Thu, Jun 20, 2013

Transfer Pricing Times: Volume X, Issue 6

Earlier this year, Richard McAlonan, director of the newly re-vamped U.S. Advanced Pricing and Mutual Agreement Program (“APMA”), noted in a Bloomberg BNA interview that the Internal Revenue Service (“IRS”) closed 140 cases in 2012, more than triple the number of applications approved in 2011.  

This marked what looked to be a promising start for the new APMA program, which saw significant changes, notably: (i) ranking cases according to difficulty; (ii) assigning teams according to geography, with separate teams formed to focus on cases with Canada, Japan, and the rest of the world; and, (iii) rapidly increasing headcount (see Duff & Phelps Transfer Pricing Times, Volume X, Issue 2).

With the close of 2012, the IRS issued its 14th Annual Statutory Report, drafted March 25, 2013, which covers the results achieved under the new APMA program in its first year of existence. Announcement 2013-17 (“APMA Report”)1 describes the evolution of the APA Program into the current APMA Program, as well as results, general descriptions of various elements of executed APAs, and countries with which the U.S. reached agreements during the calendar year 2012. Below are some highlights:

  • Increase in Productivity – 2011 saw a decrease in productivity, in part because of the transition of the APA program to a dedicated APMA office. However, in 2012, the APMA office began its return to productivity, with the average processing time decreasing to 39.8 months in 2012, compared to 40.7 months in 2011. The 2012 figure falls just short of the average processing time of 37.2 months in 2010. However, as the APMA office increases its headcount and streamlines its review process, the IRS expects that the average processing time to complete new and renewal APAs to continue to improve going forward.
  • Increase in number of APAs submitted – In contrast to 2011, the APMA Program received 126 APA applications in 2012, representing a 31 percent increase from the 96 applications filed in 2011, and falling just short of the 144 application peak of 2010.
  • Bilateral APAs continue to make up the majority of submissions – In 2012, approximately 80 percent of submissions were bilateral, with the remaining submissions being 19 percent unilateral, and 1 percent multilateral.
  • Decrease in number of APAs canceled, revoked, or withdrawn – The number of APAs withdrawn in 2012 totaled only 6, with no APAs being revoked or cancelled. This statistic improves upon the 11 applications canceled, revoked, or withdrawn reported in 2011.
  • Decrease in number of pending APAs – Pending requests (for both new and renewal APAs) totaled 391 in 2012, a decrease from 445 in 2011 and 400 in 2010.
  • Average length of an APA – The average length of an APA term was approximately 6 years in 2012, with the majority of the terms being 5 years.
  • Computer and electronic manufacturing industry – The Computer and Electronic Manufacturing industry continued to account for the largest number of APAs completed in 2012 as it did in 2011.
  • Geography of bilateral APAs Finalized or Renewed – Of the 103 bilateral APAs executed in 2012, approximately 53 percent were executed between the U.S. and Japan, with the United Kingdom and Canada representing 10 percent and 16 percent of bilateral APAs respectively.
  • Type of transaction covered by APAs – As in 2011, the sale of tangible property from a foreign entity into the U.S. (inbound) continued to be the most common controlled transaction covered by APAs executed in 2012. However, the performance of services by a U.S. entity became the second most common controlled transaction covered in 2012, surpassing the sale of tangible property by a U.S. entity to an entity outside of the U.S. (outbound). In addition, the APMA program managed to successfully complete a number of APAs concerning intangibles in 2012.
  • Use of the Comparable Profits Method and operating margin – As in 2011, the Comparable Profits Method was again the most common method selected in the APAs executed in 2012. The operating margin also continues to be the most commonly used Profit Level Indicator (“PLI”) for the transfer of tangible and intangible property in 2012, while the Berry Ratio was the most common PLI used in executed services APAs in FY 2012 over the mark-up on total services costs that was prevalent in 2011’s executed APAs.

The 2012 statistics of the APMA program reflect the improvement in the APA process and efficiencies gained by the restructured APMA team. As McAlonan acknowledged, 2012 introduced several challenges to the APMA team. However, the new APMA Program achieved many of its 2012 goals and expects to continue to improve the process in the coming years.

In other APA news, the Italian tax administration released its second Bulletin on APA procedures (“International Standard Rulings, Edition II”) containing statistical information about the applications submitted and the agreements made over the three year period 2010 – 2012. Highlights of this bulletin include: (i) 19 APA rulings concluded in 2012, a 73 percent increase over 2011; (ii) the decrease in processing time to reach a ruling from an average of 20 months during the time period 2004-2009 to 15 months over the time period 2010 to 2012; and, (iii) the increase in the number of applications filed from 29 applications in 2011 to 38 applications in 2012. The statistics contained in this bulletin reflect the more favorable outlook on APAs in Italy, as well as the taxpayers’ building trust in the Italian APA process. This bulletin is currently available in Italian only, through the Agenzia delle Entrate.

