By Craig A. Sharon, Esq.
Bingham McCutchen LLP, Washington, DC
An Advance Pricing Agreement (APA) typically covers some future transactions. Ordinarily, those future transactions are of the same type and involve the same assets, functions, and risks as past transactions of the taxpayer. An APA might cover, for example, two past years and three future years of a U.S. company's purchases of finished goods from its foreign parent. The APA will apply to the future years as long as the facts and law remain materially the same.
But must the future transactions be of a continuing nature? Or can an APA cover transactions that have not been entered into at all, and that may not be entered into unless the APA is granted? This latter question is not purely hypothetical. Based on personal experience as APA Director and since leaving the APA Program, the issue has been raised by both taxpayers and elements within the IRS on different occasions.
This commentary addresses the legal authority of the Advance Pricing and Mutual Agreement (APMA) Program1 to accept APA requests covering purely "prospective" transactions (i.e., transactions that will not be completed until the terms of an APA are agreed). This specific legal authority is to be distinguished from the APMA Program's broad discretionary right to reject a case within its jurisdiction in the interest of "sound tax administration,"2 a case-specific question that is beyond the scope of this commentary. The key procedural rules that delineate the IRS's legal authority to consider prospective transactions do in fact support a broad interpretation of the APMA Program's authority to do so. In fact, it is difficult to understand on what basis the contra view could be taken.
Unlike APA programs in many foreign countries, the IRS APA Program was not expressly created by statute. That fact has created some uncertainty over the years about, inter alia, the original source of the APA Program's authority and the proper characterization of an APA as a closing agreement, a letter ruling, or a special kind of enforceable "non-statutory" agreement. As interesting as these questions are as a matter of administrative law, no one inside or outside the government has seriously challenged the APA/APMA Program's basic legitimacy or the general enforceability of an executed APA, either for taxable years completed and filed when the APA is executed ("filed" or "past" APA years) or for later taxable years (i.e., "unfiled" or "future" APA years).3 That legitimacy does not answer the question, however, of whether an APA may cover purely prospective transactions. On that specific question, the available rules and regulations establish that it does:
General IRS Authority
The IRS's authority to enter into APAs and similar agreements having prospective effect is conferred generally by §7805(a) of the Internal Revenue Code (IRC). Section 7801(a) provides that the administration and enforcement of the IRC shall be performed by and under the supervision of the Secretary of the Treasury. Section 7805(a) then provides in relevant part that "the Secretary may prescribe all needful rules and regulations for the enforcement of this title, including all rules and regulations as may be necessary by reason of any alteration of law in relation to internal revenue." Through Treasury Order No. 150-10 (dated Apr. 22, 1982) (formerly Treasury Order 150-37, renumbered in 1987), the Secretary has delegated the authority granted under §7805 to the Commissioner of Internal Revenue. Treasury Order 150-10 provides that the Commissioner shall be responsible for the administration and enforcement of the Internal Revenue laws.
Congress has made clear that the Secretary, acting through the Commissioner, has authority to cover prospective transactions on a taxpayer-specific basis. Section 7121 provides express authority to the Secretary of Treasury to enter into "an agreement in writing with any person relating to the liability of such person … in respect of any internal revenue tax for any taxable period." (Emphasis supplied.) The regulations under §7121 specifically provide as follows:
In general. The Commissioner may enter into a written agreement with any person relating to the liability of such person (or of the person or estate for whom he acts) in respect of any internal revenue tax for any taxable period ending prior or subsequent to the date of such agreement. A closing agreement may be entered into in any case in which there appears to be an advantage in having the case permanently and conclusively closed, or if good and sufficient reasons are shown by the taxpayer for desiring a closing agreement and it is determined by the Commissioner that the United States will sustain no disadvantage through consummation of such an agreement.
Regs. §301.7121-1(a) (emphasis supplied).4
Specific Programs with Prospective Jurisdiction
Pursuant to this extensive general authority, the IRS (including Chief Counsel) has developed various programs designed to deal with prospective transactions. As set forth in the applicable public guidance, each of these programs is subject to different procedural rules. The IRS thus has broad legal authority to handle prospective transactions and it exercises that authority differently depending on the situation and context. The overriding principle, and repeated refrain in the guidance, is that the IRS will exercise its authority in the "interest of sound tax administration."
