APA strategy - Getting the cocktail mix right!
International Tax Services, EY
The Indian APA program launched in 2012 provides a voluntary process whereby the Tax Authority and the taxpayer may resolve TP issues in a principled and cooperative manner on a prospective basis. In view of the implications of entering into an APA, applicants to the Indian APA program would need to carefully consider the factors that need evaluation to design a winning APA strategy.
An APA normally requires agreement on the following major substantive items:
- Selection and application of the transfer pricing method (TPM)
- Deciding on the years over which comparables’ results are analyzed
- Adjusting the comparables’ results
- Testing results during the APA period
- Critical assumptions
Transfer Pricing Method
In a TP analysis, one picks the most reliable combination of TPM, comparables and adjustments. Choosing this combination requires judgment. The APA Team must develop a clear, detailed understanding of the taxpayer’s business, including the taxpayer’s functional analysis, the industry involved, market conditions and contractual terms. This factual development is much easier to accomplish in cooperative efforts with taxpayers.
The various TPMs may need to be used in a creative manner, based on the economic circumstances and the legitimate concerns of both the Tax Authority and the taxpayer. For example, if an APA’s TPM features a gross margin target for an Indian distributor that purchases from a related foreign manufacturer, the APA Team may be concerned about excessive advertising expenses. Indeed, since advertising expenses do not affect gross margin, a taxpayer could, while staying within the prescribed gross margin range, conduct a large advertising campaign that primarily benefits a related foreign manufacturer that owns the brand name. To prevent this situation, an APA could specify that, for purposes of computing the distributor’s gross margin, advertising expenses above a certain level will be subtracted from sales (and thus decrease the gross margin).
In reviewing the TPMs, it is important to bear in mind the concept of “tested party” and the impact the same could have on the TP result. The choice of tested party (together with the choice of TPM) can reflect a choice about how to allocate risk. Consider a manufacturer selling to a controlled distributor. Testing only the distributor (for example, using a TNMM with an operating margin PLI) assigns the distributor a particular profit range. The distributor must then earn a profit within that range without regard to the system profit. Thus, the distributor might be guaranteed a certain positive profit level even when the manufacturer is sustaining substantial losses and the system profit is negative. In particular cases this result may be a correct assignment of risk. However, in some cases one could argue for a sharing of risk in which both parties are tested.
In some cases, one PLI can be transformed into another PLI. The result is a hybrid combining some features of each. One example is transforming an operating margin into a gross margin. Why should this hybrid approach be used? For example, a taxpayer may want to use a gross margin PLI in order to assign more risk to the tested party than an operating margin PLI would or to give the tested party more incentive to control operating expenses. Yet it may not be reliable to use the comparables’ gross margins. Backing into a gross margin using comparables’ operating margin avoids these issues.
The comparables’ results are adjusted as needed to determine an arm’s length range; and the taxpayer’s results are tested against the arm’s length range. Before all that can happen, however, one must decide the time period over which to compute the comparables’ results.
As APAs are prospective, there is usually a mismatch between the period for which the comparables’ data is used and the period during which the tested party’s results are evaluated (the “APA period”). Taxpayers/ APA Team may therefore need to consider using as late an analysis window as possible, to reduce the mismatch between the analysis window and the APA period. Typically at least three years data may need to be used. For industries with long business or product cycles, longer periods such as five years may need to be considered.
There are technical issues about how to use multiple year comparable data. One approach is averaging each comparable’s results over the analysis window, and then using those average values to construct an arm’s length range/ result. There are different ways to do the averaging. One is a simple average. Another approach is a weighted average i.e. weighting each year’s result by the denominator used in the PLI. An alternative to averaging each comparable’s result over the analysis window is “pooling”. Pooling can produce somewhat different results from averaging. The differences depend on the profit variations between comparables and between years, and which company years have missing data. Pooling might be considered in cases in which some of the comparables are missing data for some years in the analysis window.
After the comparables have been selected, if there are material differences between the controlled and uncontrolled transactions, adjustments must be made if the effect of such differences on prices or profits can be ascertained with sufficient accuracy to improve the reliability of the results. One type of adjustment which may need to be considered has been variously called an “asset intensity,” or “working capital” adjustment.
An issue that arises while undertaking an asset intensity adjustment concerns the tested party’s asset levels. Conceptually, the comparables’ results and the comparables’ and tested party’s asset intensities in the analysis window are used as a proxy for what these results and asset intensities are expected to be during the APA years. Typically the assumption that the APA years will be similar to the analysis window in this regard seems reasonable, so that one proceeds on that basis. However, in some cases this assumption is not accurate. If the tested party’s receivables intensity climbs substantially between the analysis window and the APA years, the computed arm’s length range of operating margins could change significantly in the direction of increased profitability. This may need to be addressed by considering the expected asset intensity levels as part of the critical assumptions.
Testing results during APA period
Once an arm’s length range is determined, the results of the tested party must be measured against that range. If the results are outside of that range an adjustment to income may be warranted and there may be other consequences. A preliminary question is the time period over which to test the tested party’s results. The simplest approach is to test each year’s results against the arm’s length range. Other approaches involve averaging over a multiple-year period. There are different approaches to such testing. One approach is to require only that the average results within all the APA years in aggregate fall within the arm’s length range. Another approach is to use a rolling average over a number of years, for example a three year rolling average. Taxpayers may need to consider average testing if their industry is subject to cyclical or otherwise fluctuating return.
Sometimes compromise approach may need to be considered – for example, a taxpayer maybe willing to accept a narrower range in exchange for being tested on an average basis.
An APA process may need to envisage the use of compensating adjustments where the result falls outside the agreed price but is within the critical assumptions boundary. The reason for permitting such adjustments is that it is often difficult for taxpayers to ensure a result within the range during its tax year; only after the year’s end, when complete accounting data are available, can taxpayers take final stock of the results. APAs may also need to address the collateral consequences of such adjustments as well.
APAs include critical assumptions upon which their respective TPMs depend. Critical assumptions are objective business and economic criteria that form the basis of a taxpayer’s proposed TPM. Failure to meet a critical assumption may render an APA inappropriate or unworkable. The APA may need to be renegotiated or, failing that, cancelled. It would be useful to consider the following guidelines for avoiding problems with Critical Assumptions:
- Make critical assumptions extreme outer limits.
- When possible, make critical assumptions objective. For example, refer to sales dropping by a definite percentage rather than sales dropping “substantially.”
- Try to use TPM provisions rather than critical assumptions. For example, instead of having a critical assumption that sales not fluctuate too much from budgeted amounts, it might be possible instead to provide that such fluctuations will cause certain adjustments to the range.
- Do not confuse critical assumptions with the scope of the APA. For example, an APA may specify that new product types will not be covered. This provision should be part of the definition of covered transactions; the APA should not include a critical assumption that new products not be introduced.
- Do not confuse critical assumptions with obligations of the taxpayer. For example, an APA may require a taxpayer to record certain information in a regularly compiled database. This obligation of the taxpayer is not a critical assumption and should not be so labelled.
Since the launch of the APA program, there has been an enthusiastic response from taxpayers. Taxpayers would need to consider a wide range of issues for designing a winning APA strategy as the APA process moves into the next stage. Failure to navigate or address some of these issues during the APA discussions stage could result in an adverse APA which may not provide certainty nor reduce the compliance burden. Given the nascent stage of the Indian APA program, a number of these issues are still green field areas for the Indian APA Team as well as for taxpayers. Creativity and flexibility often are critical to reaching a successful APA resolution.