Advance Pricing Agreements: What They Are and How to Get One

An Advance Pricing Agreement (APA) is a formal, binding agreement between a taxpayer and a tax authority. Its purpose is to determine the methodology for setting prices for future transactions between related entities, a process known as transfer pricing. This involves establishing prices for goods, services, and property exchanged between affiliated companies. By agreeing on a transfer pricing methodology (TPM) in advance, both parties gain certainty on how transactions will be treated for tax purposes over a fixed, multi-year period.

The primary benefit of an APA is the prevention of future tax disputes. Without an agreement, a company’s transfer pricing could be challenged during an audit, potentially leading to tax adjustments, interest, and penalties. An APA provides a framework for resolving these issues cooperatively. The agreement ensures the taxpayer’s transfer pricing is at “arm’s length,” meaning it is consistent with what unrelated parties would charge, mitigating the risk of adjustments.

Types of Advance Pricing Agreements

A unilateral APA is an agreement between a taxpayer and a single tax authority, such as the Internal Revenue Service (IRS). This agreement provides certainty for the taxpayer regarding the treatment of its cross-border transactions for that country’s tax purposes. However, it does not bind any foreign tax jurisdictions.

A bilateral APA involves the taxpayer, the home country tax authority, and a single foreign tax authority. This agreement is negotiated under the mutual agreement procedure (MAP) article of an income tax treaty between the two countries. A bilateral APA provides a higher degree of tax certainty by ensuring the agreed-upon TPM is accepted by both nations, which prevents double taxation.

A multilateral APA includes the taxpayer and the tax authorities of two or more foreign countries. These agreements are suited for complex supply chains where transactions flow between related entities in several jurisdictions. By securing the consent of all relevant tax authorities, a multilateral APA offers the highest level of certainty and protection against double taxation.

Information Required for an APA Request

An APA request is a data-intensive process requiring a detailed presentation of the company’s operations and financial structure. The submission must provide a description of the taxpayer’s business, its worldwide organizational structure, and the specific intercompany transactions to be covered. This includes detailing the flow of goods or services and explaining the business reasons for these transactions. The submission must identify all parties involved and the proposed term, which should be at least five prospective years.

Functional Analysis

A key component is the functional analysis, which documents the functions performed, assets used, and risks assumed by each related entity. For example, it specifies which entity is responsible for research and development, manufacturing, marketing, and distribution. It also clarifies which entity bears risks like market fluctuation or credit default. This breakdown is necessary for determining which entity should earn the profits associated with these activities.

Economic Analysis

The taxpayer must present an economic analysis that proposes and defends a specific transfer pricing methodology (TPM). This involves selecting the “best method” for the transactions. Common methodologies include:

• Comparable uncontrolled price (CUP)
• Resale price method (RPM)
• Cost-plus method
• Transactional net margin method (TNMM)
• Profit split method

The submission must provide a justification for the chosen TPM, supported by a comparability analysis that identifies similar transactions between unrelated parties.

Critical Assumptions

The APA request must also state all critical assumptions upon which the proposed agreement is based. These are operational and economic conditions so important that the APA might no longer be valid if they were to change. Examples include assumptions about the company’s market share, the absence of major regulatory changes, or stable economic conditions. Identifying these assumptions provides a clear basis to revisit the agreement if circumstances change.

Submission Package

The formal submission package must include the APA request document, a draft APA based on the IRS’s model template, and the user fee. The standard fee for an original APA request is $121,600, with reduced fees for renewals and small case requests. This fee must be paid for the request to be considered complete by the IRS’s Advance Pricing and Mutual Agreement (APMA) program.

The APA Submission and Negotiation Process

Taxpayers are encouraged to initiate the process with a pre-filing conference with the APMA program. This meeting provides an opportunity to discuss the case, present a summary of the proposed transactions and methodology, and receive preliminary feedback. This early interaction can help identify potential roadblocks and streamline the formal application process.

The next step is the formal submission of the complete APA request and user fee to the APMA program. Upon receipt, the request is reviewed for completeness and can be rejected if all required information is not included. Once accepted, the case is assigned to an APMA team to begin a thorough review.

The tax authority’s review phase involves a detailed examination of the taxpayer’s submission. The APMA team will review the functional analysis, the economic analysis, and the proposed TPM. They may issue questions, request additional documentation, and conduct their own analysis to test the taxpayer’s proposal. This stage involves a collaborative exchange of information between the taxpayer and the APMA team.

The negotiation phase follows the review. For a unilateral APA, this involves discussion between the taxpayer and the APMA team to reach a consensus on the TPM and critical assumptions. In bilateral or multilateral cases, the negotiation expands to include the competent authorities of the foreign tax jurisdictions. The APMA team engages in government-to-government negotiations to ensure all tax authorities agree on the terms.

After an agreement is reached, the final step is to formalize and execute the APA. The agreed-upon terms are documented in a final APA document. For a unilateral APA, this is an agreement signed by the taxpayer and the IRS. For bilateral or multilateral APAs, the competent authorities sign a government-level arrangement, after which each country executes a domestic APA with the taxpayer.

Administering an Executed APA

Once an APA is executed, the taxpayer must submit an annual report for each tax year covered by the agreement. This report must demonstrate that the taxpayer has complied with the terms and conditions of the APA. It includes the actual financial results of the covered transactions and shows how those results fall within the negotiated arm’s length range.

The annual report must also describe any material changes in the business or economic environment and state whether all critical assumptions have remained valid. If a critical assumption has been breached, the APA may need to be revised or canceled. Taxpayers are also required to maintain records that support the data in the original APA request and subsequent annual reports.

If a taxpayer’s actual year-end financial results fall outside the agreed-upon pricing range, the APA will require the taxpayer to make a compensating adjustment. This is a year-end adjustment that brings the results back into the agreed range and is reported on the tax return. This mechanism allows for minor business fluctuations without invalidating the agreement.

APAs are granted for a fixed term, and as the end of the term approaches, the taxpayer can request a renewal. The renewal process is often more efficient than the initial application, as it can leverage the original agreement and the history of compliance. A successful renewal allows the taxpayer to extend the period of tax certainty.