TAX

ADMINISTRATION

IRS’ Advance Pricing

Agreement Program

United States General Accounting Office

GAO Report to the Honorable

Byron L. Dorgan, U.S. Senate

August 2000

GAO/GGD-00-168

United States General Accounting Office General Government Division

Washington, D.C. 20548

Page 1 GAO/GGD-00-168 Advance Pricing Agreement Program

B-283781

August 14, 2000

The Honorable Byron L. Dorgan

United States Senate

Dear Senator Dorgan:

Any company that has a related company with which it transacts business

needs to establish transfer prices for its intercompany transactions. The

pricing of intercompany transactions affects the distribution of profits

among the related companies and, ultimately, the taxable income of the

companies. To help curtail complex, lengthy, multimillion-dollar transfer

pricing disputes with business taxpayers, the Internal Revenue Service

(IRS) developed an advance pricing agreement (APA) program. Under an

APA, IRS and taxpayers agree on the methods to determine the prices that

related companies charge each other when transferring goods and services

over a specified period. Taxpayers also agree to submit annual reports that

demonstrate compliance with the terms of the agreements. APAs can be

either unilateral—between only IRS and specific taxpayers—or bilateral—

involving negotiations with tax authorities in countries that have income

tax treaties with the United States.

This is the second report in response to your request that we review

various transfer pricing issues.1

As agreed with your office, the objectives

of this report are to determine (1) the extent of APA use by U.S. taxpayers,

including those that have had transfer pricing disputes with IRS; (2) the

timeliness of IRS’ APA processing; and (3) the results of IRS’ review of

taxpayers’ annual reports on compliance with APAs.

To fulfill these objectives, we interviewed IRS officials and other people

knowledgeable about IRS’ APA program. We also analyzed information

from several IRS databases. This report includes information on IRS’ APA

program from January 1991, when the first APA was approved, through

September 30, 1999. We did our review in Washington, D.C., from July 1999

through April 2000 in accordance with generally accepted government

auditing standards. (See app. I for a complete discussion of our objectives,

scope, and methodology.)

1

We previously issued Tax Administration: Foreign- and U.S.-Controlled Corporations That Did Not Pay

U.S. Income Taxes, 1989-95 (GAO/GGD-99-39, Mar. 23, 1999).
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Based on IRS information, as of September 30, 1999, 244 business

taxpayers had either entered into an APA with IRS or had one pending. IRS

records also showed that at least 88 other taxpayers were identified as

having considered APAs, but for various reasons, they did not complete

the process.2

According to an IRS official, the majority of taxpayers

involved in its APA program were large corporations, and they were

spread across many industries.

Also, most U.S. taxpayers that had recent transfer pricing disputes with

IRS had not participated in the APA program as of September 30, 1999.3

As

of that date, 10 percent of the 1,245 large corporate taxpayers with

international related parties had an approved agreement or had one

pending, but the 10 percent accounted for 42 percent of the dollar value of

the intercompany transactions in our analysis of large taxpayers.4

IRS did not consistently meet its timeliness targets for processing

unilateral APAs and the first phase of bilateral APAs. Although IRS did not

have targets for completing bilateral agreements in their entirety, some

were pending for several years, even after their proposed time periods had

expired. In particular, IRS did not have targets for completing the part of

bilateral agreements involving negotiations with tax authorities in other

countries. While IRS has acted to address what its officials said were some

of the reasons for the timeliness problems, it is unlikely to resolve them

without gathering more information to determine the causes. As a result,

we are recommending that IRS gather such information and that IRS test

target timeframes for approving bilateral APAs.

According to IRS, only a few problems were found in its reviews of APA

annual reports. IRS stated that, of the 211 annual reports reviewed

between October 1, 1995, and late September 1999, only 15 reports

involving 11 taxpayers caused IRS to adjust or consider adjusting tax

returns.

2

Some taxpayers who considered APAs did not identify themselves to IRS and, thus, are not included in

the 88 taxpayers. Taxpayers might use a representative to contact IRS informally about APAs and

remain anonymous until they decide to formally pursue an agreement.

3

This relates to taxpayers involved in IRS’ section 482 international examination or appeals cases

between Oct. 1, 1994, and Dec. 31, 1998. We used this information because IRS had already compiled

and used it in Apr. 1999, shortly before we began our work. (See table 1 and app. I for specific

timeframes.)

4

In this context, a large corporation is one with reported assets in tax year 1994 of $500 million or more

for U.S. parent companies of controlled foreign corporations or, in general, total reported receipts of

$500 million or more for foreign-controlled domestic corporations.

Results in Brief
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In commenting on a draft of this report, the Commissioner of Internal

Revenue agreed with our recommendations and described several other

IRS initiatives to improve the APA program. These initiatives included

approximately doubling the APA professional staff over 2 years and

changing the annual report review process.

Transfer pricing is governed by section 482 of the Internal Revenue Code

and its accompanying regulations. Accurate transfer pricing is important

because it affects the distribution of profits among related companies and,

thus, their taxable income and may also affect the distribution of tax

revenue among countries.

Using APAs, IRS seeks to avoid transfer pricing disputes between it and

business taxpayers by reaching prospective agreements with each

taxpayer on the (1) appropriate transfer pricing methodologies that are to

be applied to intercompany transactions and (2) results that are likely to

occur from applying the methodologies. Intercompany transactions

include those between U.S. taxpayers and their controlled foreign

corporations (CFCs) and between entities abroad and their foreigncontrolled corporations (FCCs) in the United States.5

Taxpayers who consider APAs do so voluntarily and pay IRS processing

fees when they request an APA. APAs cover a specified time, often 3-5

years, and may be renewed or revised if IRS and the taxpayer agree. IRS

may cancel or revoke an APA under certain circumstances, such as cases

involving a misrepresentation or fraud. In addition, APAs may cover all of

a taxpayer’s transfer pricing activities or may be restricted to certain

related companies or products. IRS’ policy provides that the agreed-upon

transfer pricing methodology may be applied retroactively to similar

unresolved issues identified during previous audits of the taxpayer.

