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.

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 CFO.com. 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.

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 CFO.com’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.

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