The first IRS revenue procedure published each year is the annual revenue procedure that explains how the IRS provides advice to taxpayers in the form of letter rulings and other written determinations on issues within the jurisdiction of the Chief Counsel. See, e.g., Rev. Proc. 2012-1, 2012-1 I.R.B. 1. The revenue procedure defines a "letter ruling" as a "written determination issued to a taxpayer … in response to the taxpayer's written inquiry, filed prior to the filing of returns or reports that are required by the tax law… . " Id. at §2.01. There is no requirement that the transaction at issue be completed before the request for a letter ruling is filed or even before the ruling is issued. In fact, it is common for taxpayers to condition (without IRS objection) the completion of a transaction that is the subject of a ruling request, such as a tax-free spinoff or reorganization, on the receipt of a favorable ruling.
The IRS revenue procedure governing pre-filing agreements (PFAs) allows large taxpayers to resolve certain taxable issues for multiple years, including a limited number of future years, prior to filing their tax returns. The current PFA revenue procedure, Rev. Proc. 2009-14, 2009-3 I.R.B. 324, states that "[u]nlike letter rulings and other forms of written advice …, a PFA does not determine the tax treatment of prospective or future transactions or events, but only of completed transactions or events whose tax treatment has not yet been reported on a return." Id. at §1.02. Thus, in the case of PFAs, the IRS makes a clear distinction between prospective transactions and completed transactions, with the latter, but not the former, eligible for PFA treatment. Id. at §3.08(13). Rev. Proc. 2009-14 describes a PFA that addresses future taxable years as a "non-statutory agreement" that is distinct from both "letter rulings and other forms of written guidance" and closing agreements issued under §7121. Id. at §§3.08(13) and 7.02(2). Notably, transfer pricing issues are not eligible for PFA treatment. Id. at §3.08(1). On those issues, Rev. Proc. 2009-14 refers taxpayers to the APA revenue procedure. Id.
The U.S. Competent Authority has issued its own revenue procedure setting forth the operating rules for taxpayers requesting Competent Authority relief to avoid double taxation under U.S. income tax treaties. See Rev. Proc. 2006-54, 2006-49 I.R.B. 1035.5 All such treaties include a Mutual Agreement Procedure (MAP) article that authorizes the two taxing authorities to "endeavor" to resolve double-tax disputes that arise under the treaty. Two points are worth noting about the U.S. Competent Authority's authority to consider prospective transactions as part of the mutual agreement process:
First, in the absence of express statutory authority and as a supplement to the IRS' general administrative authority described above under §7805(a), the IRS determined that the U.S. Competent Authority's authority to enter into bilateral APAs was derived from the MAP article in U.S. treaties. Although that determination rested on a liberal interpretation of the entire MAP article,6 paragraph 1 of the article lends specific support to the position that the U.S. Competent Authority can deal with prospective transactions:
Where a person considers that the actions of one or both of the Contracting States result or will result for him in taxation not in accordance with the provisions of this Convention, he may, irrespective of the remedies provided by the domestic law of those States, present his case to the Competent Authority of the Contracting State of which he is a resident or national. [Emphasis added.]
Second, Rev. Proc. 2006-54 has long applied different procedural rules to double-tax cases and APAs. For the former cases, the IRS has chosen to limit its authority regarding prospective issues. The accelerated competent authority process (ACAP) allows the IRS to roll forward a MAP agreement - from filed years covered by an audit adjustment - only to subsequently-filed years, and not to unfiled years. Rev. Proc. 2006-54, §7.06. For future-year issues, Rev. Proc. 2006-54 - like the PFA revenue procedure - refers taxpayers to the APA revenue procedure and places no limits on that jurisdiction. Id. at §§4.06 and 7.04.
Thus, APMA Program jurisdiction to cover prospective transactions in bilateral or multilateral APAs - i.e., APAs that reflect agreements entered into pursuant to MAP provisions - arguably is treaty-based. The APA Program recognized this source of its authority in the first APA revenue procedure, Rev. Proc. 91-22, 1991-1 C.B. 526:
Where any of the parties to a [APA] request are entitled to seek relief under the mutual agreement provision of a tax treaty between a foreign country and the United States, the competent authorities may enter into agreements concerning the APA. Requests similar to APA requests that are initiated through treaty partners and submitted to the U.S. competent authority will be processed under this revenue procedure.
Id. at §7.01.
The APMA Program cannot and does not, however, rely on this authority to enter into unilateral APAs (i.e., agreements between the taxpayer and the IRS only). As discussed below, the APMA Program derives its authority to enter into unilateral APAs from the general IRS grant of authority identified above.