OECD Releases Revised Guidance on Safe Harbors2 
Revised Section E on Safe Harbors in Chapter IV of the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (“Section E”) was approved by the OECD Council on May 16, 2013. An interim discussion draft was released for public comment in June 2012 and further discussed at a public consultation in November 2012. As a result of this public consultation, the draft on safe harbors was revised to reflect public comments and further discussions within the OECD. While the revised Section E does not materially differ from the draft circulated by the OECD in June 2012, it does reflect a more favored view of applying safe harbors under certain circumstances. We highlight Section E’s key areas of discussion below.

  • Benefits of safe harbors – Safe harbors provide benefits to taxpayers through simplified compliance, reduced compliance costs, and certainty that the price charged or paid on the covered controlled transaction will be accepted by tax administrations. They also provide benefits to tax administrations through administrative simplicity (e.g., permit tax administrations to refocus administrative resources from smaller taxpayers / less complex transactions to more complex, higher-risk cases).
  • Concerns over safe harbors – Adverse consequences of safe harbors may include reporting of taxable income that is not in accordance with the arm’s length principle, the risk of double taxation or double non-taxation (when adopted unilaterally), the potential for inappropriate tax planning, and issues of equity and uniformity. For example, when a taxpayer reports income above the arm’s length level due to the use of a safe harbor, more income will be reported by the domestic affiliate and less taxable income will be reported in the foreign tax jurisdiction of the counterparty to the transaction. In the event the other tax administration challenges the price of the transaction, the taxpayer may face double taxation.
  • Potential of safe harbors to cause divergence from the arm’s length principle – Safe harbors involve a trade-off between strict compliance with the arm’s length principle and simplifying administration. Tax administrations may mitigate such disadvantages by providing the option to (a) elect the safe harbor or (b) price the transactions in accordance with the arm’s length principle. This approach may reduce the administrative benefits of the safe harbor and reduce tax revenue to the tax administration since taxpayers would opt to pay the lesser of the safe harbor or the arm’s length amount. By controlling the eligibility criteria for the safe harbor (e.g., by requiring multi-year commitments to the safe harbor or requiring notification regarding the use of the safe harbor in advance) the administration may gain more comfort with the risks of providing elective safe harbors.
  • Recommendations on the use of safe harbors – The OECD supports the use of safe harbors in certain circumstances, but notes that whether adopted on a unilateral or bilateral basis, safe harbors do not bind or limit in any way any tax administration (other than the tax administration that has expressly adopted the safe harbor). 

As such, the OECD recommends the following concerning the use of safe harbors:

  • Unilateral safe harbors may lead to the potential for double taxation or double non-taxation, among other issues. To avoid situations leading to double taxation or double non-taxation, the OECD feels that tax administrations should avoid unilateral safe harbors.
  • Establish bilateral or multilateral adoption of safe harbors through competent authority agreements between countries. In such arrangements, two or more countries could establish pricing parameters that would be acceptable to each country’s administration. This could lessen the problems of non-arm’s length results and double taxation / non-taxation stemming from the use of safe harbors.
  • Reserve use of safe harbors for smaller taxpayers / less complex transactions. Bilateral or multilateral safe harbors by competent authority agreement may provide a practical approach to simplifying transfer pricing, particularly for smaller taxpayers and / or less complex transactions. However, it is unlikely safe harbors will provide a reasonable alternative to a rigorous, case-specific application of the arm’s length principle for complex and higher risk transactions.
  • Target reasonably narrow ranges of acceptable results, and require the taxpayer to consistently report income in each country that is party to the safe harbor. Such steps may alleviate tax administrations’ concerns regarding potential tax planning opportunities created by safe harbors (e.g., a cost-efficient taxpayer earning a return in excess of the safe harbor may adopt the safe harbor and shift the additional profit to a lower tax jurisdiction). Countries can also use exchange of information provisions under a bilateral safe harbor, to confirm the use of consistent reporting.

To facilitate negotiations between tax administrations, the OECD also provides sample memoranda of understanding (“MOUs”) for competent authorities to establish bilateral safe harbors for certain classes of transfer pricing cases. The OECD suggests that the following items may be relevant in the negotiation of MOUs:

  • Description of any criteria to be fulfilled by the qualifying enterprises;
  • Description of the qualifying transactions covered;
  • Determination of the arm's length range of tested party compensation;
  • The years to which the MOU applies;
  • Statement that the MOU is binding on both tax administrations involved;
  • Reporting and monitoring procedures for the MOU;
  • Documentation and information to be maintained by the participating enterprises; and
  • A mechanism for resolving disputes.

The OECD-developed guidance does not provide or specify target returns or metrics for quantitative ratios, which, along with the MOUs, would need to be agreed upon between the countries’ competent authorities for low risk manufacturing services, low risk distribution services, and low risk contract research and development services. However, Section E provides guidance from which tax administrations may draw in developing safe harbors that are beneficial to both taxpayers and tax administrations.

