By Craig A. Sharon, Esq.
Bingham McCutchen LLP, Washington, DC
As I write this commentary, I just finished my first year at Bingham after leaving the IRS Advance Pricing Agreement (APA) Program, where I served for six years, including the last three years as APA director. For readers who previously served as managers in the IRS, you know that the one-year mark is a watershed event under the IRS ethics rules, which, among other things, impose on higher-level managers a one-year ban on appearing before the IRS. The good news is that now I am "legal."
The first anniversary after leaving the government is also a good time to gather one's thoughts and make some observations, because one year of private practice necessarily involves some change in perspective, but is not enough time to have forgotten the challenges (and joys) of the other side. Don't worry, this commentary is not an introspective, fluff piece about the great friends and colleagues that I left behind (many), the great satisfaction derived from public service (best job ever), or the moral challenges that arise when moving over to the "dark side," as many in the IRS call the private sector (in jest, of course). Instead, it highlights my most notable impressions about U.S. transfer pricing enforcement from my new perch on the outside, looking in.
I do not represent that these observations are particularly keen or insightful, but they do reflect a "half-in, half-out" mentality that manifested itself, for example, in my repeated use of the royal "we" when talking about the IRS during the year. It took me at least nine months to break that habit. Indeed, at an early tax conference, I agreed to buy the audience one drink for each time I referred to the IRS as "we." I still owe that audience six drinks.
In no particular order of importance, I'd highlight the following:
- Changes to the Transfer Pricing Practice. Of greatest importance, the Transfer Pricing Practice (TPP) has changed considerably - for the better - over the year. During the 18 months that I was involved in the TPP's development, the original concept evolved, in my opinion, from good to worse as the various constituencies within the IRS weighed in on the TPP's structure and effectively cut back its authority and responsibilities. Perhaps the retrenchment was inevitable until an actual TPP director was in place to defend the TPP's interests. In fact, that seems to have occurred with Sam Maruca's hiring in May 2011. Whether or not Sam was responsible - he would refuse to take credit - changes were made that significantly strengthened the program, such as:
- The TPP director position was elevated from a GS-15 position to a Senior Executive Service (SES) position. SES status gives the TPP director the stature and access needed to be effective inside the larger organization.
- The TPP was elevated in the Large Business & International (LB&I) structure from a second-tier function within the new International Business Compliance (IBC) division to a first-tier function (sitting alongside the IBC) reporting directly to the Office of the Deputy Commissioner (International), currently headed by Mike Danilack. This shift will help maintain the program's independence and preserve the culture of its component parts over the long run.
- The TPP was given direct responsibility for both the APA Program and the double-tax allocation cases in the form of the new Advance Pricing and Mutual Agreement (APMA) Program. Neither program had been part of the TPP in earlier iterations of the practice. Instead, the TPP director was given only "dotted" line authority (i.e., persuasive authority only) over the programs, arguably the two most important within the IRS transfer pricing enforcement matrix. This change represents a significant double-win for the TPP.
- The TPP was allotted a dedicated workforce of international examiners and Field economists as part of its Field Program, a function separate from APMA that will work alongside IRS exam teams conducting transfer pricing audits. In earlier versions of the TPP, most of these employees were assigned to the IBC to be "loaned" to the TPP on an as-needed basis.
- Consistent with the consolidation of transfer pricing functions within the TPP, the new IRS "chief transfer pricing economist" was moved into the TPP, rather than reporting directly to Mike Danilack.
- The TPP was given significant new hiring authority, notwithstanding the overall cuts in the IRS budget. It looks like total employment within the TPP could reach 150 people within the next 12 months, spread out in offices across the country. In my view, that number is still too small relative to the need (e.g., if APA and double-tax case processing times are to be reduced materially), but it is a significant increase compared to the old regime (without taking into account hoped-for efficiency/productivity gains in having everyone under one roof).
In short, over the past year the TPP director was promoted to "General" and given an army to fight with.
- The Veritas Hangover. The IRS loss in Veritas has had many repercussions, e.g., a reopening of the multitude of pending buy-in cases based on the 1995 regulations, a spike in taxpayer-favorable Appeals settlements, the withdrawal of the 2007 cost-sharing coordinated issue paper (CIP), and the issuance of refined final cost-sharing regulations. Less visible has been the effect of Veritas on transfer pricing inquiries generally.
Because the IRS views the Veritas decision as turning on the specific facts of the case, IRS exam teams are now focusing like a laser on factual development in all sorts of transfer pricing audits. In theory, this new focus should be welcome news to taxpayers, which have been arguing for case-specific factual analyses for years. In reality, though, this concentration has led to increasingly detailed, overly broad, and burdensome requests for information, employee interviews, and site visits, which taxpayers are increasingly resisting, which, in turn, has led to increasing IRS threats to summons withheld information. A new balance is needed here - the latest incarnation of an age-old problem. I am partial to Sam Maruca's formulation that the factual development should focus on the IRS's "hypothesis" of the case. This approach provides some framework for discussing the proper scope of an inquiry.
Implementation of this concept can be difficult in practice, however, with exam teams continuing to insist, at least initially, on very broad, almost hit-or-miss fact-finding efforts.
- IP Migration. The IRS's refusal to accept the result in Veritas reflects, in part, a view that "it's now or never time" in protecting the U.S. tax base from the erosion caused by the many perceived non-arm's-length intellectual property (IP) migrations to date. While it is true that taxpayers have been entering cost-sharing arrangements in significant numbers for decades, there is still a tremendous amount of IP still owned and/or being developed in the United States. The U.S. economy is far too dynamic to think that the game is over. The IRS should be cognizant of that fact in deciding how best to resolve the pending buy-in cases under the 1995 regulations. The new regime needs a fresh start, without being overburdened by old battles.
