Part IV. Items of General Interest

Notice of Proposed Rulemaking and Notice of Public Hearing

Revisions to Regulations Relating to Withholding of Tax on Certain U.S. Source Income Paid to Foreign Persons and Revisions of Information Reporting Regulations

REG–125443–01

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains amendments to final regulations relating to the withholding of income tax under sections 1441 and 1442 on certain U.S. source income paid to foreign persons and related requirements governing collection, deposit, refunds, and credits of withheld amounts under sections 1461 through 1463. Additionally, this document contains amendments to final regulations under sections 6049 and 6114. These regulations affect persons making payments of U.S. source income to foreign persons.

DATES: Written or electronic comments must be received by June 27, 2005. Requests to speak (with outlines of oral comments to be discussed) at the public hearing scheduled for July 20, 2005, at 10:00AM must be received by June 29, 2005.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG–125443–01), room 5203, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions also may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG–125443–01), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC, or sent electronically, via the IRS internet site www.irs.gov/regs or via the Federal eRulemaking Portal site at www.regulations.gov (IRS and

REG–125443–01). The public hearing will be held in the IRS Auditorium, Seventh Floor, Internal Revenue Building, 1111 Constitution Avenue, N.W., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Ethan Atticks, (202) 622–3840 (not a toll-free number); concerning submissions of comments, the hearing, and/or to be placed on the building access list to attend the hearing, Robin Jones, (202) 622–7180 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in this notice of proposed rulemaking have been previously reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)) under control number 1545–1484. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid control number assigned by the Office of Management and Budget.

Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

Background

In Treasury Decision 8734, 1997–2 C.B. 109 [62 FR 53387], the Treasury Department and the IRS issued comprehensive regulations (final regulations) under chapter 3 (sections 1441–1464) and subpart G of Subchapter A of chapter 61 (sections 6041 through 6050S) of the Internal Revenue Code. Those final regulations were amended by T.D. 8804, 1999–1 C.B. 793 [63 FR 72183], T.D. 8856, 2000–1 C.B. 298 [64 FR 73408], T.D. 8881, 2000–1 C.B. 1158 [65 FR 32152], and T.D. 9023, 2002–2 C.B. 955

[67 FR 70310].

In Notice 2001–4, 2001–1 C.B. 267, Notice 2001–11, 2001–1 C.B. 464, and Notice 2001–43, 2001–2 C.B. 72, the Treasury Department and the IRS announced the intention to amend the final regulations to address the matters discussed in those notices. These proposed regulations would implement certain changes announced in those notices and other changes.

Under section 1441 of the Internal Revenue Code (Code), as amended by the American Jobs Creation Act of 2004 (Public Law 108–357, 118 Stat. 1418), “interest-related dividends” and “short-term capital gain dividends” paid by regulated investment companies are exempt from withholding. These proposed regulations would amend the withholding rules in order to reflect the treatment of these new categories of dividends.

Explanation of Provisions

I. Notice 2001–4

A. TIN requirement for certain foreign grantor trusts

The final regulations provide that a withholding certificate that specifies certain payee information and that meets certain requirements may be used for a variety of purposes, including certifying a payee’s status as a foreign person or foreign intermediary. Section 1.1441–1(e)(4)(vii)(G) of the final regulations provides that a taxpayer identification number (TIN) must be stated on a withholding certificate from a person representing to be a foreign grantor trust with 5 or fewer grantors.

After the final regulations took effect, some taxpayers requested documentation and reporting relief for simple and grantor trusts that hold an account with a qualified intermediary (QI). In response to this request, the Treasury Department and the IRS provided in section III.C of Notice 2001–4 that, if a foreign simple or grantor trust provides a QI with a Form W–8IMY, “ Certificate of Foreign Intermediary, For- eign Flow-Through Entity, or Certain U.S. Branches for United States Tax Withhold- ing,” and the trust has 5 or fewer owners, the IRS will not require the trust to provide the QI with a TIN, notwithstanding

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vided in section V.D of Notice 2001–4 that documentary evidence may be used in lieu of Form W–8 in a possession of the United States and announced the intention to amend §1.6049–5(c)(1) accordingly.

These proposed regulations would implement Section V.D of Notice 2001–4.

D. Information reporting of foreign source services income

Under section 6041, a U.S. payor must report certain payments made for services performed outside the United States. However, §1.6041–4 provides that information reporting is not required if the payee has provided documentation to establish its status as a foreign beneficial owner or a foreign payee, or if the payee is presumed to be a foreign payee under the presumption rules. Under the presumption rules of §§1.6049–5(d)(2) and 1.1441–1(b)(3)(iii), a U.S. payor must presume that the payee is a U.S. payee if the payee is an individual.

When the final regulations took effect, U.S. payors commented that these rules were overly burdensome because they require U.S. payors making payments for services performed outside the United States to ask all payees to represent that such payees are not U.S. persons.

In response to this comment, the Treasury Department and the IRS provided in section V.E of Notice 2001–4 that a U.S. payor will not be required to report, under section 6041, income paid for services performed outside the United States if (1) the payee of the income is an individual, (2) the U.S. payor does not know that the payee is a U.S. citizen or resident, (3) the payor does not know, and has no reason to know, that the income is (or may be) effectively connected with the conduct of a trade or business within the United States, and (4) all of the services for which payment is made were performed by the payee outside the United States.

The proposed regulations would implement section V.E of Notice 2001–4. The Treasury Department and the IRS are considering whether there are appropriate circumstances, and if so, an appropriate manner, in which such an exception could be extended to payments made to foreign partnerships. Comments are requested on this issue.

§1.1441–1(e)(4)(vii)(G). Section III.C of Notice 2001–4 was superseded by Rev. Proc. 2003–64, 2003–2 C.B. 306, which provides comprehensive guidance for withholding partnerships and withholding trusts. However, Rev. Proc. 2003–64 does not provide any relief from the TIN requirement of §1.1441–1(e)(4)(vii)(G) in the QI context.

In addition to requesting reinstatement of the previously granted relief from the TIN requirement in the QI context, withholding agents have requested relief from the TIN requirement beyond the QI context. In light of these requests, the Treasury Department and the IRS have reexamined the TIN requirement of §1.1441–1(e)(4)(vii)(G) and have concluded that the rule is not serving to enhance enforcement objectives. Therefore, the proposed regulations would reinstate the relief granted in section III.C of Notice 2001–4 for withholding certificates provided to a QI by a foreign grantor trust with 5 or fewer grantors. In addition, the proposed regulations would grant relief from the TIN requirement for withholding certificates that are executed after December 31, 2003, and that are provided to a withholding agent by a foreign grantor trust with 5 or fewer grantors.

B. Reporting relief for U.S. payors in U.S. possessions

U.S. payors that pay foreign source income outside the United States to U.S. non-exempt recipients generally must report these payments on Form 1099 and, if required, apply backup withholding. After the final regulations became effective, withholding agents requested that the Treasury Department and the IRS reconsider this rule to the extent it requires Form 1099 reporting and backup withholding with respect to income from sources within a possession of the United States paid to a U.S. citizen even if the income is exempt from tax under section 931, 932, or 933.

In response to this request, the Treasury Department and the IRS provided in section V.C of Notice 2001–4 that the final regulations would be amended to provide that income that is derived from sources within a possession of the United States, that is exempt from taxation under section 931, 932, or 933, and that a payor reasonably believes to be paid to a resident of a

possession of the United States is not required to be reported on Form 1099. Section V.C of Notice 2001–4 also provides that U.S payors will not be required to report such income until the regulations are amended.

These proposed regulations would amend §1.6049–5(c) to implement section V.C. of Notice 2001–4, with modifications. The proposed regulations would provide that U.S. payors are not required to report on Form 1099 income from sources within a possession of the United States that is exempt from tax under section 931, section 932, or section 933. Under the proposed regulations, this exception from Form 1099 reporting would be applicable if the payor could reliably associate the payment of such income with valid documentation that supports a claim that the beneficial owner of the payment is a resident of the U.S. possession.

In addition, the proposed regulations would add new §1.1441–1(c)(30), which for these purposes would define posses- sions of the United States as Guam, American Samoa, the Nothern Mariana Islands, Puerto Rico, and the Virgin Islands.

C. Use of documentary evidence in possessions of the United States

The final regulations provide certain exceptions from certain information reporting requirements. One such exception applies in cases in which, among other things, a payment is made outside the United States and the payor can rely on appropriate documentation to treat the payment as made to a foreign person. Section 1.6049–5(c)(1) allows a payor to rely on documentary evidence instead of an applicable withholding certificate described in §1.1441–1(c)(16) (Form W–8) in the case of a payment made to an offshore account. For this purpose, the term offshore account means an account maintained at an office or branch of a U.S. or foreign bank at any location outside the United States and outside of possessions of the United States.

When the final regulations took effect, taxpayers requested that the Treasury Department and the IRS consider allowing the use of documentary evidence for an account in a possession of the United States. In response to this request, the Treasury Department and the IRS pro

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clarification was requested regarding coordination of the representation requirement with the filing requirement.

Finally, because §1.1441–6(b)(1) states that the filing requirement applies only to amounts received during the calendar year that exceed $500,000 in the aggregate, and because §301.6114–1(a)(1) permits a taxpayer to adopt a taxable year for filing different from the calendar year, taxpayers requested clarification regarding a fiscal-year taxpayer’s obligation to report such amounts.

In response to these and other comments, Treasury and the IRS issued Notice 2001–43. Section 2 of Notice 2001–43 provided that the following rules would apply, effective January 1, 2001.

First, reporting is waived for a treaty-based return position described in §301.6114–1(b)(4)(ii), unless the conditions in paragraph (b)(4)(ii)(A) and (B) of this section, paragraph (b)(4)(ii)(C) of this section, or paragraph (b)(4)(ii) (D) of this section are met.

Second, reporting under §301.6114–1 (b)(4)(ii)(D) is waived for taxpayers that are not individuals or States and that receive amounts of income subject to withholding that do not exceed $10,000 in the aggregate.

Third, the related-person test for purposes of applying the representation requirement of §1.1441–6(b)(i) was conformed to the related-person test that applies for purposes of the filing requirement of §301.6114–1(b)(4)(ii)(C).

Fourth, the calendar-year rule in §1.1441–6(b)(1) was replaced with a taxable-year rule to conform to §301.6114–1(a)(1).

These proposed regulations would implement Section 2 of Notice 2001–43.

B. Conversion of foreign currency amounts

Section 1.1441–3(e)(2) of the final regulations provides that if an amount subject to tax is paid in a currency other than the U.S. dollar, the amount of withholding under section 1441 shall be determined by applying the applicable rate of withholding to the foreign currency amount and by converting the amount withheld into U.S. dollars at the spot rate on the date of payment. A withholding agent that makes regular or frequent payments in foreign cur

II. Notice 2001–11 — Reporting/Withholding on Payments to Financial Institutions in U.S. Possessions

Corporations and partnerships organized in a possession of the United States generally are treated as foreign persons for purposes of applying the final regulations. Accordingly, under the final regulations, a possessions financial institution acting as an intermediary is treated as a nonqualified intermediary that must provide documentation and allocation information for the beneficial owners on whose behalf it acts. In contrast, a U.S. branch of a foreign financial institution may agree with a withholding agent to be treated as a U.S. person. See §1.1441–1(b)(2)(iv)(A) and (E). Under §1.1441–1(b)(1), if such a U.S. branch agrees to be treated as a U.S. person, payments of U.S. source income made to it will be treated as made to a U.S. payee and therefore will not be subject to withholding under section 1441. Possessions financial institutions generally are subject to all of the withholding and reporting obligations of a U.S. withholding agent. Section 7651.

When the final regulations took effect, possessions financial institutions commented that the requirement to provide a withholding agent with customer information should not apply to them, because possessions financial institutions are subject to all of the withholding and information reporting requirements that apply to U.S. withholding agents under Chapters 3 and 61 and section 3406 of the Code, and because they are subject to direct audit supervision by the Internal Revenue Service.

