Advance Pricing Arrangements (“APAs”) are the subject of extensive discussion in the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations at Chapter IV, Section F. The development of working arrangements between competent authorities is considered at paragraph 4.175:
Between those countries that use APAs, greater uniformity in APA practices could be beneficial to both tax administrations and taxpayers. Accordingly, the tax administrations of such countries may wish to consider working agreements with the competent authorities for the undertaking of APAs. These agreements may set forth general guidelines and understandings for the reaching of mutual agreement in cases where a taxpayer has requested an APA involving transfer pricing issues.
It should be noted that the use of the term “agreement” in the above quotation is not intended to give any status to such procedural arrangements above that provided for by the Mutual Agreement Article of the OECD Model Tax Convention. Additionally, the Committee on Fiscal Affairs stated at paragraph 4.171 of the Guidelines that it intended “to monitor carefully any expanded use of APAs and to promote greater consistency in practice amongst those countries that choose to use them.”
This annex follows up on the above recommendations. The objective is to improve the consistency of application of APAs by providing guidance to tax administrations on how to conduct mutual agreement procedures involving APAs. Although the focus of the annex is on the role of tax administrations, the opportunity is taken to discuss how best the taxpayer can contribute to the process. This guidance is intended for use by those countries – both OECD members and non-members – that wish to use APAs.
Many jurisdictions have had, for some time, procedures (e.g. rulings) enabling the taxpayer to obtain some degree of certainty regarding how the law will be applied in a given set of circumstances. The legal consequences of the proposed action are determined in advance, based on assumptions about the factual basis. The validity of this determination is dependent upon the assumptions being supported by the facts when the actual transactions take place. The term APA refers to a procedural arrangement between a taxpayer or taxpayers and a tax administration intended to resolve potential transfer pricing disputes in advance. The APA differs from the classic ruling procedure, in that it requires the detailed review and to the extent appropriate, verification of the factual assumptions on which the determination of legal consequences is based, before any such determination can be made. Further, the APA provides for a continual monitoring of whether the factual assumptions remain valid throughout the course of the APA period.
An APA is defined in the first sentence of paragraph 4.134 of the Guidelines as “an arrangement that determines, in advance of controlled transactions, an appropriate set of criteria (e.g. method, comparables and appropriate adjustments thereto, critical assumptions as to future events) for the determination of the transfer pricing for those transactions over a fixed period of time.” It is also stated in paragraph 4.142 that “The concept of APAs also may be useful in resolving issues raised under Article 7 of the OECD Model Tax Convention relating to allocation problems, permanent establishments, and branch operations.”
In the Guidelines (see paragraph 4.140) the arrangements solely between a taxpayer or taxpayers and a tax administration are referred to as “unilateral APAs”. The Guidelines encourage bilateral APAs and recommend at paragraph 4.173 that “Wherever possible, an APA should be concluded on a bilateral or multilateral basis between competent authorities through the mutual agreement procedure of the relevant treaty.” A bilateral APA is based on a single mutual agreement between the competent authorities of two tax administrations under the relevant treaty. A multilateral APA is a term used to describe a situation where there is more than one bilateral mutual agreement.
Although, commonly an APA will cover cross-border transactions involving more than one taxpayer and legal enterprise, i.e. between members of a MNE group, it is also possible for an APA to apply to only one taxpayer and legal enterprise. For example, consider an enterprise in Country A that trades through branches in Countries B, C and D. In order to have certainty that double taxation will not occur, countries A, B, C and D will need to share a common understanding of the measure of profits to be attributed to each jurisdiction in respect of that trading activity under Article 7 of the OECD Model Tax Convention. This certainty could be achieved by the negotiation of a series of separate, but mutually consistent, bilateral mutual agreements, i.e. between A and B, A and C and A and D. The existence of multiple bilateral mutual agreements raises a number of special issues and these are discussed further in Section B, paragraphs 21-27 of this annex.