The foregoing discussion demonstrates that the IRS has broad general and specific legal authority to deal with future events, including prospective transactions. In some instances, the IRS has elected to limit its authority by adopting restrictive rules as a matter of general policy (e.g., the U.S. Competent Authority's limit on ACAP proceedings to filed years), while in other instances it has preferred to resolve issues on a more flexible, case-by-case basis, but always in the interest of sound tax administration. In none of the above programs does it seem arguable that the IRS lacks the legal authority to deal with prospective transactions, for example, as part of ongoing efforts to improve the efficiency and effectiveness of the international tax enforcement process. The extent to which the IRS has exercised its authority in particular situations and contexts is a matter of administrative discretion. As discussed above, IRS practice appears to vary from program to program.
The APMA Program likewise has been granted specific authority to cover prospective transactions. The APA Program was created for a special purpose, and it has been given exclusive authority to carry out that purpose. The very nature of the Program, including its name, suggests that it would be the most open and flexible in dealing with prospective transactions. In fact, the applicable APA revenue procedure has always contained expansive language about the Program's purpose and included few express limitations on the Program's authority. Various provisions in Rev. Proc. 2006-9 confirm this point:
The second paragraph of section 4.07 provides that the first year of the APA can be "no later" than the actual filing date of the return for such year. That limitation does not preclude a taxpayer from filing its request earlier. In fact, some taxpayers file their APA requests a year or two preceding the first proposed APA year (especially in APA renewals) to accelerate the process and maximize the prospectivity of the agreement. Given the length of time that it typically takes to complete an APA, it is rare that a taxpayer is able to reach an agreement before the beginning of the first APA year, but it is theoretically possible. Indeed, it seems to be contemplated in the case of: (i) small business transactions, which are anticipated to take only six months to complete, id. at §9.02(4); and (ii) simple APA renewal requests, where taxpayers are encouraged to file their requests nine months before the expiration of the original APA term with a promise of expedited consideration in a process that is generally expected to take only 12 months. Id. at §12.01 and §6.01.7
Recognizing that the purpose of the APMA Program is to issue advance rulings on transfer pricing matters and knowing that the IRS in other situations has acknowledged the difference between prospective and completed transactions and expressly limited its authority to deal with prospective transactions in different ways in specific situations, it is virtually impossible not to infer from Rev. Proc. 2006-9 (and earlier APA revenue procedures) that the IRS understands that the APMA Program has broad legal authority to handle prospective transactions (i.e., transactions that are completed only after an APA agreement is reached), subject only to the following expressed, overriding policy consideration:
The [APMA] Program reserves the right not to accept an APA request or to terminate consideration of an APA request if the request or the continued development of the case is contrary to the principles of sound tax administration.
To the extent that the Program has indicated its preference for certain practices (e.g., a preference for bilateral APAs when available, encouragement of pre-filing conferences, continuing taxpayer disclosure obligations even after an APA is executed, etc.), those preferences represent upfront policy decisions about recurring matters, rather than the implementation of a legal restriction on the Program's authority.
Prospective Transactions vs. Hypothetical Transactions
The above discussion shows that the IRS has broad legal authority to cover "prospective" transactions and that such jurisdiction has been conveyed to and embraced by the APMA Program. As noted above, none of the relevant authorities dealing with "prospective" transactions defines the term generally or in connection with specific situations. The PFA revenue procedure comes the closest, distinguishing between "prospective or future transactions" and "completed transactions." If "prospective" means any "non-completed" transaction, then the various references to "prospective" in Rev. Proc. 2006-9 would surely allow APA coverage of a transaction that would not close until the APA is agreed (i.e., a non-completed transaction by definition).
The more important distinction may be between prospective transactions and "hypothetical" transactions. For example, the annual revenue procedure governing IRS letter ruling requests and other written determinations, currently Rev. Proc. 2012-1, provides that the IRS "will not issue a letter ruling or a determination on alternative plans of proposed transactions or on hypothetical situations." Id. at §6.12. No additional guidance is provided in the revenue procedure about the meaning and scope of these terms, but it has generally been interpreted to mean that the IRS will not issue advisory opinions on speculative transactions.
Whatever the precise meaning of the language in Rev. Proc. 2012-1, there is no reason to believe that the restriction on alternative plans or hypothetical transactions is based on a restrictive reading of the IRS's overall legal authority to accept such cases. Instead, the language seems to convey an administrative judgment that accepting such ruling requests may not be, among other things, a good use of IRS resources.
