This article discusses some of the implications of the current economic downturn for advance pricing agreements (APAs) being contemplated or under current negotiation with the Internal Revenue Service (IRS). It discusses various options taxpayers may have in accounting for the impact of the downturn on their APAs. The article lays out factors a taxpayer may want to consider in choosing from the methodological options potentially available, given the taxpayer’s constraints, expectations and preferences. The article also presents case studies illustrating the application of some of the approaches discussed in the article. As this is a rapidly evolving area, application of a particular approach and its reception by the IRS and other tax authorities is expected to be on a case-by-case basis.
Economies around the world have witnessed a severe recession in recent times. At the same time, President Obama has called for dramatic reform of the U.S. system of taxation of foreign income.
In the current economic and political environment, and given the increased staffing at the IRS, a significant increase in transfer pricing audit activity may be in the offing.
The Advance Pricing Agreement (APA) Program is designed to resolve actual or potential transfer pricing disputes in a principled and cooperative manner, as an alternative to the traditional adversarial process.
An APA has its pros and cons, which can be magnified in a recessionary period. On the one hand, given the challenges engendered by a recession such as the current one, there can be much greater uncertainty related to a company’s prices and profits, which can call for a fresh look at the taxpayer’s transfer pricing approach. On the other hand, in order to have certainty, the taxpayer may settle for a method that in retrospect may be less than ideal given the ultimate realization of economic conditions.
One aspect of a recession, especially one as severe as the current one, is that it makes determining appropriate transfer pricing approaches challenging. Transfer pricing approaches that were developed in periods of moderate expansion or contraction and based on market comparisons that were good benchmarks during periods of expansion may not work well in a recessionary period such as the current one. Thus, many companies may find it appropriate to adjust transfer pricing approaches developed during non-recessionary periods to approaches that reflect current economic conditions. Making adjustments for a recession is also consistent with the guidance provided in the section 482 regulations.
In determining how to implement adjustments for a down economy, it is expected that the APA Program will consider the stage of a particular case – that is, whether the APA is currently being negotiated with the taxpayer, or the recommended negotiating position is completed or pending. Once an APA has been signed, it is not expected that the IRS would consider re-opening discussions unless a critical assumption had been violated. Critical assumptions are discussed below.
This article focuses on various Transfer Pricing Method (“TPM”) adjustments that might be considered when negotiating APAs with the IRS in order to reflect the impact of the downturn. The receptivity of the IRS or another tax authority to any particular methodological approach is expected to be on a case-by-case basis.
Comparable companies selected under normal economic conditions may not provide good benchmarks in economic downturns. To improve comparability, there may be different ways to refine or expand the selection criteria for comparable companies. One simple way is to screen potential comparable companies based on quantitative criteria, such as ratios of selling, general and administrative expenses (“SG&A”) to sales, or percentage declines in sales for the applicable period. Taxpayers might also consider using regression analyses to identify the sensitivity of operating profits to sales declines. Further, taxpayers may want to consider a year-pooling approach, under which the arm’s-length range would include the profitability levels of the comparable companies only for those years in which a comparable company’s growth rate was similar to the tested party’s for the tested year. For example, comparable company data can be obtained from the early 1990s, which may be pertinent if the sales decline then was similar to that of the tested party for the tested year.
Consideration might also be given to the use of pooling to select observations to establish a range for benchmarking. Pooling simply takes each available year of comparables data as a separate observation. Thus, an appropriate range might be created from a relatively small number of companies or for a small number of years. Note, however, that the IRS APA Office has indicated a preference toward multiple-year averaging of comparable results over pooling.2
Taxpayers might consider extending the time period over which comparable company benchmarks are obtained in order to include financial data from prior recessions. For example, instead of using only the most recent years preceding the APA term for profit benchmarking, a taxpayer might propose to extend the multiple year period back to the last recession in the early 2000s.