In January 1991, IRS approved its first APA and, shortly after that, issued

procedures that implemented its APA program. It also adopted streamlined

procedures in December 1998 to encourage small businesses meeting

certain total gross income or intercompany transaction thresholds to

participate in the program.

Several IRS organizational units are involved in the APA program,

principally the APA program office within the Office of Chief Counsel. This

5

A CFC is a foreign corporation in which U.S. shareholders own more than 50 percent of the value of

the outstanding voting stock or all of the value of the outstanding stock. In the context of our report,

an FCC is a U.S. company in which a foreign shareholder owns at least 25 percent of the voting power

of stock allowed to vote, or 25 percent of the value of all the corporation’s stock.

Background
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office is to work closely with IRS examiners who audit income tax returns,

Appeals representatives who work on appeals of examined cases, and

others in developing the proposed agreements with taxpayers.

When the APA program office considers a bilateral agreement, it develops

its position on the proposed APA with the taxpayer but leaves the

negotiation with the foreign government on such matters as the

appropriateness of the transfer pricing methodology to the U.S. Competent

Authority. Under U.S. tax treaties, the IRS Assistant Commissioner

(International) is the U.S. Competent Authority, a role recently assumed

under an IRS reorganization by the IRS Director, International. A tax treaty

requires each country to designate a “competent authority” to administer

the treaty’s operative provisions. The U.S. and foreign competent

authorities negotiate APA matters with each other under the applicable

treaty’s framework. The U.S. Competent Authority uses IRS’ Tax Treaty

Division as staff.

In administering approved agreements, APA program officials and IRS

examiners are to review taxpayers’ annual reports on their APAs

describing actual operations during the year to ensure that they

demonstrate compliance with the terms of the agreements. The annual

report for each year of the agreement is to identify all material differences

between the taxpayer’s actual and expected business operations, all

material changes in its methods of estimation, and all failures to meet

critical assumptions.

Legislation enacted in December 1999 prohibited disclosure of specific

APAs and APA background files but required the Department of the

Treasury to report annually to Congress general information on APAs.6

The

first report, which included such information as the number of APA

applications filed, the number of APAs revoked or canceled, the number of

APAs by industry, and general descriptions about the substance of the

APAs, covered January 1, 1991, through December 31, 1999. It was issued

on March 30, 2000.7 Because our APA cutoff date differed from IRS’, some

statistics in our report also differ from IRS’.

6

P.L. 106-170, Ticket to Work and Work Incentives Improvement Act of 1999.

7

Annual Report Concerning Advance Pricing Agreements (IRS, Mar. 30, 2000).
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Various measures exist on the extent to which taxpayers have used IRS’

APA program. For instance,

• 244 taxpayers involved in various industries and countries had approved or

pending APAs;

• most taxpayers with recent section 482 international examination findings

or appeals determinations did not participate in APAs;8 and

• a few large taxpayers that participated in APAs accounted for much

intercompany trade.

As of September 30, 1999, 244 taxpayers had entered into an APA, that is,

agreed to one that IRS also approved, or had one pending. In addition to

these taxpayers, at least 88 others considered APAs but did not complete

the process for various reasons, including their voluntary withdrawal of

their proposal or IRS’ rejection of it.9

Although a majority of the taxpayers

with APAs were large corporations according to an IRS official, eight small

business taxpayers had completed agreements under IRS’ small business

APA program as of September 30, 1999.

Also as of September 30, 1999, IRS reported that of the 400 APAs in its

records, 210 had been approved since the program’s inception in 1991, and

190 others were in various stages of development. The number of

taxpayers involved was less than the number of agreements because some

taxpayers had more than one APA.10 According to IRS data, 247 of the 400

approved and pending APAs were bilateral ones with 15 countries, and

most of them involved 4 countries.

The taxpayers in IRS’ APA program represented many different industries.

As reported by IRS in March 2000, the agreements reached between IRS

and taxpayers as of December 31, 1999, were spread over 21 broad

industrial categories.11 However, five industries were predominant among

the 21 categories—financial institutions and products; computer items and

computer software; chemicals and related products; transportation

equipment; and electrical equipment and components.

8

See table 1 notes for specific time periods.

9

We could not obtain employer identification numbers for 20 of the 88 taxpayers for which the APA

process was discontinued. This means that the tables in this report might not include all taxpayers in

the databases we studied that considered obtaining an APA but did not complete the process.

10About 19 percent of the 400 agreements were renewals of previous agreements.

11IRS’ March 2000 APA annual report. The industrial categories were devised by IRS staff who reviewed

APA files to develop the APA annual report.

The Extent of APA Use

by Taxpayers Varied

244 Taxpayers Involved in

Various Industries and

Countries Had Entered Into

APAs or Had Them Pending
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Most taxpayers with recent section 482 international examination

proposed adjustments to income or significant section 482 issues subject

to appeals determinations did not have approved or pending APAs as of

September 30, 1999.

As table 1 shows, taxpayers with approved or pending APAs as of

September 30, 1999, accounted for a small proportion of the taxpayers (72,

or 6 percent of 1,150) that had section 482 examination disputes with IRS

in fiscal years 1996 through 1998. For these 1,150 taxpayers, IRS’

international tax return examiners proposed $15.4 billion in section 482

adjustments to income.12 (See app. II for more information on the extent of

APA use by taxpayers with recent section 482 proposed adjustments.)

APA status

Number of taxpayers with

Approved or

pending

agreements

Process

discontinued

No APA

experience Total

Proposed examination adjustmentsa72 23 1,055 1,150

Nontrial appeals closedb17 11 91 119

Appeals openc 18 10 76 104

Note 1: The information in this table is for the APA program as of Sept. 30, 1999.

Note 2: Because we could not obtain employer identification numbers for 20 taxpayers whose APA

process was discontinued, this table might not properly reflect those taxpayers. If any of them had an

employer identification number that matched an employer identification number in the examination or

appeals database, those taxpayers would have appeared in the “process discontinued” column.

a

These taxpayers had section 482 international examination cases closed in fiscal years 1996-98.

b

These taxpayers had section 482 appeals cases closed between Oct. 1, 1994, and Dec. 31, 1998.

c

These taxpayers had appeals cases open as of Dec. 31, 1998.