It is important to distinguish the different types of APAs and so the bilateral or multilateral APAs, which are the main subject of this annex, are hereafter referred to as “MAP APAs”. The APAs that do not involve a mutual agreement negotiation are referred to as “unilateral APAs”. The generic term “APA” is used where the feature to be discussed applies to both types of APA. It should be noted that, in the vast majority of cases a bilateral APA will be concluded under the mutual agreement procedure of a double tax convention. However, in some cases where a bilateral APA has been sought and the treaty is not appropriate, or where a treaty is not applicable, the competent authorities of some countries may nevertheless conclude an arrangement using the executive power conferred on the heads of tax authorities. The term MAP APA should be interpreted, with the necessary adaptations, as including such exceptional agreements.
The focus of this annex is on providing guidance to enable tax authorities to resolve disputes through the mutual agreement procedure, thereby helping to eliminate the risk of potential double taxation and providing the taxpayer with reasonable certainty of tax treatment. However, it should be noted that there are other mechanisms for achieving the same goals which are not discussed in this annex.
It has been the experience of a number of countries that the resolution of transfer pricing disputes by traditional audit or examination techniques has often proved very difficult and also costly for taxpayers and tax authorities both in terms of time and resources. Such techniques inevitably examine transfer prices (and the surrounding conditions) some time after they were set and there can be genuine difficulties in obtaining sufficient information to evaluate properly whether arm’s length prices were used at the time they were set. These difficulties led in part to the development of the APA process as an alternative way of solving transfer pricing issues in some cases in order to avoid some of the problems described above. The objectives of an APA process are to facilitate principled, practical and co-operative negotiations, to resolve transfer pricing issues expeditiously and prospectively, to use the resources of the taxpayer and the tax administration more efficiently, and to provide a measure of predictability for the taxpayer.
To be successful, the process should be administered in a non- adversarial, efficient and practical fashion and requires the co-operation of all the participating parties. It is intended to supplement, rather than replace, the traditional administrative, judicial, and treaty mechanisms for resolving transfer pricing issues. Consideration of an APA may be most appropriate when the methodology for applying the arm’s length principle gives rise to significant questions of reliability and accuracy, or when the specific circumstances of the transfer pricing issues being considered are unusually complex.
One of the key objectives of the MAP APA process is the elimination of potential double taxation. Unilateral APAs give rise to considerable concerns in this area, which is why “most countries prefer bilateral or multilateral APAs” (paragraph 4.141 of the Guidelines). However, some kind of confirmation or agreement between the taxpayer and the tax administration is necessary in order to give effect to the MAP APA in each of the participating jurisdictions. The exact form of such confirmation or agreement depends on the domestic procedures in each jurisdiction (discussed in more detail at paragraphs 65-66 of this annex). Such a confirmation or agreement also provides a mechanism to ensure that the taxpayer complies with the terms and conditions of the MAP APA on which this confirmation or agreement is based.
Further, in order to meet the objectives described in this section, the MAP APA process needs to be conducted in a neutral manner. In particular, the process should be neutral as regards the residence of the taxpayer, the jurisdiction in which the request for the MAP APA was initiated, the audit or examination status of the taxpayer and the selection of taxpayers in general for audit or examination. The guidance at paragraph 4.167 of the Guidelines on possible misuse by tax administrations in their examination practices of information obtained in the APA process should also be borne in mind. The guidance given in this annex is intended to assist in attaining the objectives described in this section.