- IRS Exam Coverage. Judging from taxpayer comments during my time with the IRS, I would have thought IRS exam teams were aggressively auditing transfer pricing on a widespread basis. From what I can tell, however, it appears that IRS audit coverage is spotty at best - nearly non-existent in certain industries and geographies and approaching random in terms of the taxpayers and issues selected for examination - and not very effective. For most U.S. companies, the audit risk is higher overseas, as evidenced by the very high percentage of foreign-initiated adjustments.
The TPP has stated its intention to develop more sophisticated criteria for selecting cases and issues for audit. That's great - and a big challenge - but there is a flip side to case selection that has been mostly overlooked or at least under-estimated. That is, it's probably harder for the IRS to halt a "bad" case (i.e., a proposed audit of a low-risk taxpayer or issue) than it is to identify and pursue a "good" case. Neither is easy to do, but internal dynamics make it harder to kill the bad cases. If the decision becomes a confrontation between the national office and a local exam team that feels strongly (as they often do) about pursuing a case, it's far easier to let the exam team go about its business to preserve the long-term relationship. My impression is that the TPP is already learning this the hard way. If the TPP is serious about focusing its resources on the highest-risk cases, it will need to develop tools that improve its visibility into the Field, establish rules of engagement that give it final case-selection or at least issue-pursuit authority, and then use that authority to de-select the low-risk cases/issues chosen for audit by exam teams.
- Unilateral APAs. I've been surprised by the number of U.S. companies with large numbers of foreign unilateral APAs. I understand why these companies seek such APAs, given the aggressiveness of so many foreign tax authorities, but the volume and breadth was unexpected because the IRS has long encouraged bilateral APAs, when they are available, out of respect for treaty-country relationships. Apparently, many of our treaty partners do not share this view. So the U.S. Competent Authority should add this to its list of issues to discuss with its treaty partners, along with taxpayer "self-initiated" adjustments, "sandwich" transactions that create multilateral problems, and foreign treaty partners pressuring U.S. companies not to request Competent Authority relief on foreign-initiated adjustments.
- Bilateral/Multilateral Challenges for Taxpayers. I was involved in a large number of bilateral negotiations during my years at the APA Program and am well aware of the strengths and weaknesses of the process from a tax authority perspective. Yes, the Mutual Agreement Procedure (MAP) process takes too long, can be expensive, and too often produces a negotiated result, but in the end it avoids double taxation in the vast majority of cases. From a taxpayer's perspective, however, the MAP process is a minefield - a "black box" process with vague rules, informal precedent, and fuzzy coordination with domestic procedures, that is increasingly multilateral and highly unpredictable in outcome. Although the U.S. Competent Authority is surprisingly accessible, it cannot always answer or advise on the many questions and practical issues that come up even in seemingly simple cases, such as those affecting multiple foreign jurisdictions. I do not have ready answers to the various issues, but the challenges for taxpayers are real and only likely to increase going forward.
- FIN 48. An advisor in the private sector cannot help but learn a lot about FIN 48 (ASC 740-10). Woe to the corporate tax department that underestimates the tax reserve. That part I understand. I have more trouble with the fact that many seemingly reasonable taxpayers will refuse a settlement, even if the offer is consistent with a more current assessment of the hazards, because the offer would produce a tax liability greater than the reserve amount (if any). Two insights here: (1) taxpayers that want to maximize their flexibility in resolving future tax disputes should include tax controversy lawyers earlier in the risk-assessment process; and (2) FIN 48 - and now schedule UTP - is a great source of business for the Big Four.
- Taxpayer Resources. This last item animates much of the foregoing discussion. Notwithstanding the prevailing tax authority view that taxpayers have nearly unlimited resources to deal with tax matters, it is clearly not the case. It may be generally true that taxpayers have greater resources relative to most tax authorities, but from what I can tell, most corporate tax departments are leanly staffed, overworked, and operating on limited budgets. That fact needs to be better appreciated by tax authorities if transfer pricing enforcement is to become more efficient and effective for tax authorities and taxpayers alike.
I have other items on my "observation" list - such as my perception about the effect of Mayo on the final cost-sharing regulations (explains, e.g., the more aggressive Preamble language) and why individual taxpayers get so impatient with the delays in APA case processing (because they only have one case to worry about) - but the above items seem most significant to me. Of greatest importance to the U.S. transfer pricing system, the TPP is off to a hopeful start. For sure, significant implementation challenges remain, but there is reason to be optimistic that the IRS is heading in the right direction (finally). It will take time, though, so taxpayers will need to be patient - admittedly, easier said than done.
This commentary also will appear in the April 2012 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Maruca and Warner, 886 T.M., Transfer Pricing: The Code, the Regulations, and Selected Case Law, Levey, Carmichael, van Herksen, Patton, Levi, Krupsky, and Kellar, 890 T.M., Transfer Pricing: Alternative Practical Strategies (Chapter 8, Advance Pricing Agreements, and Chapter 9, Cost Sharing Arrangements), Gleicher, 892 T.M., Transfer Pricing: Competent Authority Consideration, and Cole, Kawano, and Schlaman, 940 T.M., U.S. Income Tax Treaties - U.S. Competent Authority Functions and Procedures, and in Tax Practice Series, see ¶3600, Section 482 - Allocation of Income and Deductions Between Related Taxapyers, and ¶7160, U.S. Income Tax Treaties.