In response to these comments, the Treasury Department and the IRS issued Notice 2001–11, which provided that a possessions financial institution will be treated as a U.S. branch that is subject to the rules of §1.1441–1(b)(2)(iv) and announced the intention to amend the final regulations accordingly.

These proposed regulations would implement Notice 2001–11.

III. Notice 2001–43

A. Reporting of treaty-based return positions

Section 301.6114–1(a) of the final regulations provides that, if a taxpayer takes a return position that a tax treaty overrules or modifies any provision of the Internal Revenue Code and thereby effects a reduction of any tax at any time, the taxpayer must disclose that return position, either on a statement attached to the return or on a return filed for the purpose of making such disclosure. Section 301.6114–1(b) provides that reporting is required unless it is expressly waived. It further provides a nonexclusive list of particular positions for which reporting is required. Section 301.6114–1(c) provides a list of specific exceptions from the general reporting requirements of §301.6114–1(a) and (b).

When the final regulations took effect, taxpayers requested guidance regarding the scope of the reporting required under §301.6114–1(a) and (b) in the case of claims for treaty-reduced withholding made by foreign persons that are not individuals or States. In particular, taxpayers requested the following clarification and relief.

First, because §301.6114–1(c)(1)(i) waives reporting only for individuals and States, clarification was requested regarding whether taxpayers that are not individuals or States and that do not meet the requirements to report under §301.6114–1(b)(4)(ii)(C) are nevertheless required to disclose treaty-based return positions described in subparagraph (b)(4)(ii) under the general rules of §301.6114–1(a) and (b).

Second, because §301.6114–1(c)(2) waives reporting only for individuals who receive less than the threshold amount, a de minimis exception was requested for taxpayers that are not individuals.

Third, because the representation under §1.1441–6(b)(1) (that the beneficial owner will file the statement required under §301.6114–1(d)) is required when the beneficial owner is related to the withholding agent within the meaning of section 482, and because the filing under §301.6114–1(b)(4)(ii)(C) is required when the beneficial owner is related to the person obligated to pay the income within the meaning of sections 267(b) and 707(b),

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rency is permitted to use a month end spot rate or a monthly average spot rate.

After the final regulations took effect, some withholding agents that make regular and frequent payments in foreign currency commented that the permitted conversion conventions can expose them to currency risks that would require management by means of hedging transactions. Also, they commented that permitted conventions can require multiple accounting adjustments when payment amounts in the base currency are adjusted or corrected in the course of processing and settlement. They requested that they be permitted to use the spot rate on the date the amount of tax is deposited.

In response to this comment, in Section 3 of Notice 2001–43, the Treasury Department and the IRS provided that a withholding agent that makes regular or frequent payments in foreign currency is permitted to convert the amount withheld into U.S. dollars at the spot rate on the day the tax is deposited, provided that the deposit is made within seven days of the date of payment. Section 3 of Notice 2001–43 also provided that taxpayers using this alternative convention must do so consistently for all nondollar amounts withheld and from year to year. It also provided that such convention could not be changed without the consent of the Commissioner.

These proposed regulations would implement Section 3 of Notice 2001–43.

IV. The American Jobs Creation Act of 2004

The final regulations provide generally that if the amount of distributions designated by a regulated investment company as being subject to 852(b)(3)(C) (relating to capital-gain dividends) or 852(b)(5)(A) (relating to exempt-interest dividends) exceeds the amount that may be designated under those sections for the taxable year, then no penalties will be asserted for any resulting underwithholding if the designations were based on a reasonable estimate, as defined in regulations, and the adjustments to amount withheld are made in accordance with regulations. §1.1441–3(c)(3)(i). These proposed regulations would extend the reasonable-estimate rule to cover distributions designated as being subject to new section 871(k)(1)(C) (relating to in

terest-related dividends) or 871(k)(2)(C) (relating to short-term capital gain dividends).

Proposed Effective Date

These regulations are proposed to be applicable when final regulations are published in the Federal Register .

Special Analyses

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and, because the regulations do not impose a new collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any written comments (a signed original and eight (8) copies) that are submitted timely (in the manner described in the “ADDRESSES” portion of this preamble) to the IRS. The Treasury Department and the IRS request comments on the clarity of the proposed rules and how they can be made easier to understand. All comments will be available for public inspection and copying.

A public hearing has been scheduled for July 20, 2005, beginning at 10:00 a.m. in the IRS Auditorium (7 ^th Floor), Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC. Due to building security procedures, visitors must enter at the 10 ^th Street entrance, located between Constitution and Pennsylvania Avenues, NW. In addition, all visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 30 minutes before the hearing starts. For information about

having your name placed on the building access list to attend the hearing, see the “FOR FURTHER INFORMATION CONTACT” portion of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who wish to present oral comments must submit written comments and an outline of the topics to be discussed and the time to be devoted to each topic (a signed original and eight (8) copies) by Wednesday, June 29. A period of 10 minutes will be allotted to each person for making comments. An agenda showing the scheduling of the speakers will be prepared after the deadline for reviewing outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Drafting Information

The principal author of the proposed regulations is Ethan Atticks, Office of Associate Chief Counsel (International). However, other personnel from the IRS and Treasury Department participated in their development.

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Proposed Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 301 are proposed to be amended as follows:

PART 1 — INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.1441–1 is amended as follows:

1. Paragraph (b)(2)(iv)(A) is revised.
2. Paragraph (b)(3)(iii)(E) is added.
3. Paragraph (c)(30) is added.
4. Paragraph (e)(4)(vii)(G) is revised. The revisions and additions read as follows:

§1.1441–1 Requirement for the deduction and withholding of tax on payments to foreign persons.

• • • • (b) - * (2) - * (iv) Payments to a U.S. branch of cer- tain foreign banks or foreign insurance companies - (A) U.S. branch treated

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under those sections for the taxable year, then no penalties will be asserted for any resulting underwithholding if the designations were based on a reasonable estimate (made pursuant to the same procedures as described in paragraph (c)(2)(ii)(A) of this section) and the adjustments to the amount withheld are made within the time period described in paragraph (c)(2)(ii)(B) of this section. Any adjustment to the amount of tax due and paid to the IRS by the withholding agent as a result of underwithholding shall not be treated as a distribution for purposes of section 562(c) and the regulations thereunder. Any amount of U.S. tax that a foreign shareholder is treated as having paid on the undistributed capital gain of a regulated investment company under section 852(b)(3)(D) may be claimed by the foreign shareholder as a credit or refund under §1.1464–1.

(ii) Reliance by intermediary on rea- sonable estimate . For purposes of determining whether a payment is a distribution designated as subject to section 852(b)(3)(C) or (5)(A), or 871(k)(1)(C) or (2)(C), a withholding agent that is not the distributing regulated investment company may, absent actual knowledge or reason to know otherwise, rely on the designations that the distributing company represents have been made in accordance with paragraph (c)(3)(i) of this section. Failure by the withholding agent to withhold the required amount due to a failure by the regulated investment company to reasonably estimate the required amounts or to properly communicate the relevant information to the withholding agent shall be imputed to the distributing company. In such a case, the IRS may collect from the distributing company any underwithheld amount and subject the company to applicable interest and penalties as a withholding agent.

• • • • (e) * - (2) Payments in foreign currency . If the amount subject to withholding tax is paid in a currency other than the U.S. dollar, the amount of withholding under section 1441 shall be determined by applying the applicable rate of withholding to the foreign currency amount and converting the amount withheld into U.S. dollars on the date of payment at the spot rate (as defined in §1.988–1(d)(1)) in effect on that date. A

as a U.S. person in certain cases . A payment to a U.S. branch of a foreign person is a payment to a foreign person. However, a U.S. branch described in this paragraph (b)(2)(iv)(A) and a withholding agent (including another U.S. branch described in this paragraph (b)(2)(iv)(A)) may agree to treat the branch as a U.S. person for purposes of withholding on specified payments to the U.S. branch. Notwithstanding the preceding sentence, a withholding agent making a payment to a U.S. branch treated as a U.S. person under this paragraph (b)(2)(iv)(A) shall not treat the branch as a U.S. person for purposes of reporting the payment made to the branch. Therefore, a payment to such U.S. branch shall be reported on Form 1042–S under §1.1461–1(c). Further, a U.S. branch that is treated as a U.S. person under this paragraph (b)(2)(iv)(A) shall not be treated as a U.S. person for purposes of the withholding certificate it may provide to a withholding agent. Therefore, the U.S. branch must furnish a U.S. branch withholding certificate on Form W–8 as provided in paragraph (e)(3)(v) of this section and not a Form W–9. An agreement to treat a U.S. branch as a U.S. person must be evidenced by a U.S. branch withholding certificate described in paragraph (e)(3)(v) of this section furnished by the U.S. branch to the withholding agent. A U.S. branch described in this paragraph (b)(2)(iv)(A) is any U.S. branch of a foreign bank subject to regulatory supervision by the Federal Reserve Board or a U.S. branch of a foreign insurance company required to file an annual statement on a form approved by the National Association of Insurance Commissioners with the Insurance Department of a State, a Territory, or the District of Columbia. In addition, a financial institution organized in a possession of the United States will be treated as a U.S. branch for purposes of this paragraph (b)(2)(iv)(A). The Internal Revenue Service (IRS) may approve a list of U.S. branches that may qualify for treatment as a U.S. person under this paragraph (b)(2)(iv)(A) (see §601.601(d)(2) of this chapter). See §1.6049–5(c)(5)(vi) for the treatment of U.S. branches as U.S. payors if they make a payment that is subject to reporting under chapter 61 of the Internal Revenue Code. Also see §1.6049–5(d)(1)(ii) for the treatment of

U.S. branches as foreign payees under chapter 61 of the Internal Revenue Code.

• • • • (3) - - (iii) * - * (E) Certain payments for services . A payment for services is presumed to be made to a foreign person if —

( 1 ) The payee is an individual; ( 2 ) The withholding agent does not know, or have reason to know, that the payee is a U.S. citizen or resident;

( 3 ) The withholding agent does not know, or have reason to know, that the income is (or may be) effectively connected with the conduct of a trade or business within the United States; and

( 4 ) All of the services for which the payment is made were performed by the payee outside of the United States.

• • • • (c) - - (30) Possessions of the United States . For purposes of the regulations under chapter 3 and 61 of the Internal Revenue Code, possessions of the United States means Guam, American Samoa, the Northern Mariana Islands, Puerto Rico, and the Virgin Islands.
• • • • (e) - - (4) - - (vii) * * * (G) A withholding certificate executed on or before December 31, 2003, from a person representing to be a grantor trust with 5 or fewer grantors, except where such withholding certificate is provided to a qualified intermediary.
• • • • Par. 3. Section 1.1441–3 is amended by revising paragraphs (c)(3) and (e)(2) to read as follows:

§1.1441–3 Determination of amounts to be withheld.

• • • • (c) - - (3) Special rules in the case of dis- tributions from a regulated investment company - (i) General rule . If the amount of any distributions designated as being subject to section 852(b)(3)(C) or 5(A), or 871(k)(1)(C) or (2)(C), exceeds the amount that may be designated

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regarding reliance on a withholding certificate by a withholding agent. The provisions of §1.1441–1(b)(3)(iv) dealing with a 90-day grace period shall apply for purposes of this section.

• • • • Par. 5. Section 1.6049–5 is amended as follows:

1. Paragraph (c)(1) is revised.

2. Paragraphs (c)(5)(i), (ii), (iii), (iv), (v) and (vi) are redesignated as paragraphs (c)(5)(i)(A), (B), (C), (D), (E), and (F), respectively.

3. A new heading is added to paragraph (c)(5)(i).

4. New paragraph (c)(5)(ii) is added. The revisions and additions read as follows:

§1.6049–5 Interest and original issue discount subject to reporting after December 31, 1982.