The first question that arises is whether it is possible for there to be an APA. The eligibility of a taxpayer to apply for a unilateral APA will be determined by the specific domestic requirements of the relevant tax administration. MAP APAs are governed by the mutual agreement procedure of the applicable double tax agreement, Article 25 of the OECD Model Tax Convention, and are administered at the discretion of the relevant tax administrations. The work pursuant to Action 14 of the BEPS Action Plan to ensure the timely, effective and efficient resolution of treaty- related disputes recommended, as non-binding best practice 4, that countries should implement bilateral APA programmes as soon as they have the capacity to do so, recognising that APAs provide a greater level of certainty in both treaty partner jurisdictions, lessen the likelihood of double taxation and may proactively prevent transfer pricing disputes. In this regard, it should be noted that the country mutual agreement procedure profiles prepared pursuant to element 2.2 of the Action 14 minimum standard include information on the bilateral APA programmes.
In some cases the taxpayer will only request a unilateral APA. The reasons for the taxpayer not requesting a MAP APA should be explored. Following the guidance given by the Guidelines at paragraph 4.173 that “wherever possible, an APA should be concluded on a bilateral or multilateral basis”, the tax authorities should encourage the taxpayer to request a MAP APA if the circumstances so warrant. Some countries if they determine that another tax administration should be involved may refuse to enter into unilateral negotiations with the taxpayer, even though the taxpayer still insists on a unilateral approach.
The negotiation of a MAP APA requires the consent of the relevant competent authorities. In some cases, the taxpayer will take the initiative by making simultaneous requests to the affected competent authorities. In other cases the taxpayer may file a request with one jurisdiction under the relevant domestic procedure and ask it to contact the other affected jurisdiction(s) to see if a MAP APA is possible. Consequently, as soon as is administratively practicable, the competent authority in that jurisdiction should notify the relevant tax treaty partner(s) to determine whether they want to participate. The other tax administration should respond to the invitation as quickly as practicable, bearing in mind the need to have sufficient time to evaluate whether their participation is possible or feasible.
However, Article 25 does not oblige the competent authorities to enter into MAP APAs at the request of the taxpayer. The willingness to enter into MAP APAs will depend on the particular policy of a country and how it interprets the mutual agreement article of its bilateral treaties. Some competent authorities will only consider such an agreement for cases that require the resolution of “difficulties or doubts arising as to the interpretation or application of the Convention”. The desire of the taxpayer for certainty of treatment is therefore not, in isolation, sufficient to pass the above threshold. Other competent authorities apply a less restrictive threshold for entering into MAP APAs, based on their view that the MAP APA process should be encouraged. Additionally, the taxpayer must qualify for the benefit of a particular treaty (e.g. by qualifying as a resident of one of the Contracting States) and must satisfy any other criteria contained in the mutual agreement article.
The fact that a taxpayer may be under audit or examination should not prevent the taxpayer from requesting a MAP APA in respect of prospective transactions. The audit or examination and the mutual agreement procedure are separate processes and generally can be resolved separately. Audit or examination activities would not normally be suspended by a tax administration whilst the MAP APA is being considered, unless it is agreed by all parties that the audit or examination should be held in abeyance because the obtaining of the MAP APA would assist with the completion of the audit or examination. Nevertheless, the treatment of the transactions being audited or examined may be informed by the methodology agreed to be applied prospectively under the MAP APA, provided that the facts and circumstances surrounding the transaction under audit or examination are comparable with those relating to the prospective transactions. This issue is discussed further in paragraph 69 below.
The ability to conclude a MAP APA is predicated on full co- operation by the taxpayer. The taxpayer and any associated enterprises should: a) provide their full co-operation in assisting the tax administrations with the evaluation of their proposal; and b) provide, upon request, any additional information necessary for that evaluation, for example, details of their transfer pricing transactions, business arrangements, forecasts and business plans, and financial performance. It is desirable that this commitment from the taxpayer be sought before commencing the MAP APA process.
In some cases the freedom of one or both competent authorities to agree to a MAP APA may be limited, for example by a legally binding decision affecting issues subject to the APA proposals. In such circumstances, as the MAP APA process is by definition consensual, it is within the discretion of the affected competent authorities (subject to the domestic laws and policies of each jurisdiction) whether to engage in MAP APA discussions. For example, a competent authority may decline to enter into discussions if it determines that such a limitation on the position of the other competent authority unacceptably reduces the likelihood of mutual agreement. However, it is likely that in many cases MAP APA discussions would be viewed as desirable even though the flexibility of one or both competent authorities is restricted. This is a matter for the competent authorities to determine on a case by case basis.