For an APA currently in negotiations, a taxpayer might consider proposing to shorten the APA term to exclude recession years in order to meet the profit range being proposed for the APA. Or a taxpayer might consider segmenting the term of the APA into non-recessionary and recessionary periods, and applying different tests to the normal and the recessionary periods. Also the taxpayer might propose to expand the term to include more future years to smooth out the current recessionary impact, or request the inclusion of profitable rollback years for multiple year term testing.
Numerous possibilities exist for adjusting profit ranges for APAs. A simple option is to use a lower 50 percentage point interval within the entire profit range to reflect the impact of recession years, such as the 10th to 60th percentile levels, rather than the customary interquartile range (the 25th to 75th percentile levels). Another option is to use the entire profit range, as volatility and uncertainty increase when recent recession years are included in the APA term. Alternatively, the taxpayer could determine the correlation between average comparable company profitability and an economic indicator such as the capacity utilization index. The range could be adjusted based on the realization of the value of the capacity utilization index. Also, a taxpayer could investigate interest rates to be used for working capital adjustment to see if they are appropriate during recessionary times. For example, the use of company specific short term borrowing rates may be more suited to capture differences in the recessionary impact on each company’s performance (which could affect external borrowing rates of the company) for the comparable companies and the taxpayer.
A taxpayer could consider adjusting the tested party results to correct for relatively high SG&A, such that the SG&A-to-Sales ratio is representative of a “normal” year. In a recessionary environment, companies often attempt to reduce the level of SG&A to adjust for declines in sales and profitability. However, due to employment and/or capital/office lease contracts, there can be a lag between the sales/profit decline and when such cost cutting measures finally begin to bear fruit and SG&A expense is reduced. Therefore, the SG&A to sales adjustment during such a catch-up period could be considered in an APA context.
Depending on the situation, it is possible that the TPM suggested for normal years may no longer be the best method when applied to recessionary years. In such a situation, it may then be appropriate to revise the best method. For example, the Comparable Profits Method (“CPM”) may no longer be the best method under a system loss situation in which related parties participating in a certain intercompany transaction all generate losses due to the global impact of the current economic downturn. Then, a taxpayer may want to consider proposing a more suitable TPM, such as a transactional method or a profit/loss split method, to be the new best method.
It is important that a taxpayer understands the sources of profitability of its various business segments. When losses are generated predominantly from unrelated party transactions, it is generally helpful for the taxpayer to segment them out (and allocate the SG&A if separate books are not kept) to help clean up the segmented financial information of the covered transactions under an APA. This assumes that such segmentation and allocation can be performed reliably.
A taxpayer could consider using projections rather than historical data to benchmark appropriate profitability. It should be kept in mind that a high level of accountability for such projections is essential.
During the economic downturn, many production facilities operate below full production capacity. Some facilities are closed temporarily or are placed on a reduced production schedule. When such information is identified for a taxpayer or for comparable companies, taxpayers might consider adjusting part of SG&A and certain direct production costs included in cost of goods sold to reflect the level of production capacity.
In a U.S. APA context, a critical assumption is “any fact the continued existence of which is material to the taxpayer's proposed TPM, whether related to the taxpayer, a third party, an industry, or business and economic conditions.”3 Failure to meet a critical assumption can result in cancellation of the APA, absent agreement by the affected parties to revise it.4
A challenge for taxpayers seeking prospective treatment of their related party transactions in an uncertain economy is developing an approach that provides an adequate balance of flexibility and certainty. An APA critical assumption could be used in this regard as a sort of “stop loss” mechanism, whereby the taxpayer and the tax authority can reconsider whether the arrangement needs to be revised or terminated due to material changes in the economic environment.
While we have presented numerous approaches to adjusting the transfer pricing methods to account for the economic downturn, not every approach will work equally well in every situation.
For instance, if it is known with a fair degree of certainty that there will be significant changes in the taxpayer’s business shortly after the end of the original APA term, then expanding the APA term to include more future years to smooth out the current recessionary impact may not work well since the TPM will likely not be applicable in the later years.
