“We have been thinking about this issue since mid to late summer, and we have started to field a fair number of enquiries,” said Craig Sharon, director of the APA program.
“The issue is starting to come up in some competent authority discussions and we are starting to get new APA applications that deal directly with the situation.”
So far, the taxpayers that have requested a change have been impressed with the attitude of the officials.
“They are being extraordinarily accommodating,” said one senior DC adviser of the officials’ recent dealings with a major US corporate client. “They are trying to update the comparables and are being extremely indulgent.”
The APA program is, however, yet to allow a change to any agreement.
“We are still feeling our way. We have formed a special group of experienced economists and team leaders within the APA program to keep track of the requests and our reactions to them to help develop consistent positions as things evolve,” said Sharon. “To date no requests to alter existing APAs have been granted.”
Guidance from the IRS states that an APA may be altered by agreement between the taxpayer and the tax authorities, consistent with the principles set forth in revenue procedure 2006-9 and the interests of sound tax administration. Each APA relies upon certain specified critical assumptions that are material to an agreement’s transfer pricing method. Taxpayers seeking to convince the program to reopen an APA may try to persuade the officials that the economic downturn has triggered a violation of the agreement’s critical assumptions. If an APA’s critical assumption is violated, it is either renegotiated or cancelled.
Taxpayers seeking to prove that a critical assumption violation has occurred must demonstrate that a material change to the business activities has occurred, rather than a mere change in business results, which makes the situation more complex.
“I think you used to see some time ago, a lot of critical assumptions about changes to economic conditions,” said Mark Bronson, who spent two years as a lead economist with the APA program and is now with Ceteris. “But I think that in more recent years you saw a real push towards having very quantifiable, measurable critical assumptions so if you are going to say “major change in economic conditions”, you needed to say what that meant, is this an x% drop in GDP or a y% drop in sales, what is it exactly?”
To the extent that taxpayers have negotiated those kinds of provisions in their agreements, they may have been triggered for some taxpayers and action to change the agreement may be possible.
“I think that generally speaking the APA program is going to be quite hesitant to modify existing agreements that didn’t have those provisions,” warned Bronson.
Bronson’s expectations are confirmed by Sharon.
“In the US, a mere change in financial results is not generally going to trigger a critical assumption,” said Sharon. “But if a company completes a merger, discontinues a business or files for bankruptcy, those all have the potential of triggering a critical assumption. So far people haven’t come in under those circumstances. They are simply saying they can’t meet their profit targets because the economy is so bad.”
The APA program has four options to deal with each case.
It could do nothing for any number of reasons. The transfer pricing method may not require adjustment, the taxpayer’s industry may not be suffering or the general transfer pricing method may allow for enough fluctuation in results as it is.
It could shorten the APA term, cutting it off at a stage before the downturn became really significant.
It may hold the case and wait for more current financial data to become available so the taxpayer can update the analysis and incorporate it into the general method.
It could do something unusual, something out of the ordinary to accommodate the change in circumstances, such as expand the range, or lower it, or use financial data from the last recession and include that in the analysis when setting the range and so on.
Because of all the choices for potential action, it means the process of getting a decision can be long. The best solution all-round has to be found.
Taxpayers cannot expect the Program to be too welcoming of change to the agreements, and both sides will have to make concessions.
“The authorities will be looking for a symmetrical solution,” said Bronson. “After all, if conditions had been the reverse and times had suddenly been a lot better, no one would expect to see a lot of taxpayers going to the APA program to say: ‘we’re not paying enough, please revise our agreement.’ So to some extent this is the downside of an APA, there are going to be companies that are held to agreements and held to a standard that they might not have been held to if they weren’t in an APA and were just trying to justify results to the field.”
“My experience with the APA office is that they are keenly aware of that and very sensitive to it,” said another tax professional. “And they are not the only ones, other countries are very aware of the adverse impact of the adverse economic circumstances that we find ourselves in and are making adjustments. That is the way the system is supposed to work.”
“All countries are aware of the potential need to be flexible with APAs,” said Sharon.
Taxpayers need to be extremely diligent in the information they set out for the program when asking for a change to their agreements.
For taxpayers with an existing APA which has terms they have come to find onerous because of a significant change in economic conditions, the advice is to first of all look at the critical assumptions to see whether there is something within those that would allow new discussions.
“[If that is not the case], I would advise them to undertake research to look for evidence of third-party deals that have been changed and use that in support of their application or request for an amendment to their agreement,” said Bronson.
“The APA Program very much wants to capture and embody the principle of arm’s-length behaviour, so if you present evidence that, under broadly similar changes and circumstances, there have been material changes to agreements where one party could have enforced it but agreed not to because of changes in economic conditions, then I think that is excellent evidence of third-party behaviour showing recognition of the fact that the existing agreement was unsustainable.”
“To the extent that [you can show] examples of agreement changes within your industry or within a broadly similar transaction structure, that’s even better,” he added.
Taxpayers considering entering into new APAs need to negotiate carefully. They can have pre-filing conferences with APA program officials to address their economic situation. The APA program will not commit to any provisions at the conference, but may indicate what their response will be to positions that the taxpayer may take in official negotiations.
“Taxpayers need to consider whether or not this is the best time for them to be in an APA,” said Bronson. “There are obviously upsides and downsides to being in an APA. If you go into the program and you are able to get to a negotiated solution that you feel is reasonable given the economic conditions you are going to face for the next few years, then good for you.”
“However, there may be taxpayers who wish to just take things through audit for the next few years while economic conditions settle and become clear before they enter into an APA, hopefully during a period that is more stable.”
For now, in the absence of other considerations and in the interest of symmetry and fairness, it is expected the APA Program will generally hold taxpayers to their agreements unless they can show compelling third-party evidence that the agreement should be modified.
The burden of convincing the IRS that the APA file should be reopened is firmly with the taxpayer and if the program agrees to an amendment, it must include reciprocal concessions by taxpayers in future years when economic conditions improve.
“If we are going to do something unusual today, when the economy turns around we are going to look to see if something needs to be done on the upside,” said Sharon.
“It depends on whether we do anything and what we do,” he continued. “When the economy turns around, we will have to work to make sure taxpayers don’t get the benefit of the bad years twice. For example, if we broadened the range to allow for more volatility at the lower end, we will want to keep the range broad when the economy turns around to allow more profit on the upside. Similarly, if we accelerate the current 'bad' financial data into the analysis, we'll want to accelerate 'good" financial data in the future.”