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 judgement 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:
a) Does the methodology and the other terms and conditions of the proposal respect the guidance given by the Guidelines? If not, it will be desirable to get the taxpayer to revise the proposal accordingly, in order to increase the chances of reaching a mutual agreement. As paragraph 17 of the preface to the Guidelines states “these guidelines are also intended primarily to govern the resolution of transfer pricing cases in mutual agreement proceedings”.
b) Are any “difficulties or doubts as to the interpretation or application of the Convention” likely to significantly increase the risk of double taxation and so justify the use of resources to settle any problems in advance of the proposed transactions?
c) Would the transactions covered by the proposal be ongoing in nature and is there a significant part of any limited life project left?
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.
e) Is a transfer pricing audit already in progress in relation to past years where the fact pattern was substantially similar? If so, the outcome of the audit may be expedited by participating in a MAP APA, the terms of which could then be applied to inform or resolve the audit and any unresolved mutual agreement for earlier years.
The desire for certainty has resulted in an emerging trend for taxpayers to seek multilateral MAP APAs covering their global operations. The taxpayer approaches each of the affected jurisdictions with an overall proposal and suggests that it would be desirable if the negotiations be conducted on a multilateral basis involving all the affected jurisdictions, rather than by a series of separate negotiations with each tax authority. It should be noted that there is no multilateral method of implementing any agreement that may be reached, except by concluding a series of separate bilateral MAP APAs. The successful negotiation of a series of bilateral MAP APAs in this way would provide greater certainty and lower costs to the MNE group than if separate MAP APAs were undertaken bilaterally and in isolation of each other.
Although, as described above, there are potential benefits to having multilateral MAP APAs, a number of issues need to be considered. First, it is unlikely to be appropriate for a single transfer pricing methodology to be applied to the wide variety of facts and circumstances, transactions and countries likely to be the subject of a multilateral MAP APA, unless the methodology can be appropriately adapted to reflect the particular facts and circumstances found in each country. Therefore, care would need to be taken by all the participating jurisdictions to ensure that the methodology, even after such adaptation, represented a proper application of the arm’s length principle in the conditions found in their country.
Second, issues also arise because under a multilateral MAP APA several competent authorities are effectively involved in a process that was designed for a bilateral process. One issue is the extent to which it may be necessary to exchange information between all the affected jurisdictions. This could be problematic in cases where there are no transaction flows or common transactions between two or more of the affected treaty partners, so creating doubts as to whether the information is relevant to the particular bilateral MAP APA being discussed. However, in cases where similar transactions are conducted by different parts of the MNE or in which the area considered relates to trading on an integrated basis, there may be a need to have information about flows between other parties in order to be able to understand and evaluate the flows that are the subject of the particular bilateral MAP APA. Another problem is that it may be difficult to judge whether such information is indeed relevant prior to obtaining it.
Further, even if the information is relevant to the particular bilateral MAP APA, there may still be potential problems of confidentiality preventing the exchange of that information, either under the terms of the exchange of information article(s) of the relevant treaty or under the domestic law of one of the participating tax administrations. Given the wide range of possible circumstances likely to be found in multilateral MAP APAs, no general solution to these problems can be prescribed. Rather such issues need to be addressed specifically in each of the separate bilateral MAP APAs.
