Small and Medium Enterprises Should Consider Making Advance Pricing Agreements

By James G. Collins, Friedman LLP, New York, NY

Editor: Stephen E. Aponte, CPA

Procedure & Administration

Small and medium-size enterprises (SMEs) comprise some 97% of all U.S. exporters. They produce almost a third of all goods and services exported, as measured by value (Office of Trade and Industry Information, International Trade Administration, U.S. Department of Commerce (2008)). In 2008, export revenues for SMEs were nearly $360 billion.

In what has become a global economy, SMEs compete globally not only to make sales but to employ labor, consume raw materials, and obtain low-cost capital. SMEs have looked overseas for one or more of these business resources for generations and have incorporated affiliates where they can be most efficiently obtained. But whenever companies have crossed borders and dealt with controlled affiliates, tax collectors have followed. And foremost among tax collectors’ concerns is the matter of intercompany pricing—i.e., assuring that prices charged among related corporations are at arm’s length.

This item acquaints readers with the procedures that SMEs can use to obtain advance pricing agreements (APAs) with the IRS so they can minimize their exposure to intercompany pricing adjustments on audit. As used here, and as limited by the IRS, SMEs are those with less than $200 million in gross sales or entities with covered transactions with an aggregate value of less than $50 million, and $10 million or less annually of covered transactions involving intangible property (Rev. Proc. 2006-9). These limits are set for all entities owned or controlled directly or indirectly by the same interests controlling the taxpayer seeking the ruling (Rev. Proc. 2006-9, §4.12(6)).

Why Should SMEs Consider APAs?

Arm’s-length pricing (ALP) of transactions between controlled affiliates is a statutory prerequisite for proper tax compliance in the United States. A failure to comply can result in a penalty of 20% or even 40% of the tax in the United States (Sec. 6662). Virtually all the major U.S. trading partners have their own provisions for managing intercompany pricing for their own jurisdictions, and most belong to multinational associations of tax administrators who are attempting to unify intercompany pricing regimes. The IRS already works with its counterparts in foreign jurisdictions with which the United States has tax treaties to assure a proper allocation of income and expenses across foreign borders.

The IRS recently announced its intention to develop a protocol for “joint” tax audits with other foreign jurisdictions so that intercompany pricing between related affiliates will become even more transparent and seamless (see remarks of IRS Commissioner Douglas Shulman before the OECD Business and Industry Advisory Committee, June 8, 2010). Finally, the IRS has recently taken significant steps to strengthen its transfer pricing specialty practice, hiring the greatest number of economists in IRS history, identifying agents with an aptitude for the area, and institutionalizing the IRS knowledge base in the field (see Ossi and Shepherd, “The IRS’s Renewed Emphasis on Transfer Pricing,” J. Corp. Tax’n 3 (July–August 2010)).

There are six pricing methods. The comparable uncontrolled price method, the resale price method, the cost-plus method, the comparable profits method, and the profits split method are used primarily for tangible property. Comparable uncontrolled transactions, the profits split method, and the comparable profits method are used for intangible property. The IRS also allows an undefined “other reasonable method.” A full discussion of these methods is beyond the scope of this item. Because the IRS has not adopted a comprehensive procedure to address SME ALP intangibles pricing and cost-sharing arrangements, those aspects of ALP are also not addressed here. (The closest the IRS comes to discussing intangibles and cost-sharing arrangements for SMEs is to say that they will be considered on a case-by-case basis (Rev. Proc. 2006-9, §9.01).)

An APA is an agreement between a taxpayer and the IRS to determine the best transfer pricing method (TPM) of controlled transactions under Sec. 482. Generally the agreement describes the controlled transaction, the APA term, assumptions, records that must be maintained, and reporting responsibilities. But APAs can also “provide a process whereby the Service and taxpayers may resolve other issues arising . . . under income tax treaties, the Code or the . . . regulations for which transfer pricing principles are relevant” (Rev. Proc. 2008-31). Thus, according to the IRS, the APA process can help resolve whether income is effectively connected to a U.S. trade or business and determine amounts of income derived from sources partly within and partly outside the United States (Rev. Proc. 2008-31). These additional aspects of APAs can be particularly helpful when a company is considering moving operations overseas, participating in a joint venture, or considering check-the-box plans.

