Advanced Pricing Agreements (APAs) are helpingto alleviate the risk of double taxation. In turn,Mutual Agreement Procedures (MAPs) may offer asmoother path to conflict resolution. But neither isa panacea.

With cash-strapped exchequers fixing theirsights on transfer pricing and globalisation addingto the already complex web of intra-company andinter-government arrangements, corporations stillneed to mount a strong and proactive defenceagainst potential disputes. This includes makingsure their transfer pricing policy justifications andassociated documentation can stand up to intensescrutiny and challenge. Policies will also need tobe pragmatic in balancing the trade-off betweencertainty, risk and tax optimisation.

So what does recent experience tell us abouthow to pick through the transfer pricing minefield?

Transfer pricing has always been one of the mostfraught areas of tax management. An EU study in2001 described transfer pricing as one of biggestobstacles to the single market.

The OECD guidelines have helped to formalisecertain aspects of transfer pricing, but the OECDrecognises that this is ‘not an exact science’, withconsiderable room for interpretation and variationaround the world.

The arm’s length principle of what an unrelatedcompany would pay is often arbitrary as there maybe limited empirical evidence upon which to base atransfer price. No two commercial situations areexactly the same, leading to a range of differentoutcomes. As almost every corporation has found totheir cost, this uncertainty opens up considerablerisk of adjustment and double taxation.

Picking through the minefield: Dispute prevention and conflictresolution in transfer pricing

The impact on tax liabilities is only part of theexpense. Corporations also need to consider thedrain on time and resources created by disputes thatcan run for several years and even then may notcome to a lasting or satisfactory resolution. Thechallenge of finding a solution is compounded bythe presence of at least three potentially conflictingparties – a tax payer and two tax authorities.

Escalating riskFiscal deficits have sharpened the focus on transferpricing. Many tax authorities believe that directingresources to transfer pricing yields the best returns,which is leading to an increase in the frequency anddepth of investigations.

Globalisation is increasing the variety of intra-company transactions and the number of countriesthat need to be considered in transaction pricingstrategies. Our work with a number of emergingmarket tax authorities highlights the differentpriorities and perspectives in play. Some emergingmarket tax authorities are taking increasinglyoutlying positions, even if this leads to prolongedconflicts over revenue. Cases in point include howto allocate the location savings from large newmarkets or supplies of offshore services forInformation Technology (IT) and other services.

APA: unilateral or bilateralAPAs have emerged as a proactive strategy ascorporations look to deliver greater certainty andavoid disputes (Figure 1 outlines the steps in theAPA process and Figure 2 highlights the potentialbenefits).

Corporations can directly present their case toone tax authority and negotiate terms for a unilateralAPA. Some corporations are also seeking bilateraland multilateral APAs, which provide additionalprotection.

Seeking a bilateral agreement can increase thetime and complexity of preparation, evaluation andnegotiation. But they are generally seen as betterthan unilateral agreements as they can provide asafeguard against the risk of double taxation. Theyalso offer a true arm’s length range based onnegotiations at both ends, rather than negotiating asingle agreement, which could be lopsided.

Nonetheless, some tax authorities are moreaccommodating than others. When dealing with arelatively aggressive regime like India, a unilateralagreement would have the advantage of avoiding therigorous annual audit and heightened potential forlitigation.

The nature of the agreements in particularcountries is a factor. In Japan, for example, unilateralagreements are very similar to transfer pricing auditsand therefore quite rare.

The choice between unilateral and bilateralagreement would also depend on the quality of therelationship between the ‘competent authorities’ ineach jurisdiction. The competent authorities areexperts in the tax authority delegated to act onbehalf of the government. Some are more likely tosee eye to eye than others, which might be reflectedin the relative number of agreements in placebetween counterparts from particular countries.

Time is a further consideration, especially ifseeking a bilateral agreement. The OECD guidelinessuggest that cases should be settled ‘promptly andefficiently’. The amount of resources tax authoritiescan dedicate to APAs varies, which can lead todelays.

If seeking an APA, it is important to considerwhether a transaction may be excluded because it issubject to an ongoing audit case.

Therefore while APAs can deliver certainty, it isimportant to factor timings, the approach of thecountries involved and relationship between theparties into choices, preparations and negotiations.