In cases where information about flows between other parties is found to be relevant, some exchange of information problems could possibly be overcome by not relying on treaty information exchange provisions, but instead asking the taxpayer to assume responsibility for providing information to all the affected tax administrations (though procedures would still be needed to verify that the same information is in fact provided to all tax administrations). Finally, in some cases the mutual agreement articles of the relevant treaties may not provide an adequate basis for such multilateral consideration and discussion, although the mutual agreement article of the OECD Model Tax Convention is designed to assist in the elimination of double taxation in a wide variety of circumstances, and therefore would, if applicable, appear to provide adequate authority in most situations.
In summary, as discussed in Section A, the desire by the taxpayer for certainty is not by itself sufficient to oblige a tax administration to enter into a MAP APA where this might be inappropriate. An invitation to participate in a multilateral MAP APA would therefore be evaluated in accordance with the usual criteria for determining whether a bilateral MAP APA could be pursued and each proposed bilateral APA would also be separately evaluated. A decision would then be taken whether the completion of the negotiations for the bilateral MAP APAs that the administration has decided to pursue, would best be served by its participation in multilateral negotiations. This evaluation will be made on a case-by-case basis.
The development of multilateral MAP APAs is at a relatively early stage, except perhaps in the global trading field. Indeed, where global trading is conducted on a fully integrated basis (i.e. the trading and risk management of a book of financial products takes place in a number of different locations, usually at least three), a multilateral, as opposed to a bilateral, APA has become the norm1. It is intended to monitor closely further developments in the area of multilateral MAP APAs.
Although a MAP APA by its nature involves an agreement between tax administrations, the process needs considerable involvement by the taxpayer or taxpayers in order to be successful. This section looks at the first stages in this process, namely the request for the MAP APA which is normally initiated by the taxpayer(s). (N.B. Some tax administrations consider that they should take the initiative and actively encourage taxpayers to make requests in appropriate cases, for example following completion of an audit or risk assessment analysis.) Once it has been decided that a MAP APA is indeed appropriate, the primary responsibility for providing the participating tax administrations with sufficient information for them to be able to conduct mutual agreement negotiations will inevitably rest with the taxpayer(s). Consequently, the taxpayer should submit a detailed proposal for review by the relevant tax administration and be prepared to provide further information as requested by the tax administration.
A feature of many domestic procedures for the obtaining of a unilateral APA is the ability to have a preliminary meeting (or meetings) before a formal request is made. Such a meeting (or meetings) provides a taxpayer with an opportunity to discuss with the tax administration the suitability of an APA, the type and extent of information which may be required and the scope of any analyses required for the completion of a successful APA. (For example, the extent of any functional analysis of affiliated enterprises; identification, selection and adjustment of comparables; and the need for, and the scope of, market, industry and geographic analyses.) The process also provides the taxpayer with an opportunity to discuss any concerns regarding disclosure and confidentiality of data, the term of the APA and the like. Experience has generally shown that the ability to have such preliminary discussions expedites the processing of any subsequent formal MAP APA proposal.
In the context of a MAP APA, the ability of the relevant competent authorities to have preliminary discussions with the taxpayer(s) may also be useful. In addition to the matters mentioned above, the discussions could usefully explore whether the circumstances were suitable for a MAP APA, for example whether there were sufficient “difficulties or doubts as to the interpretation or application of the Convention”.
The preliminary meeting may also have a useful role in clarifying the expectations and objectives of the taxpayer(s) and the tax administration. It also provides an opportunity to explain the process, the policy of the tax administration on MAP APAs and to give details of any procedures for giving effect in domestic law to the agreement when completed. At the same time, the tax administration could provide guidance as to the content of the proposal, and the time frame for evaluating and concluding the mutual agreement. Tax administrations should publish general guidance on the MAP APA process in accordance with the recommendation for other types of mutual agreements at paragraphs 4.62-4.63 of the Guidelines.