• • • • (c) Applicable rules - (1) Documen- tary evidence for offshore accounts and for possessions accounts . A payor may rely on documentary evidence described in this paragraph (c)(1) instead of a beneficial owner withholding certificate described in §1.1441–1(e)(2)(i) in the case of a payment made outside the United States to an offshore account, in the case of a payment made to a U.S. possessions account or, in the case of broker proceeds described in §1.6045–1(c)(2), in the case of a sale effected outside the United States (as defined in §1.6045–1(g)(3)(iii)(A)). For purposes of this paragraph (c)(1), an offshore account means an account maintained at an office or branch of a U.S. or foreign bank or other financial institution at any location outside the United States ( i.e., other than in any of the fifty States or the District of Columbia) and outside of possessions of the United States. Thus, for example, an account maintained in a foreign country at a branch of a U.S. bank or of a foreign subsidiary of a U.S. bank is an offshore account. For purposes of this paragraph (c)(1), a U.S. possessions account means an account maintained at an office or branch of a U.S. or foreign bank or other financial institution located within a possession of the United States. For the definition of a payment made outside the United States, see paragraph (e) of this section. A payor may

withholding agent making regular or frequent payments in foreign currency may use a month-end spot rate or a monthly average spot rate. In addition, such a withholding agent may use the spot rate on the date the amount of tax is deposited (within the meaning of §1.6302–2(a)), provided that such deposit is made within seven days of the date of the payment giving rise to the obligation to withhold. A spot rate convention must be used consistently for all non-dollar amounts withheld and from year to year. Such convention cannot be changed without the consent of the Commissioner. The U.S. dollar amount so determined shall be treated by the beneficial owner as the amount of tax paid on the income for purposes of determining the final U.S. tax liability and, if applicable, claiming a refund or credit of tax.

• • • • Par. 4. In §1.1441–6, paragraph (b)(1) is revised to read as follows:

§1.1441–6 Claim of reduced withholding under an income tax treaty.

• • • • (b) Reliance on claim of reduced with- holding under an income tax treaty (1) In general . The withholding imposed under section 1441, 1442, or 1443 on any payment to a foreign person is eligible for reduction under the terms of an income tax treaty only to the extent that such payment is treated as derived by a resident of an applicable treaty jurisdiction, such resident is a beneficial owner, and all other requirements for benefits under the treaty are satisfied. See section 894 and the regulations thereunder to determine whether a resident of a treaty country derives the income. Absent actual knowledge or reason to know otherwise, a withholding agent may rely on a claim that a beneficial owner is entitled to a reduced rate of withholding based upon an income tax treaty if, prior to the payment, the withholding agent can reliably associate the payment with a beneficial owner withholding certificate, as described in §1.1441–1(e)(2), that contains the information necessary to support the claim, or, in the case of a payment of income described in paragraph (c)(2) of this section made outside the United States with respect to an offshore account, documentary evidence described in paragraphs (c)(3), (4), and (5)

of this section. See §1.6049–5(e) for the definition of payments made outside the United States and §1.6049–5(c)(1) for the definition of offshore account. For purposes of this paragraph (b)(1), a beneficial owner withholding certificate described in §1.1441–1(e)(2)(i) contains information necessary to support the claim for a treaty benefit only if it includes the beneficial owner’s taxpayer identifying number (except as otherwise provided in paragraph (c)(1) of this section and §1.1441–6(g)) and the representations that the beneficial owner derives the income under section 894 and the regulations thereunder, if required, and meets the limitation on benefits provisions of the treaty, if any. The withholding certificate must also contain any other representations required by this section and any other information, certifications, or statements as may be required by the form or accompanying instructions in addition to, or in place of, the information and certifications described in this section. Absent actual knowledge or reason to know that the claims are incorrect (and subject to the standards of knowledge in §1.1441–7(b)), a withholding agent may rely on the claims made on a withholding certificate or on documentary evidence. A withholding agent may also rely on the information contained in a withholding statement provided under §§1.1441–1(e)(3)(iv) and 1.1441–5(c)(3)(iv) and (e)(5)(iv) to determine whether the appropriate statements regarding section 894 and limitation on benefits have been provided in connection with documentary evidence. If the beneficial owner is related to the person obligated to pay the income, within the meaning of section 267(b) or 707(b), the withholding certificate must also contain a representation that the beneficial owner will file the statement required under §301.6114–1(d) of this chapter (if applicable). The requirement to file an information statement under section 6114 for income subject to withholding applies only to amounts received during the taxpayer’s taxable year that, in the aggregate, exceed $500,000. See §301.6114–1(d) of this chapter. The Internal Revenue Service (IRS) may apply the provisions of §1.1441–1(e)(1)(ii)(B) to notify the withholding agent that the certificate cannot be relied upon to grant benefits under an income tax treaty. See §1.1441–1(e)(4)(viii)

April 18, 2005 917 2005–16 I.R.B.

1. Paragraphs (c)(1)(i) through (c)(1)(vii) are redesignated as paragraphs (c)(1)(ii) through (c)(1)(viii), respectively.

2. New paragraph (c)(1)(i) is added.

3. Paragraph (c)(7) is added. The additions and revision read as follows:

§301.6114–1 Treaty-based return positions.

• • • • (c) * * * (1) * * * (i) For amounts received on or after January 1, 2001, return positions described in paragraph (b)(4)(ii) of this section, unless the conditions in paragraphs (b)(4)(ii)(A) and (B) of this section, paragraph (b)(4)(ii)(C) of this section, or paragraph (b)(4)(ii)(D) of this section are met;
• • • • (7) Reporting under paragraph (b)(4)(ii)(D) of this section is waived with respect to a taxable year for taxpayers that are not individuals or states and that, on or after January 1, 2001, receive amounts of income subject to withholding that do not exceed $10,000 in the aggregate for such taxable year.

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Mark E. Matthews, Deputy Commissioner for Services and Enforcement .

(Filed by the Office of the Federal Register on March 29, 2005, 8:45 a.m., and published in the issue of the Federal Register for March 30, 2005, 70 F.R. 16189)

rely on documentary evidence if the payor has established procedures to obtain, review, and maintain documentary evidence sufficient to establish the identity of the payee and the status of that person as a foreign person (including, but not limited to, documentary evidence described in §1.1441–6(c)(3) or (4)); and the payor obtains, reviews, and maintains such documentary evidence in accordance with those procedures. A payor maintains the documents reviewed by retaining the original, certified copy, or a photocopy (or microfiche or similar means of record retention) of the documents reviewed and noting in its records the date on which and by whom the document was received and reviewed. Documentary evidence furnished for the payment of an amount subject to withholding under chapter 3 of the Code must contain all of the information that is necessary to complete a Form 1042–S for that payment. A payor may also rely on documentary evidence associated with a flow-through withholding certificate for payments treated as made to foreign partners of a nonwithholding foreign partnership, as defined in §1.1441–1(c)(28), the foreign beneficiaries of a foreign simple trust, as defined in §1.1441–1(c)(24), or foreign owners of a foreign grantor trust, as defined in §1.1441–1(c)(26), even though the partnership or trust account is maintained in the United States.

• • • • (5) * * * (i) Definition . - * *

(ii) Reporting by U.S. payors in U.S. possessions . U.S. payors are not required to report on Form 1099 income that is from sources within a possession of the United States and that is exempt from taxation under section 931, 932, or 933, each of which sections exempts certain income from sources within a possession of the United States paid to a bona fide resident of that possession. For purposes of this paragraph (c)(5)(ii), a U.S. payor may treat the beneficial owner as a bona fide resident of the possession of the United States from which the income is sourced if, prior to payment of the income, the U.S. payor can reliably associate the payment with valid documentation that supports the claim of residence in the possession of the United States from which the income is sourced. This paragraph (c)(5)(ii) shall not apply if the U.S. payor has actual knowledge or reason to know that the documentation is unreliable or incorrect or that the income does not satisfy the requirements for exemption under section 931, 932, or 933. For the rules determining whether income is from sources within a possession of the United States, see section 937(b) and the regulations thereunder.

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PART 301 - PROCEDURE AND ADMINISTRATION

Par. 6. The authority citation for part 301 continues to read, in part, as follows: Authority: 26 U.S.C. 7805 * * * Par. 7. In §301.6114–1 is amended as follows:

Announcement and Report Concerning Advance Pricing Agreements

Announcement 2005–27

March 31, 2005

This Announcement is issued pursuant to § 521(b) of Pub. L. 106–170, the Ticket to Work and Work Incentives Improvement Act of 1999, which requires the Secretary of the Treasury to report annually to the public concerning Advance Pricing Agreements (APAs) and the APA Program. The first report covered calendar years 1991 through 1999. Subsequent reports covered calendar years 2000, 2001, 2002, and 2003. This sixth report describes the experience, structure and activities of the APA Program during calendar year 2004. It does not provide guidance regarding the application of the arm’s length standard.

Matthew W. Frank Director, Advance Pricing Agreement Program

2005–16 I.R.B. 918 April 18, 2005

Background

Internal Revenue Code (IRC) § 482 provides that the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among two or more commonly controlled businesses if necessary to reflect clearly the income of such businesses. Under the § 482 regulations, the standard to be applied in determining the true taxable income of a controlled business is that of a business dealing at arm’s length with an unrelated business. The arm’s length standard has also been adopted by the international community and is incorporated into the transfer pricing guidelines issued by the Organization for Economic Cooperation and Development (OECD). OECD, TRANSFER PRICING GUIDELINES FOR MULTINATIONAL ENTERPRISES AND TAX ADMINISTRATORS (1995). Transfer pricing issues by their nature are highly factual and have traditionally been one of the largest issues identified by the IRS in its audits of multinational corporations. The APA Program is designed to resolve actual or potential transfer pricing disputes in a principled, cooperative manner, as an alternative to the traditional examination process. An APA is a binding contract between the IRS and a taxpayer by which the IRS agrees not to seek a transfer pricing adjustment under IRC § 482 for a Covered Transaction if the taxpayer files its tax return for a covered year consistent with the agreed transfer pricing method (TPM). In 2004, the IRS and taxpayers executed 65 APAs and amended 4 APAs.

Since 1991, with the issuance of Rev. Proc. 91–22, 1991–1 C.B. 526, the IRS has offered taxpayers, through the APA Program, the opportunity to reach an agreement in advance of filing a tax return on the appropriate TPM to be applied to related party transactions. In 1996, the IRS issued internal procedures for processing APA requests. Chief Counsel Directives Manual (CCDM), ¶¶ 42.10.10 – 42.10.16 (November 15, 1996). Also in 1996, the IRS updated Rev. Proc. 91–22 with the release of Rev. Proc. 96–53, 1996–2 C.B. 375. In 1998, the IRS published Notice 98–65, 1998–2 C.B. 803, which set forth streamlined APA procedures for Small Business Taxpayers.

On July 1, 2004, the IRS updated the procedural rules for obtaining, processing, and administering APAs with the issuance of Rev. Proc. 2004–40, 2004–29 I.R.B. 50 (July 19, 2004). Rev. Proc. 2004–40 supersedes Rev. Proc. 96–53 and Notice 98–65 and is effective for all APA requests (including requests for renewals) filed on or after August 19, 2004. Rev. Proc. 96–53 continues to apply to APA requests filed before August 19, 2004, although a taxpayer with an APA request pending on that date may ask to apply Rev. Proc. 2004–40 to the pending APA.

Also in 2004, the APA Program published IRS Announcement 2004–98, 2004–50 I.R.B. 983 (December 13, 2004), announcing its intention to hold public hearings in early 2005 requesting comments on the state of, and ideas for improving, the APA Program.

Advance Pricing Agreements

An APA generally combines an agreement between a taxpayer and the IRS on an appropriate TPM for the transactions at issue (Covered Transactions) with an agreement between the U.S. and one or more foreign tax authorities (under the authority of the mutual agreement process of our income tax treaties) that the TPM is correct. With such a “bilateral” APA, the taxpayer ordinarily is assured that the income associated with the Covered Transactions will not be subject to double taxation by the IRS and the foreign tax authority. It is the policy of the United States, as reflected in §§ 2.08 and 6 of Rev. Proc. 2004–40, to encourage taxpayers that enter the APA Program to seek bilateral or multilateral APAs when competent authority procedures are available with respect to the foreign country or countries involved. However, the IRS may execute an APA with a taxpayer without reaching a competent authority agreement (a “unilateral” APA).