Source: GAO analysis of IRS information.

As was the case with section 482 proposed adjustments, taxpayers with

approved or pending APAs accounted for a small percentage (14 percent)

of section 482 large issue appeals determinations.13 Of the 119 taxpayers

that had $8.1 billion in appeals cases closed between October 1, 1994, and

December 31, 1998, without trial, 17 taxpayers had an approved or pending

APA as of September 30, 1999. Taxpayers with approved or pending APAs

accounted for 18 of the 104 taxpayers involved in open section 482 appeals

cases, which had $16.2 billion at issue as of December 31, 1998.

12Other taxpayers with approved and pending APAs had section 482 adjustments proposed in

examinations closed before fiscal year 1996.

13IRS did not track every section 482 issue but focused on significant ones for large corporations.

Most Taxpayers With

Recent Transfer Pricing

Disputes Did Not

Participate in APAs

Table 1: Involvement in APA Program of

Taxpayers With Section 482 Disputes
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Another way to describe the extent of APA use by taxpayers is to discuss

the extent to which taxpayers in international intercompany trade

participated in the APA process. According to IRS data, a small percentage

of the 1,245 large taxpayers with international intercompany transactions

participated in IRS’ APA program; however, those taxpayers that did

participate included some with the largest receipts from, or payments to,

related parties. As of September 30, 1999, 10 percent of the large taxpayers

had approved or pending APAs. However, these taxpayers accounted for

42 percent of the dollar value of the large corporations’ intercompany

transactions included in the information we used.14 These percentages

cover both transactions with CFCs and transactions with FCCs and their

foreign related parties. (See app. III for information on the extent of APA

use by U.S. parent companies of CFCs and app. IV for data on the extent of

APA use by FCCs.)

IRS did not consistently meet its timeliness targets for completing APA

processing. In some instances, APAs were pending for years. We found

many reasons why IRS was unable to complete the processing of APAs as

quickly as IRS officials had hoped; some were related to its management of

the APA program and some were related to differences in views with its

treaty partners. IRS took some actions to improve APA timeliness, but did

not go as far as it could have.

The timeliness of IRS’ APA processing varied. For unilateral APAs, IRS’

target was generally 12 months from application, with the target for small

businesses being 6 months. For fiscal year 1999 unilateral APAs, the

median completion time was 12.5 months—slightly more than the target

and the lowest median since 1993. Eleven 1999 unilateral APAs exceeded

the target by 2 to 32 months. The median completion time for fiscal year

1998 was 16 months. The median for fiscal years 1998 and 1999 together

was 14.5 months, but excluding renewals and small businesses, the median

was 24 months.15 The median times for APA renewals and small businesses

for the 2 years were 7.5 and 5 months, respectively, with the small business

actual time less than the target. IRS procedures did not specify a separate

targeted completion time for approving renewals.

With regard to bilateral APAs, IRS had a target for completing only the first

phase of the two-phase process. In the first phase, IRS and the taxpayer

14We did not determine if these transactions were actually involved in APAs.

15According to APA officials, renewals entail reviewing submitted information and meeting with

taxpayers and could involve changed business circumstances or transfer pricing methodologies. The

first small business APA was approved in fiscal year 1998.

A Few Large Taxpayers

Participating in APAs

Accounted for Much

Intercompany Trade

IRS Did Not

Consistently Meet Its

APA Timeliness

Targets

The Timeliness of IRS’ APA

Processing Varied
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agree on the transfer pricing methodology, and the IRS APA team then

formulates a negotiating position for use by the U.S. Competent Authority

in further negotiations with foreign tax authorities. IRS’ target for this part

of the bilateral APA process was 9 months. However, for the bilateral

agreements IRS approved in fiscal year 1999 for which we had information,

the APA office used a median time of 18 months to complete the initial

phase of bilateral processing. Including competent authority time, for

which IRS does not have a target, that year’s approved bilateral

agreements required a median time of 32 months for approval, the most

time since the program began in 1991.16 Approved bilateral agreements

required a range of 10 to 60 months. Forty-two bilateral APAs were

pending as of September 30, 1999, even though their applications were

filed between calendar years 1993 and 1996. (See app. V for competent

authority contributions to APA processing time.)

Despite the intended prospective nature of APAs, IRS was unable to

consistently approve all APAs before their proposed terms of coverage

ended, so the agreements would have to be applied retroactively. Based on

IRS mid-calendar year 1999 data, at least 25 applications for bilateral APAs

were still pending even though their proposed terms had passed. While the

taxpayers involved might have filed their tax returns knowing IRS’ transfer

pricing preferences, the “advance” nature of the APAs might have been

compromised. Also, completing APAs after relevant tax returns were filed

could have kept taxpayers in suspense about their tax treatment and

required adjusting their tax returns.

In many instances, IRS reviews of APA annual reports were pending for a

longer amount of time than the period the reports covered. According to

an IRS official, IRS did not meet various informal timeliness guidelines

relating to its process for reviewing the annual reports. On the basis of IRS

statistics, 120 of 240 annual reports pending IRS review as of September

30, 1999, had been pending with IRS for more than a year, and 50 had been

pending for more than 2 years. According to an IRS official, APA teams

reviewing renewal applications had reviewed some of these annual

reports, but this was not reflected in the Chief Counsel’s database that

contains such information. The IRS official could not say when the annual

report review backlog would be eliminated. However, IRS was planning to

revamp its procedures for reviewing annual reports to speed up the

process.

16Seven renewed bilateral APAs and one revision completed between Sept. 30, 1997, and Sept. 30, 1999,

took a median of 24.5 months, less than the 31-month median for new bilateral APAs in those 2 years.

Many IRS Reviews of APA

Annual Reports Were

Pending for More Than a

Year
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IRS officials and others knowledgeable about IRS’ APA program were

concerned about how much time it took to complete APAs and offered

reasons for APA delays. IRS officials said that they had acted to address

some of their concerns and were considering other suggestions.

