How to Get on the Same Page as the Taxman

More companies are looking to make deals with tax authorities on transfer-pricing terms to avoid unexpected penalties, tax advisers report.
Sarah JohnsonOctober 20, 2009

Charlie Brown’s sister should have been a tax authority. When badgering her brother into writing her Christmas list, Sally made a memorable declaration that would resonate with any taxman: “All I want is what I have coming to me. All I want is my fair share.”

Indeed, tax authorities are increasingly insisting that they get their piece of the pie as they step up enforcement efforts over transfer pricing, or the pricing of sales and services between a company’s subsidiaries. These transactions in particular have caught the eye of international tax authorities whose coffers have dwindled as the global economic crisis shrunk the revenue of multinationals and, subsequently, their taxable income.

The authorities “want to make sure they definitely get their fair share as their tax revenue is going down,” David Canale, director of Ernst & Young’s transfer-pricing controversy services, tells Moreover, as one jurisdiction gets more aggressive, others seem to jump on the bandwagon as well, to fight for any taxable dollars that could get lost in the push-pull involved in transfer-pricing disputes.

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To mitigate their risk of unexpected penalties for transfer pricing that an overseas or domestic tax agency may deem unfair, inaccurate, or even fraudulent, companies are increasingly pursuing advance pricing agreements (APAs) with U.S. and international tax authorities to lock in some tax certainty for a specific period of time, say tax advisers. Canale says these agreements cover at least 5 years’ worth of taxes, and sometimes as much as 10 years.

Last year the Internal Revenue Service received 123 APA applications, the most since its program began in the early 1990s. Companies that have entered into APAs or are in the process of negotiating with the IRS include Abercrombie & Fitch, Ford, Hewlett-Packard, Kellogg, Oracle, Skechers, Tempur Pedic, and Warner Chilcott (which all declined or did not respond to’s request to comment for this story).

In a recent report detailing the trends of how 49 countries oversee companies’ transfer-pricing practices, E&Y said international tax authorities have transfer pricing high on their priority list, with some of them adding staff focused solely on the issue. Although the transactions are considered complex, they’re an easy target for tax agencies: their terms are subjective, and they’re “low-hanging fruit,” says Larry Harding, president of High Street Partners, an international business-expansion consultancy.

Transfer-pricing rules require that intercompany transactions made across borders be conducted at arm’s length. In other words, one business unit must charge its sister business unit the going market rate for its services. Tax authorities are on the lookout for misreported taxable income from these transactions recorded to raise or lower the profits of a particular unit, depending on whether the business is located in a low- or high-tax country.

Companies agree to meet the taxmen halfway, so to speak, for an APA in order to prospectively avoid a disagreement, or even to resolve a transfer-pricing dispute that has already arisen. Once an APA — either a unilateral agreement between just the IRS and the company or an agreement including one or more other countries besides the United States — is reached, the corporate taxpayer has a binding contract from tax authorities on how to structure a specific transaction. In return for some time-consuming effort on the companies’ part, they get “cost certainty,” says Harding.

It does appear to give CFOs some assurance. For instance, pharmaceutical company Warner Chilcott entered into an APA with the IRS last year for 2006 through 2010. Without the deal, CFO Paul Herendeen implied in a conference call with investors, his company’s future tax liability would not be known. However, “with that agreement in place, I think we have a reasonable degree of confidence that we can sustain what we view as a very attractive cash tax rate, for the foreseeable future.”

Still, there’s a downside: APAs cost money and time. The fee to enter the IRS’s program is $50,000 for large companies. Plus, companies have to undergo lots of information sharing with the tax agencies, which may require the time of not only tax directors but also executives in other departments, such as human resources or operations.

Companies that expect to restructure in the near term or do anything that could change their transfer-pricing methodologies within the next two years are advised not to bother. E&Y says the IRS takes an average of 21.5 months to complete a unilateral APA and 38.1 months for a bilateral APA. The agency was able to process only a little more than half of the applications it received last year, though Canale says processing was slower than normal because the IRS was short on resources.

The agency expects to hire 800 more people in its enforcement division during the next year, depending on the outcome of the next federal budget. While these staffers won’t be handling APAs, many are expected to concentrate on scrutinizing transfer-pricing practices. And E&Y suggests the increase in the number of enforcers could give companies more reason to try to head off potential disputes by considering whether an APA is worth going after.

However, not all countries offer APAs. Austria, Brazil, and Denmark don’t, and India is just now considering establishing a program. Where APAs are available, industries that are especially keen on them include automotive, consumer products, financial services, oil and gas, and pharmaceutical, E&Y found.

Location is a factor in other ways as well; for example, Japanese authorities have been pursuing medical devices and technology-related industries, and transactions conducted in low-tax jurisdictions are more likely to attract scrutiny.


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