A unilateral APA is an agreement between a taxpayer and the IRS establishing an approved TPM for U.S. tax purposes. A unilateral APA binds the taxpayer and the IRS, but does not prevent foreign tax administrations from taking different positions on the appropriate TPM for a transaction. As stated in § 6.07 of Rev. Proc. 2004–40, should a transaction covered by a unilateral APA be subject to double taxation as the result of an adjustment by a foreign tax administration, the taxpayer may seek relief by requesting that the U.S. Competent Authority consider initiating a mutual agreement proceeding, provided there is an applicable income tax treaty in force with the other country.

When a unilateral APA involves taxpayers operating in a country that is a treaty partner, information relevant to the APA (including a copy of the APA and APA annual reports) may be provided to the treaty partner under normal rules and principles governing the exchange of information under income tax treaties.

The APA Program

An IRS team headed by an APA team leader is responsible for the consideration of each APA. As of December 31, 2004, the APA program had 17 team leaders. The team leader is responsible for organizing the IRS APA team. The IRS APA team leader arranges meetings with the taxpayer, secures whatever information is necessary from the taxpayer to analyze the taxpayer’s related party transactions and the available facts under the arm’s length standard of IRC § 482 and the regulations thereunder (Treas. Reg.), and leads the discussions with the taxpayer.

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The APA team generally includes an economist, an international examiner, LMSB field counsel, and, in a bilateral case, a U.S. Competent Authority analyst who leads the discussions with the treaty partner. The economist may be from the APA Program or the IRS field organization. As of December 31, 2004, the APA Program had five economists. The APA team may also include an LMSB International Technical Advisor, other LMSB exam personnel, and an Appeals Officer.

The APA Process

The APA process is voluntary. Taxpayers submit an application for an APA, together with a user fee as set forth in Rev. Proc. 2004–40, § 4.12. The APA process can be broken into five phases: (1) application; (2) due diligence; (3) analysis; (4) discussion and agreement; and (5) drafting, review, and execution.

(1) Application

In many APA cases, the taxpayer’s application is preceded by a pre-file conference with the APA staff in which the taxpayer can solicit the informal views of the APA Program. Pre-file conferences can occur on an anonymous basis, although a taxpayer must disclose its identity when it applies for an APA. Taxpayers must file the appropriate user fee on or before the due date of the tax return for the first taxable year that the taxpayer proposes to be covered by the APA. Many taxpayers file a user fee first and then follow up with a full application later. The procedures for pre-file conferences, user fees, and applications can be found in § 3 of Rev. Proc. 2004–40.

The APA application can be a relatively modest document for small businesses. Section 8 of Rev. Proc. 2004–40 describes the special APA procedures for Small Business Taxpayers. For most taxpayers, however, the APA application is a substantial document filling several binders. The APA Program makes every effort to reach an agreement on the basis of the information provided in the taxpayer’s application.

The application is assigned to an APA team leader who is responsible for the case. The APA team leader’s first responsibility is to organize the APA team. This involves contacting the appropriate LMSB International Territory Manager to secure the assignment of an international examiner to the APA case and the LMSB Counsel’s office to secure a field counsel lawyer. In a bilateral case, the U.S. Competent Authority will assign a U.S. Competent Authority analyst to the team. In a large APA case, the international examiner may invite his or her manager and other LMSB personnel familiar with the taxpayer to join the team. When the APA may affect taxable years in Appeals, the appropriate appellate conferee will be invited to join the team. In all cases, the APA team leader contacts the Manager, LMSB International Technical Advisors, to determine whether to include a technical advisor on the team. The IRS APA team will generally include a technical advisor if the APA request concerns cost-sharing, intangibles, or services. The APA team leader then distributes copies of the APA application to all team members and sets up an opening conference with the taxpayer. The APA office strives to hold this opening conference within 45 days of the assignment of the case to a team leader. At the opening conference, the APA team leader proposes a case plan designed, if feasible, to complete a unilateral APA or, in the case of a bilateral APA, the recommended U.S. negotiating position within 12 months from the date the full application is filed. The actual median and average times for completing unilateral APAs, recommended negotiating positions for bilateral APAs, and APAs for Small Business Taxpayers are shown below in Tables 2, 5, and 10, respectively.

(2) Due Diligence

The APA team must satisfy itself that the relevant facts submitted by the taxpayer are complete and accurate. This due diligence aspect of the APA is vital to the process. It is because of this due diligence that the IRS can reach advance agreements with taxpayers in the highly factual setting of transfer pricing. Due diligence can proceed in a number of ways. Typically, the taxpayer and the APA team will agree to dates for future meetings during the opening conference. In advance of the opening conference, the APA team leader will submit a list of questions to the taxpayer for discussion. The opening conference may result in a second set of questions. These questions are developed by the APA team and provided to the taxpayer through the APA team leader. It is important to note that this due diligence is not an audit and is focused on the transfer pricing issues associated with the transactions in the taxpayer’s application, or such other transactions that the taxpayer and the IRS may agree to add.

(3) Analysis

A significant part of the analytical work associated with an APA is done typically by the APA economist and/or an IRS field economist assigned to the case. The analysis may result in the need for additional information. Once the IRS APA team has completed its due diligence and analysis, it begins discussions with the taxpayer over the various aspects of the APA including the selection of comparable transactions, asset intensity and other adjustments, the TPM, which transactions to cover, the appropriate critical assumptions, the APA term, and other key issues. The APA team leader will discuss particularly difficult issues with his or her managers, but generally the APA team leader is empowered to negotiate the APA.

2005–16 I.R.B. 920 April 18, 2005

(4) Discussion and Agreement

The discussion and agreement phase differs for bilateral and unilateral cases. In a bilateral case, the discussions proceed in two parts and involve two IRS offices — the APA Program and the U.S. Competent Authority. In the first part, the APA team will attempt to reach a consensus with the taxpayer regarding the recommended position that the U.S. Competent Authority should take in negotiations with its treaty partner. This recommended U.S. negotiating position is a paper drafted by the APA team leader and signed by the APA Director that provides the APA Program’s view of the best TPM for the Covered Transaction, taking into account IRC § 482 and the regulations thereunder, the relevant tax treaty, and the U.S. Competent Authority’s experience with the treaty partner.

The experience of the APA office and the U.S. Competent Authority is that APA negotiations are likely to proceed more rapidly with a foreign competent authority if the U.S. negotiating position is fully supported by the taxpayer. Consequently, the APA office works together with the taxpayer in developing the recommended U.S. negotiating position. On occasion, the APA team will agree to disagree with a taxpayer. In these cases, the APA office will send a recommended U.S. negotiating position to the U.S. Competent Authority that includes elements with which the taxpayer does not agree. This disagreement is noted in the paper. The APA team leader also solicits the views of the field members of the APA team, and, in the vast majority of APA cases, the international examiner, LMSB field counsel, and other IRS field team members concur in the position prepared by the APA team leader.

Once the APA Program completes the recommended U.S. negotiating position, the APA process shifts from the APA Program to the U.S. Competent Authority. The U.S. Competent Authority analyst assigned to the APA takes the recommended U.S. negotiating position and prepares the final U.S. negotiating position, which is then transmitted to the foreign competent authority. The negotiations with the foreign competent authority are conducted by the U.S. Competent Authority analyst, most often in face-to-face negotiating sessions conducted periodically throughout the year. At the request of the U.S. Competent Authority analyst, the APA team leader may continue to assist the negotiations.

In unilateral APA cases, the discussions proceed solely between the APA Program and the taxpayer. In a unilateral case, the taxpayer and the APA Program must reach agreement to conclude an APA. Like the bilateral cases, the APA team leader almost always will achieve a consensus with the IRS field personnel assigned to the APA team regarding the final APA. The APA Program has a procedure in which the IRS field personnel are solicited formally for their concurrence in the final APA. This concurrence, or any item in disagreement, is noted in a cover memorandum prepared by the APA team leader that accompanies the final APA sent forward for review and execution.

(5) Drafting, Review, and Execution

Once the IRS and the taxpayer reach agreement, the drafting of the final APA generally takes little time because the APA Program has developed standard language that is incorporated into every APA. The current versions of this language are found in Attachment A, with “Model 1” based on Rev. Proc. 96–53 and “Model 2” based on Rev. Proc. 2004–40. APAs are reviewed by the Branch Chief and the APA Director. In addition, the team leader prepares a summary memorandum for the Associate Chief Counsel (International) (ACC(I)). On March 1, 2001, the ACC(I) delegated to the APA Director the authority to execute APAs on behalf of the IRS. See Chief Counsel Notice CC–2001–016. The APA is executed for the taxpayer by an appropriate corporate officer.

Model APA at Attachment A

[§ 521(b)(2)(B)]

Attachment A contains the current versions of the model APA language. As part of its continuing effort to improve its work product, the APA Program has revised the model language to reflect the program’s collective experience with substantive and drafting issues.

The Current APA Office Structure, Composition, and Operation

In 2004, the APA office consisted of four branches with Branches 1 and 3 staffed with APA team leaders and Branch 2 staffed with economists and a paralegal. Branch 4, the APA West Coast branch, is headquartered in Laguna Niguel, California, with an additional office in San Francisco, and is presently staffed with both team leaders and an economist.

Overall, the APA staff declined in 2004 from 36 to 32. The number of APA team leaders fell from 18 to 17, the number of APA economists fell from seven to five, and a temporary vacancy reduced the number of APA branch chiefs from four to three.

As of December 31, 2004, the APA staff was as follows:

April 18, 2005 921 2005–16 I.R.B.

Director’s Office
1 Director
1 Special Counsel to the Director
1 Secretary to the Director

APA Training

In 2004, the APA office continued to emphasize training as a priority. Training sessions addressed APA-related current developments, new APA office practices and procedures, and international tax law issues. The APA New Hire Training materials were updated, as necessary, throughout the year. The updated materials are available to the public through the APA internet site at http://www.irs.gov/businesses/corporations/article/0,,id=96221,00.html . These materials do not constitute guidance on the application of the arm’s length standard.

APA Program Statistical Data

[§ 521(b)(2)(C) and (E)]

The statistical information required under § 521(b)(2)(C) is contained in Tables 1 and 9 below; the information required under § 521(b)(2)(E) is contained in Tables 2 and 3 below:

TABLE 1: APA APPLICATIONS, EXECUTED APAs, AND PENDING APAs

1 Consistent with past practice, the “APAs executed” figures in this table include APA renewals, but exclude revised or amended APAs.

2005–16 I.R.B. 922 April 18, 2005

TABLE 2: MONTHS TO COMPLETE APAs ²

Months to Complete Advance Pricing Agreements in Year 2004

2 The one multilateral APA was treated as a bilateral APA for purposes of these calculations.

April 18, 2005 923 2005–16 I.R.B.

TABLE 3: APA COMPLETION TIME – MONTHS PER APA

TABLE 4: RECOMMENDED NEGOTIATING POSITIONS

Recommended Negotiating Positions Completed in Year 2004 25

2005–16 I.R.B. 924 April 18, 2005

TABLE 5: MONTHS TO COMPLETE RECOMMENDED NEGOTIATING POSITIONS

TABLE 6: RECOMMENDED NEGOTIATING POSITIONS COMPLETION TIME – MONTHS PER APA

Tables 7 and 8 below are new from previous annual reports and show how long each APA request pending at the end of 2004 has been in the system as measured from the filing date of the APA submission. We believe that reporting the age of both completed cases and pending cases reflects more accurately the APA Program’s success or failure in moving cases and improves the public’s ability to evaluate the current timeliness of the APA process. (The numbers in Tables 7 and 8 for pending unilateral and bilateral cases differ from the numbers in Table 1 because whereas Table 1 includes any case for which a user fee has been paid, Tables 7 and 8 reflect only cases for which submissions have been received.)