In addition to the inherent difficulty of handling contentious cases

involving large amounts of tax, IRS officials and others attributed delays

within IRS’ APA program office to various factors. Both IRS officials and

others cited the need for more APA staff and less staff turnover.

Individuals outside IRS also mentioned the following: (1) IRS’ field staff,

with their traditional audit focus, were overly involved in a process that

was intended to be cooperative; (2) IRS had difficulty making decisions

about proposed APAs; and (3) taxpayers delayed the process by not

expeditiously giving IRS requested information.

IRS officials and others agreed that bilateral APA negotiations between it

and U.S. tax treaty partners could take a substantial amount of time

because, for instance,

• other countries sometimes preferred a different transfer pricing

methodology than IRS preferred;

• APA negotiation meetings between IRS and some countries were

infrequent;

• the level of some foreign governments’ resources devoted to APAs was

inadequate; and

• other countries were reluctant to negotiate on APAs because they feared

changes in APA confidentiality before the 1999 legislation prohibited

disclosing APAs and APA background files.

In addition, individuals knowledgeable about IRS’ APA program said that

having a single office negotiate with both the taxpayer and the foreign

government, a structure that some foreign tax authorities have had, was

more efficient than IRS’ structure of using two offices to negotiate bilateral

agreements. Other knowledgeable individuals, however, saw benefit in

having people involved who had experience negotiating with treaty

partners. Our work did not address the efficiency of IRS’ structure for

processing APA applications or those of foreign tax authorities.

IRS has acted over the past few years to address the reasons for its APA

timeliness problems. According to IRS officials, the APA program office

started requiring a case plan and schedule for each proposed APA,

specifying timeframes for completing various negotiation steps with the

taxpayer within the APA office. IRS also targeted for completion all APA

APA Timeliness Concerns

Existed for Many Reasons

Reasons Given for APA Delays

IRS Actions to Improve APA

Timeliness
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cases that were at least 2 years old. In addition, to speed up reviewing APA

annual reports, IRS assigned one person to coordinate the reviews, rather

than having APA negotiating staff be responsible.

Although IRS had taken actions over the past few years to address its APA

timeliness concerns, it was not systematically gathering information to

determine the reasons for processing delays and, thus, did not have

reliable information to make process improvements. For instance, its APA

case files did not specifically annotate whether timeframes in its plans and

schedules were met, and if they were not met, the reasons why. Nor did

IRS make full use of the APA data in its Chief Counsel’s Automated

Systems Environment (CASE) database. APA officials did not use

information from CASE on step-by-step processing times because, among

other things, the dates in the database were not always accurate. As a

result of these failures to collect and use APA data, IRS lacks information

for making improvements to the program.

APA officials were concerned about the extra burden associated with

annotating case files. One way to help reduce the burden would be for APA

officials to capture this information for approved APAs when recording the

data needed to prepare the annual report to Congress on APAs. Another

way would be to modify CASE to continually capture information on why

problematic APAs were delayed and where the responsibility for delays

resided. An APA official said that this was a less costly alternative for

capturing information on processing delays than annotating case files.

On a related matter, IRS did not have a timeliness target for completing all

processing related to bilateral APAs, including the negotiation with foreign

tax authorities. An IRS official told us that at least in recent years, IRS had

not focused on having a target. The United Kingdom, however, publicly

wrote that it and other affected tax authorities should aim to complete

bilateral APAs within 18 months, depending on the applicant’s ability to

provide information in a timely way.

Also emphasizing the importance of targets, a private firm representing

taxpayers advised IRS to include in the impending revisions to its APA

procedures the target times it already had for approving unilateral APAs

and formulating the negotiating position to use with foreign tax authorities

for bilateral agreements. By doing so, the firm said, it would reinforce the

idea that timely completion of APAs is both an IRS priority and an element

critical to the APA program’s future success.

Possibilities for Improving APA

Timeliness
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IRS officials were open to the possibility of establishing targets for

completing bilateral APAs. However, they were wary of adopting other

countries’ targets as their own and using them in negotiations with those

countries or having different targets for different countries. In addition,

one official was concerned that another country’s target might be

optimistic. Also, according to IRS officials, targets would need to achieve a

balance between efficient processing and prudent tax administration, not

sacrificing appropriate APA outcomes for the sake of meeting deadlines.

These officials described giving taxpayers good customer service and

providing a model for relations with other countries as benefits of setting

targets. IRS officials told us they wanted APAs approved more quickly than

they have been, and having an APA’s term elapse before completion was

disappointing and frustrating to both them and taxpayers. Taxpayers had

no certainty, and IRS had to acknowledge the lengthy process up front

when dealing with taxpayers.

According to IRS, only a few problems were found in the APA annual

reports that staff reviewed. Of the 211 annual reports staff reviewed

between October 1, 1995, and late September 1999, IRS staff found

circumstances in 15 reports affecting 11 taxpayers that appeared to be

problematic. For these taxpayers, adjustments to their income tax returns

had been made or were still being considered when we completed our

review. Adjustments were needed because IRS believed the taxpayers did

not fully comply with the terms of the APA. Problems included

inappropriate costs being charged and certain income not being reported.

An IRS official estimated these adjustments to taxpayers’ income would

total at least $132 million, with additional amounts still being developed.

Delays in APA processing could adversely affect business taxpayers,

leading, for instance, to retroactive adjustments to tax returns and

preventing taxpayers from getting the advance certainty about their tax

situations that they seek. Delays that discourage participation in the APA

program could also lead to more disputes that are costly to both the

taxpayer and the government.

With better information on the reasons for APA delays, IRS would have

more of a basis for making improvements to the APA program. Also,

although IRS officials were wary of setting targets for completing the

processing of bilateral APAs, such targets might establish expectations for

more timely bilateral APA negotiations on the part of both American

taxpayers and other countries.

IRS’ Reviews of APA

Annual Reports Found

Few Problems

Conclusions
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We recommend that the Commissioner of Internal Revenue take steps to

cost-effectively collect data on APA processing suitable for analyzing the

causes of delays and developing options for improvement. Such steps

might include documenting deviations from plans or schedules and the

reasons why in case files or modifying CASE to systematically capture

such data.