All companies that have transactions with controlled affiliates should consider their intercompany pricing, for the reasons set out above. But there is no requirement for any enterprise to obtain an APA; that is entirely voluntary and is initiated by the taxpayer. For some SMEs, the costs of obtaining an APA—even without outside experts—may be prohibitive. The IRS filing fee alone is $22,500. But while APAs should be undertaken with due consideration, cost alone should not cause taxpayers to dismiss the prospect of an APA out of hand because preparing for an APA can ultimately reduce the cost of tax compliance over the years for which it is effective. The cost of compliance, notwithstanding the cost of an APA, should certainly not serve as an excuse to neglect Sec. 482 or the intercompany pricing regulations. Failure to comply can incur the Sec. 6662 penalties mentioned above. (The IRS has ruled, at least privately, that the costs of an APA are deductible as tax compliance costs (TAM 199929038).) Moreover, since the cost of Sec. 482 compliance is mandated, the true “cost” of the APA for its term should be measured as the cost that exceeds the cost of regular Sec. 482 compliance for the term, including any penalties and any ALP defense that may arise in the term. When those costs are considered, an APA may very likely be more cost advantageous for the taxpayer than preparing transfer pricing documentation and defense for each tax year with no assurance that the IRS will accept the chosen TPM.

Some companies may determine that an APA is not necessary. Trading companies that buy and sell commodities, for instance, can probably obtain readily determinable arm’s-length pricing merely by checking daily market quotes. Other companies may have intercompany operations that are limited to buying and selling products that they also sell to unrelated third parties. Those companies likely have comparables readily available that they can use to set intercompany prices. Nevertheless, companies that may have convenient and readily available ALP for their intercompany pricing are still required to compile the data for all transfer pricing methods to show that they have complied with the “best method” rules of Regs. Sec. 1.482-1(c).

Most small and medium-size businesses with controlled foreign affiliates will want to at least take the preliminary steps to consider obtaining an APA, even if they do the work entirely in-house and ultimately determine not to advance the APA to completion. The exercise will bring the SME into better compliance with the demands of the regulations and will reveal shortcomings that the SME can correct. Finally, and perhaps most important, preparing for an APA will put controlled transaction ALP front and center in the minds of the company’s financial executives, who might otherwise neglect it, with consequent tax penalties.

For paid tax advisers, going through the exercise, explaining the importance of ALP to clients, compiling the documentation, and reflecting (or disclosing) the results on the client’s tax return, even without formally completing the APA, may have a prophylactic effect on the paid preparer penalty imposed for negligence or intentional disregard of the regulations (see, e.g., Regs. Sec. 1.6694-3(c)). The documentation accumulated in preparing for an APA can be invaluable in proving that the preparer was duly diligent in assessing the client’s intercompany pricing and acted accordingly.

For SMEs that require certified opinions, APAs can be extremely beneficial. First, they provide a higher level of assurance that a company’s intercompany pricing is ALP so that management and financial statement users have a proper picture of each separate company’s financial performance. Second, the higher level of intercompany pricing assurance allows the SME to cite the APA to outside auditors so the SME can present the tax positions subject to FIN 48, and their related deferred tax assets, at full value. Finally, preparing for an APA will help clarify whether the client has any uncertain tax positions in its TPMs, which the IRS will likely require taxpayers to disclose in the very near future.

For controlled taxpayers that achieve an APA with the IRS and the tax authority of the controlled foreign affiliate in bilateral or multilateral APAs (discussed later), there is the assurance that the U.S. tax treaty competent authorities will seek to achieve substantially identical (i.e., offsetting) treatment with the foreign jurisdiction. So, for example, if an APA determines that the price charged by a U.S. taxpayer for inventory it sold to its foreign affiliate is appropriate, the competent authorities would try to ensure that the tax authorities in the foreign affiliate’s country increase its cost of goods sold, thereby reducing the affiliate’s taxable income in the foreign tax jurisdiction (Rev. Proc. 2006-9, §11.02(6)).

Finally, of course, those companies that fully implement an APA and adhere to it in their tax reporting can generally rest assured that their intercompany pricing of covered transactions will not be challenged on audit.

The Process

The IRS recently reported that nearly 10% of its active APA cases involved SMEs (Announcement 2010-21). The average time from application to completion is two and a half years, up substantially from just five years ago, when they took slightly over a year and a half. The IRS’s hiring of some 1,500 new international tax examiners is likely to increase both the amount of SME APA requests and the time they are in inventory.

All APAs are initiated by the taxpayer, although the IRS may suggest the benefits of an APA and urge taxpayers to consider obtaining one. For SMEs, Treasury attempts to accelerate the process as much as possible, although often with only limited success. The IRS attributes this to a variety of factors, including an SME’s inexperience with, and limited resources devoted to, transfer pricing.

The formal APA process begins with the taxpayer defining the scope. First, the taxpayer should select the controlled transactions that the APA is to cover. Taxpayers can “cherry pick” the controlled transactions they choose to submit for an APA, but the IRS may opt to expand (or narrow) the scope (Rev. Proc. 2006-9, §2.04(3)). The IRS cautions that taxpayers should complete their analysis of each of the transfer pricing methods of covered transactions and compile all the required documentation well in advance of approaching the IRS. Taxpayers must have compiled this documentation and analysis annually for controlled transactions, even if they have determined not to pursue an APA. It must be compiled before the taxpayer files the tax return and must be delivered within 30 days of an agent issuing an information document request for it.