The OECD procedural guidelines for APAs8 suggest that a similar distinction - between prospective and hypothetical transactions - may be relevant to whether a member country's APA program should accept a case. Section 20.d of the guidelines is right on point:
When deciding whether a MAP APA is appropriate, a key consideration is the extent of the advantage to be gained by agreeing a method for avoiding the risk of double taxation in advance. This requires the exercise of judgment and the need to balance the efficient use of limited resources, both financial and human, with the desire to reduce the likelihood of double taxation. Tax administrations might consider the following items as relevant:
* * *
d) Are the transactions in question seriously contemplated and not of a purely hypothetical nature? The process should not be used to find out the likely views of the tax administration on a general point of principle - there are other established methods for doing this in many countries.
This OECD guideline does not suggest that a hypothetical transaction could not be considered under a standard MAP provision, but only that coverage might not be "appropriate." The APA Program could have adopted a similar, non-restrictive administrative guideline, but did not do so.9
Unlike Rev. Proc. 2012-1 and OECD guideline 20.d, the applicable APA revenue procedure has never incorporated language limiting the types of prospective cases that the APA Program could accept. Instead, the APA Program has chosen to deal with individual requests on a case-by-case basis (and may have rejected specific cases on the basis that they were purely hypothetical), but has retained the right to accept even a hypothetical case if the circumstances warrant (e.g., based on the value and novelty of the case, the profile of the taxpayer or issue, the ability of other taxpayers to replicate the transaction, the identity and position of the foreign tax authority on the transactions, etc.).
The foregoing analysis unquestionably supports a determination that the APMA Program possesses the legal authority to consider prospective transactions with closings conditioned on an advance agreement with the IRS.
This commentary also will appear in the June 2012 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Levey, Carmichael, van Herksen, Patton, Levi, Krupsky, and Kellar, 890 T.M., Transfer Pricing: Alternative Practical Strategies (Chapter 8, Advance Pricing Agreements), and in Tax Practice Series, see ¶3600, Section 482 - Allocations of Income and Deductions Between Related Taxpayers.
1 The new APMA Program merged the legacy APA Program and the Competent Authority functions relating to transfer pricing and other allocation issues. It stood up officially on February 27, 2012. Until the APMA Program issues new procedural guidance with respect to APAs and Competent Authority assistance, Rev. Proc. 2006-9, 2006-2 I.R.B. 278, will remain in effect for APA case processing, as slightly modified by IRS News Release IR-2012-38 (3/27/12). In this commentary, the terms APA Program and APMA Program are used interchangeably.
2 Rev. Proc. 2006-9, §2.03.
3 The issue of enforceability of an APA may become relevant in a recently-filed U.S. Tax Court petition. See Eaton Corp. v. Comr., T.C. No. 5576-12, petition filed 2/29/12.
4 An accompanying illustration indicates that the IRS has the power to enter into closing agreements on future transactions still under consideration and perhaps not even contemplated:Example: A owns 500 shares of stock in the XYZ Corporation which he purchased prior to March 1, 1913. A is considering selling 200 shares of such stock but is uncertain as to the basis of the stock for purposes of computing gain. Either prior or subsequent to the sale, a closing agreement may be entered into determining the market value of such stock as of March 1, 1913, which represents the basis for determining gain… . Not only may the closing agreement determine the basis for computing gain on the sale of the 200 shares of stock, but such an agreement may also determine the basis [absent a change in law] of the remaining 300 shares of stock upon which gain will be computed on a subsequent sale.
5 Rev. Proc. 2006-54, as it applies to transfer pricing cases, will remain in effect until replaced by a combined APA/USCA revenue procedure for APMA. See note 1.
6 The 1995 and 2010 OECD transfer pricing guidelines reflect this view: "APAs involving the competent authority of a treaty partner should be considered within the scope of the mutual agreement procedure under Article 25 of the OECD Model Tax Convention, even though such arrangements are not expressly mentioned there." OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, §4.139 (July 2010) (the "OECD Guidelines").
7 The OECD Guidelines contain language about the prospectivity of APAs similar to the above-cited provisions in Rev. Proc. 2006-9, e.g.:
9 The OECD procedural guidelines might become a discussion point in a bilateral APA proceeding if the United States and the treaty country are debating whether or not to accept jurisdiction of an APA covering only prospective transactions.
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