The United States has concluded bilateral tax treaties with over 60 states around the world.1 These treaties typically include an administrative provision called the Mutual Agreement Procedure (MAP), through which the competent authorities of the two treaty partners may consult together to mutually resolve differences in interpretation or application of the treaty and to prevent double taxation of the residents or nationals that are covered by the treaty.2 The United States Competent Authority (USCA) is the Internal Revenue Service (IRS) LMSB Deputy Commissioner (International). Regular meetings are conducted between the USCA and the competent authorities of Canada, France, Germany, India, Japan, Korea, Mexico, the Netherlands, and the United Kingdom. Meetings with the competent authorities of other countries are scheduled as needed.
A US taxpayer may request the assistance of the USCA whenever the taxpayer believes the actions of either treaty partner will result in double taxation in violation of the terms of the treaty, and the MAP option exists “irrespective of the remedies provided by the domestic law” of the treaty partners.3 As a result, a US taxpayer confronted with a transfer pricing adjustment (either US- or foreign-initiated), is equipped with an additional tool for obtaining a favorable resolution. This article will focus on US-initiated transfer pricing adjustments and discuss the benefits (and costs) of involving the USCA in the dispute resolution process.
Traditional Administrative Avenues and Litigation
As an initial matter, a US taxpayer seeking the assistance of the USCA is still entitled to all of the avenues of dispute resolution ordinarily afforded to taxpayers, including (1) disputing the adjustment with the IRS Compliance Team (Compliance) that is performing the audit; (2) protesting the adjustment with the IRS Office of Appeals (Appeals) and (3) challenging the assessment in US Tax Court or seeking a refund in US District Court or the Court of Federal Claims. However, the complexities of a transfer pricing dispute and, more importantly, the possibility of double taxation inherent in transfer pricing disputes,4 can make it challenging for a US taxpayer to achieve a favorable resolution in an efficient manner.
A transfer pricing question may be a novelty for Compliance or even a seasoned Appeals officer. Compliance must focus solely on US tax law and has no room to negotiate a settlement, let alone consider the issue of potential double taxation or the international implications of its proposed adjustment. While the mission of Appeals is to reach a settlement with the taxpayer, settlements in Appeals are primarily based upon the litigating hazards of the case; the risk of double taxation by a foreign tax authority may not be factored into the equation.
Litigating a transfer pricing case involves similar challenges. Transfer pricing cases may involve extremely complicated facts and this will add to the complexity and cost of litigation. Expert witnesses are often required to provide economic analyses of the transactions at issue. Moreover, a taxpayer litigating a transfer pricing dispute faces a high burden of proof. Section 482 of the Internal Revenue Code5 provides that “the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances…if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of such organizations,” and thus grants the IRS broad discretion. As a result, the taxpayer has the burden of proving both that the adjustment proposed by the Internal Revenue Service is “arbitrary, capricious, or unreasonable,”6 and that the transaction at issue satisfies the arm’s length standard of Treasury Regulation Section 1.482-1(b).7
Benefits of Seeking Competent Authority Assistance
The USCA functions as an advocate for both the United States and US taxpayers, and its mandate is to endeavor to avoid double taxation in the jurisdictions involved. The USCA has extensive institutional expertise in transfer pricing issues, with a substantial portion of its case load comprised of transfer pricing disputes and the negotiation of Advance Pricing Agreements (APAs). Additionally, the USCA, as a result of its ongoing discussions with treaty partners, is cognizant of developments outside of the United States and how the positions and concerns of treaty partners can shape US transfer pricing issues and policies. The APA process in particular has fostered a mutually beneficial working relationship between the USCA and competent authorities around the world, who have grown accustomed to cooperating to resolve transfer pricing matters.
