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APMA Wary of Creative COVID-Related Transfer Pricing Positions

Posted on Mar. 8, 2021

The IRS’s advance pricing and mutual agreement program is aware that taxpayers are taking some creative positions regarding the classification of costs related to the COVID-19 pandemic, including categorizing costs as extraordinary expenses.

According to John Hughes, director of the IRS’s APMA program, the questionable treatment of COVID-related costs is one of the issues the U.S. competent authority is starting to see more frequently. Speaking during a March 5 virtual tax law conference held by the Federal Bar Association, Hughes said some taxpayers have been trying to classify costs as nonoperating items in an attempt to improve the controlled party’s operating profitability for purposes of a comparable profits method or transactional net margin method analysis.

“We’re seeing this issue arising more and more — no doubt it’s because companies are now looking at 2020 and digesting the full scope of issues that they need to grapple with going forward,” Hughes said. “We are seeing some creativity, if you will, surrounding the categorization of expenses. And, of course, that can make the difference between meeting that applicable quartile of a range and not, and thus [requiring] a compensating adjustment or not.”

According to Hughes, another frequent issue associated with the pandemic involves taxpayers with an advance pricing agreement nearing the end of its term. Hughes advised taxpayers with APAs not to raise COVID-related issues with APMA prematurely, but added that they should avoid taking steps that complicate bilateral competent authority negotiations in the meantime.

“One thing that we ask that you don’t do is, in a sense, try to take a position that, if you will, kind of anchors one side versus the other. Importantly, the two competent authorities are likely going to need to come together to find a solution,” Hughes said. “If a taxpayer takes a position that leans very heavily toward one country versus the other, that can complicate — that will complicate — the competent authority discussions.”

The classification of expenses and the effect of the pandemic on APAs are among the subjects addressed in the OECD’s December 2020 guidance note on the transfer pricing implications of COVID-19. Regarding another issue raised in the guidance note, Zeb Kelley, senior counsel for branch 6 of the IRS’s Office of Chief Counsel, said identifying examples of independent parties that invoke force majeure or otherwise terminate arm’s-length contracts does not establish that a controlled party can do so under the arm’s-length standard.

“The right question, in my mind, is not necessarily whether you can point to uncontrolled parties who did or did not invoke their force majeure clauses last year. It’s really looking at the particular facts and circumstances of your related parties and asking whether unrelated parties would, in those same circumstances, invoke the force majeure,” Kelley said.

If there is reason to believe that unrelated parties in the same circumstances would not invoke force majeure, it raises questions, Kelley said. Citing the OECD transfer pricing guidelines’ chapter on business restructurings, Kelley added that the arm’s-length standard may require that one of the parties compensate the other for terminating the arrangement.

“If you didn’t have a valid basis under the provision for invoking force majeure, or say you had no force majeure clause and you just decide to break off the deal or renegotiate the deal, I think you have to consider whether at arm’s length you would have to pay an indemnification fee to your counterparty for breaking off the deal or renegotiating it. And the amount of that fee would have to be arm's length,” Kelley said. “If you invoke force majeure, you break off the deal, [and] then later on you enter a new deal with your affiliate — say, when conditions in the market have improved some — you have to think about the pricing of that new arrangement and what the arm’s-length terms of that new deal would be.”

Kelley also noted that the IRS is eager to return to the process of finalizing some version of the expired 2015 aggregation regulation and updating the section 482 regulations to reflect the Tax Cuts and Jobs Act. “Hopefully, as part of that project, it’s a little more than just making housekeeping [changes] to definitions in the regs, and we can maybe go a little deeper into certain areas that could be helpful to taxpayers and the Service,” he said.

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