Taxpayer-initiated transfer pricing adjustments in MAP

Editor: Mary Van Leuven, J.D., LL.M.

The phrase “transfer pricing adjustment” typically calls to mind a rather bleak picture: a hard-fought audit spanning years, cash tax to be paid or net operating losses that will evaporate, possible penalties, and all the back-end complexity that comes with implementing the adjustment once it has been determined. Yet adjustments can also be made proactively by taxpayers, and without most of the gloomy trappings of an IRS-initiated adjustment. In the United States, taxpayers are permitted to use their timely, original U.S. returns to adjust the transfer prices on their books, if necessary to achieve an arm’s-length result — an important concession that can ease operational transfer pricing pressures and help taxpayers avoid penalties.

In a perfect world, everything would dovetail, with a taxpayer-initiated upward adjustment in the United States offset by a corresponding taxpayer-initiated downward adjustment in the counterparty jurisdiction. But we do not live in a perfect world, and not all jurisdictions permit post-year-end adjustments, so making a taxpayer-initiated transfer pricing adjustment often raises the specter of double tax. When the double tax is significant, taxpayers may be able to obtain relief via the mutual agreement procedure (MAP) under a relevant income tax treaty. This item provides an overview of the MAP process as it relates to taxpayer-initiated adjustments, as well as some collateral consequences that taxpayers need to consider.

MAP for taxpayer-initiated adjustments

Taxpayers may find a substantial benefit in initiating a transfer pricing adjustment before undergoing a government audit. The need for an adjustment may come to light due to undiscovered facts or an internal (or third-party) review that causes a reconsideration of the initial position. For many taxpayers, the reality is more pedestrian: The facts are what they were always understood to be, but just complying with established transfer pricing policies can be challenging at the operational level. By self-initiating an adjustment, a taxpayer can remedy operational transfer pricing challenges and mitigate penalty exposure as well as control its narrative.

In cases where the adjustment increases U.S. income, the foreign jurisdiction will generally lack incentive — and often a procedure — for allowing a post-year-end adjustment to reduce the foreign taxpayer’s income. Historically, this was also true in the United States. Naturally, the IRS does not object to taxpayers’ changing their transfer pricing results to report more U.S. income from a controlled transaction, but until the 1990s, there was no way for taxpayers to change the actual results of their controlled transactions to report less U.S. income. With the introduction of the transfer pricing penalty regime, however, a limited right to make taxpayer-initiated transfer pricing adjustments under Regs. Sec. 1.482-1(a)(3) was introduced, allowing taxpayers to adjust their transfer pricing on original, timely filed returns if necessary to achieve an arm’s-length result (and thus avoid penalties). After the return is filed, however, taxpayers are still forbidden from filing amended returns to decrease U.S. taxable income under Sec. 482.

MAP procedures

In many cases, a taxpayer-initiated U.S. adjustment will create double tax, and seeking MAP relief will be necessary to effectively eliminate it. Rev. Proc. 2015-40 provides special procedures that must be followed in MAP cases arising from taxpayer-initiated adjustments. For these cases, taxpayers must submit a prefiling memorandum identifying the taxpayer (in contrast to prefiling proceedings related to a tax authority–initiated adjustment, which may be held on an anonymous basis). The memorandum must describe: (1) the factual and legal basis for the taxpayer’s position; (2) any administrative, legal, or other procedural steps undertaken in the foreign jurisdiction (e.g., the filing and acceptance of a return with the adjusted transfer pricing); and (3) any previous communications with the foreign competent authority concerning the relevant issues. Taxpayer-initiated adjustment cases are also ineligible for treatment as small-case MAP requests, meaning a full MAP submission under Rev. Proc. 2015-40 is required.

Importantly, the U.S. competent authority may decline to provide assistance if the taxpayer failed to make a timely request or the taxpayer otherwise prejudiced or impeded full and fair negotiation of the issues by the competent authorities (see Rev. Proc. 2015-40, §7.02(3)(f)). Therefore, in most cases, taxpayers should promptly proceed to MAP when undertaking a taxpayer-initiated adjustment for which no corresponding self-help is available in the counterparty jurisdiction.

While the U.S. competent authority has shown it is willing to engage in MAP proceedings regarding taxpayerinitiated adjustments, other countries may not have the same willingness and may take the position that, since a tax authority has not made an affirmative adjustment, taxation not in accordance with the applicable income tax treaty has not occurred and MAP is unavailable.