Next, the taxpayer should determine whether the scope should be unilateral (with the IRS only), bilateral (with the IRS and the tax authority of another country), or multilateral (with the IRS and two or more other taxing jurisdictions where entities in a controlled transaction are located). Both care and discretion should be exercised in making these decisions.

The content of APAs is strictly confidential and cannot legally be disclosed to the public. Nevertheless, SMEs in particular may have considerable trepidation about exposing what may be their most sensitive trade secrets to IRS scrutiny. Unlike larger taxpayers, SMEs do not have a large portfolio of income-generating assets. The trade secret being shared may be the SME’s only trade secret, or one of only a handful. Fears understandably multiply when the SME seeks a bilateral or multilateral APA, especially since the IRS puts the burden on the taxpayer, not itself, to clearly identify relevant concerns that may affect the negotiation of the APA request with the tax authorities of foreign jurisdictions.

Once the scope of controlled transactions and the determination as to whether to obtain a unilateral, bilateral, or multilateral APA has been made, taxpayers should go about compiling the data used to support their pricing methodology for the controlled transaction for tax return purposes so that they can assess whether it is adequate to fulfill the requirements of the Sec. 482 regulations. If data are missing or inadequate and the taxpayer can readily obtain the data, it should do so. But if data seem extraneous to the pricing method and are difficult or expensive to obtain, taxpayers should just note the shortcoming because the IRS may not require it. (For SMEs, the IRS has fairly broad authority to reduce or eliminate specific items otherwise required for larger taxpayers (Rev. Proc. 2006-9, §9.03).)

Once these preliminary steps are completed, a taxpayer seeking the APA may wish to consider approaching the IRS in Washington, DC, or California (where the IRS APA program offices are located) for an APA prefiling conference. The IRS allows such arrangements to be made anonymously if the taxpayer so chooses. At least one week prior to the meeting, the SME should submit to the IRS the names (first names or titles if the meeting is to be anonymous) of the SME attendees and an agenda for the meeting. If the SME attendee identifies himself or herself, the IRS attendees will normally be someone from the SME’s Service Operating Division (i.e., the office where the SME files its return) and likely also from the Division Counsel. SMEs requesting a “rollback” APA may have a representative from Appeals. Finally, SMEs seeking bilateral or multilateral APAs can expect a representative from Competent Authority to address the treaty issues that arise with the foreign country or countries implicated in the controlled transactions.

According to the IRS, the purpose of the prefiling conference is to

clarify what information, documentation, and analyses are likely to be necessary for the Service to consider an APA request. Among the areas of discussion are the covered transactions, the potentially applicable TPMs, the probability of agreement among the competent authorities, and the APA Program’s schedule and method for coordinating and evaluating the request. [Rev. Proc. 2006-9, §3.02]

But taxpayers can also use the meeting to determine whether the APA should proceed, whether they are comfortable with the scope of the matters the IRS appears to have interest in, and whether the IRS’s schedule for meetings, other discussions, and ultimately completion will comport with their own. (Rev. Proc. 2006-9 contains full details of arranging a prefiling conference.) Most importantly, SMEs can use the meeting to possibly obtain tentative IRS approval to dispense with some of the “boilerplate” APA requirements that are intended for larger businesses. Taxpayers seeking bilateral or multilateral agreements are unlikely to find much relief in this regard, however, because the Competent Authority will need to present a more comprehensive case to the foreign jurisdiction.

Ordinarily, formal submission of the APA begins only when the taxpayer pays the APA fee and files an APA request. Published advice says that the IRS offers to commence the due diligence process earlier in the case of SMEs (Rev. Proc. 2006-9, §9.02). The advice says that the SME and the APA program may meet to determine a TPM at a prefiling conference and that the SME can submit copies of the contemporaneous pricing data it maintains for Sec. 6662(e) as support for the TPM in its APA request. Nevertheless, the procedures published in the 2006 revenue procedure appear to be more difficult in practice than was anticipated, according to the APA program reporting. SMEs and their advisers should be prepared to deal with a much more lengthy and involved process than the written advice would lead taxpayers to believe.

The information required for the APA request is detailed in Rev. Proc. 2006-9, §§4.02–4.10 (although at the IRS’s discretion certain of the boilerplate items may be set aside for SMEs). Once the SME submits the application, a representative of the APA program will contact the SME (or its representative) to discuss any preliminary questions and to request additional information that may be necessary. When the SME answers the questions and provides the information, under the normal APA provisions the APA program will begin the process.