We also recommend that the Commissioner test the use of written

timeliness targets for processing bilateral APAs to determine the feasibility

of using them for all bilateral APAs.

In commenting on a draft of our report, the Commissioner of Internal

Revenue said it was fair and informative. He agreed with our

recommendations and also described other initiatives to improve the APA

program. He shared our concerns about the time taken to process APAs

and found our recommendations helpful.

In agreeing to collect more data on APA processing, the Commissioner

said that, by September 1, 2000, the APA program would create codes

within CASE to capture data on the causes of APA case-processing delays.

According to the Commissioner, the change will allow IRS to monitor the

causes for delays and address and correct structural and case-specific

problems identified.

The Commissioner also mentioned three other measures to improve APA

processing times. First, because it believed resource constraints were the

main cause of APA cases taking a long time, IRS expected to

approximately double the size of the APA professional staff over 2 years.

Second, the Commissioner for Large and Mid-size Business within IRS

indicated that, as part of his initiative to promote IRS-taxpayer cooperation

before tax returns are filed, he was preparing a staffing initiative to help

the processing of bilateral APAs. Finally, agreeing that the backlog in

reviewing annual reports should be reduced, IRS was planning to change

the review process. Although the APA program office has made marked

progress in reviewing annual reports, starting September 1, 2000, IRS’

operating divisions, with their larger resources, and not the APA program

office, are to do the first and primary review of annual reports.

Agreeing with our recommendation that IRS test the use of written

timeliness targets for processing bilateral APAs, the Commissioner said

IRS will immediately approach several treaty partners to pursue such

targets bilaterally. It will do so in the context of not jeopardizing the timely

resolution of non-APA cases. Also, it will do so keeping in mind that

Recommendations to

the Commissioner of

Internal Revenue

Agency Comments
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general timeliness targets should not be misunderstood. That is, the time

to process specific cases may vary substantially depending on their

complexity.

The full text of the Commissioner’s comments is reprinted in appendix VI.

As agreed with your office, unless you publicly announce its contents

earlier, we plan no further distribution of this report until 30 days from the

date of this letter. At that time, we will send copies to Senator William V.

Roth, Jr., Chairman, and Senator Daniel Patrick Moynihan, Ranking

Minority Member, Senate Committee on Finance; Representative Bill

Archer, Chairman, and Representative Charles B. Rangel, Ranking Minority

Member, House Committee on Ways and Means; the Honorable Charles O.

Rossotti, Commissioner of Internal Revenue; and other interested parties.

Copies will be made available to others upon request.

If you or your staff have any questions about this report, please contact

Charlie Daniel or me on (202) 512-9110. Key contributors to this report are

acknowledged in appendix VII.

Sincerely yours,

James R. White

Director, Tax Policy

and Administration Issues
Page 14 GAO/GGD-00-168 Advance Pricing Agreement Program

Contents

1 Letter

Appendix I 16

Objectives, Scope, and

Methodology

Appendix II 20

The Extent of APA Use

by Taxpayers With

Section 482 Proposed

Adjustments

Appendix III 22

The Extent of APA Use

by Large U.S. Parent

Companies of

Controlled Foreign

Corporations

Appendix IV 24

The Extent of APA Use

by Large ForeignControlled

Corporations

Appendix V 26

Competent Authority

Contributions to APA

Processing Times
Contents

Page 15 GAO/GGD-00-168 Advance Pricing Agreement Program

Appendix VI

Comments From the

Internal Revenue

Service

27

Appendix VII 32

GAO Contacts and

Staff

Acknowledgments

Table 1: Involvement in APA Program of Taxpayers With

Section 482 Disputes

6

Table III.1: Participation of Large CFC Parent Companies

and Their CFCs in IRS’ APA Program

22

Table III.2: Payments by CFCs Whose Parent Companies

Were or Were Not Involved in APAs

23

Table IV.1: Largest FCCs’ Involvement in IRS’ APA

Program

24

Tables

Abbreviations

APA advance pricing agreement

CASE Chief Counsel's Automated Systems Environment

CFC controlled foreign corporation

FCC foreign-controlled corporation

IRS Internal Revenue Service

USCC U.S.-controlled corporation
Appendix I

Objectives, Scope, and Methodology

Page 16 GAO/GGD-00-168 Advance Pricing Agreement Program

The objectives of this report were to determine (1) the extent of advance

pricing agreement (APA) use by U.S. taxpayers, including those that have

had transfer pricing disputes with IRS; (2) the timeliness of APA

processing; and (3) the results of IRS’ review of taxpayers’ annual reports

on compliance with APAs.

In determining the extent of APA use, we took two approaches. First, by

analyzing databases containing APA information, we ascertained the

number of taxpayers involved in the APA program and gathered from the

databases descriptive information about each taxpayer, such as the

employer identification number. Second, by matching these databases with

others, we determined the extent to which taxpayers with contentious

transfer pricing histories or international intercompany transactions

became part of the APA process.

The information we are reporting, such as the number of taxpayers with

approved or pending APAs and the number of taxpayers with histories of

transfer pricing disputes with IRS, was not an assessment of the

effectiveness of the APA program. Such an assessment would require a

more substantive, in-depth analysis than our work intended. However,

some of our analysis could be used to draw inferences that could lead to

improving the program. In addition, recognizing that APAs are voluntary

agreements by taxpayers is important because taxpayers might have

legitimate reasons for not participating in IRS’ APA program. For example,

some taxpayers might not want to pay the fee involved with the APA

process, which could be up to $25,000.

For our study, we obtained certain types of information, such as the

identity of taxpayers that did identify themselves to IRS before filing APA

applications, from the Chief Counsel’s Automated Systems Environment

(CASE). This system was designed to, among other things, track various

Chief Counsel cases. We also used IRS’ APA program office databases of

APA cases that included information on those that were approved or

pending.

