This article originally appeared in the June 27, 2005 edition of Tax Notes.
"The National Office negotiates as if IRS needs the APA more than the taxpayer does."
That is an IRS agent complaining about the generous dealmaking in the IRS Advance Pricing Agreement Program, wherein the IRS cuts transfer pricing deals with large corporate taxpayers. That's the sort of damaging information that is contained in the recently completed draft of the long-awaited report on the Senate Finance Committee investigation of the APA program. The draft is being reviewed on Capitol Hill pending final release and possibly a Senate hearing.
Separate-company accounting, the arm's length method, and transfer pricing are all basically unenforceable, and the APA program has been a fig leaf for the legislative and executive branches to avoid admitting that it doesn't work. That's all well and good -- other OECD countries are doing the same. The problem, as the draft report points out using case studies (drawn from real cases), is that the program is badly managed, and the IRS is giving away the store. No wonder the program is hugely popular with taxpayers and practitioners, as public hearings earlier this year showed. (For the unofficial transcripts.)
The IRS is afraid of the report, and IRS officials have been trying to minimize the significance of the Senate investigation ever since it started. Yet the report was widely expected to be a whitewash, since senators on both sides of the aisle like the APA program because business likes it. The Court of Appeals for Aggrieved Business is not about to kill a program that business is happy with. So the draft report attempts to balance the good aspects of the APA program with the rather significant bad aspects.
The draft report shows that although the APA program has provisions for taxpayers to be kicked out, and some have abandoned APA requests because of delay, only a handful of taxpayers have been kicked out. By and large, every taxpayer that comes into the program goes away with a sweet deal. There have been nearly 600 APAs completed, and the IRS seems to take pride in bragging about the number of agreements.
How sweet? Senate investigators looked at foreign-parented companies that were fingered in 1990 at the so-called Pickle hearings for not paying tax because of transfer pricing. Some companies are still not paying tax, only now they have the imprimatur of the APA program. (The late J.J. Pickle was in 1990 the Chair of the House Ways and Means Subcommittee on Oversight.
Moreover, the nonpaying companies' home countries go to bat for them. Those countries have learned that stonewalling American competent authorities usually results in a concession because American negotiators are terrified of double taxation, particularly when the taxpayer is an American company. Other countries, unburdened by religious qualms about taxation of the same income twice, hold out for a number that requires American negotiators to give up U.S. revenue. And they do concede, resulting in a subsidy to foreign governments through lost revenue and foreign tax credits to boot, as the draft report shows. Which countries were jerking the Americans around? The largest U.S. trading partners.
Nor is the IRS much more competent at negotiating unilateral APAs. Senate investigators found that pushier taxpayers got better deals, and got transfer price breaks. Investigators found that the IRS knowingly allowed some taxpayers to set their transfer prices at a discount below comparable uncontrolled prices. Of course, arm's length pricing dogma requires that prices be set at the comparable uncontrolled level. But dogma seems to go out the window when an APA has to be pushed out the door. Senate investigators also found a revolving door of APA officials going into the private sector, and some back scratching.
How much money is going out the door through the APA program? The IRS doesn't really know, because there is no dollar figure put on APAs. That is, not only is the IRS not quantifying the tax cost of each of the agreements, but also it is not even attempting to quantify the total value of controlled intercompany transactions covered by each agreement.
The revenue loss has got to be massive. Huge financial intermediaries have gotten APAs covering billions of dollars worth of transactions. Senate investigators could not quantify the lost revenue, but they confirmed the fact of the loss by looking at tax returns.
The draft report makes some recommendations for improving the APA program. Few of them will go down well with taxpayers, who are being very protective of their sweet deals.
The draft report recommends that the IRS put a dollar figure on the controlled intercompany transactions covered by each APA. As previously stated, there is no attempt to quantify the transactions covered now, so the IRS does not even know how much money it is giving away. The IRS would not be expected to calculate the revenue loss from each deal, given the variability due to taxpayer net operating losses, foreign tax credits, etc., but only the dollar amount of transactions covered.
There are some procedural recommendations that are likely to be adopted. Senate investigators noted that bilateral APAs for American companies involve two lengthy and duplicative negotiations. First, the taxpayer negotiates with the IRS APA office, which usually adopts the taxpayer's position as its negotiating position. Then the IRS APA office hands off the case to the competent authority. The competent authority does what it can, with no taxpayer input. That second negotiation is likely to produce a result very different from the first negotiation.
So the draft report recommends that the taxpayer directly plead its case to both competent authorities at once, as is done in some European countries. The draft report also suggests increasing the fees charged for APAs, with the extra revenue dedicated to the program. The IRS acknowledges that fees are too low. Taxpayers, practitioners, and the IRS itself have called for more resources for the program.
Taxpayers have complained about delays in getting APAs, even though Senate investigators found IRS officials signing off on APAs in a hurry in their anxiousness to make a deal and show a good number of deals completed. The draft report recommends that both sides be able to take the case to baseball arbitration if either side is found to be dilatory in meeting deadlines. (In baseball arbitration, each party chooses a number and the arbitrator selects one of those numbers.) The IRS says that it will attempt to set deadlines, but without the threat of arbitration.