Editor: Mary Van Leuven, J.D., LL.M.
Transfer-pricing disputes have a tendency to protract themselves over a number of years and discrete stages. For one thing, the uncertainties inherent in questions of valuation and the highly factual nature of transfer-pricing inquiries lend themselves to a lengthy process. For another, the intrinsically bilateral or multilateral nature of a transfer-pricing adjustment means that transfer-pricing disputes are frequently resolved via the mutual agreement procedure (MAP) under an applicable bilateral tax treaty.
Where available, MAP is an attractive option: Statistics from the Organisation for Economic Co-operation and Development (OECD) demonstrate that MAP with most major U.S. treaty partners is very successful at eliminating double taxation. However, there are a number of pitfalls that beset taxpayers seeking to access MAP and to implement MAP resolutions. This item reviews some of the most common traps for the unwary.
Navigating the road map
Let us take the case of a transfer-pricing adjustment that arises from an IRS audit. The IRS's Transfer Pricing Examination Process guide contemplates that transfer-pricing exams should take two to three years to resolve. That timeline begins with the opening conference between the taxpayer and the examination team and thus does not include the planning and risk assessment work that the IRS exam team must do prior to meeting with the taxpayer. Exam teams are not bound to the timeline — contentious IRS transfer-pricing audits can take much longer.
MAP can be requested as soon as the IRS has issued a notice of proposed adjustment (NOPA), but many taxpayers wish to explore resolution options with the IRS before proceeding to MAP. When doing so, it is crucial to consider Rev. Proc. 2015-40's rules on coordination with IRS examination and the IRS Independent Office of Appeals.
The Appeals coordination rules pose a serious trap for the unwary. Historically, taxpayers were able to go through the IRS Appeals process before proceeding to MAP, and many opted to do so. Since the adoption of Rev. Proc. 2015-40, the ability to obtain Appeals consideration of an issue before seeking MAP relief has been severely curtailed. The U.S. competent authority will no longer consider issues that have been under Appeals' jurisdiction unless the MAP request is filed within 60 days following the Appeals opening conference, and then only if the taxpayer demonstrates that the MAP issues have been severed from any issues that remain under Appeals consideration. However, Rev. Proc. 2015-40 does provide a simultaneous appeals procedure through which a taxpayer can obtain Appeals consideration of issues under the competent authority's jurisdiction.
Minding the treaty
Just like IRS examinations, foreign transfer-pricing audits can take many years to resolve. With most U.S. treaty partners, this is not an issue. Consistent with the OECD Model Convention, many treaties require MAP requests to be presented within a certain time (often three years) following the first notification of the adjustment giving rise to double taxation. While countries' interpretations of what exactly constitutes "first notification" vary, the general principle is clear: If a tax authority takes seven years to conduct an audit before notifying the taxpayer that it is proposing an adjustment, the timeline for presenting a case runs from that notification, not from the inception of the audit.
Because presentation time limits are generally not problematic, taxpayers can be taken by surprise when dealing with the handful of U.S. tax treaties that include a notification time frame in lieu of a presentation time frame. The two most notable examples are the Canada and Mexico treaties, with notification deadlines, respectively, six years from the end of the relevant tax year and 4½ years from the due date or filing date — whichever is later — of the return in the state receiving the notification.
If a U.S. or foreign transfer-pricing audit drags on too long, an adjustment may not be proposed until after the notification time frame has expired, and failure to comply with notification time frames can cost a taxpayer its chance at MAP. For vigilant taxpayers, however, this should not be a problem: A treaty notification may be submitted before an adjustment is proposed, and in the United States it must be updated annually in accordance with the rules of Rev. Proc. 2015-40. Notification issues are by no means insuperable, but they do mean that taxpayers need to be thinking about MAP before an exam concludes.
Planning for the endgame
Taxpayers' goals for the MAP process vary. Some are hoping that the leverage of the competent authority in the counterparty jurisdiction will induce a tax authority to withdraw or substantially reduce a proposed adjustment. Others agree with the proposed adjustment and are seeking correlative relief. Many simply want relief from double taxation and are agnostic as to how that is achieved. Whatever the goal, it is important to consider the likelihood of different outcomes. As a consensus-based process, MAP tends to facilitate compromises to eliminate double tax, rather than all-or-nothing determinations.
Yet, simply thinking through the primary adjustment and any correlative relief is not enough. Many countries, including the United States, Germany, and India, also require secondary adjustments. (Many others — including China, Japan, and the United Kingdom — do not, making this a conceptually fraught area.) In countries that do recognize secondary adjustments, it is crucial to consider the impact they may have on potential resolutions and how they can be managed through the MAP process.
Secondary adjustments address the book-tax discrepancy that arises from a primary transfer-pricing adjustment: from a tax perspective, one entity's income has been increased, and its counterparty's income has been decreased; from a book perspective, the funds that correspond to the adjustment remain with the counterparty entity. In the United States, this discrepancy can be resolved in two ways. By default, one or more deemed transactions (i.e., deemed distributions or deemed capital contributions) will be inferred to align the tax treatment with the book treatment and explain, from a tax perspective, how the counterparty entity came into possession of the relevant funds. These deemed transactions can have significant consequences: Deemed distributions can trigger sizeable withholding tax obligations to the extent they qualify as dividends, and inbound deemed dividends that relate to years before passage of the law known as the Tax Cuts and Jobs Act, P.L. 115-97, can create U.S. taxable income.
The U.S. rules permit taxpayers to avoid these deemed transactions by instead aligning the book situation with the tax treatment, i.e., by electing to make a repatriation payment under Rev. Proc. 99-32 to move the funds from the counterparty to the adjusted entity. A repatriation payment must include an arm's-length interest component and must be accomplished within 90 days to avoid the default secondary adjustment treatment. If the primary adjustment relates to older years, the mandatory interest inclusion can be significant.
Thankfully, U.S. taxpayers are often able to avoid these issues in MAP. Under Rev. Proc. 2015-40, the taxpayer may request competent authority repatriation. Competent authority repatriation follows the same general principles as Rev. Proc. 99-32, but it is not bound by its specific rules, allowing the competent authorities to negotiate the terms of any repatriation obligation. Most notably, competent authorities commonly agree to the waiver of interest on repatriation payments, which is generally an ideal means of implementing the secondary adjustment from the taxpayer's perspective. Importantly, a request for competent authority repatriation must be submitted in writing before a tentative MAP resolution has been reached, making it crucial for taxpayers to consider these issues early in the process.
Thinking a step ahead
The traps for the unwary discussed above illustrate the importance of forethought and careful planning. In cases when MAP relief may be desired, it is critical that taxpayers and their advisers carefully think through timing and procedural issues to ensure that effective relief is not imperiled.
Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or firstname.lastname@example.org.
Contributors are members of or associated with KPMG LLP.
The information in these articles is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of Section 10.37(a)(2) of Treasury Department Circular 230 because the content is issued for general informational purposes only. The information is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. The articles represent the views of the author or authors only, and do not necessarily represent the views or professional advice of KPMG LLP.