Part III. General Descriptions Of APAs Executed In 2017
This Announcement is issued pursuant to § 521(b) of Pub. L. 106-170, the Ticket to Work and Work Incentives Improvement Act of 1999, which requires the Secretary of the Treasury to report annually to the public concerning advance pricing agreements (APAs) and the Advance Pricing and Mutual Agreement Program (APMA Program), formerly known as the Advance Pricing Agreement Program (APA Program). The first report covered calendar years 1991 through 1999. Subsequent reports covered each calendar year 2000 through 2016 separately. This nineteenth report describes the experience, structure, and activities of the APMA Program during calendar year 2017. It does not provide guidance regarding the application of the arm’s length standard.
[Pub. L. 106-170 § 521(b)(2)(D) and (E)]
In the majority of APAs, the covered transactions involve numerous business functions and risks. For instance, with respect to functions, APAs involving manufactured products typically involve a controlled group that conducts research and development (R&D), engages in product design and engineering, manufactures the product, markets and distributes the product, and performs support functions such as legal, finance, and human resources services. Regarding risks, the controlled group may assume a variety of risks, including market risks, R&D risks, financial risks, credit and collection risks, product liability risks, and general business risks. In the APA evaluation process, a significant amount of time and effort is devoted to understanding how the functions and risks are allocated amongst the controlled group of companies that are party to the covered transactions. Generally, for methods requiring selection of a tested party, the tested party that is chosen will be the least complex of the controlled taxpayers.
Transfer Pricing Methods Used
Consistent with prior years, in 2017, the primary transfer pricing method (TPM) used for both the sale of tangible property and the use of intangible property was the comparable profits method/transactional net margin method (CPM/TNMM). The CPM/TNMM was used for 87 percent of transfers of tangible and intangible property while all other methods combined accounted for the other 13 percent of such transactions.
For covered transfers of tangible and intangible property that used the CPM/TNMM, the operating margin (OM) continues to be the most common profit level indicator (PLI) used to benchmark results. It was used 85 percent of the time. Other PLIs, such as the Berry Ratio and return on assets or capital employed, made up the other 15 percent. As used here, OM means the ratio of operating profits to sales,9 and “Berry Ratio” means the ratio of gross profit to operating expenses.10 Most services transactions (86 percent) also used the CPM/TNMM, and the OM was also the most common PLI (used 62 percent of the time).11
Sources Of Comparables, Comparables Selection Criteria, And Nature Of Adjustments To Comparables Or Tested Party Data
For the APAs executed in 2017 that used external comparable data in the analysis, the most widely used data source for comparables was Standard and Poor’s Compustat/Capital IQ database. Other sources were also used in appropriate cases (e.g., where the tested party was not the U.S. entity or where transaction-based methods were applied). The other more commonly used databases are listed in the table below.
In making comparability adjustments, the standard balance sheet adjustments identified in Treas. Reg. § 1.482-1(d) and § 1.482-5(c), including adjustments for differing amounts of payables, receivables, and inventory, were made in the majority of cases. Where appropriate, adjustments for different accounting practices were made to convert from LIFO to FIFO inventory accounting, and a small number of cases also involved the accounting reclassification of expenses, e.g., from COGS to operating expenses.
Ranges, Targets, And Adjustment Mechanisms
Most transactions covered in APAs target an interquartile range as described in Treas. Reg. 1.482-1(e)(2)(iii)(C). Where the transaction involves a royalty payment for the use of intangible property, both specific royalty rates and ranges have been used. Where the covered transaction is the payment of a royalty based solely on external royalty agreements, a secondary method, e.g., a test of the post-royalty operating margin or cost-plus mark-up, has been used.
The testing periods of the APAs executed in 2017 were either: (1) a single year, (2) the term of the APA only, or (3) the term of the APA plus rollback years.
APAs executed in 2017 included several mechanisms for making adjustments to tested party results when the results fall outside the range or do not match the point required by the APA. The following are examples of the mechanisms used: an adjustment bringing the tested party’s results to the closest edge of the range applied to the results of a single year; an adjustment to the closer edge of the range applied to the results over the APA term; an adjustment to the specified point or royalty rate; or an adjustment to the median of the range for a single year.
The model APA used by the IRS (included as Appendix 1 of this report) includes a standard critical assumption that there will be no material changes to the taxpayer’s business or to its tax or financial accounting practices during the APA term. A few bilateral cases have also included critical assumptions tied either to the taxpayer’s profitability in a certain year or over the term of the APA, or to the amount of non-covered transactions as a percentage of the taxpayer’s revenue. Pursuant to § 7.06(3) of Rev. Proc. 2015-41, 2015 I.R.B. 263, APMA will cancel an APA in the event of a failure of a critical assumption unless the parties agree to revise the APA.
Term Lengths Of APAs Executed In 2017
As described in § 3.03(1) of Rev. Proc. 2015-41, taxpayers should request an APA term that would cover at least five prospective years and may also request that the APA be “rolled back” to cover one or more earlier taxable years, although the appropriate APA term is decided on a case- by-case basis. Of the APAs executed in 2017, 22 percent included rollback years. A substantial number of those APAs with terms of greater than five years were submitted as a request for a five-year term, and the additional years were agreed to between the taxpayer and the IRS (or, in the case of a bilateral APA, between the IRS and the foreign government upon the taxpayer’s request) to ensure a reasonable amount of prospectivity in the APA term.
Amount Of Time Taken To Complete New And Renewal APAs
The median time required to complete an APA in 2017 increased slightly (32.8 months in 2016 versus 33.8 in 2017).
Efforts To Ensure Compliance With APAs
As described in § 7.02(1) of Rev. Proc. 2015-41, taxpayers are required to file annual reports to demonstrate compliance with the terms and conditions of their APA. The filing and review of these annual reports are critical parts of the APA process. Through annual report review, the APMA Program monitors taxpayer compliance with APAs on a contemporaneous basis. Annual report review also provides current information on the success or problems associated with the various TPMs adopted in the APA process.
Nature Of Documentation Required In Annual Report
APAs require taxpayers to file timely and complete annual reports describing their operations and demonstrating compliance with the APA’s terms and conditions. Not every annual report will include each of the items listed in the following table12; they are required where the facts demonstrate a need for such documentation.
Approaches For Sharing Of Currency Or Other Risks
In appropriate cases, APAs may provide specific approaches for dealing with risks, including currency risk, such as adjustment mechanisms and/or critical assumptions.
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