Using bilateral advance pricing agreements to resolve tax transfer pricing disputes.

INTRODUCTION

Income earned by a multinational enterprise can be subject to double taxation if multiple tax authorities assert the right to tax the income. In particular, double taxation arises to the extent that governments use different transfer prices to allocate income between countries. In the 1997, 1999, and 2001 Ernst & Young LLP Transfer Pricing Global Surveys, over 80 percent of multinationals identified "double tax relief" as an important international tax issue because transfer pricing adjustments typically result in double taxation (Ackerman and Hobster, 2001).

Governments also have severe difficulties with transfer pricing disputes. Transfer pricing cases are factually intensive investigations featuring both legal and economic analysis and involving both domestic and foreign entities. Billions of dollars of tax revenue are at stake; for example, in 2004 the multinational pharmaceutical firm GlaxoSmithKline was assessed a $2.7 billion U.S. tax deficiency notice arising from transfer pricing disputes involving its 1989-1996 tax years (Sullivan, 2004); the case was settled in 2006 for $3.4 billion, covering tax and interest relating to its 1989-2005 tax years (Nutt, 2006). In 2006, Symantec Corp. disclosed that it was contesting a $1 billion deficiency relating to transfer pricing disputes involving tax years from 2000-2004 (Sikora, 2006). The rapidly growing volume of international transactions between related entities has put the traditional system of international tax compliance under considerable strain.

In response to this mutually unsatisfactory situation, the U.S. has developed and many countries have implemented a model of tax compliance: the bilateral advance pricing agreement (BAPA). In a BAPA, the taxpayer approaches the governments prior to engaging in a transaction with a foreign related party to negotiate a mutually acceptable transfer price. (1) The taxpayer provides detailed information regarding the proposed transaction to the governments. In return, the governments commit to a transfer price that ensures that the taxpayer will not be subject to double taxation. (2)

Korb (2004) reports that the Internal Revenue Service (IRS) currently completes about 60-70 agreements per year, most covering five years or more. While the IRS does not disclose the dollar value of the transactions covered by the agreements, U.S. cross-border trade of merchandise between related parties was $770 billion in 2002. This figure includes neither services nor licensing of intangibles. Williams (1996) describes the BAPA program, the procedures involved, and the costs and benefits of the program. Ring (2000) also describes the program and evaluates it in terms of legal theories of administrative law. Ackerman (2001) examines how the program has evolved into a more standardized format over time. Sheppard (2005) argues that the United States tax authorities are the most eager to complete a BAPA, and make substantial concessions to other countries in order to come to an agreement. The IRS issues annual reports describing the program and providing some descriptive statistics regarding the number of agreements and length of time it takes to complete an agreement (U.S. Department of the Treasury, 2006).

In this paper, we investigate the use of BAPAs using a game-theoretic approach to tax compliance. We examine two research questions. First, under what circumstances do we expect firms and governments to enter into a BAPA, and under what circumstances do we expect firms to follow the traditional approach involving auditing and litigation? Second, what are the effects of the BAPA program on aggregate tax compliance costs, which we define to be the sum of expected audit costs and the cost of negotiating and implementing the BAPA?

With respect to our first research question, we first find that a reduction in aggregate tax compliance costs is a necessary but not sufficient condition for a BAPA to occur. The fact that by definition a BAPA requires the parties to agree upon a single transfer price can make an agreement infeasible even though aggregate tax compliance costs would be lower with an agreement. Second, we find that a BAPA is more likely to be used when the amount of income subject to double taxation because of disagreement over the transfer price is low. Although the rationale for the BAPA program is to provide a mechanism by which the firm can avoid double taxation, the ability of the firm and the tax authorities of the countries to find a mutually acceptable transfer price decreases as the amount of income potentially subject to double taxation increases. Third, we find that BAPAs occur less frequently when the tax rates of the two countries are similar. Expected audit costs are lower when the tax rates are similar because the country with the higher tax rate does not have to audit as frequently to deter the taxpayer from shifting its taxable income toward the lower tax rate country via its choice of transfer price. When expected audit costs are lower, there is less to gain from a BAPA and so it is used less frequently.

With respect to our second research question, we find that the effect of the BAPA program on compliance costs depends on whether the absence of a BAPA reveals information about the taxpayer that influences the governments' audit decisions. Even if the tax authorities can credibly commit not to use disclosures made by the taxpayer in the BAPA process in other tax compliance proceedings, the absence of a BAPA may reveal taxpayer information. If the absence of a BAPA reveals no taxpayer information, the existence of the program reduces aggregate compliance costs. However, if the absence of a BAPA does reveal taxpayer information, the existence of the program can increase aggregate tax compliance costs by inducing the countries to increase the frequency with which they audit the taxpayer, compared to what they would have done if the BAPA program had not existed. Despite the increase in expected total compliance costs in these cases, the BAPA program increases the expected payoff (taxes collected minus compliance costs) of the country with the higher tax rate. Therefore, we expect that high tax countries will most aggressively promote the use of BAPAs. This is consistent with the United States being the most eager to negotiate a BAPA, as Sheppard (2005) suggests, if the United States has the higher tax rate. Sheppard also suggests that the U.S. eagerness to negotiate a BAPA implies that they give away too much in the negotiations. However, our model highlights the importance of audit costs when evaluating a BAPA, a factor that Sheppard does not consider. Since a BAPA can yield a significant reduction in compliance costs, giving away a lot in the transfer price negotiations does not imply incompetence; it may be necessary in order to get the other parties (the low tax country and the firm) to accept a BAPA.

In the next section we review the literature that relates to our paper. The third section presents the model. The fourth section characterizes the equilibrium behavior of the taxpayer and the two tax authorities when a BAPA does not occur. The fifth section characterizes the equilibrium behavior of the taxpayer and the two tax authorities regarding their decision to enter a BAPA, and the corresponding equilibrium behavior in absence of a BAPA. In the sixth section we discuss the implications of our results. We also examine the effects of the BAPA program on tax compliance costs. The seventh section concludes.

RELATED LITERATURE

Tomohara (2004) is the only other paper to investigate formally the economic effects of BAPAs. That paper considers a complete information setting in which the firm and both governments agree upon a transfer price, after which pretax profits and taxes are derived endogenously. The focus of that paper is on the firm's production decisions in the presence of a BAPA, and the productive efficiency losses that arise as the firm alters its production decisions in response to the transfer price and the tax rate differences between the two countries. In contrast, our paper considers an incomplete information setting in which countries must incur costs to overcome their informational disadvantage. We consider a given set of transactions, so that the firm's pretax income from these transactions is fixed, and focus on whether the taxpayer and governments will enter into a BAPA, how the presence of the BAPA program affects their reporting and auditing decisions, and how the BAPA program affects total tax compliance costs.

Our paper relates to several topics that have been thoroughly explored in the tax literature. Many papers have modeled the interaction between the taxpayer and the tax authority as a game between a wealth-maximizing taxpayer and a tax authority trying to maximize government revenues net of audit costs (Graetz, Reinganum, and Wilde, 1986; Reinganum and Wilde, 1986; Beck and Jung, 1989; Sansing, 1993; Rhoades, 1997; Rhoades, 1999; Mills and Sansing, 2000; Feltham and Paquette, 2002). De Waegenaere, Sansing, and Wielhouwer (2006) extend the standard tax compliance model to a multinational setting in which the taxpayer interacts with two tax authorities enforcing the transfer pricing rules of countries with different tax rates. We use a similar approach to determine the equilibrium behaviors of the taxpayer and the tax authorities in case the parties do not enter into a BAPA.