Figure 2: APA benefits

Figure 1: OECD guidelines Annex to Chapter IV:Steps in the APA process

Pre filing conference

Formal APA request

Signing of APA

Review and negotiation of APA request– evaluation of request

– involvement of competent authority– acceptance of request

Annual reports

Renewal of APA

Certainty oftransfer pricing

methods

Reduces time-cost and

effort

No fees for pre-filing

consultation

Avoidance ofdouble taxation

Anonymous pre-filing

Penaltyavoidance

Consistentfinancial reporting

Protectionagainst

adjustments

Possibility ofdownwardadjustments

Plan future transfer pricing

strategies

No parallel transfer pricing

audits

Resolve auditissues for 5 years

Benefits

2

Some details of this case study have beenchanged and simplified for this article.

The NTX Group is an IT services and solutionsprovider headquartered in the UK, with officesin India as well as other locations. The Groupprocures the business from their clients in therespective local markets and sub-contracts it infull or in part to NTX India, which in turndevelops the software offshore for the Group.NTX India directly provides IT services to theclients of the other NTX Group members. NTXIndia not only delivers the outsourced work forNTX UK and other NTX group members but alsoprovides IT services to its independent thirdparty clients (see Figure 3).

The projects entered into by NTX India could beeither time-and-material (T&M) or fixed priceprojects. However, the contracts with NTX Groupmembers are always T&M. In case of T&Mcontracts the development effort is billed based onthe pre-negotiated and mutually agreed hourly rate.However, in the case of fixed price contracts, theproject fees are determined on the basis ofnegotiations and mutual agreement with the client,factoring in the project scope and complexity.

Current transfer pricing policyNTX India provides IT services to NTX UK. NTX India also provides similar IT services toindependent third parties i.e. X1, X2 etc. Theservices provided by NTX India to NTX UK aresimilar to the services provided to the independentthird parties. As internal comparables are available(T&M contracts of NTX India with independentthird parties), the Comparable Uncontrolled Price(CUP) method was implemented.

The issueGoing forward there is a possibility of allindependent third party contracts being convertedinto fixed price contracts. In such situations, theadoption of the internal CUP method as the ‘mostappropriate method’ may not be viable as an hourly rate would not be available and sufficientcomparability under OECD guidelines notexhibited. Thus NTX proposes to adopt the CostPlus Method (CPM) for intercompany servicesgoing forward. The CPM has previously been usedto corroborate the application of the CUP method.

At present, no adjustments have been made byHMRC in the previous several years under audit,however, NTX India annual audits have alwayscontested the idea of CUP being the most suitablemodel and this caused duplication of time,resources and effort, and costs year on year. TheAPA is being sought to resolve whether tocontinue to apply the internal CUP and/or move toCPM as and when CUPs are no longer available.

The group has decided to apply for a bilateralAPA to seek agreement from the two taxauthorities as to the correct method and, where theCPM is adopted, the mark up rates to be applied.This should give certainty going forward and savemanagement time and effort in resolving anydifferences between the UK and Indianperspectives.

Case study: IT services

Figure 3: Service delivery model

Customer

Customer (X1, X2 etc)

NTX Group

NTX India

US/UK

India

Independent

contracts

Providing

services

Providing

services

3

Uncertain resolutionIf transfer pricing adjustments emerge, arbitrationprocedures exist within the EU. Many non-EUjurisdictions also have arbitration through theirdouble tax treaties. Some older agreements may nothave scope for formal arbitration.

MAPs allow competent authorities to negotiate abi-partisan agreement over conflicts or areas that sitoutside the tax conventions. They are an importantoption in dispute resolution, but the results can bemixed.

While the tax payer can present its case to thecompetent authority, and a clear and persuasive casewill certainly be welcomed, they cannot directlyparticipate in the negotiations.

Moreover, most competent authorities have along backlog of cases, so the MAP is unlikely toprovide a swift resolution. Even with time, the twosides may only reach a partial agreement that stillincludes some double taxation or indeed fail to reachan agreement altogether. Delays and difficulties withresolution are common especially where thecompetent authorities have different perspectives.

Another important factor to bear in mind is thetime limitations. Treaties may include time limits forfiling MAP claims. Local tax authorities may alsoinclude their own restrictions.

A UK company buys goods and services fromits US parent, which it trades around the EU.The amount due to the US parent was left in anintercompany account, spurring the IRS toinsist that the balance should be subject tointerest charges. After lengthy negotiations, asettlement was agreed in which the US parentrecorded the interest due in its profit and lossaccount for tax purposes and its UK armrecorded this as a charge in its P&L.

