in the future the procedure will be restated to reflect pricing methodologies that provide taxpayers with options to select case law decisions or newly issued proposed transfer pricing regulations.

Robert Feinschreiber, LLM. is the editor of the Interstate Tax Report and U..S. correspondent for Tax News Service, published by the International Bureau of Fiscal Documentation in Amsterdarm. He is the author and editor of numerous books (most recently, Tax Reporting for Foreign-owned Corporations published by John Wiley & Sons) and articles on a wide variety of tax topics and has served as tax consultant to several foreign governments Mr. Feinschreiber has taught accounting and law and has lectured at many tax conferences.

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