The preliminary meeting process may be conducted on either an anonymous or a named basis, depending on domestic custom and practice. If on an anonymous basis, however, sufficient information about the operations will be required in order to make any discussion meaningful. The form of any meetings should be agreed between the parties and a preliminary meeting may range from an informal discussion to a formal presentation. Typically, it is in the taxpayer’s interest to provide the tax administration with a memorandum outlining the topics for discussion. More than one preliminary meeting may be required in order to achieve the objective of having an informal discussion of the potential suitability of a MAP APA request, its likely scope, the appropriateness of a methodology or the type and extent of information to be provided by the taxpayer.
As well as informal discussions with its taxpayer(s), it may be useful for the respective competent authorities to have an early exchange of views on whether a MAP APA would be appropriate. This could avoid unnecessary work if it is unlikely that one of the competent authorities will participate. These discussions may be of an informal nature and do not necessarily require a formal face to face meeting. Also there may be opportunities to have such exchanges during the course of regular competent authority meetings and negotiations.
If the taxpayer wishes to pursue a MAP APA request, it will need to make a detailed proposal to the relevant tax administration, pursuant to any domestic procedural requirements, e.g. a requirement to file the request with a designated part of the domestic tax administration. For a MAP APA, the purpose of the taxpayer’s proposal is to give the relevant competent authorities all the information needed to evaluate the proposal and to undertake mutual agreement discussions. Countries have a number of ways of ensuring the competent authorities get the necessary information. One way is for the taxpayer to be able to make the proposal directly to the competent authority. Another way of achieving this goal is for the taxpayer to make available a copy of any domestic APA proposal to the other participating jurisdictions. Ideally, the exact form and content of the proposal will have been established at any preliminary meetings.
The scope of the MAP APA would depend on the wishes of the participating jurisdictions, as well as those of the taxpayer. It can apply to resolve issues covered by Articles 7 and 9 of the OECD Model Convention and would determine to what extents profits would arise in the tax jurisdictions involved.
The MAP APA may cover all of the transfer pricing issues of a taxpayer (or of the members of a MNE group) or may be more limited, for example to a particular transaction, sets of transactions, product lines or to only some members of a MNE group. Some countries, whilst recognising the need for flexibility in the process, have concerns over the appropriateness of specific issue APAs. It may be difficult to evaluate some issues in isolation, for example where the transactions covered by the proposal are highly interrelated with transactions not covered by the proposal, or where there is a need to analyse transfer pricing issues in a wider context because intentional set offs are involved (see paragraphs 3.13-3.17 of the Guidelines).
A MAP APA may also cover issues other than the transfer pricing methodology, provided that these other issues are sufficiently clearly connected to the underlying transfer pricing issues so as to make it worthwhile attempting to resolve them in advance and provided that the other issues come within the terms of the mutual agreement article in the relevant treaty. That will be something to be decided between the affected parties for each individual case.
The content of the proposal and the extent of the necessary supporting information and documentation will depend on the facts and circumstances of each case and the requirements of the individual participating tax administrations. It is therefore not considered practicable to list or define exactly what should be provided. The guiding principle, however, should be to provide the information and documentation necessary to explain the facts relevant to the proposed methodology and to demonstrate its application in accordance with the appropriate Article of the relevant treaty. The proposal should therefore be consistent with any general guidance given by the Commentary of the OECD Model Tax Convention on the corresponding Articles, together with the guidance on the application of the arm’s length principle of Article 9 given by the Guidelines in cases involving transfer pricing between associated enterprises.