Her Majesty’s Revenue and Customs (HMRC) inthe UK subsequently rejected the charge as itargued that the UK company had no obligation topay interest to its US parent. It also argued that anysuch adjustment would require an MAP. An MAPwas subsequently submitted, which sanctioned thearrangement between the UK company and itsparent. As the interest had been paid, no furtheradjustment was deemed necessary.

The MAP did thus resolve the issue, but theprocess took around nine months, most of whichwas taken up in waiting for the competentauthorities to get round to the case. A moreproactive approach would have saved a lot of timeand expense by assessing the interest charge issue aspart of the up-front transfer price strategy andmanaging the subsequent risk of challenge fromHMRC on the agreement in the US.

Case study: MAP on interest due

4

It is also important to lay all the cards on thetable to secure buy-in from tax authorities. Theremay be particular suspicion if a corporation seeks anAPA in one area (eg royalties), but not another (egsupply of goods).

In seeking a multilateral APA, a useful strategy is to tackle a ‘difficult’ tax authority first (‘softprecedent’) so that others may be reluctant to goagainst this for fear of being seen as outliers.

The need for a justifiable policy and thecorroboration to support this is equally important if a MAP becomes required. A good foundation willmake it easier for the competent a uthority to arguethe case on the tax payer’s behalf.

On the front footSo how can corporations get the right balancebetween uncertainty and optimisation and how canthey make the most of the APA and MAPprocedures?

The first and most important consideration isthat the onus is on the corporation itself to provide awatertight justification for its policy and thecorroboration and documentation to support this –there is no room for ‘chancing your arm’ or ‘makingit up as you go’. This includes ensuring that theintra-company arrangements are in line with theeconomic substance of the transaction. It alsoincludes assessing any potential vulnerabilities orareas not covered that could be open to challenge(the case study on page four cited interest onbalances as an example). As Figure 4 highlights,these solid foundations provide the basis foreffective dispute avoidance and management.

Preparing an APA case is a lengthy, complex andcostly process and sufficient resources need to bemade available. Presentations also need to be clear. Itis particularly important to test the validity ofcritical assumptions, which if breached will mean thewhole agreement needs to be revisited and may beset aside.

Corporations will naturally seek to optimise theterms of their APAs. But there is a risk that whatlooks good now may not be advantageous in thefuture as the business environment and strategieschange and economic returns fluctuate.

It is important to be flexible to take account ofchanges in strategy and returns. Preparations shouldinclude scenario analysis to evaluate the impact ofchanges. Flexibility also includes not over-engineering proposals. Start with an initial meeting(which can be on a no names basis), ascertain anacceptable transfer pricing policy and work fromthere.

Figure 4: Considering the trade-off between tax certainty, risk andoptimisation – Dispute management v Dispute avoidance

Dispute management

TP audits

Dispute avoidance

File and defend

Robust documentationand comparables

(inc new chapters I-IIIOECD guidelines)

EU ArbitrationConvention

APA (inc with rollback)

Competent Authority(MAP)

Litigation

5

ConclusionTransfer pricing policies have always been a trade-off between certainty, risk and tax optimisation, withhow to ensure effective dispute avoidance anddispute resolution at the heart of the balance. APAscould provide greater up front certainty, butchallenges remain in a fragmented global taxenvironment. Similarly, while the MAP can help toovercome disputes, there is no certainty that it willbe taken up by the competent authorities orguarantee a solution.

Policies therefore need to be clear, flexible andpragmatic, taking into consideration the need for apersuasive case. They also need to factor inunfolding scenarios and changes in circumstances,the different perspectives of each tax authority andhow to make life easier for overstretched competentauthorities.

It is impossible to take the risk entirely out oftransfer pricing, especially as overly cautiousapproaches could lead to damagingly high tax bills.But well-prepared corporations can eliminate anyunnecessary risk and aggravation.

If you would like any further information onany of the issues raised in this article please contactthe authors or your usual Grant Thornton contact.

Karishma PhatarphekarIndiaT +91 22 5695 4861E karishma.rp@in.gt.com

Paolo BesioItalyT +39 02 76 00 87 51E paolo.besio@bernoni.it.gt.com

Wendy Nicholls UKT +44 (0)20 7728 2302E wendy.nicholls@uk.gt.com

Graham HeadUKT +44 (0)1908 359592E graham.c.head@uk.gt.com

www.gti.org

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