A taxpayer challenging a US-initiated adjustment has the option to seek USCA relief either after participation in the Appeals process or concurrent with Appeals by initiating a Simultaneous Appeals Procedure (SAP) in conjunction with its request for USCA assistance. In a SAP, an Appeals officer assigned to the case will work with the taxpayer and the USCA to resolve un-agreed issues before the USCA presents its position to the foreign competent authority.8 Any agreement reached with Appeals through the SAP will be non-binding, and the terms of that tentative agreement will serve as the basis for the USCA’s negotiating position in the MAP process. The SAP process permits the taxpayer to negotiate directly with an Appeals officer while still taking advantage of the added benefits of the USCA’s unique expertise and international perspective.
If the taxpayer requests the assistance of the USCA after participating in Appeals, the MAP options may be more limited. The stated primary mission of the USCA is to seek a correlative adjustment on behalf of the taxpayer.9 However, as long as the case has not reached a final resolution, the USCA is not precluded from granting unilateral relief. In fact, if the IRS’s asserted transfer pricing adjustment is inconsistent with US transfer pricing principles, it is unlikely the USCA would advocate such a position to its treaty partners in an effort to obtain correlative relief. A hallmark of a MAP, and, indeed, of tax treaties, is comity and the USCA can, where necessary to avoid an unjust result, reject an IRS-initiated adjustment to avoid double taxation.
If, however, the taxpayer has executed a closing agreement with Appeals or reached a final determination through litigation (including a settlement), the USCA may only seek a correlative adjustment from the treaty partner.10 This means the USCA will only attempt to elicit a corresponding adjustment from the foreign tax authority in the same amount.
The USCA is extremely successful in resolving transfer pricing disputes, whether initiated by the US or foreign tax authorities. Over the past five years, cases that have been fully considered by the USCA resulted in 49 percent of adjustments being withdrawn and correlative adjustments equaling 41 percent of the total proposed amounts being received. A mere ten percent of adjustments were afforded only partial (4.45 percent) or no relief (5.36 percent) after full participation in the competent authority process.
Burdens of Requesting Competent Authority Consideration
Participation in the mutual agreement procedure comes at a price, as taxpayers who seek competent authority assistance are required to disclose substantial information on their business operations and on the terms of the transactions at issue.11 The USCA, in the course of seeking correlative relief from the foreign tax authority, will serve, in a sense, as the representative of the US taxpayer’s interest. While the taxpayer participates directly in meetings with the USCA and can also participate directly in meetings with the foreign competent authority, the taxpayer may not participate in the formal meetings between the two competent authorities. Thus, it is the taxpayer’s obligation to provide the USCA with sufficient information to allow the USCA to be fully informed during its meetings with the foreign competent authority. The amount of such information typically exceeds what a taxpayer would be required to disclose during an IRS audit.
In addition, while any adversarial proceeding takes time, the USCA meets with the competent authorities of its treaty partners relatively infrequently, and this can result in a significantly drawn out process. There is also a sizable backlog of cases pending USCA consideration. In 2008, for example, the USCA received 308 new cases, disposed of 230, and ended the year with a 578-case inventory, and the US-initiated cases that closed last year had been pending for an average of 424 days.12
However, there may be a silver lining for taxpayers willing to expend the necessary time and effort to go through the competent authority process: the information provided by the taxpayer, the USCA’s position paper and any mutual agreement reached by the treaty partners can cumulatively provide a strong basis for the conclusion of an Advance Pricing Agreement that will govern the terms of the transactions at issue going forward. Thus, in addition to obtaining resolution of the disputed issue for the years under audit, the taxpayer may be able to obtain certainty on these transactions for future years.
The Mutual Agreement Procedures available under bilateral tax treaties provide taxpayers with many unique benefits, one of which is the ability to obtain the assistance of USCA in US-initiated transfer pricing adjustments. Similar benefits are afforded with respect to foreign-initiated transfer pricing adjustments, as well as in several other areas of international taxation including questions of residency and determinations as to the existence of a permanent establishment. It is important that multinational companies understand fully the benefits available to them under the vast network of tax treaties.