Deloitte Tax Testifies on APAs Before IRS

Dear Messrs. Korb, Hicks, and Frank:

These comments are being submitted in response to the Announcement 2004-98, 2004-50 I.R.B. 983 (Dec. 13, 2004). Public comments and suggestions were requested with respect to the operation of the Advance Pricing Agreement (APA) Program within the Office of Associate Chief Counsel (International). Accordingly, the present comments address these and some of the issues raised by the Senate Finance Committee Chair Charles E. Grassley, and ranking minority member Max Baucus, in their letter dated January 28, 2005.

Thank you for the opportunity to participate in this dialogue and provide our comments with respect to this important government program. My comments today are based on my firm's current involvement in over 50 APA cases.

General

As a baseline comment, I want to emphasize that the APA Program is still the most principled and business-like forum in which to develop and resolve transfer pricing issues. As we focus throughout the day on ways to improve the APA Program, it is important that we be mindful that it remains the best alternative for difficult transfer pricing cases.

Comments and Suggestions

APA Program Accessibility

Overall, we have no problem with the accessibility of the APA program. The informal nature of the pre-filing process and the ability to have anonymous pre-filing conferences makes the program extremely accessible. There are not many other government programs that allow a taxpayer to call on the telephone to talk about issues, come in and meet -- all without disclosing the taxpayer's identity. Anonymous pre-filing conferences are very important to taxpayers concerned about sharing their information.

However, the accessibility of the APA program can be improved in some areas. Probably the biggest obstacle to the accessibility is the relative cost of the APA program for smaller taxpayers. User fees and substantial professional fees are not an insurmountable obstacle for larger taxpayers. On the other hand, the relative costs of the APA Program present a significant obstacle for smaller taxpayers. I will discuss below some suggestions for the small business taxpayer (SBT) APA procedures.

The APA staff has been very generous at providing outreach to taxpayers, making sure that they understand how the APA process works, what it provides for the government, and how that balances with the taxpayer interests. I hope the APA staff continue to speak and continue to be involved in professional activities, because it really does help taxpayers get comfortable with the APA process.

Timeliness and efficiency

Timeliness and efficiency are areas that need improvement. The two most prominent areas for improvement are APA staffing and travel budget. Additional improvement could be achieved in processing of renewals and coordination between APA and competent authority staff.

Staffing. Practitioners in the area are increasingly concerned that the APA Program does not have enough staff to deal with the growing number of cases. Compared to nearly 22 employees just about a year ago, the APA Program now has only 17 members. With some of the additional support requirements necessary for dealing with the Senate Finance inquiry and for coordination within the IRS, returning to the previous high level of staffing at 22 is advisable.

Travel Budget. The current APA Program travel budget is woefully inadequate. The current travel budget is around $90,000. To provide some perspective on these figures, I have been involved in a single case where the other government had more than $60,000 in travel budget. APAs are very factual in their development, particularly when difficult issues like valuable intangibles are involved, and there is no substitute for actually seeing how the taxpayer's business works. By not being able to travel, the IRS risks prolonging the negotiation process because of lack of mutual understanding regarding the facts and could place itself at a disadvantage in bilateral negotiations.

Joint site visits contribute to overall APA Program efficiency. Absent joint site visits, the position papers could be drafted based upon the differing factual assumptions, and it is very hard to resolve those cases. During joint site visits, any factual disagreements between tax authorities can be exposed and resolved, avoiding factual discrepancies in the drafting of position papers. If the taxpayer wants to be proactive about dealing with a potential difference of understanding of the facts, that can best be dealt with at the site visits -- before either government has finalized its negotiation position.

APA renewals. The APA Program has received criticism because some APA renewal requests involve higher costs and more significant time commitments than the original APA request. This should be a highly unusual situation. The express intention of the APA Program has always been that renewals should "update and adjust" the original agreement. We understand that, on occasion, the APA Program needs to be able to re-evaluate the original APA, but we believe that such situations should be an unusual exception rather than the rule.

Competent authority coordination. APA Program team members and competent authority (CA) staff involved in the APA process should strive to achieve coordination of their respective efforts. It would be helpful if designated APA and CA staff have informal discussions with the other country, even before the APA case is fully developed. This would significantly save time and possibly lead to a better understanding of underlying transactions by the tax authorities (US and foreign country) and the respective responsibility centers within the IRS (APA Program and CA).

One of the biggest bottlenecks in the APA process is the handoff of the case from the APA team leader to U.S. competent authority analyst. Even when both the APA staff and competent authority staff are doing their jobs, the handoff sometimes is poorly timed when it involves the competent authority meetings with other countries. It would be helpful if, throughout the process, an expectation is established regarding timing for handoff of the case. Informal expectations already exist; anything that can be done to formalize the expectation would be helpful.

Industry Guidance. From polling my colleagues, we were not convinced of the need for specific industry development. There has been some recent discussion about addressing the needs of the financial services industry, because there have not been as many APAs in recent years. My general understanding was that the proposed regulations and some of the positions that were established by the APA program in Announcement 94-40 were sufficient and that a lot of companies no longer find it worth the effort and expense of going through the APA process.