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TABLE 7: UNILATERAL APAs – TIME IN INVENTORY – MONTHS PER APA

2005–16 I.R.B. 926 April 18, 2005

TABLE 8: BILATERAL APAs – TIME IN INVENTORY – MONTHS PER APA

TABLE 9: SMALL BUSINESS TAXPAYER APAs

April 18, 2005 927 2005–16 I.R.B.

TABLE 10: MONTHS TO COMPLETE SMALL BUSINESS TAXPAYER APAs

TABLE 11: INDUSTRIES COVERED ³

Trades or Businesses

[§ 521(b)(2)(D)(i)]

The nature of the relationships between the related organizations, trades, or businesses covered by APAs executed in 2004 is set forth in Table 12 below:

3 The categories in this table are drawn from the North American Industry Classification System (NAICS), which has replaced the U.S. Standard Industrial Classification (SIC) system. NAICS was developed jointly by the U.S., Canada, and Mexico to provide new comparability in statistics about business activity across North America.

2005–16 I.R.B. 928 April 18, 2005

TABLE 12: NATURE OF RELATIONSHIPS BETWEEN RELATED ENTITIES

Covered Transactions

[§ 521(b)(2)(D)(ii)]

The controlled transactions covered by APAs executed in 2004 are set forth in Table 13 and Table 14 below:

TABLE 13: TYPES OF COVERED TRANSACTIONS

TABLE 14: TYPES OF SERVICES INCLUDED IN COVERED TRANSACTIONS

April 18, 2005 929 2005–16 I.R.B.

Business Functions Performed and Risks Assumed

[§ 521(b)(2)(D)(ii)]

The general descriptions of the business functions performed and risks assumed by the organizations, trades, or businesses whose results are tested in the Covered Transactions in the APAs executed in 2004 are set forth in Tables 15 and 16 below:

TABLE 15: FUNCTIONS PERFORMED BY THE TESTED PARTY

2005–16 I.R.B. 930 April 18, 2005

TABLE 16: RISKS ASSUMED BY THE TESTED PARTY

Discussion

The vast majority of APAs have Covered Transactions that involve numerous business functions and risks. For instance, with respect to functions, companies that manufacture products have typically conducted research and development, engaged in product design and engineering, manufactured the product, marketed and distributed the product, and performed support functions such as legal, finance, and human resources services. Regarding risks, companies have been subject to market risks, R&D risks, financial risks, credit and collection risks, product liability risks, and general business risks. In the APA evaluation process, a significant amount of time and effort is devoted to understanding how the functions and risks are allocated among the controlled group of companies that are party to the Covered Transactions.

In its APA submission, the taxpayer must provide a functional analysis. The functional analysis identifies the economic activities performed, the assets employed, the economic costs incurred, and the risks assumed by each of the controlled parties. The importance of the functional analysis derives from the fact that economic theory posits that there is a positive relationship between risk and expected return and that different functions provide different value and have different opportunity costs associated with them. It is important that the functional analysis go beyond simply categorizing the tested party as, say, a distributor. It should provide more specific information because, in the example of distributors, not all distributors undertake similar functions and risks.

Thus, the functional analysis is critical in determining the TPM (including the selection of comparables). Although functional comparability is an essential factor in evaluating the reliability of the TPM (including the selection of comparables), the APA evaluation process also involves consideration of economic conditions such as the economic condition of the particular industry.

In evaluating the functional analysis, the APA Program considers contractual terms between the controlled parties and the consistency of the conduct of the parties with respect to the allocation of risk. In accordance with the section 482 regulations, the APA Program also gives consideration to the ability of controlled parties to fund losses that might be expected to occur as a result of the assumption of risk. Another relevant factor considered in evaluating the functional analysis is the extent to which a controlled party exercises managerial or operational control over the business activities that directly influence the amount of income or loss realized. The section 482 regulations posit that parties at arm’s length will ordinarily bear a greater share of those risks over which they have relatively more control.

Related Organizations, Trades, or Businesses Whose Prices or Results are Tested to Determine

Compliance with APA Transfer Pricing Methods

[§ 521(b)(2)(D)(iii)]

The related organizations, trades, or businesses whose prices or results are tested to determine compliance with TPMs prescribed in APAs executed in 2004 are set forth in Table 17 below:

April 18, 2005 931 2005–16 I.R.B.

TABLE 17: RELATED ORGANIZATIONS, TRADES, OR BUSINESSES WHOSE PRICES OR RESULTS ARE TESTED ⁴

Transfer Pricing Methods and the Circumstances Leading to the Use of Those Methods

[§ 521(b)(2)(D)(iv)]

The TPMs used in APAs executed in 2004 are set forth in Tables 18–20 below:

TABLE 18: TRANSFER PRICING METHODS USED FOR TRANSFERS OF

TANGIBLE AND INTANGIBLE PROPERTY ⁵

4 “Multiple tested parties” includes covered transactions that utilize profit splits, CUPs, and CUTs.

5 Profit Level Indicators (PLIs) used with the Comparable Profit Method of Treas. Reg. § 1.482–5, and as used in these TPM tables, are as follows: (1) operating margin (ratio of operating profit to sales); (2) gross margin (ratio of gross profit to sales); (3) Berry ratio (gross profit to operating expenses); (4) markup on total costs (percentage markup on total costs); and (5) rate of return on assets or capital employed (ratio of operating profit to operating assets).

2005–16 I.R.B. 932 April 18, 2005

TABLE 19: TRANSFER PRICING METHODS USED FOR SERVICES

TABLE 20: TRANSFER PRICING METHODS USED FOR FINANCIAL PRODUCTS

Discussion

The TPMs used in APAs completed during 2004 were based on the section 482 regulations. Under Treas. Reg. § 1.482–3, the arm’s length amount for controlled transfers of tangible property may be determined using the Comparable Uncontrolled Price (CUP) method, the Resale Price Method, the Cost Plus Method, the Comparable Profits Method (CPM), or the Profit Split Method. Under Treas. Reg. § 1.482–4, the arm’s length amount for controlled transfers of intangible property may be determined using the Comparable Uncontrolled Transaction (CUT) method, CPM, or the Profit Split Method. An “Unspecified Method” may be used for both tangible and intangible property if it provides a more reliable result than the enumerated methods under the best method rule of Treas. Reg. § 1.482–1(c). For transfers involving the provision of services, Treas. Reg. § 1.482–2(b) provides that services performed for the benefit of another member of a controlled group should bear an arm’s length charge, either deemed to be equal to the cost of providing the services (when non-integral, see Treas. Reg. § 1.482–2(b)(3)) or which should be an amount that would have been charged between independent parties.

In addition, Treas. Reg. § 1.482–2(a) provides rules concerning the proper treatment of loans or advances, and Treas. Reg. § 1.482–7 provides rules for qualified cost sharing arrangements under which the parties agree to share the costs of development of intangibles in proportion to their shares of reasonably anticipated benefits. APAs involving cost sharing arrangements generally address both the method of allocating costs among the parties as well as determining the appropriate amount of the “buy-in” payment due for the transfer of pre-existing intangibles to the controlled participants.

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In reviewing the TPMs applicable to transfers of tangible and intangible property reflected in Table 18, the majority of the APAs followed the specified methods. However, several points should be made. The § 482 regulations note that for transfers of tangible property, the Comparable Uncontrolled Price (CUP) method will generally be the most direct and reliable measure of an arm’s length price for the Controlled Transaction if sufficiently reliable comparable transactions can be identified. Treas. Reg. § 1.482–3(b)(2)(ii)(A). It was the experience of the APA Program in 2003, that in the cases that came into the APA Program, sufficiently reliable CUP transactions were difficult to find. In APAs executed in 2004, no Covered Transaction used the CUP method.

Similar to the CUP method, for transfers of intangible property, the CUT method will generally provide the most reliable measure of an arm’s length result if sufficiently reliable comparables may be found. Treas. Reg. § 1.482–4(c)(2)(ii). It has generally been difficult to identify external comparables, and APAs using the CUT method tend to rely on internal transactions between the taxpayer and unrelated parties. In 2004, eight Covered Transactions utilized the CUT TPM.

The Cost Plus Method (tangibles only) and Resale Price Method were applied in 2004 in three or fewer APAs and 11 APAs, respectively. See Treas. Reg. § 1.482–3(c), (d).

The CPM is frequently applied in APAs. This is because reliable public data on comparable business activities of independent companies may be more readily available than potential CUP data, and comparability of resources employed, functions, risks, and other relevant considerations are more likely to exist than comparability of product. The CPM also tends to be less sensitive than other methods to differences in accounting practices between the tested party and comparable companies, e.g., classification of expenses as cost of goods sold or operating expenses. Treas. Reg. § 1.482–3(c)(3)(iii)(B), and –3(d)(3)(iii)(B). In addition, the degree of functional comparability required to obtain a reliable result under the CPM is generally less than required under the Resale Price or Cost Plus methods, because differences in functions performed often are reflected in operating expenses, and thus taxpayers performing different functions may have very different gross profit margins but earn similar levels of operating profit. Treas. Reg. § 1.482–5(c)(2).

Table 18 reflects more than 54 uses of the CPM (with varying PLIs) in Covered Transactions involving tangible or intangible property. In some APAs, the CPM was also used concurrently with other methods.

The CPM has proven to be versatile in part because of the various PLIs that can be used in connection with the method. Reaching agreement on the appropriate PLI has been the subject of much discussion in many of the cases, and it depends heavily on the facts and circumstances. Some APAs have called for different PLIs to apply to different parts of the Covered Transactions or with one PLI used as a check against the primary PLI.

The CPM was also used regularly with services as the Covered Transactions in APAs executed in 2004. There were at least 13 services Covered Transactions using the CPM method with various PLIs according to the specific facts of the taxpayers involved. Table 19 reflects the methods used to determine the arm’s length results for APAs involving services transactions.

In 2004, three or fewer APAs involving tangible or intangible property used the Residual Profit Split Method, Treas. Reg. § 1.482–6(c)(3). In residual profit split cases, routine contributions by the controlled parties are allocated routine market returns, and the residual income is allocated among the controlled taxpayers based upon the relative value of their contributions of non-routine intangible property to the relevant business activity.

Profit splits have also been used in a number of financial product APAs in which the primary income-producing functions are performed in more than one jurisdiction. Nine APAs executed in 2004 applied a profit split method.

Critical Assumptions

[§ 521(b)(2)(D)(v)] Critical Assumptions used in APAs executed in 2004 are described in Table 21 below:

TABLE 21: CRITICAL ASSUMPTIONS

2005–16 I.R.B. 934 April 18, 2005

Discussion

APAs include critical assumptions upon which their respective TPMs depend. A critical assumption is any fact (whether or not within the control of the taxpayer) related to the taxpayer, a third party, an industry, or business and economic conditions, the continued existence of which is material to the taxpayer’s proposed TPM. Critical assumptions might include, for example, a particular mode of conducting business operations, a particular corporate or business structure, or a range of expected business volume. Rev. Proc. 2004–40, § 4.05. Failure to meet a critical assumption may render an APA inappropriate or unworkable.

A critical assumption may change (and/or fail to materialize) due to uncontrollable changes in economic circumstances, such as a fundamental and dramatic change in the economic conditions of a particular industry. In addition, a critical assumption may change (and/or fail to materialize) due to a taxpayer’s actions that are initiated for good faith business reasons, such as a change in business strategy, mode of conducting operations, or the cessation or transfer of a business segment or entity covered by the APA.

If a critical assumption has not been met, the APA may be revised by agreement of the parties. If such an agreement cannot be achieved, the APA may be canceled. If a critical assumption has not been met, it requires taxpayer’s notice to and discussion with the Service, and, in the case of a bilateral APA, competent authority consideration. Rev. Proc. 2004–40, § 10.05.