We compared the information from these databases on the taxpayers that

had been involved in the APA program as of September 30, 1999, with

information on taxpayers in two of IRS’ Statistics of Income Division

databases. Our purpose was to determine the extent to which large

taxpayers with international intercompany transactions were involved in

the APA program. We used the Statistics of Income Division’s tax year

1994 databases on foreign corporations controlled by large U.S.

multinational corporations and on large foreign-owned domestic
Appendix I

Objectives, Scope, and Methodology

Page 17 GAO/GGD-00-168 Advance Pricing Agreement Program

corporations, which we call foreign-controlled corporations (FCCs). These

databases were the most recent available when we began our work.

As IRS wrote in an article resulting from the use of the FCC database, it

could not locate all the needed corporate income tax returns in time to be

included in its population of FCCs.1Thus, some of the returns it did have

were given a sampling weight of more than one to compensate for those

missing. Because of some imprecision owing to sampling variability, we

used IRS’ sampling weights to calculate confidence intervals for the FCC

estimates used in this report. Unless otherwise noted, we are 95-percent

confident that actual population values are within plus or minus 5 percent

of the estimates we report.

To determine the extent to which taxpayers with section 482 examination

findings appeared in IRS’ APA databases, we compared information for

examinations completed in fiscal years 1996 through 1998 from IRS’

International Case Management System with information from the APA

databases. The International Case Management System contains the

results of IRS examinations of the international features of tax returns. We

used information from fiscal years 1996 through 1998 because IRS had

already segregated this information for its April 1999 report to Congress on

section 482.2

Further, we matched the taxpayers in IRS’ APA databases as of September

30, 1999, with taxpayers that had appeals cases with section 482 issues.

Our purpose in doing this was to obtain general information on the extent

to which taxpayers involved in IRS’ appeals process were also involved

with APAs. We used an IRS database that tracks appeals cases covering

large corporations and major appeals issues. Our focus was on cases that

had closed between October 1, 1994, and December 31, 1998, or were still

open as of December 31, 1998. Like the examination findings data, the

appeals data on closed section 482 cases had already been used by IRS in

its 1999 report to Congress on section 482.

Although we did not audit to determine the accuracy and reliability of the

information in any of these databases, we checked the reasonableness of

the results we obtained against other information we acquired from IRS.

Such checking was necessary because we determined from our

discussions with IRS officials with knowledge about the different

1

“Transactions Between Large Foreign-Owned Domestic Corporations and Related Foreign Persons,

1994,” IRS, SOI Bulletin (Winter 1997–1998).

2

Report on the Application and Administration of Section 482 (IRS, Apr. 1999).
Appendix I

Objectives, Scope, and Methodology

Page 18 GAO/GGD-00-168 Advance Pricing Agreement Program

databases that there were varying degrees of control over the quality of the

input. If our checks showed that information was not reliable, we did not

use it, or we qualified our use of it. For instance, in trying to determine the

number of APAs that foreign-controlled business taxpayers entered into or

had pending, we noticed that the information in CASE was internally

inconsistent and also inconsistent with other information we obtained.

Therefore, we decided not to use these specific data.

Throughout our analysis, in comparing information across the different

databases, we used the employer identification number IRS assigned to

each taxpayer. In circumstances where the employer identification

numbers were not used in certain databases or seemed to be in error, we

worked with IRS to resolve any discrepancies.

In matching the databases, we were interested in determining the extent to

which the taxpayers that had section 482 examination or appeals issues

with IRS were also involved in IRS’ APA program. However, we could not

determine whether the APAs dealt with the same transfer pricing issues

that were the subject of IRS’ previous compliance findings.

Also, in matching the databases, we used information from different time

periods. This was because we were analyzing the APA experience of

taxpayers that were at least of a certain size for a specified time period or

had section 482 examination or appeals issues and enough time had

elapsed since those issues arose for them to become involved with the

APA program.

To determine the timeliness of APA processing, we analyzed information

on processing times contained in IRS’ databases. This information

included data on specific taxpayers with approved or pending APAs as of

September 30, 1999, and on a few taxpayers that started the process of

securing an APA but discontinued it. We also used this information to

determine how much time IRS used to renew APAs and to review APA

annual reports.

To determine the results of IRS’ reviews of APA annual reports, we

discussed the review process with IRS officials and analyzed relevant

documentation.

In addressing all three objectives, we interviewed people knowledgeable

about the APA program both inside IRS, such as officials in the APA

program, and outside IRS, such as taxpayer representatives. We also
Appendix I

Objectives, Scope, and Methodology

Page 19 GAO/GGD-00-168 Advance Pricing Agreement Program

reviewed IRS surveys, reports, and other documents relating to the APA

program.
Appendix II

The Extent of APA Use by Taxpayers With

Section 482 Proposed Adjustments

Page 20 GAO/GGD-00-168 Advance Pricing Agreement Program

This appendix provides descriptive information on APA use by business

taxpayers whose tax returns were reviewed by IRS international

examiners who proposed section 482 adjustments to income. This

information is based on the data in table 1 in this report, which shows that

1,150 taxpayers had international examination cases closed with section

482 proposed adjustments in fiscal years 1996 through 1998 and that 1,055

of them had no experience with IRS’ APA program. This information is

also derived from the other sources we used in our work. In general, the

data show that taxpayers with approved or pending APAs comprised small

percentages of various subgroups of the 1,150 taxpayers with closed

examinations. The information follows:

• IRS’ international examination database identified 760 of the 1,150

taxpayers as foreign-controlled corporations (FCCs) and 269 as U.S.-

controlled corporations (USCCs) but did not have information for the

remaining 121.1

About 6 percent of these FCCs and 9 percent of the USCCs

were taxpayers that had entered into an APA with IRS or had one pending.

• According to IRS information, 366 of the 1,150 taxpayers had assets of

$250 million or more, and about 12 percent of the 366 had entered into an

APA with IRS or had one pending.

• Of the 100 taxpayers with the largest section 482 proposed adjustments, 21

had approved or pending APAs.

• In 13 industries, 448 taxpayers accounted for 39 percent of the 1,150

taxpayers with section 482 proposed adjustments for the years covered by

our analysis. These same taxpayers accounted for 62 percent of the $15.4

billion in proposed adjustments.2

Taxpayers with approved or pending

APAs existed in all of the 13 industries except one, but accounted for only

7 percent of the 448 taxpayers.

