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Revenue Service, acting in conjunction with the Associate Chief Counsel (International) in the case of interpretive issues.43

The U.S. model permits a resident (including a corporation, partnership, or other person) or national of a treaty country to present his case to the competent authority of the country in which he is a resident if he considers the actions of one or both of the treaty countries have resulted (or will result) for him in taxation not in accordance with the treaty.44 An example of taxation not in accordance with the treaty resulting from actions of one or both of the treaty countries might be where one of the countries allocates income to a related enterprise under the provisions of the associated enterprises article, thereby causing that income to be taxed by both countries. Where the objection appears justifiable and if the competent authority is not able in and of itself to arrive at a satisfactory solution, then the U.S. model states that the competent authority shall endeavor to resolve the case by mutual agreement with the competent authority of the other treaty country.45 Once reached, an agreement between the Competent Authorities may be implemented, under a treaty like the U.S. or OECD model, without regard to any time limits or other procedural limitations in the domestic law of the two countries. Thus, such an agreement may be implemented under some treaties even though the time period for granting relief under domestic law has expired with respect to the taxable year at issue, though some treaties do not contain this provision and others limit the time period to some other specified period. As a practical matter, even where authority is granted to override the statute of limitations, it might not be exercised. In light of this and the fact that some treaties do not even contain authority to override the domestic statute of limitations of treaty countries at all, a standard form letter is generally issued by the IRS in section 482 cases which advises the taxpayer that it should consider taking action to keep open the statute of limitations in other countries.

The mutual agreement procedure provided in tax treaties differs in theory from other procedures that might be available to a taxpayer to contest a proposed adjustment in that it not only takes account of the merits of the allocation as viewed under U.S. law, but also might take account of the merits of a correlative allocation under foreign law and the desirability of avoiding double taxation

particular case. However, the mutual agreement procedure does not guarantee a taxpayer that the competent authorities will agree that the internal laws of each country support the allocation requested by one; nor does it guarantee that in the absence of such agreement relief from actual or potential double taxation will in fact be granted.

Guidelines for invoking competent authority procedure

Guidelines for seeking the assistance of the U.S. competent authority in cases where either the United States or a treaty partner

43 Treasury Department Order No. 150-83, 1973-2 C.B. 508, and Delegation Order No. 114 (Rev. 8), 1988-1 C.B. 470.

44 Paragraph 1 of Article 25 of the U.S. model.

45 Paragraph 2 of Article 25 of the U.S. model.

has allocated income pursuant to the associated enterprises article of the relevant treaty are currently provided in Revenue Procedure 82-29.46 This Revenue Procedure states that in seeking an agreement with the competent authority of the other treaty country, the U.S. competent authority will be guided by the standards of arm's length dealing under section 482 and the equivalent standard of arrangements or conditions that would have been made between independent persons (referred to in a number of treaties). A person should file a written request for U.S. competent authority consideration as soon as practical after a treaty country has sufficiently developed its position regarding an allocation of income or deductions, and in no case later than 90 days after a formal proposal to allocate has been made by that country. If the IRS allocates or proposes to allocate income or deductions attributable to transactions involving a U.S. taxpayer subject to the tax jurisdiction of a treaty country, a written request for competent authority assistance should be submitted as soon as the adjustment is determined, communicated in writing to the taxpayer, and agreed to by the taxpayer subject to competent authority relief. Taxpayers who do not agree with the correctness of the adjustment are encouraged to pursue their right of administrative review before the Appeals Division before requesting competent authority relief.

The U.S. competent authority will only accept cases involving citizens or residents of the United States. Nonresident alien individuals and foreign entities must seek assistance from the competent Authority of their country of residence. The U.S. competent authority may refuse a taxpayer's request for assistance if (1) under the facts and circumstances the taxpayer is not entitled to such assistance (e.g., actual or economic double taxation does not exist), (2) the taxpayer indicates unwillingness to be bound by a competent authority agreement except under certain conditions, (3) the taxpayer is not willing to be excluded from the negotiation process with the other government, (4) the taxpayer fails to furnish in a timely manner all of the information necessary for administration of the case by the competent authority, (5) the taxpayer is under the jurisdiction of another competent authority, or (6) the taxpayer is unwilling to extent the period of limitations on assessment of tax for the years under consideration.

A taxpayer who requests competent authority assistance must present details (and documentation translated into English) regarding the facts of its case, the proposed adjustment, and the positions taken by the governments involved. In addition, the taxpayer must supply additional information required to achieve a resolution of the case, as well as inform the competent authority of any relevant proceedings in the other country or of any other pertinent developments affecting the case.