Sources of Comparables, Selection Criteria, and the Nature of Adjustments to Comparables and Tested Parties

[§ 521(b)(2)(D)(v), (vi), and (vii)]

The sources of comparables, selection criteria, and rationale used in determining the selection criteria for APAs executed in 2004 are described in Tables 22 through 24 below. Various formulas for making adjustments to comparables are included as Attachment B.

TABLE 22: SOURCES OF COMPARABLES

April 18, 2005 935 2005–16 I.R.B.

TABLE 23: COMPARABLE SELECTION CRITERIA

TABLE 24: ADJUSTMENTS TO COMPARABLES OR TESTED PARTIES

2005–16 I.R.B. 936 April 18, 2005

Discussion

At the core of most APAs are comparables. The APA Program works closely with taxpayers to find the best and most reliable comparables for each Covered Transaction. In some cases, CUPs or CUTs can be identified. In other cases, comparable business activities of independent companies are utilized in applying the CPM or a profit split method. Generally, in the APA Program’s experience since 1991, CUPs and CUTs have been most often derived from the internal transactions of the taxpayer.

For profit-based methods in which comparable business activities or functions of independent companies are sought, the APA Program typically has applied a three-part process. First, a pool of potential comparables has been identified through broad searches. From this pool, companies having transactions that are clearly not comparable to those of the tested party have been eliminated through the use of quantitative and qualitative analyses, i.e., quantitative screens and business descriptions. Then, based on a review of available descriptive and financial data, a set of comparable transactions or business activities of independent companies has been finalized. The comparability of the finalized set has then been enhanced through the application of adjustments.

Sources of Comparables

Comparables used in APAs can be U.S. or foreign, depending on the relevant market, the type of transaction being evaluated, and the results of the functional and risk analyses. In general, comparables have been located by searching a variety of databases that provide data on U.S. publicly traded companies and on a combination of public and private non-U.S. companies. Table 22 shows the various databases and other sources used in selecting comparables for the APAs executed in 2004.

Although comparables were most often identified from the databases cited in Table 22, in some cases comparables were found from other sources, such as comparables derived internally from taxpayer transactions with third parties.

Selecting Comparables

Initial pools of potential comparables generally are derived from the databases using a combination of industry and keyword identifiers. Then, the pool is refined using a variety of selection criteria specific to the transaction or business activity being tested and the TPM being used.

The listed databases allow for searches by industrial classification, by keywords, or by both. These searches can yield a number of companies whose business activities may or may not be comparable to those of the entity being tested. Therefore, comparables based solely on industry classification or keyword searches are rarely used in APAs. Instead, the pool of comparables is examined closely, and companies are selected based on a combination of screens, business descriptions, and other information found in the companies’ Annual Reports to shareholders and filings with the U.S. Securities and Exchange Commission (SEC).

Business activities are required to meet certain basic comparability criteria to be considered comparables. Functions, risks, economic conditions, and the property (product or intangible) and services associated with the transaction must be comparable. Determining comparability can be difficult – the goal has been to use comparability criteria restrictive enough to eliminate business activities that are not comparable, but yet not so restrictive as to have no comparables remaining. The APA Program normally has begun with relatively strict comparability criteria and then has relaxed them slightly if necessary to derive a pool of reliable comparables. A determination on the appropriate size of the comparables set, as well as the business activities that comprise the set, is highly fact specific and depends on the reliability of the results.

In addition, the APA Program, consistent with the section 482 regulations, generally has looked at the results of comparables over a multi-year period. Sometimes this has been a three-year period, but it has been more or less, depending on the circumstances of the controlled transaction. Using a shorter period might result in the inclusion of comparables in different stages of economic development or use of atypical years of a comparable due to cyclical fluctuations in business conditions.

April 18, 2005 937 2005–16 I.R.B.

Many Covered Transactions have been tested with comparables that have been chosen using additional criteria and/or screens. These include sales level criteria and tests for financial distress and product comparability. These common selection criteria and screens have been used to increase the overall comparability of a group of companies and as a basis for further research. The sales level screen, for example, has been used to remove companies that, due to their size, might face fundamentally different economic conditions from those of the transaction or business activities being tested. In addition, APA analyses have incorporated selection criteria related to removing companies experiencing “financial distress” due to concerns that companies in financial distress often have experienced unusual circumstances that render them not comparable to the business activity being tested. These criteria include an unfavorable auditor’s opinion, bankruptcy, and, in certain circumstances, operating losses in a given number of years.

An additional important class of selection criteria is the development and ownership of intangible property. In some cases in which the business activity being tested is a manufacturer, several criteria have been used to ensure, for example, that if the controlled entity does not own significant manufacturing intangibles or conduct research and development (R&D), then neither will the comparables. These selection criteria have included determining the importance of patents to a company or screening for R&D expenditures as a percentage of sales. Again, quantitative screens related to identifying comparables with significant intangible property generally have been used in conjunction with an understanding of the comparable derived from publicly available business information.

Selection criteria relating to asset comparability and operating expense comparability have also been used at times. A screen of property, plant, and equipment (PP&E) as a percentage of sales or assets, combined with a reading of a company’s SEC filings, has been used to help ensure that distributors (generally lower PP&E) were not compared with manufacturers (generally higher PP&E), regardless of their industry classification. Similarly, a test involving the ratio of operating expenses to sales has helped to determine whether a company undertakes a significant marketing and distribution function.

Table 25 shows the number of times various screens were used in APAs executed in 2004:

TABLE 25: COMPARABILITY SCREENS

Adjusting Comparables

After the comparables have been selected, the regulations require that “[i]f 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.” Treas. Reg. § 1.482–1(d)(2). In almost all cases involving income-statement-based PLIs, certain “asset intensity” or “balance sheet” adjustments for factors that have generally agreed-upon effects on profits are calculated. In addition, in specific cases, additional adjustments are performed to improve reliability.

2005–16 I.R.B. 938 April 18, 2005

The most common balance sheet adjustments used in APAs are adjustments for differences in accounts receivable, inventories, and accounts payable. The APA Program generally has required adjustments for receivables, inventory, and payables based on the principle that there is an opportunity cost for holding assets. For these assets, it is generally assumed that the cost is a short-term debt interest rate.

To compare the profits of two business activities with different relative levels of receivables, inventory, or payables, the APA Program estimates the carrying costs of each item and adjusts profits accordingly. Although different formulas have been used in specific APA cases, Attachment B presents one set of formulas used in many APAs. Underlying these formulas are the notions that (1) balance sheet items should be expressed as mid-year averages, (2) formulas should try to avoid using data items that are being tested by the TPM (for example, if sales are controlled, then the denominator of the balance sheet ratio should not be sales), (3) a short term interest rate should be used, and (4) an interest factor should recognize the average holding period of the relevant asset.

The APA Program also requires that data be compared on a consistent accounting basis. For example, although financial statements may be prepared on a first-in first-out (FIFO) basis, cross-company comparisons are less meaningful if one or more of the comparables use last-in first-out (LIFO) inventory accounting methods. This adjustment directly affects costs of goods sold and inventories, and therefore affects both profitability measures and inventory adjustments.

Still important in some cases is the adjustment for differences in relative levels of PP&E between a tested business activity and the comparables. Ideally, comparables and the business activity being tested will have fairly similar relative levels of PP&E, since major differences can be a sign of fundamentally different functions and risks. Typically, the PP&E adjustment is made using a medium term interest rate.

Additional adjustments used less frequently include those for differences in other balance sheet items, operating expenses, R&D, or currency risk. Accounting adjustments, such as reclassifying items from cost of goods sold to operating expenses, are also made when warranted to increase reliability. Often, data is not available for both the controlled and uncontrolled transactions in sufficient detail to allow for these types of adjustments.

The adjustments made to comparables or tested parties in APAs executed in 2004 are reflected in Table 24 above.

Nature of Ranges and Adjustment Mechanisms

[§ 521(b)(2)(D)(viii)-(ix)]

The types of ranges and adjustment mechanisms used in APAs executed in 2004 are described in Table 26 and 27 below.

TABLE 26: TYPES OF RANGES ⁶

6 The numbers do not include TPMs with cost or cost-plus methodologies.

April 18, 2005 939 2005–16 I.R.B.

TABLE 27: ADJUSTMENTS WHEN OUTSIDE OF THE RANGE

Discussion

Treas. Reg. § 1.482–1(e)(1) states that sometimes a pricing method will yield “a single result that is the most reliable measure of an arm’s length result.” Sometimes, however, a method may yield “a range of reliable results,” called the “arm’s length range.” A taxpayer whose results fall within the arm’s length range will not be subject to adjustment.

Under Treas. Reg. § 1.482–1(e)(2)(i), such a range is normally derived by considering a set of more than one comparable uncontrolled transaction of similar comparability and reliability. If these comparables are of very high quality, as defined in the § 482 regulations, then under Treas. Reg. § 1.482–1(e)(2)(iii)(A), the arm’s length range includes the results of all of the comparables (from the least to the greatest). However, the APA Program has only rarely identified cases meeting the requirements for the full range. If the comparables are of lesser quality, then under Treas. Reg. § 1.482–1(e)(2)(iii)(B), “the reliability of the analysis must be increased, when it is possible to do so, by adjusting the range through application of a valid statistical method to the results of all of the uncontrolled comparables.” One such method, the “interquartile range,” is ordinarily acceptable, although a different statistical method “may be applied if it provides a more reliable measure.” The “interquartile range” is defined as, roughly, the range from the 25th to the 75th percentile of the comparables’ results. See Treas. Reg. § 1.482–1(e)(2)(iii)(C). The interquartile range was used 58 times in 2004.

More than twenty-five Covered Transactions reflected on Table 26 specified a single, specific result. Nine of these Covered Transactions involved a CPM in which the taxpayer agreed to a “point.” Some APAs specify not a point or a range, but a “floor” or a “ceiling”. When a floor is used, the tested party’s result must be greater than or equal to some particular value. When a ceiling is used, the tested party’s result must be less than or equal to some particular value. Three or fewer APAs executed in 2004 used a floor and none used a ceiling.

Some APAs look to a tested party’s results over a period of years (multi-year averaging) to determine whether a taxpayer has complied with the APA. In 2004, rolling multi-year averaging was used for 14 Covered Transactions. Twelve of those used three-year averages and the other two used five-year averages. Five Covered Transactions used cumulative multi-year averages, while 26 other Covered Transactions used term averages.

Adjustments

Under Treas. Reg. § 1.482–1(e)(3), if a taxpayer’s results fall outside the arm’s length range, the Service may adjust the result “to any point within the arm’s length range.” Accordingly, an APA may permit or require a taxpayer and its related parties to make an adjustment after the year’s end to put the year’s results within the range, or at the point specified by the APA. Similarly, to enforce the terms of an APA, the Service may make such an adjustment. When the APA specifies a range, the adjustment is sometimes to the closest edge of the range, and sometimes to another point such as the median of the interquartile range. Depending on the facts of each case, automatic adjustments are not always permitted. APAs may specify that in such a case there will be a negotiation between the competent authorities involved to determine whether and to what extent an adjustment should be made. APAs may permit automatic adjustments unless the result is far outside the range specified in the APA. Thus, APAs provide flexibility and efficiency, permitting adjustments when normal business fluctuations and uncertainties push the result somewhat outside the range.

Where a taxpayer’s actual transactions do not comply with the TPM, a taxpayer must nonetheless report its taxable income in an amount consistent with the TPM (an APA primary adjustment), as further discussed in § 10.02 of Rev. Proc. 2004–40.