Similarly, while on paper a number of different approaches may appear to be equally appropriate for a taxpayer, the taxpayer may prefer one or more over the others given its business culture and preferences. For instance, the taxpayer may prefer certainty over flexibility in the TPM. Thus, the taxpayer may prefer to settle on an adjusted comparables range knowing that economic conditions may deteriorate even more than anticipated rather than agree to a test where the arm’s-length range will not be determined until the end of the term.
The article provides three examples for adjusting the TPM to account for the recession.
This example presents the interquartile range and 10th and 60th percentile operating margins for the set of comparable distributors to the taxpayer.
While the original proposal by the taxpayer might have been to test the cumulative operating margin of the taxpayer at the end of the APA term against the 25th to 75th percentile range for the comparable companies, the TPM could be adjusted to account for the economic downturn as follows:
“The 10th to 60th percentile results of the comparable companies, instead of the interquartile range, could be used to benchmark the taxpayer’s results at the end of the term if the severity of the recession crosses an objective threshold. The severity of the recession could be measured, for instance, by the taxpayer’s industry’s capacity utilization index, which in turn could be shown to be correlated with the taxpayer’s results.”
In order to achieve greater comfort that any drop in operating margin (“OM”) observed over the term of the APA is driven by economic reasons rather than transfer pricing, annual gross margin (“GM”) tests could be used in addition to the OM term test.
In order to account for the economic downturn, the APA range created using historical information could be adjusted at the end of the APA term based on a capacity utilization (or other economic) index. For example, if capacity utilization fell below a certain level, the APA range would be reduced as a function of actual capacity utilization. This example shows the application of a regression-based approach similar to one suggested in an article by an APA economist, David Broomhall.5
As discussed above, during times of recession, different companies have different abilities to adjust their cost structures to match their reduced sales potential. In order to make a reliable comparison for transfer pricing purposes, adjustments must be made for such differences. Instead of (or in addition to) adjusting the results determined by the comparables, the tested party results could be adjusted to correct for its relatively high SG&A, such that the SG&A/Sales ratio is representative of a “normal” (i.e., non-recessionary) year, as illustrated by this example.
It bears repeating that the facts and circumstances of every pending or potential APA are different, and an APA approach that is appropriate in one situation may not be acceptable in another. Taxpayers are also faced with the need to make a decision about the level of flexibility and resultant uncertainty with which they are willing to live in order to obtain relief from the tax authorities. It should be noted that, absent specific language in APAs already executed, the existence of the current global recession is not generally considered to be sufficient to trigger a critical assumption that would terminate or revise an active APA.
When working with the IRS APA Office or any other tax authority, it is important to have open and direct communication. In fact, for those taxpayers still in the prefiling stage, the IRS has informally recommended that options for accounting for the downturn be discussed upfront at a pre-filing conference. From the authors’ experience, it has been necessary for taxpayers to demonstrate the impact that the current recession is having on them, and to propose a mechanism for relief.
1. The authors are members of the Global Transfer Pricing Services practice of KPMG LLP. Steven D. Felgran, Ph.D. is a KPMG Principal with offices in Boston and New York, Steven D. Harris is a Principal in KPMG’s New York office, Atsuko Kamen, Ph.D. is a managing director in KPMG’s New York office, and Prita Subramanian, Ph.D. is a senior manager in KPMG’s Boston office.
2. "See" APA Training Materials, http://www.irs.gov/pub/irs-apa/test_periods_avging_ranges_results.pdf (October 18, 2001).
3. Sec. 5.07, Rev. Proc. 2006-09.
4. Sec. 11.06(3), Rev. Proc. 2006-09.
5. Broomhall, D. (2007). Dynamic adjustment in transfer pricing agreements. "Business Economics", April 2007.
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"This piece is an excerpt of an article that appeared in Tax Management Transfer Pricing Report, Vol. 18, No. 8, 09/10/2009. Copyright © 2009 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com."
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