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TaxBlawg’s Guest Commentator, David L. Bernard, is the former Vice President of Taxes for Kimberly-Clark Corporation, a past president of the Tax Executives Institute, and a periodic contributor to TaxBlawg.
My last blog post suggested that the best defense against transfer pricing assessments is the adoption of a globally consistent transfer pricing policy supported by appropriate documentation. Near the conclusion of that post, I noted that the Competent Authority (CA) process and Advance Pricing Agreements (“APAs”) were tools that could be employed if your company faced transfer pricing adjustments.
Although the goal of your transfer pricing policy and related documentation is to manage risk and avoid tax assessments, the nature of the beast is such that there is no precise price one can pinpoint in transfer pricing matters that can completely eliminate the risk of a tax authority’s challenge. Rather, there is usually a range of potential prices that may be appropriate. A tax authority may be inclined to pick a price at the end of the range most favorable to its country from a revenue perspective, leaving the Chief Tax Officer (CTO) to consider a menu of potential remedies, including administrative appeals, litigation, APAs, or perhaps a request for CA assistance.
Litigation challenging a proposed transfer pricing adjustment is almost always the most costly option and, absent a settlement, requires a 100% win to avoid double taxation of the same income by U.S. and foreign taxing authorities. Consequently, the litigation option should be considered as a last resort.
In the U.S. and most foreign jurisdictions, taxpayers should almost always take advantage of the opportunity to resolve a matter short of litigation through an administrative appeals with the IRS Appeals Office or its foreign equivalent. However, even a case settled with IRS Appeals may still result in a degree of double taxation because the settlement is unilateral, which is to say that it does not bind the foreign taxing authority to respect the pricing agreement reached between your company and the IRS.
That leaves the CA process and APAs as the only options that can completely eliminate the risk of double taxation because they are bilateral processes involving the taxing authorities of both jurisdictions in which the U.S. company and its foreign affiliate are subject to tax. This post focuses on the competent authority process. A subsequent post will discuss the benefits of APAs.
Recent surveys suggest that many tax professionals have no direct experience with the competent authority process. For those who do not, this is intended as a primer and a recommendation that tax professionals should familiarize themselves with the CA process; it may present the most best path to satisfactorily resolving a proposed transfer pricing adjustment.
The CA process is a product of the network of bilateral tax treaties among the U.S. and many of its largest trading partners. The Mutual Agreement Procedure clause within each treaty governs actions by one of the parties that may result in double taxation. The most common such action is a tax adjustment relating to transfer pricing. (Other examples of issues include permanent establishment and residency claims, but this discussion focuses on CA proceedings involving transfer pricing adjustments).
If a CTO faces a transfer pricing adjustment by a party to one of the bilateral treaties, the CTO has a choice: either s/he can protest the proposed adjustment with the IRS Appeals Office, or s/he can solicit CA relief. If the former road is taken, this does not necessarily preclude the company from seeking CA relief after the company has exhausted its appeal rights. However, a request for CA relief cannot be sought while a transfer pricing matter is under consideration before Appeals. If such relief is sought after a matter has been transferred to Appeals, the Appeals Officer must suspend settlement discussions on the subject issue.
Rev. Proc. 2006-54 sets forth the procedures for requesting CA relief. It is a lengthy document (approximately 10 pages) but a summary of the basic rules for a request for U.S. competent authority assistance follows.
The Deputy Commissioner (International), Large Business & International (“DCI”), acts as the U.S. CA in administering the operating provisions of the tax treaties. The DCI interprets and applies tax treaties and reaches mutual agreement with treaty partners, but acts only with the concurrence of the Associate Chief Counsel (International). If the CTO facing a transfer pricing adjustment is unsure whether relief may be available under the applicable treaty, the CTO should contact the DCI office. (Perhaps the case manager or team coordinator can assist in identifying a specific contact person.)