2005–16 I.R.B. 940 April 18, 2005

APA Term and Rollback Lengths

[§ 521(b)(2)(D)(x)]

The various term lengths for APAs executed in 2004 are set forth in Table 28 below:

TABLE 28: TERMS OF APAs

The number of rollback years to which an APA TPM was applied in 2004 is set forth in Table 29 below:

TABLE 29: NUMBER OF YEARS COVERED BY ROLLBACK OF APA TPM

Nature of Documentation Required

[§ 521(b)(2)(D)(xi)]

APAs executed in 2004 required that taxpayers provide various documents with their annual reports. These documents are described in Table 30 below:

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TABLE 30: NATURE OF DOCUMENTATION REQUIRED ⁷

Approaches for Sharing of Currency or Other Risks

[§ 521(b)(2)(D)(xii)]

During 2004, there were 48 tested parties that faced financial risks, including interest rate and currency risks. In appropriate cases, APAs may provide specific approaches for dealing with currency risk, such as adjustment mechanisms and/or critical assumptions.

Efforts to Ensure Compliance with APAs

[§ 521(b)(2)(F)]

As described in Rev. Proc. 2004–40, § 10.01, APA taxpayers are required to file annual reports to demonstrate compliance with the terms and conditions of the APA. The filing and review of annual reports is a critical part of the APA process. Through annual report review, the APA program monitors taxpayer compliance with the APA on a contemporaneous basis. Annual report review provides current information on the success or problems associated with the various TPMs adopted in the APA process.

7 The first eight categories of documentation listed in this table were drawn from the standard APA language used in 2004. The facts and circumstances of some APAs may eliminate the need for some standard documentation requirements.

2005–16 I.R.B. 942 April 18, 2005

All reports received by the APA office are tracked by one designated APA team leader who also has the primary responsibility for annual report review. Other APA team leaders and economists assist in this review, especially when the team leader who negotiated the case is available, since that person will already be familiar with the relevant facts and terms of the agreement. Once received by the APA office, the annual report is sent out to the district personnel with exam jurisdiction over the taxpayer.

The statistics for the review of APA annual reports are reflected in Table 31 below. As of December 31, 2004, there were 337 pending annual reports. In 2004, 143 reports were closed.

TABLE 31: STATISTICS OF ANNUAL REPORTS

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ATTACHMENT A Model 1 (Based on Revenue Procedure 96–53)

ADVANCE PRICING AGREEMENT

between

[ Insert Taxpayer’s Name ]

and THE INTERNAL REVENUE SERVICE

PARTIES

The Parties to this Advance Pricing Agreement (APA) are the Internal Revenue Service (IRS) and [ Insert Taxpayer’s Name ], EIN (Taxpayer).

RECITALS

Taxpayer’s principal place of business is [ City, State ]. [ Insert general description of taxpayer and other relevant parties ] .

This APA contains the Parties’ agreement on the best method for determining arm’s-length prices of the Covered Transactions under I.R.C. section 482, any applicable tax treaties, and the Treasury Regulations.

Unless otherwise specified, terms in the plural include the singular and vice versa. Appendix D contains definitions for capitalized terms not elsewhere defined in this APA.

{If renewal, add} [Taxpayer and IRS previously entered into an APA covering taxable years ending to , executed on . ]

AGREEMENT

The Parties agree as follows:

1. Covered Transactions . This APA applies to the Covered Transactions, as defined in Appendix A.

2. Transfer Pricing Method . Appendix A sets forth the Transfer Pricing Method (TPM) for the Covered Transactions.

3. Term . This APA applies to Taxpayer’s taxable years ending through (APA Term).

4. Operation .

a. Revenue Procedure 96–53 governs the interpretation, legal effect, and administration of this APA.

b. Nonfactual oral and written representations, within the meaning of sections 10.04 and 10.05 of Revenue Procedure 96–53 (including any proposals to use particular TPMs), made in conjunction with the APA Request constitute statements made in compromise negotiations within the meaning of Rule 408 of the Federal Rules of Evidence.

5. Compliance .

a. For each taxable year covered by this APA (APA Year), if Taxpayer complies with the terms and conditions of this APA, then the IRS will not make or propose any allocation or adjustment under I.R.C. section 482 to the Covered Transactions.

b. If Taxpayer does not comply with the terms and conditions of this APA, then the IRS may:

i. enforce the terms and conditions of this APA and make or propose allocations or adjustments under I.R.C. section 482 consistent with this APA;

ii. cancel or revoke this APA under section 11.05 or 11.06 of Revenue Procedure 96–53; or

iii. revise this APA, if the Parties agree.

c. Taxpayer must timely file an Annual Report for each APA Year in accordance with Appendix C and section 11.01 of Revenue Procedure 96–53. Taxpayer must file an original and four copies of the Annual Report by the later of (a) 90 days after the time prescribed by law (including extensions) for filing its federal income tax return for the APA Year covered by the report, or (b) 90 days after the effective date of this APA. [ The Service and the Taxpayer may agree to alternative filing dates .] The IRS may request additional information reasonably necessary to clarify or complete the Annual Report. Taxpayer will provide all requested information within 30 days. Additional time may be allowed for good cause.

2005–16 I.R.B. 944 April 18, 2005

d. The IRS will determine whether Taxpayer has complied with this APA based on Taxpayer’s U.S. Returns, Financial Statements, and other APA Records, for the APA Term and any other year necessary to verify compliance. For Taxpayer to comply with this APA, an independent certified public accountant must { use the following or an alternative } render an opinion that the Taxpayer’s Financial Statements present fairly, in all material respects, Taxpayer’s financial position under U.S. GAAP.

e. In accordance with section 11.04 of Revenue Procedure 96–53, Taxpayer will (1) maintain its APA Records, and (2) make them available to the IRS in connection with an examination under section 11.03. Compliance with this subparagraph constitutes compliance with the record-maintenance provisions of I.R.C. sections 6038A and 6038C for the Covered Transactions for any taxable year during the APA Term.

f. If Taxpayer’s actual transactions do not result in compliance with the TPM, Taxpayer:

i. Must report its taxable income in an amount that is consistent with the TPM and all other requirements of this APA on its timely filed U.S. Return. However, for any APA Year, if Taxpayer’s timely filed U.S. Return is filed no later than 60 days after the effective date of this APA, then Taxpayer may instead report its taxable income in an amount that is consistent with the TPM and all other requirements of this APA on an amended U.S. Return filed no later than 120 days after the effective date of this APA.

ii. May make compensating adjustments under Revenue Procedure 96–53, section 11.02, subject to any modifications or restrictions in Appendix A or elsewhere in this APA.

g. { Insert when U.S. Group or Foreign Group contains more than one member .} [This APA addresses the arm’s-length nature of prices charged or received in the aggregate between Taxpayer[s] and Foreign Participants. Except as explicitly provided, this APA does not address and does not bind the IRS with respect to prices charged or received, or the relative amounts of income or loss realized, by particular legal entities that are members of U.S. Group or that are members of Foreign Group.]

h. The True Taxable Income within the meaning of Treasury Regulations sections 1.482–1(a)(1) and (i)(9) of a member of an affiliated group filing a U.S. consolidated return will be determined under the I.R.C. section 1502 Treasury Regulations.

i. {Optional for US Parent Signatories} To the extent that Taxpayer’s compliance with this APA depends on certain acts of Foreign Group members, Taxpayer will ensure that each Foreign Group member will perform such acts.

6. Critical Assumptions . This APA’s critical assumptions, within the meaning of Revenue Procedure 96–53, section 5.07, appear in Appendix B. Revenue Procedure 96–53, section 11.07, governs if any critical assumption has not been met.

7. Disclosure . This APA, and any background information related to this APA or the APA Request, are: (1) considered “return information” under I.R.C. section 6103(b)(2)(C); and (2) not subject to public inspection as a “written determination” under I.R.C. section 6110(b)(1). Section 521(b) of Pub. L. 106–170 provides that the Secretary of the Treasury must prepare a report for public disclosure that includes certain specifically designated information concerning all APAs, including this APA, in a form that does not reveal taxpayers’ identities, trade secrets, and proprietary or confidential business or financial information.

8. Disputes . If a dispute arises concerning the interpretation of this APA, the Parties will seek a resolution by the IRS Associate Chief Counsel (International), to the extent reasonably practicable, before seeking alternative remedies. If any dispute arises that is not related to interpreting this APA, the Parties will seek to resolve the dispute in a manner consistent with Revenue Procedure 96–53, section 11.03(4).

9. Materiality . In this APA the terms “material” and “materially” will be interpreted consistently with the definition of “material facts” in Revenue Procedure 96–53, section 11.05(1).

10. Section Captions . This APA’s section captions, which appear in italics, are for convenience and reference only. The captions do not affect in any way the interpretation or application of this APA.

11. Entire Agreement and Severability . This APA is the complete statement of the Parties’ agreement. The Parties will sever, delete, or reform any invalid or unenforceable provision in this APA to approximate the Parties’ intent as nearly as possible.

12. Successor in Interest . This contract binds, and inures to the benefit of, any successor in interest to Taxpayer.

13. Notice . Any notices required by this APA or Revenue Procedure 96–53 must be in writing. Taxpayer will send notices to the IRS at the address and in the manner set forth in Revenue Procedure 96–53, section 5.13(2). The IRS will send notices to:

April 18, 2005 945 2005–16 I.R.B.

Taxpayer Corporation Attn: Jane Doe, Sr. Vice President (Taxes) 1000 Any Road Any City, USA 10000 (phone: )

14. Effective Date and Counterparts . This APA is effective starting on the date, or later date of the dates, upon which all Parties execute this APA. The Parties may execute this APA in counterparts, with each counterpart constituting an original.

WITNESS,

The Parties have executed this APA on the dates below.

[Taxpayer Name in all caps]

By: Date: , 20 Jane Doe Sr. Vice President (Taxes)

IRS

By: Date: , 20 Matthew W. Frank Director, Advance Pricing Agreement Program

APPENDIX A

COVERED TRANSACTIONS AND TRANSFER PRICING METHOD (TPM)

1. Covered Transactions .

[ Define the Covered Transactions .]

2. TPM .

{Note: If appropriate, adapt language from the following examples.}

• CUP Method

The TPM is the comparable uncontrolled price (CUP) method. The price charged for must equal between and (the Arm’s Length Range). Taxpayer must realize, recognize, and report results on its U.S. Returns that clearly reflect such pricing.

• Resale Price Method (RPM)

The TPM is the resale price method (RPM). Taxpayer must realize, recognize, and report results on its U.S. Returns that clearly reflect a gross margin (defined as gross profit divided by sales revenue as those terms are defined in Treasury Regulations sections 1.482–5(d)(1) and (2)) of between % and % (the Arm’s Length Range) for the Covered Transactions.

• Cost Plus Method

The TPM is the cost plus method. Taxpayer must realize, recognize, and report results on its U.S. Returns that clearly reflect a ratio of gross profit to production costs (within the meaning of Treasury Regulations sections 1.482–3(d)(1) and (2)) of between % and % (the Arm’s Length Range) for the Covered Transactions.

• CPM with Berry Ratio PLI

The TPM is the comparable profits method (CPM). Taxpayer must realize, recognize, and report results on its U.S. Returns that clearly reflect a gross profit to operating expenses ratio (as those terms are defined in Treasury Regulations sections 1.482–5(d)(2) and (3)) of between and (the Arm’s Length Range) for the Covered Transactions.

• CPM using an Operating Margin PLI

2005–16 I.R.B. 946 April 18, 2005

The TPM is the comparable profits method (CPM). The profit level indicator is an operating margin. Taxpayer’s reported operating profit (within the meaning of Treasury Regulations sections 1.482–5(d)(5)) must clearly reflect an operating margin (defined as the ratio of operating profit to sales revenue as those terms are defined in Treasury Regulations section 1.482–5(d)(1) and (4)) of between % and % (the Arm’s Length Range) for the Covered Transactions.

• CPM using a Three-year Rolling Average Operating Margin PLI

The TPM is the comparable profits method (CPM). The profit level indicator is an operating margin. Taxpayer’s Three-Year Rolling Average operating margin is defined as follows for any APA Year: the sum of Taxpayer’s reported operating profit (within the meaning of Treasury Regulations section 1.482–5(d)(5)) for that APA Year and the two preceding years, divided by the sum of Taxpayer’s sales revenue (within the meaning of Treasury Regulations section 1.482–5(d)(1)) for that APA Year and the two preceding years. Taxpayer’s Three-Year Rolling Average operating margin must be between % and % (the Arm’s Length Range.)