A team leader will be appointed who will appoint an APA team, which will consist of an economist, an international examiner, an attorney, and, for bilateral and multilateral applications, a competent authority analyst. Team members’ supervisors may also be team members, in addition to a representative from Appeals, if the SME requested an APA rollback (i.e., retrospective application of the TPM agreed to in the APA) for a year that is before Appeals.

Normally within six weeks of submitting the APA request, the APA team leader will contact the SME and arrange the first APA meeting. At the meeting, the IRS and the SME will work to clarify any points that are not clear from the APA request and to set the scope and nature of the APA team’s due diligence. The meeting will also set, and the parties will agree to, a case plan wherein firm dates are set for both the IRS and the SME to provide and evaluate data, visit the taxpayer, and arrange follow-up meetings. A taxpayer’s consistent failure to abide by the dates in the case plan will be viewed as a withdrawal of the APA request. While SME requests are supposed to be handled as expeditiously as possible, SMEs can still expect a fairly lengthy process with the IRS, averaging two years, with meetings and negotiations as required before the APA is completed.

A discussion of the APA team’s analysis is beyond the intended scope of this item, but some background to the workings is useful.

Among the first things the APA team will evaluate is any portion of the APA request or the proposed TPMs that are “nonstarters”—those elements of the submitted request that are outside the scope of the IRS to rule upon or that the taxpayer may have submitted as a “throwaway” position to be used in negotiations.

Early in the process, the APA team and the team leader will evaluate the SME’s APA request to achieve the best TPM under Sec. 482. They will perform due diligence to familiarize themselves with the SME and make various preliminary computations of performance ratios of data in the SME’s financial statements to measure the SME’s business operations and will then reconcile the financial data to the taxpayer’s tax return. These performance ratios will then be compared with industry comparables, and the APA team economist will attempt to match the comparable selected by the SME in the APA request using commercially available databases.

Since SMEs generally have operating circumstances peculiar to themselves and not widespread within an industry, it is important that SMEs and their representatives understand the importance of selecting the right dataset in negotiation with the APA team. There are a number of factors that enter into the selection criteria for comparables. Regs. Sec. 1.482-1(d)(3) contains a partial list of factors to consider in the selection criteria. While the IRS offers assistance with economic analysis to SMEs that submit APA requests, SMEs should strongly consider engaging their own economist to work with them or their advisers.

The selection of the dataset for comparables determined at this stage will fix the upper and lower limits of what will ultimately be the TPM and the agreed transfer price, so taxpayers should be particularly attentive to the selection and be prepared to negotiate alternatives. Notably, the IRS has said that “it is important to understand the U.S. tax effects of ‘the bottom line’ of any proposed TPM” and that the team leader should determine the TPM’s tax effect (IRS, “Case Analysis and Fact Development” at 4). SMEs would be naive, and unprepared, not to do the same.

Another aspect of the APA important to the IRS and the SME negotiators is the critical assumptions of the analysis. These assumptions are intended to define the environment in which the TPM is acceptable to both the SME and the IRS. Where critical assumptions are not met (for example, if sales fail to meet the minimum threshold in the critical assumptions because the SME suffers some type of catastrophic event, such as a fire that destroys a plant), the failure to meet those assumptions should render the APA TPM void.

If the APA request is bilateral or multilateral, the APA team will conduct these processes in order to develop a negotiating position for use by the competent authority in negotiating the APA with the treaty partners. Likewise, if the APA request is for a rollback period, the APA team will evaluate the APA request for its effect on the amounts already at issue.

After all these processes have been completed, the APA will be executed by the SME and the APA director and will be effective as a binding agreement between the taxpayer and the IRS for its term, usually no less than five years. But the APA program may reject the APA request or refuse to execute it, even after the APA due diligence process has been completed. (If the rejection occurs after the due diligence, the IRS is likely to retain the user fee.)

For each year covered by the APA, the taxpayer must submit a complete report showing compliance with the APA. An original and four copies of the report must be filed with the APA director within 90 days of the date for filing the SME’s tax return (including extensions). The report will show, among other things, how the SME applied the TPM agreed to in the APA in its actual tax return. The SME files the report under penalty of perjury. Failing to submit the report as required can cause the APA to be canceled or revoked.


The APA process for SMEs can be demanding. But it provides substantial assurance that the IRS will respect the transfer pricing used by the SME and, when made as a bilateral or multilateral APA, by U.S. tax treaty partners. Even if they do not make formal application to the IRS for an APA, SMEs dealing in a global economy should undertake the steps for applying for an APA to assure compliance with U.S. and foreign laws and to limit their potential tax exposure.


Stephen Aponte is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.

For additional information about these items, contact Mr. Aponte at (212) 792-4813 or

Unless otherwise noted, contributors are members of or associated with DFK International/USA.

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