In the case of a U.S. initiated proposed adjustment, a requirement for CA assistance can be filed as soon as the transfer pricing adjustment has been proposed in writing to the taxpayer (i.e. receipt of Form 5701- Notice of Proposed Adjustment). In the case of a foreign initiated transfer pricing adjustment, the request may be submitted as soon as the taxpayer believes the filing is warranted based on the actions of the foreign country proposing the adjustment. The request should be filed in the form of a letter to the DCI stating that competent authority assistance is being requested and providing prescribed information, including but not limited to the bilateral treaty and provision pursuant to which the request in being filed, identification of the U.S. and foreign taxpayers involved and their legal and business relationships, descriptions of the issues and underlying transaction, and an explanation of the relief sought. While there are many other requirements in Rev. Proc. 2006-54, suffice it to say that the overall process in not burdensome.
There are several compelling reasons why a CTO should consider a CA request when faced with a transfer pricing adjustment. First, the job of each respective CA and the team of case managers and analysts beneath them is to resolve transfer pricing disputes in a manner that avoids double taxation. The respective CA groups strive to achieve this goal and show flexibility during the negotiation process to accomplish that result.
Second, once your issue is under CA jurisdiction, the burden of proof falls upon the jurisdiction proposing the transfer price adjustment. Unlike litigation or administrative appeals procedures the taxpayer no longer carries the burden of proving that its return filing position was correct. Moreover, once a request for CA assistance is accepted with respect to a U.S. initiated adjustment, the IRS postpones further administrative actions with respect to the issues under CA jurisdiction. Although this does not stay the audit on other issues under examination, nor necessarily delay the issuance of a 30-day letter (which starts the running of hot-interest), a taxpayer who files a protest of unagreed issues does not need to address those submitted for consideration by the Competent Authority. Following the receipt of the taxpayer's protest, Appeals procedures are initiated with respect to all unagreed issues not under Competent Authority consideration.
There are a few other facts worth noting. First, both the U.S. CA office and its counterparts in the other treaty countries are bound by the arm’s-length standard. While the U.S. CA is also guided by the section 482 regulations, those regulations are not necessarily controlling, especially if specific provisions in the regulations are interpretations of the arm’s-length standard and are at odds with the interpretations of the arm-length’s standard held by the treaty partner.
Also, a taxpayer may request a pre-filing conference with the U.S. CA to clear any questions with respect to the process before going to the effort and expense of filing a request. Moreover, the U.S. CA will endeavor to consult with the taxpayer regarding the status and progress of the bilateral negotiations. A closing conference can also be requested to discuss the final resolution.
The process is also flexible. CA assistance can be requested before an administrative appeal is initiated, after an unsuccessful appeal, or in conjunction with an appeal’s proceeding. Depending on the specifics of the governing treaties the CA process may even be available after the normal statute of limitations has tolled. (For example in the case of a foreign initiated adjustment resulting the potential double taxation, the U.S. CA may accept a request for assistance after the U.S. statute has tolled).
To be fair, there are some downsides, the biggest one of which is that it can take several years to resolve a case. The typical case requires one to two years to resolve but complex cases, delays in the liaison process, and request backlogs can protract the process beyond that. Moreover, some taxpayers may be hesitant to disclose details about the businesses and transactions necessary to appropriately equip the treaty partners with the facts necessary to resolve the issue. However as a practical matter, these facts have likely been fully vetted in the development of the issue during the audit by the tax jurisdiction initiating the adjustment. Finally, there is no assurance that a satisfactory agreement with all taxing jurisdictions will be reached through the CA process. However, should the CA authorities fail to reach an agreement, or if the taxpayer rejects a mutually reached agreement by the CA authorities, the taxpayer can always refer the issue to IRS Appeals for further consideration.
Overall, despite the cautions mentioned above, competent authority has many advantages over other avenues of relief. Two such advantages are all you need to remember. First, in the case of a U.S. intitiated transfer pricing adjustment, a CA proceeding shifts the burden of proof from the taxpayer to the IRS. Second, in the case of a foreign initiated adjustment, the IRS is not your adversary but actually an advocate for your return position in the CA proceeding.
In sum, unless a transfer pricing dispute involves a low-tax foreign jurisdiction where concerns about double taxation resulting from a unilateral settlement with only the IRS are substantially ameliorated or eliminated, the benefits of participating in the competent authority process deserve active consideration by every CTO faced with the unenviable prospect of a tranfer pricing adjustment.