In terms of the supporting information and documentation to be included, the guidance in Chapter IV (paragraphs 4.165-4.168) and Chapter V of the Guidelines on documentation requirements should be borne in mind. However, because of the prospective nature of the agreement sought, different types of information may need to be supplied than in mutual agreement cases, which only relate to transactions already undertaken. As a guide, the following information may be of general relevance for MAP APAs, although it should be stressed that the list below is not intended to be exhaustive or prescriptive in nature:
a) The transactions, products, businesses or arrangements that will be covered by the proposal; (including, if applicable, a brief explanation of why not all of the transactions, products, businesses or arrangements of the taxpayer(s) involved in the request have been included);
b) The enterprises and permanent establishments involved in these transactions or arrangements;
c) The other country or countries which have been requested to participate;
d) Information regarding the world-wide organisational structure, history, financial statement data, products, functions and assets (tangible and intangible) of any associated enterprises involved;
e) A description of the proposed transfer pricing methodology and details of information and analyses supporting that methodology, e.g. identification of comparable prices or margins and expected range of results etc.;
f) The assumptions underpinning the proposal and a discussion of the effect of changes in those assumptions or other events, such as unexpected results, which might affect the continuing validity of the proposal;
g) The accounting periods or tax years to be covered;
h) General description of market conditions (e.g. industry trends and the competitive environment);
i) A discussion of any pertinent ancillary tax issues raised by the proposed methodology;
j) A discussion of, and demonstration of compliance with, any pertinent domestic law, tax treaty provisions and OECD guidelines that relate to the proposal; and
k) Any other information which may have a bearing on the current or proposed transfer pricing methodology and the underlying data for any party to the request.
The rest of this section discusses some of the most important items from the above list in more detail.
The taxpayer should include a discussion of the availability and use of comparable pricing information. This would include a description of how the search for comparables was carried out (including search criteria employed), what data relating to uncontrolled transactions was obtained and how such data was accepted or rejected as being comparable. The taxpayer should also include a presentation of comparable transactions along with adjustments to account for material differences, if any, between controlled and uncontrolled transactions. In cases where no comparables can be identified, the taxpayer should demonstrate, by reference to relevant market and financial data (including the internal data of the taxpayer), how the chosen methodology accurately reflects the arm’s length principle.
The MAP APA proposal should provide a full description of the chosen methodology. In cases involving associated enterprises, the chosen methodology should also respect the guidance found in the Guidelines on applying the arm’s length principle of Article 9 of the OECD Model Tax Convention. It is stated at paragraph 2.11 of the Guidelines that “further, any method should be permitted where its application is agreeable to the members of the MNE group involved with the transaction or transactions to which the methodology applies and also to the tax administrations in the jurisdictions of all those members.” That guidance on use of transfer pricing methods is particularly relevant in the context of a MAP APA, because of the opportunity to obtain advance agreement on the method to be used. The application of the methodology should be supported by data which can be obtained and updated over the period of the MAP APA without imposing too great a burden on the taxpayer, and which can be reviewed and verified effectively by the tax administrations.
The taxpayer should, to the extent possible, provide an analysis of the effect of applying the chosen methodology or methodologies during the proposed period of the agreement. Such an analysis necessarily will have to be based on projected results and so details of the assumptions on which those projections were made will be needed. It may also be helpful to illustrate the effect of applying the APA methodology or methodologies to the periods immediately before the APA period. The usefulness of this analysis, even as an illustration, will depend on the facts and circumstances surrounding the transactions in question being comparable to those applying to the prospective transactions contemplated under the proposal.
In entering into a MAP APA relating to the arm’s length pricing of controlled transactions that have not yet occurred, it is necessary to make certain assumptions about the operational and economic conditions that will affect those transactions when they take place. The taxpayer should describe in the proposal the assumptions on which the ability of the methodology to accurately reflect the arm’s length pricing of future transactions is based. Additionally, the taxpayer should explain how the chosen methodology will satisfactorily cope with any changes in those assumptions. The assumptions are defined as “critical” if the actual conditions existing at the time the transactions occur could diverge from those that were assumed to exist, to the extent that the ability of the methodology reliably to reflect arm’s length pricing is undermined. One example might be a fundamental change to the market arising from new technology, government regulations, or widespread loss of consumer acceptance. In such a case, the divergence may mean that the agreement would need to be revised or cancelled.