However, the commentary to the Organisation for Economic Co-operation and Development (OECD) model treaty provides support for taxpayerinitiated adjustments triggering MAP:

It should be noted that the mutual agreement procedure, unlike the disputed claims procedure under domestic law, can be set in motion by a taxpayer without waiting until the taxation considered by him to be “not in accordance with the Convention” has been charged against or notified to him. [Commentary on OECD Model Tax Convention on Income and on Capital (“OECD Model Convention”) (2017), Article 25, ¶14]

Similar favorable statements are made regarding taxpayer-initiated adjustments in the commentary to Article 7 (Business Profits) and Article 9 (Associated Enterprises), providing that in cases where a taxpayer-initiated adjustment is made in one state:

To the extent that taxes have been levied on the increased profits in the first-mentioned State, that State may be considered to have included in the profits of an enterprise of that State, and to have taxed, profits on which an enterprise of the other State has been charged to tax. In these circumstances, Article 25 enables the competent authorities of the Contracting States to consult together to eliminate the double taxation. [Commentary on OECD Model Convention (2017), Article 9, ¶6.1; see also Commentary on OECD Model Convention (2017), Article 7, ¶59.1]

However, not all income tax treaties follow the OECD model treaty, and not all jurisdictions subscribe to the views espoused in the commentary to the OECD model. Thus, it is important to communicate with the competent authorities of all affected jurisdictions prior to filing the MAP request.

Secondary adjustments in MAP cases

Because a primary adjustment is made to a single taxpayer’s results, it in itself creates potential double taxation. Courts recognized early on that this was inappropriate, and Regs. Sec. 1.482-1(g)(2) now requires the IRS to make appropriate correlative allocations (e.g., if the foreign party’s income is increased, the U.S. parties’ income must be decreased). Of course, the U.S. correlative allocation does not mean that the counterparty can realize the benefit of an offsetting adjustment for foreign tax purposes. That is where MAP comes in.

The primary adjustment also creates a discrepancy between the taxpayer’s book position (which reflects the results of its unadjusted transfer pricing) and its tax position (which reflects the adjustment). While this disparity is effectively ignored by many countries, the United States requires the disparity be addressed through yet another adjustment, referred to as a “secondary” or “conforming” adjustment. For a global survey of secondary adjustment rules by country, see Foley, Taheri, and Sullivan, “Countryby- Country Survey of Global Secondary Adjustment Rules,” 103 Tax Notes Int’l 29 (July 5, 2021).

The U.S. secondary adjustment concept eliminates the book-tax discrepancy in one of two ways: (1) by inferring one or more deemed transactions that align the tax position with the book position, or (2) through the movement of funds aligning the book position with the tax position. These secondary adjustments can trigger significant tax consequences (e.g., withholding tax on a deemed distribution) and must be carefully considered.

In the absence of any action by the taxpayer, the creation of deemed transactions (specifically, deemed distributions and/or deemed capital contributions) is the default treatment under Regs. Sec. 1.482-1(g)(3). In lieu of this default treatment, eligible taxpayers can elect to repatriate funds under Rev. Proc. 99-32, thereby aligning book positions with adjusted tax positions. Repatriation accounts established under Rev. Proc. 99-32 bear interest from the beginning of the year after the year to which the primary adjustment relates and must be satisfied within 90 days to avoid application of the default treatment. When the primary adjustment is made after a lengthy audit and relates to an older year, the interest component can be significant. However, Rev. Proc. 99-32 does not directly apply to MAP or advance pricing agreement cases.

When taxpayers are in MAP, Rev. Proc. 2015-40 allows them to apply for “competent authority repatriation,” which is effectively the same as Rev. Proc. 99-32 repatriation, with the potential for one substantial benefit: The terms of repatriation are whatever is agreed to by the competent authorities. In practice, this generally means that repatriation accounts established pursuant to MAP do not need to bear interest. Competent authority repatriation must be requested in writing before the competent authorities reach a tentative resolution. If it is not timely requested, normal repatriation under Rev. Proc. 99-32 remains available via Rev. Proc. 2015-40.

Alternatively, the U.S. competent authority may allow the primary adjustment to be “telescoped” into a current-year tax return, which effectively eliminates the need for a secondary adjustment. While telescoping is generally acceptable for years after the implementation of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97 (i.e., years beginning after Dec. 31, 2017), telescoping can pose challenges when the years covered under the MAP span both pre-and post-TCJA years, as reflected in IRS telescoping guidance from 2020. It is important to discuss the possibility of telescoping the adjustment with the U.S. competent authority during the MAP proceedings to ensure all stakeholders’ views are understood before negotiations are finalized.

Seeking the best option

Taxpayer-initiated adjustments are an important tool for avoiding potential transfer pricing penalties, and MAP is an important tool for addressing the double taxation that taxpayer-initiated adjustments can create. The collateral adjustments that follow from primary transfer pricing adjustments — whether they are IRS- or taxpayer-initiated — can themselves have material tax consequences, which must be carefully considered. In MAP cases, competent authority repatriation offers one means of addressing secondary adjustments with minimal tax consequences, but the best option for secondary adjustments will depend on the facts of the taxpayer’s case.

Editor notes

Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C. Contributors are members of or associated with KPMG LLP. For additional information about these items, contact Van Leuven at mvanleuven@kpmg.com.