IRS had section 482 examination issues with taxpayers of different sizes.

However, according to an APA official, the taxpayers with APA experience

were less diverse.

• About 67 percent of the 1,150 taxpayers for which IRS had section 482

proposed adjustments to income for fiscal years 1996-98 reported that they

had no balance sheet or less than $250 million in assets. However, an APA

1

USCCs are domestic corporations that are not foreign controlled, although certain entities such as

subchapter S corporations, which are corporations that are treated for federal income tax purposes

like partnerships, are not included in either category.

2

We chose the 13 industries to give us reasonably broad coverage of both the number of taxpayers with

section 482 proposed adjustments and the amount of adjustments associated with the taxpayers.
Appendix II

The Extent of APA Use by Taxpayers With Section 482 Proposed Adjustments

Page 21 GAO/GGD-00-168 Advance Pricing Agreement Program

official told us that most of the taxpayers in the APA program were among

the largest corporations in the country.3

• About 32 percent of the taxpayers with section 482 proposed adjustments

were taxpayers with $250 million or more in assets. However, of the

taxpayers with both section 482 findings and approved or pending APAs,

60 percent were taxpayers reporting assets in this range.

After we began our review, IRS collected information on the extent to

which the 129 taxpayers that had entered into APAs as of August 23, 1999,

had been the subject of previous section 482 findings. IRS found that about

half, or 65, of the 129 taxpayers had previous transfer pricing examination

issues or disputes related to their APAs for which the IRS examiners had

proposed increases to income of $3.2 billion. Additionally, IRS and the

taxpayers agreed to retroactively apply the APA transfer pricing

methodology to cover open transfer pricing issues for adjustments totaling

about $920 million. This means that, at most, about 29 percent of the

original proposed adjustments for these taxpayers were covered through

retroactive applications. In addition, IRS reported that, even without

retroactively applying the transfer pricing methodology, the APA process

helped it settle another $630 million in proposed adjustments to income

applicable to previous years. These settlements included almost $300

million for situations in which IRS and the taxpayer agreed that no

adjustment was needed.

3

We did not verify this assertion because the indicator in the Chief Counsel’s Automated Systems

Environment database noting whether a taxpayer was in IRS’ Coordinated Examination Program—the

program containing the nation’s largest corporations—did not provide information that was consistent

within CASE or with other information we had.
Appendix III

The Extent of APA Use by Large U.S. Parent

Companies of Controlled Foreign

Corporations

Page 22 GAO/GGD-00-168 Advance Pricing Agreement Program

This appendix provides data on the extent of APA use by large U.S. parent

companies of controlled foreign corporations (CFCs). In this context, a

large U.S. parent company is one with reported assets in tax year 1994 of

$500 million or more. Information in table III.1 shows the following:

• Sixty-six large parent companies of CFCs had approved or pending APAs

as of September 30, 1999. This was about 8 percent of the 801 largest

taxpayers that reported having CFCs in tax year 1994, the year covered by

the database underlying IRS’ most recently published information on CFCs

at the time we began our work.1

• Another 28 large parent companies of CFCs, or 4 percent, were identified

as having considered obtaining an APA but not completing the process.

• More of the large U.S. parent companies that had approved or pending

APAs, and more of their 7,500 largest CFCs, were in the manufacturing

industry compared to the other industry groups.

APA status

Industry group Approved Pending

Process

discontinued

No APA

experience Total

CFC parent companies

Manufacturing 33 11 17 415 476

Other 17 5 11 292 325

Total 50 16 28 707 801

CFCsa

Manufacturing 345 118 146 2,236 2,845

Otherb620 121 361 3,553 4,655

Total 965 239 507 5,789 7,500

Note 1: Because we could not obtain employer identification numbers for 20 taxpayers whose APA

process was discontinued, this table might not properly reflect those taxpayers. If any of them had an

employer identification number that matched an employer identification number in the CFC database,

those taxpayers would have appeared in the “process discontinued” column.

Note 2: Industry groups in the “other” category include agriculture, forestry, and fishing; mining;

construction; transportation and public utilities; wholesale and retail trade; finance, insurance, and real

estate; and services.

a

The numbers in this section of the table refer to the number of CFCs whose parent companies were

or were not involved with APAs. The same parent could have more than one CFC.

b

The largest industry group within this category was finance, insurance, and real estate, which had

418 CFCs whose parent companies had approved or pending APAs, less than the 463 manufacturing

CFCs whose parent companies had approved or pending APAs.

Source: GAO analysis of IRS information on APA participation as of Sept. 30, 1999.

The few large taxpayers that had CFCs and also approved or pending APAs

represented proportionately larger shares of CFC transactions.

11“Controlled Foreign Corporations, 1994,” IRS, SOI Bulletin (Summer 1998).

Table III.1: Participation of Large CFC

Parent Companies and Their CFCs in

IRS’ APA Program
Appendix III

The Extent of APA Use by Large U.S. Parent Companies of Controlled Foreign Corporations

Page 23 GAO/GGD-00-168 Advance Pricing Agreement Program

Specifically, the 66 large taxpayers (8 percent of the 801 taxpayers) with

CFCs and approved or pending APAs accounted for almost half the

related-party payments by all the large taxpayers’ CFCs (see table III.2).

Dollars in billions for 1994 tax returns

Approved or

pending APAs

APA process discontinued

or no APA experience Total

Payments by CFCs $228 $269 $497

Note 1: For U.S. taxpayers involved or not involved in IRS’ APA program as of Sept. 30, 1999.

Note 2: Because we could not obtain employer identification numbers for 20 taxpayers whose APA

process was discontinued, this table might not properly reflect those taxpayers. If any of them had an

employer identification number that matched an employer identification number in the CFC database,

those taxpayers would be included in the “process discontinued” category.

Source: GAO analysis of IRS information.

Although about 8 percent of large taxpayers with CFCs had approved or

pending APAs, this percentage was higher for taxpayers with CFCs that

had large amounts of receipts or payments. Of the 73 large taxpayers

whose CFCs reported related-party receipts or payments of at least $1

billion, 19 of them, or 26 percent, had completed an agreement or had one

pending.