If the competent authorities of the two countries are unable to reach an agreement, the taxpayer may proceed with other administrative and judicial remedies. If the competent authorities of the two countries involved are able to resolve a case, the taxpayer is not necessarily bound by the resolution. If an agreement (or partial

46 Rev. Proc. 82-29, 1982-1 C.B. 481. (For the procedures applicable to U.S. competent authority assistance in other cases see Rev. Proc. 77-16, 1977-1 C.B. 573.)

agreement) reached by the competent authorities of the two countries is not acceptable to the taxpayer, it may withdraw the request for competent authority consideration and may then pursue all rights to administrative and judicial review otherwise available under the laws of the treaty country and the United States. Conversely, if the taxpayer is satisfied with the resolution, a binding closing agreement will generally be signed by the taxpayer and both tax authorities.

II. ISSUES AND ANALYSIS

A. Inherent Difficulties in Determining Transfer Prices

In general

Determining accurate transfer prices between related parties operating in multiple jurisdictions is a major concern in the proper measurement of net income subject to income tax in each jurisdiction. With different rates of tax in each jurisdiction, business enterprises may have an incentive to set transfer prices among affiliates so as to reduce total taxation.

Outbound transfer prices

One area of controversy is the pricing of goods and services transferred to overseas subsidiaries of U.S. corporations, sometimes referred to as "outbound" transfer pricing. For example, assume a U.S. multinational enterprise manufactures a product in the United States, and transfers the product to a foreign marketing affiliate. If the United States imposes tax at a higher effective rate than the affiliate's residence country, and the enterprise enjoys deferral of U.S. tax for income earned abroad, then there is an incentive to establish a low related-party price for the product. A low related-party price would cause income in the United States (which is subject to tax at a high rate) to be artificially low, while income in the affiliate's residence country would be artificially high.

By thus manipulating transfer prices, taxable income can be shifted and the total tax burden on the enterprise can be reduced below the level that would result from using a transfer price which reflected real value and measured economic income. In the absence of restrictions these manipulations are likely because, unlike prices between unrelated parties which directly affect overall before-tax profitability, transfer prices between related parties do not affect overall before-tax profitability of the group. In brief, by adjusting transfer prices, related parties in multiple jurisdictions can significantly increase their combined after-tax profitability with no significant effect on their real business activities.47

Inbound transfer prices

Another area of controversy is the pricing of goods and services transferred by foreign manufacturers to their controlled U.S. subsidiaries, sometimes referred to as "inbound" transfer pricing. For example, assume a U.S. corporation distributes a product at the

47 Adjustment of transfer prices between related parties will change how profits are allocated between related parties and could distort accounting information that is important to the firm for other purposes. For example, if a firm relied solely on this information for decisions about allocation of funds for new capital and research expenditures and for amounts of executive compensation, these allocations of funds would be distorted.

wholesale level which is manufactured by a foreign corporation which controls or owns a majority interest in the U.S. corporation. If the United States imposes income tax at a higher effective rate than the residence of the foreign parent (or of third countries to which the parent can allocate income), then there is an incentive for the foreign parent to set a high price for sales to its controlled U.S. subsidiary. The higher the price, the higher the foreign profits, and the lower the U.S. profits. Since it has been assumed in this example that the U.S. income taxes are effectively higher than the foreign income taxes, the controlled group can reduce its worldwide tax.

As in the case of outbound transactions, in the absence of restrictions, by adjustment of accounting entries, these related parties can substantially reduce their tax with no commensurate change in their business activities. This has been noted in an 1979 OECD report: "The prices charged for such transfer do not necessarily represent a result of the free play of market forces, but may, for a number of reasons and because the [multinational enterprise] is in a position to adopt whatever principle is convenient to it as a group, diverge considerably from prices which would have been agreed upon in the same or similar transactions in the open market."

" 48

Analogous allocation issues

Issues analogous to those arising in the determination of transfer prices for sales between U.S. corporations and related foreign corporations arise in the allocation of income and expenses to U.S. branches of foreign corporations. For example, interest expense of the multinational corporation may be incurred on behalf of both its U.S. and foreign operations, and may not be identified economically with any separate part of the enterprise. Rules have been developed to allocate interest expense between the U.S. and foreign components of the enterprise, but the extent to which these rules achieve the appropriate allocation of interest expense between jurisdictions often engenders dispute.

B. The Arm's Length Approach Versus Formulary Methods Issues related to the arm's length standard

The international norm for transfers between different countries taxing jurisdictions has generally been the arm's length standard and the Treasury Department has recently reendorsed the arm's length concept in its "White Paper" study of intercompany transfer pricing issues. The Treasury Department quoted Stanley Surrey, in defense of the arm's length method:

Presumably, most transactions are governed by the general framework of the marketplace and hence it is appropriate to seek to put intra-group transactions under that general framework. Thus, use of the standard of arm's length, both to test the actual allocation of income and ex

48 Transfer Pricing and Multinational Enterprises-Report of the OECD Committee on Fiscal Affairs, Organisation for Economic Co-operational Development, Paris, 1979, at para. 2.

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