On a related topic, I wondered if it might be worthwhile to pursue a cross-industry focus on specific tested-party scenarios. Specifically, you have a significant number of inbound distributor APAs. A lot of those full-fledged distributors use an operating-margin PLI. Without binding any taxpayer to a specific approach like an operating margin, the APA Program could develop a model APA based upon some representative function and risk analysis. Taxpayers would still need to demonstrate that they fit that particular mold, but it might shorten the steps to agreement if taxpayers had some expectation. Obviously, comparables selection could be difficult to generalize, but merely giving some expectation about the functional and risk profiles that would lead into a certain methodology would shortcut some of the early steps in the APA process.

In any discussions of standardization, you at least must acknowledge that one of the things that taxpayers most respect and appreciate about the APA Program is its flexibility. Thus, any attempt to achieve some level of standardization of process must protect the APA Program's ability to be flexible.

Sound Tax Administration

Published guidance. The APA Program has been in existence since 1991 and has accumulated substantial experience in several industries and numerous categories of transactions. In the absence of published guidance, taxpayers are challenged in drafting APA requests and negotiating APAs with the right approach to successfully participate in the APA process. Published guidance could be accomplished and it would be very helpful to taxpayers and the IRS in implementing sound tax administration principles. For example, Announcement 94-40, released in 1994 by the APA Program, was very helpful in understanding the issues in the financial services industry and at least one approach that taxpayers could take.

The APA Program could release certain methodologies, summarizing the analysis in concluded APAs. Published guidance will create certain expectations by taxpayers and contribute to the achievement of more efficiency in the APA process. I do not think there is any real downside to the APA Program of publication.

One recent example we have encountered is the APA economists' interest in five-year comparables for comparison rather than three years that might be anticipated by the regulations. That was explained as a reaction to the fact that some of the most recent years would include recession years, and so the five years was an attempt to pull in a more robust set of comparables on which base the APA. That concept made sense, and it would be helpful if those kinds of things might be available to taxpayers that are not in the APA process, just to understand current IRS thinking.

Geographic specialization of APA team leaders. Providing APA team leaders with responsibility over specific geographic area similar to the competent authority staff could improve the APA Program. Currently, there is no geographic specialization among the team leaders for a geographic area to equip a team leader to efficiently negotiate an APA. Such team leader could also be a focal point of contact with respect to APA requests filed by taxpayers from different geographic areas. This suggestion could reduce the time necessary to complete an APA and will further promote the APA process efficiency.

Arm's length standard. In the past, the APA Program has sometimes agreed to APAs that employ something other than an arm's length range -- "floors and ceilings". I have had floors and ceilings proposed in a number of APAs. Increasingly, with the regulations aside, our greatest concern was if another country became aware of a unilateral APA that used a floor, they might think the IRS was not as principled as previously thought. In my experience, the floor and ceiling were only used in unilateral APAs, because the other countries would object in bilateral negotiations. I find hard to support anything in a unilateral APA that could not be done in a bilateral APA.

Small Business Taxpayers. I have some concrete suggestions. First, expand the small transaction exception to $100 million. It's now at $50 million. Although that covers a lot of taxpayers, there are a lot of inbound companies or inbound transactions with between $50 million and $100 million that are truly simple transactions.

Second, give specific responsibility within the office to a dedicated group of people interested in SBT APA, and it would be helpful if there was some involvement by people that are responsible for reviewing the annual reports.

Third, more standardized practices are advisable with regard to SBT APAs. The submission structure, a checklist, and an ordering of how the submission ought to be done should be standardized so that the APA team can always find the relevant discussions. A standardized time frame already exists, and there is general expectation regarding one post-filing meeting and a couple of sets of questions, but maybe that expectation ought to be more formalized. Also, as is in the current procedure, the use of the very substantive pre-filing should be used to set the expectations for SBT APAs. In addition, I recommend that the IRS experiment with bilateral SBT APAs. Other countries are interested in it. It is just the matter of agreeing to a definition of a "small" taxpayer with some of these other countries.

Finally, there ought to be goals regarding the cost to taxpayer, and part of the responsibility rests with practitioners. I think the goal ought to be that the cost of a small business taxpayer APA, including professional fees and user fees, ought to be about the same as the cost of five years of documentation.

Critical assumptions.

We do not believe that any change is necessary to the standard APA, including the critical assumption language. As a practical matter, taxpayers are seeking certainty in the APA process, and every new critical assumption reduces that certainty. As long as APAs are renewed, the impact of any unusual circumstance should be minimized in the long run. Should any additional critical assumption be desired to deal with large swings in economic activity, we suggest a simple critical assumption regarding percentage change in gross revenue.

Consistent treatment of similarly situated taxpayers

The APA Program should continue to do just what it is doing to achieve a consistent treatment of similarly situated taxpayers. You can be in the same industry, but the internal circumstances of the risks and the functions can be extremely different even in the same industry. The flexibility that the APA program retains now is something that all clients expect. Even if two different taxpayers are in the same industry, it does not necessarily mean that they should get the same result. That is what functional analysis and risk analysis intended to accomplish, and that is why you need to go through that in each case.

Conclusion

To conclude, we would like to emphasize two major achievements of the APA Program:

Kerwin Chung, Deloitte Tax LLP

Richard McAlonan, Deloitte Tax LLP