Our analysis of related-party payments and receipts by industry showed

that 12 industries each accounted for more than $10 billion of receipts or

payments. Taxpayers had different experiences in these industries as

noted in the following:

• Taxpayers whose CFCs accounted for most of the dollars in some of those

industries had approved or pending APAs, and taxpayers accounting for

most of the dollars in other industries did not.

• In some industries, IRS had approved or pending APAs with the few large

taxpayers that had most of those industries’ related-party receipts and

payments by large taxpayers’ CFCs.

• In other industries, IRS had approved or pending APAs with few of the

large number of large taxpayers involved, and those taxpayers represented

a small percentage of those industries’ related-party receipts or payments

by large taxpayers’ CFCs.

Table III.2: Payments by CFCs Whose

Parent Companies Were or Were Not

Involved in APAs
Appendix IV

The Extent of APA Use by Large ForeignControlled Corporations

Page 24 GAO/GGD-00-168 Advance Pricing Agreement Program

This appendix provides data on the extent of APA use by large foreigncontrolled corporations (FCCs). In this context, a large FCC is one that

had, in general, total reported receipts of $500 million or more. Table IV.1

shows that, of the 444 large FCCs that IRS identified from 1994 tax

returns,1

53, or 12 percent, had an approved or pending APA as of

September 30, 1999.

FCCs

Approved or pending

APAs

APA process discontinued

or no APA experience Total

Selected countriesa40b156 196

All other countries 13 235 248

Total 53b 391 444

Payments to foreign

related partiesc

$85 $135 $220

Note: Because we could not obtain employer identification numbers for 20 taxpayers whose APA

process was discontinued, this table might not properly reflect those taxpayers. If any of them had an

employer identification number that matched an employer identification number in the FCC database,

those taxpayers would have been included in the “process discontinued” category.

a

For each of these countries, at least 16 percent of the large FCCs with a parent company in the

country had an approved or pending APA.

b

The 95-percent confidence interval--plus or minus 3--surrounding this number exceeds plus or minus

5 percent.

c

Dollars in billions from 1994 tax returns.

Source: GAO analysis of IRS information on APA participation as of Sept. 30, 1999.

Table IV.1 summarizes information on large FCCs that were involved in

IRS’ APA program by two country groupings. Country names are omitted

to avoid disclosing taxpayer data. We make the following observations:

• For an aggregation of certain selected countries, 40 of 196 large FCCs had

approved or pending APAs, a ratio of about 1 in 5.

• The corresponding ratio for the other countries and for the 13 FCCs with

no country identified in IRS’ database was about 1 in 19.

The following observations were also derived from information in table

IV.1:

• Although 12 percent of the large FCCs had approved or pending APAs,

they had 39 percent ($85 billion of $220 billion) of the total payments made

to foreign related parties from all large FCCs.

1

“Transactions Between Large Foreign-Owned Domestic Corporations and Related Foreign Persons,

1994,” IRS, SOI Bulletin (Winter 1997–1998).

Table IV.1: Largest FCCs’ Involvement in

IRS’ APA Program
Appendix IV

The Extent of APA Use by Large Foreign-Controlled Corporations

Page 25 GAO/GGD-00-168 Advance Pricing Agreement Program

• Of the 49 large FCCs that reported foreign related-party receipts or

payments of at least $1 billion, 16, or about a third, had an approved or

pending APA.

In addition to analyzing the FCC information by country and size of

receipts and payments, we also examined it by industry. We found the

following:

• Like most of the large FCCs, most of the 53 large FCCs with approved or

pending APAs were in the manufacturing and wholesale and retail trade

industrial sectors.

• Some industries had at least seven large FCCs but none in IRS’ APA

program.

• For the four largest wholesale trade industries in terms of intercompany

payments made by large FCCs, about 63 percent of the payments were

made by large FCCs that had approved or pending APAs.
Appendix V

Competent Authority Contributions to APA

Processing Times

Page 26 GAO/GGD-00-168 Advance Pricing Agreement Program

The time an APA spent in the competent authority part of the APA process

was often a significant, albeit not the only, contributor to the overall time

to complete APA processing, as follows:

• Median competent authority times for cases closed in fiscal years 1997

through 1999 and resulting in an APA varied by country involved in the

process. For the 3-year period taken as a whole, the median competent

authority times ranged between 12 and 19 months for different countries,

with one country having a much lower median time.

• The median total times spent on these cases over the 3-year period, with

the same exception for a shorter time, ranged from 20 to 44 months,

depending on the country.

• In 23 of the 60 cases closed in this period, the time spent in IRS’ competent

authority process, as recorded by the competent authority office, was

more than half the entire time reported by the APA office.

• The amount of time spent by competent authority on individual cases

ranged from 2 to 51 months.

• IRS’ competent authority staff did not have a goal for how long the

competent authority part of the APA process should take, but they said

that timely resolution was critical.
Appendix VI

Comments From the Internal Revenue Service

Page 27 GAO/GGD-00-168 Advance Pricing Agreement Program
Appendix VI

Comments From the Internal Revenue Service

Page 28 GAO/GGD-00-168 Advance Pricing Agreement Program
Appendix VI

Comments From the Internal Revenue Service

Page 29 GAO/GGD-00-168 Advance Pricing Agreement Program
Appendix VI

Comments From the Internal Revenue Service

Page 30 GAO/GGD-00-168 Advance Pricing Agreement Program
Appendix VI

Comments From the Internal Revenue Service

Page 31 GAO/GGD-00-168 Advance Pricing Agreement Program
Appendix VII

GAO Contacts and Staff Acknowledgments

Page 32 GAO/GGD-00-168 Advance Pricing Agreement Program

James R. White (202) 512-9110

Charlie W. Daniel (202) 512-9110

In addition to those named above, Lawrence Korb, John Lesser, and

John Mingus made key contributions to this report.

GAO Contacts

Acknowledgments
Page 33 GAO/GGD-00-168 Advance Pricing Agreement Program
Page 34 GAO/GGD-00-168 Advance Pricing Agreement Program
Page 35 GAO/GGD-00-168 Advance Pricing Agreement Program
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