44. To increase the reliability of the MAP APA methodology, taxpayers and tax administrations should attempt to identify critical assumptions that are, where possible, based on observable, reliable and independent data. Such assumptions are not limited to items within the control of the taxpayer. Any set of critical assumptions needs to be tailored to the individual circumstances of the taxpayer, the particular commercial environment, the methodology, and the type of transactions covered. They should not be drawn so tightly that certainty provided by the agreement is jeopardised, but should encompass as wide a range of variation in the underlying facts as the parties to the agreement feel comfortable with. In general, however, and by way of example only, critical assumptions might include:
a) Assumptions about the relevant domestic tax law and treaty provisions.
b) Assumptions about tariffs, duties, import restrictions and government regulations.
c) Assumptions about economic conditions, market share, market conditions, end-selling price, and sales volume.
d) Assumptions about the nature of the functions and risks of the enterprises involved in the transactions.
e) Assumptions about exchange rates, interest rates, credit rating and capital structure.
f) Assumptions about management or financial accounting and classification of income and expenses; and
g) Assumptions about the enterprises that will operate in each jurisdiction and the form in which they will do so.
It may also be helpful to set parameters for an acceptable level of divergence for some assumptions in advance, in order to provide the necessary flexibility. These parameters would need to be set individually for each particular MAP APA and would form part of the negotiations between the competent authorities. Only if the divergence from the prediction exceeded the parameter would the assumption become “critical” and action considered. Any action to be taken might also depend on the nature of the assumption and the level of divergence.
If the reliability of the proposed transfer pricing methodology is known to be sensitive to exchange rate fluctuations, it would seem sensible to design a methodology that was capable of accommodating a certain degree of expected fluctuation, perhaps by providing for prices to be adjusted to take into account exchange rate movements. Also it could be agreed in advance that movements in either direction of up to X% would require no action, that movements greater than X % but less than Y% would trigger a prospective review of the methodology to make sure it remained appropriate, whilst a movement of more than Y% would mean that a critical assumption had been breached and it would be necessary to prospectively re-negotiate the MAP APA. These parameters would need to be set individually for each particular MAP APA and would form part of the negotiation between the competent authorities.
A problem may arise when the results of applying the transfer pricing methodology agreed in the MAP APA do not fulfil the expectations of one of the parties, as that party may question whether the critical assumptions, and the methodology which they support, are still valid. The resolution of such questions may take a considerable amount of time and effort, thereby negating one of the objectives of the whole process. One possible solution to this problem is to include enough flexibility in the proposal to cope with likely changes in the facts and circumstances so that unexpected results are less likely to occur so that there is less risk that the MAP APA agreement based upon the proposal will need to be renegotiated. The proposal must still, of course, conform to the arm’s length principle.
One way of achieving the above objective is to design a methodology that appropriately takes into account likely changes in facts and circumstances; for example, some variation between projected and actual sales volume can be built in to the pricing methodology at the outset by including prospective price adjustment clauses or allowing pricing to vary with volume. The allowable level of deviation should be set by reference to what would have been accepted by independent parties.
Another possible way of achieving the objective of increasing certainty, is to agree an acceptable range of results from applying the method of the MAP APA. In order to conform with the arm’s length principle, the range should be agreed by all affected parties in advance, thereby avoiding the use of hindsight, and based on what independent parties would have agreed to in comparable circumstances (see paragraphs 3.55-3.66 for discussion of the range concept). For example, the quantum of an item, such as a royalty, would be accepted so long as it remained within a certain range expressed as a proportion of the profits.
If the results fall outside the agreed range, the action to be taken would depend on what had been negotiated in the proposal in accordance with the wishes of the parties. Some parties may not wish to take the risk that the results will be significantly different from what they expected. Accordingly, they would use the range concept simply as a means of determining whether a critical assumption had been breached as described in paragraph 46. Other parties may place more emphasis on certainty of treatment than on avoiding unexpected results and so may agree that the MAP APA should contain a mechanism for adjusting the results so that they fall within the range agreed in advance.