Measurement and Allocation of Location Specific Advantages in Competitive Markets
Several announcements have come out regarding location specific  advantages (“LSA”) and the impact such potential savings may have on transfer pricing (See Duff & Phelps Transfer Pricing Times, Volume X, Issue 5). Increasingly, taxing authorities in countries with developing economies are considering the effects of LSAs when determining taxable income. LSAs may occur when a multinational enterprise (“MNE”) sets up operations in a relatively low-cost location, often focusing on labor, materials, or real estate expenditures. When significant LSAs occur within a MNE (e.g., due to a restructuring of existing operations or a new venture), a question arises as to how to divide the savings and resulting profit among related entities. Under most transfer pricing regulations and guidelines, the intercompany transactions occurring in connection with LSAs should be priced in accordance with the arm’s length standard. However, determining what would occur at arm’s length is particularly difficult when LSAs are present.

In practice, standard transfer pricing analyses may not specifically consider how LSAs affect arm’s length dealings. For example, under a typical profits-based method (e.g., the Comparable Profits Method [“CPM”] / Transactional Net Margin Method [“TNMM”]), comparables may be regional and selected from various developed economic markets (primarily due to availability of reliable data). These comparables may not reflect the same market conditions that lead to LSAs, and therefore may shift additional profits to the principal. With the increasing global use of the CPM / TNMM, and the growing awareness of transfer pricing, taxing authorities of low-cost markets are beginning to argue for additional profits to reflect location rents. As such, taxpayers should weigh the potential impact of LSAs for entities in low-cost jurisdictions (e.g., China, India, Russia), particularly if they have captive entities such as contract manufacturers or contract service providers.

Given the difficulty in determining arm’s length pricing when LSAs are present, countries are dealing with the concept through local practical guidance:

  • India – the Income Tax Appellate Tribunal recognizes that market and industry conditions should be considered when establishing the profitability of an Indian subsidiary of a MNE. As such, any LSAs should be captured in the profitability of the comparables used for benchmarking purposes. This is part of the reason the Indian tax authorities tend to require the use of Indian-specific comparables. In their view, regional comparables may not capture the premium profits still associated with operations outsourced to India.
  • China – the State Administration of Taxation (“SAT”) asserts that a MNE which establishes operations in low-cost jurisdictions should attribute the “non-routine” profit to those operations to account for the net savings. The SAT typically considers LSAs as the primary driver for establishing operations in China, and therefore may adjust pricing in which all residual profits related to the relocation inure to the principal entity outside of China. In practice, the SAT asserts that higher mark-ups are necessary to achieve this result. 
  • OECD – the OECD has acknowledged the concept of LSAs through a July 2010 publication describing its view and providing examples of applying the arm’s length standard to specific situations. One consideration that is rightly emphasized by the OECD is the potential impact of intangibles owned by the multinational. In June 2013, the OECD announced it expects to add to its commentary on LSAs through its final next discussion draft related to intangibles which it expects to release sometime in 2013.
  • United Nations – the United Nation’s draft Transfer Pricing Practice Manual for Developing Countries (“UN Manual”) also includes consideration of LSAs. The UN Manual supplements the OECD’s position with particular attention to developing markets, in large part through a section specific to China and the unique characteristics of that market. (In addition to advocating for local-country comparables over regional comparables, this section points out that China also has a local customer base with significant spending power, a characteristic not present in many low-cost markets for outsourced operations. This also needs to be taken into account when determining the transfer price for companies operating in China.
  • United States – the US transfer pricing regulations do not provide much direction on LSAs apart from the directive that taxpayers should “consider the relative competitive positions of buyers and sellers” when deciding whether LSA adjustments are warranted.

It is possible that the transfer pricing issues raised by LSAs may be transitory in many cases. Economic theory suggests that LSAs erode over time. Assuming competitive markets, any LSAs created by outsourced operations will eventually be passed on to end-users in the form of lower product prices. Therefore, profit from LSAs is a short-term phenomenon (often referred to as “location rents”) that should not be expected to continue into perpetuity. For example, if a company is an early adopter in outsourcing manufacturing to a low-cost location, this company may enjoy premium profits until its competitors follow suit. As other companies begin reducing their own manufacturing costs, the first-mover’s premium profits could decrease as market pressures force all the players to pass on the cost savings to their customers.

If location advantages prove to be more lasting, however, taxpayers should carefully prepare transfer pricing planning analyses and local documentation to support their intercompany pricing and the allocation of any LSAs. In addition, taxpayers should weigh the costs / benefits of advance pricing agreements to gain greater certainty for their pricing in these situations.

1More information on the transition of the APA Program to the APMA Program, as well as Statistics for 2012 is available at:

2More information on the revisions to Section E of Chapter IV of the OECD Transfer Pricing Guidelines is available at:

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