Transfer pricing is regularly viewed as one of the most important and complex tax issues for multinational corporations. The complexity of transfer pricing seems to be growing as businesses continuously restructure operations around the globe to remain competitive and tax authorities struggle to prevent tax base erosion.

Tax authorities around the globe have dramatically increased transfer pricing compliance efforts to prevent tax base erosion and to raise tax revenues. This is evidenced by the raft of new regulations that are being introduced by the tax authorities.

What clearly emerges from this flurry of activity is that the tax authorities will focus on (a) risk-shifting arrangements between related parties and (b) economic ownership of intellectual property among members of a multinational group. The tax authorities are more likely to use arguments that stretch the arm’s-length principle and, therefore, lead to more controversies.

Negotiating an advance pricing agreement (APA) can be an extremely cost-effective strategy to obtain prospective agreement with the tax authorities on transfer pricing. The strategy not only helps in avoiding audits, adjustments and penalties but also indirectly saves on compliance costs and potential costs of controversies. While the benefits can be quantified, they are expected to be generated over several years. However, the costs of APA are usually front-loaded. In bad economic times, many corporations hesitate to incur such upfront costs.

Of course, APAs are not suitable for all kinds of transactions. In considering an APA, the following should be considered – (a) unilateral or bi/multilateral - most controversial issues are better handled bilaterally because of the inherent balancing impact of the interests of two taxing authorities. However, not all transactions are between treaty partners or countries with APA programmes; (b) likelihood of future controversy - the higher the likelihood the higher the benefits of APA; (c) experience of the tax authorities in dealing with similar transactions - the lower their experience, the higher is the cost of educating them and (d) differences in facts and circumstances relative to industry average or industry norms - the larger the difference, the more beneficial it is to have an APA.

The APA process requires the taxpayer to propose an appropriate transfer pricing methodology to the tax authorities for their review, negotiations, and potential counter-proposal. An APA request that contains a thorough and thoughtful transfer pricing analysis (including addressing potential alternative methodologies) is generally viewed as more credible and persuasive compared to a request with a less thorough and thoughtful analysis. A thorough analysis that evaluates the taxpayer’s proposed methodology and the potential methodologies that the tax authority is likely to apply also allows the taxpayer to be proactive in the negotiations by being able to quickly respond to tax authority questions instead of reacting to numerous requests for additional data and analyses. The appropriate level of thoroughness depends on (a) the complexity of transactions and (b) the experience level of the tax authorities in dealing with such issues.

While it costs more to prepare a thorough and thoughtful analysis to include in the APA request, the additional credibility and persuasion it provides makes the APA process more efficient and less costly during the negotiation phase because it allows the taxpayer to proactively manage the negotiation process. It also, allows the taxpayer to have better control over the final outcome.

In bad economic times some may be tempted to file an APA request with a less than thorough analysis to save upfront costs. However, the tax authorities often view a less than thorough transfer pricing analysis as self-serving and less credible. This is likely to result in the tax authorities taking control of the negotiation process by making additional requests for information and proposing many alternative methodologies to which the taxpayer must respond, which are costly. Also such back and forth with the tax authorities prolongs the review and negotiation process, making this less thorough approach potentially far more expensive when all costs are aggregated. Therefore, the correct way to analyse the costs and benefits of an APA should be to look at the benefits over the APA period in accordance with the aggregate costs of negotiating the APA (not just the cost of filing an application).

Information published by the tax authorities demonstrate that there are many cases that take five or more years to settle from the time of filing. Anecdotal evidence also suggests that tax authorities are beginning to reject applications that do not contain a full description of facts and a thorough analysis. The authorities are reluctant to do the work for the taxpayers.