• Residual Profit Split Method

The TPM is the residual profit split method. Taxpayer must realize, recognize, and report results on its U.S. Returns that clearly reflect the following: [ insert description of profit-split mechanism ].

[ Insert additional provisions as needed .]

3. Adjustments.

{For use with a CPM}

For each APA Year, if Taxpayer’s year-end [Three-Year Rolling Average] {specify PLI used} for the Covered Transactions is not in compliance with the TPM, Taxpayer will make an adjustment that brings its [Three-Year Rolling Average] {specify PLI used} to {if the TPM specifies a point value, use that; if the TPM specifies an Arm’s Length Range, use the nearest edge of the Arm’s Length Range or a point such as the median within the Arm’s Length Range} .

[ Insert additional provisions as needed .]

APPENDIX B

CRITICAL ASSUMPTIONS

This APA’s critical assumptions are:

1. The business activities, functions performed, risks assumed, assets employed, and financial and tax accounting methods and classifications [and methods of estimation] of Taxpayer in relation to the Covered Transactions will remain materially the same as described or used in Taxpayer’s APA Request. A mere change in business results will not be a material change.

[ Insert additional provisions as needed. ]

APPENDIX C

APA RECORDS AND ANNUAL REPORT

APA RECORDS

The APA Records will consist of:

1. All documents listed below for inclusion in the Annual Report, as well as all documents, notes, work papers, records, or other writings that support the information provided in such documents.

2. [Insert here other records as required.]

ANNUAL REPORT

The Annual Report will include a cover sheet and a table of contents. The cover sheet will specify:

i. the Parties to the APA;

ii. the APA Term (defined in section 3 of this APA);

iii. the APA’s effective date (defined in section 14 of this APA);

iv. whether the APA is a renewal, and if so the term of the prior APA;

April 18, 2005 947 2005–16 I.R.B.

v. whether the APA has been amended, and if so the amendment’s effective date;

vi. any information needed to distinguish the APA at issue from any other APAs involving the same parties;

vii. any changes to the Taxpayer notice information in section 13 of this APA.

The table of contents and the Annual Report will be organized as listed below. Taxpayer must include the following items in its Annual Report for each APA Year.

1. Statements that fully identify, describe, analyze, and explain:

a. All material differences between any of Taxpayer’s business operations (including functions, risks assumed, markets, contractual terms, economic conditions, property, services, and assets employed) during the APA Year and the description of the business operations contained in the APA Request. If there have been no material differences, the Annual Report will include a statement to that effect.

b. All material changes in Taxpayer’s accounting methods and classifications, and methods of estimation, from those described or used in Taxpayer’s request for this APA. If there have been no such material changes, the Annual Report will include a statement to that effect.

c. Any failure to meet any critical assumption. If there have been no failures, the Annual Report will include a statement to that effect.

d. Any change to any entity classification for federal income tax purposes (including any change that causes an entity to be disregarded for federal income tax purposes) of any Worldwide Group member that is a party to the Covered Transactions or is otherwise relevant to the TPM.

e. Any changes to Taxpayer’s financial accounting methods that were made to conform to U.S. GAAP changes and that affect the Covered Transactions.

f. The amount, reason for, and financial analysis of any compensating adjustments under paragraph 5(f)(ii) of this APA for the APA Year, including but not limited to:

i. the amounts paid or received by each affected entity;

ii. the character (such as capital, ordinary, income, expense) and country source of the funds transferred, and the specific affected line item(s) of any affected U.S. Return; and

iii. the date(s) and means by which the payments are or will be made.

g. The amounts, description, reason for, and financial analysis of any book-tax differences relevant to the TPM for the APA Year, as reflected on Schedule M–1 of the U.S. Return for the APA Year.

2. The Financial Statements, and any necessary account detail to show compliance with the TPM, with a copy of the independent certified public accountant’s opinion required by paragraph 5(d) of this APA.

3. A financial analysis that reflects Taxpayer’s TPM calculations for the APA Year. The calculations must reconcile with and reference the Financial Statements in sufficient account detail to allow the IRS to determine whether Taxpayer has complied with the TPM.

4. An organizational chart for the Worldwide Group, revised annually to reflect all ownership or structural changes of entities that are parties to the Covered Transactions or are otherwise relevant to the TPM.

2005–16 I.R.B. 948 April 18, 2005

APPENDIX D

DEFINITIONS

The following definitions control for all purposes of this APA. The definitions appear alphabetically below:

April 18, 2005 949 2005–16 I.R.B.

ATTACHMENT A Model 2 (Based on Revenue Procedure 2004–40)

ADVANCE PRICING AGREEMENT

between

[ Insert Taxpayer’s Name ]

and THE INTERNAL REVENUE SERVICE

PARTIES

The Parties to this Advance Pricing Agreement (APA) are the Internal Revenue Service (IRS) and [ Insert Taxpayer’s Name ], EIN (Taxpayer).

RECITALS

Taxpayer’s principal place of business is [ City, State ]. [ Insert general description of taxpayer and other relevant parties ] .

This APA contains the Parties’ agreement on the best method for determining arm’s-length prices of the Covered Transactions under I.R.C. section 482, any applicable tax treaties, and the Treasury Regulations.

Unless otherwise specified, terms in the plural include the singular and vice versa. Appendix D contains definitions for capitalized terms not elsewhere defined in this APA.

{If renewal, add} [Taxpayer and IRS previously entered into an APA covering taxable years ending to , executed on . ]

AGREEMENT

The Parties agree as follows:

1. Covered Transactions . This APA applies to the Covered Transactions, as defined in Appendix A.

2. Transfer Pricing Method . Appendix A sets forth the Transfer Pricing Method (TPM) for the Covered Transactions.

3. Term . This APA applies to Taxpayer’s taxable years ending through (APA Term).

4. Operation .

a. Revenue Procedure 2004–40 governs the interpretation, legal effect, and administration of this APA.

b. Nonfactual oral and written representations, within the meaning of sections 9.04 and 9.05 of Revenue Procedure 2004–40 (including any proposals to use particular TPMs), made in conjunction with the APA Request constitute statements made in compromise negotiations within the meaning of Rule 408 of the Federal Rules of Evidence.

5. Compliance .

a. For each taxable year covered by this APA (APA Year), if Taxpayer complies with the terms and conditions of this APA, then the IRS will not make or propose any allocation or adjustment under I.R.C. section 482 to the Covered Transactions.

b. If Taxpayer does not comply with the terms and conditions of this APA, then the IRS may:

i. enforce the terms and conditions of this APA and make or propose allocations or adjustments under I.R.C. section 482 consistent with this APA;

ii. cancel or revoke this APA under section 10.06 or 10.07 of Revenue Procedure 2004–40; or

iii. revise this APA, if the Parties agree.

c. Taxpayer must timely file an Annual Report for each APA Year in accordance with Appendix C and section 10.01 of Revenue Procedure 2004–40. Taxpayer must file an original and four copies of the Annual Report by the later of (a) 90 days after the time prescribed by law (including extensions) for filing its federal income tax return for the APA Year covered by the report, or (b) 90 days after the effective date of this APA. [ The Service and the Taxpayer may agree to alternative filing dates .] The IRS may request additional information reasonably necessary to clarify or complete the Annual Report. Taxpayer will provide all requested information within 30 days. Additional time may be allowed for good cause.

2005–16 I.R.B. 950 April 18, 2005

d. The IRS will determine whether Taxpayer has complied with this APA based on Taxpayer’s U.S. Returns, Financial Statements, and other APA Records, for the APA Term and any other year necessary to verify compliance. For Taxpayer to comply with this APA, an independent certified public accountant must { use the following or an alternative } render an opinion that the Taxpayer’s Financial Statements present fairly, in all material respects, Taxpayer’s financial position under U.S. GAAP.

e. In accordance with section 10.04 of Revenue Procedure 2004–40, Taxpayer will (1) maintain its APA Records, and (2) make them available to IRS in connection with an examination under section 10.03. Compliance with this subparagraph constitutes compliance with the record-maintenance provisions of I.R.C. sections 6038A and 6038C for the Covered Transactions for any taxable year during the APA Term.

f. If Taxpayer’s actual transactions do not result in compliance with the TPM, Taxpayer:

i. Must report its taxable income in an amount that is consistent with the TPM and all other requirements of this APA on its timely filed U.S. Return. However, for any APA Year, if Taxpayer’s timely filed U.S. Return is filed no later than 60 days after the effective date of this APA, then Taxpayer may instead report its taxable income in an amount that is consistent with the TPM and all other requirements of this APA on an amended U.S. Return filed no later than 120 days after the effective date of this APA.

ii. May make compensating adjustments under Revenue Procedure 2004–40, section 10.02, subject to any modifications or restrictions in Appendix A or elsewhere in this APA.

g. { Insert when U.S. Group or Foreign Group contains more than one member .} [This APA addresses the arm’s-length nature of prices charged or received in the aggregate between Taxpayer[s] and Foreign Participants. Except as explicitly provided, this APA does not address and does not bind the IRS with respect to prices charged or received, or the relative amounts of income or loss realized, by particular legal entities that are members of U.S. Group or that are members of Foreign Group.]

h. The True Taxable Income within the meaning of Treasury Regulations section 1.482–1(a)(1) and (i)(9) of a member of an affiliated group filing a U.S. consolidated return will be determined under the I.R.C. section 1502 Treasury Regulations.

i. {Optional for US Parent Signatories} To the extent that Taxpayer’s compliance with this APA depends on certain acts of Foreign Group members, Taxpayer will ensure that each Foreign Group member will perform such acts.

6. Critical Assumptions . This APA’s critical assumptions, within the meaning of Revenue Procedure 2004–40, section 4.05, appear in Appendix B. Revenue Procedure 2004–40, section 10.05, governs if any critical assumption has not been met.

7. Disclosure . This APA, and any background information related to this APA or the APA Request, are: (1) considered “return information” under I.R.C. section 6103(b)(2)(C); and (2) not subject to public inspection as a “written determination” under I.R.C. section 6110(b)(1). Section 521(b) of Pub. L. 106–170 provides that the Secretary of the Treasury must prepare a report for public disclosure that includes certain specifically designated information concerning all APAs, including this APA, in a form that does not reveal taxpayers’ identities, trade secrets, and proprietary or confidential business or financial information.

8. Disputes . If a dispute arises concerning the interpretation of this APA, the Parties will seek a resolution by the IRS Associate Chief Counsel (International), to the extent reasonably practicable, before seeking alternative remedies. If any dispute arises that is not related to interpreting this APA, the Parties will seek to resolve the dispute in a manner consistent with Revenue Procedure 2004–40, section 10.03(4).

9. Materiality . In this APA the terms “material” and “materially” will be interpreted consistently with the definition of “material facts” in Revenue Procedure 2004–40, section 10.07(1).

10. Section Captions . This APA’s section captions, which appear in italics, are for convenience and reference only. The captions do not affect in any way the interpretation or application of this APA.

11. Entire Agreement and Severability . This APA is the complete statement of the Parties’ agreement. The Parties will sever, delete, or reform any invalid or unenforceable provision in this APA to approximate the Parties’ intent as nearly as possible.

12. Successor in Interest . This contract binds, and inures to the benefit of, any successor in interest to Taxpayer.

13. Notice . Any notices required by this APA or Revenue Procedure 2004–40 must be in writing. Taxpayer will send notices to the IRS at the address and in the manner set forth in Revenue Procedure 2004–40, section 4.11. The IRS will send notices to:

April 18, 2005 951 2005–16 I.R.B.

Taxpayer Corporation Attn: Jane Doe, Sr. Vice President (Taxes) 1000 Any Road Any City, USA 10000 (phone: )

14. Effective date and Counterparts . This APA is effective starting on the date, or later date of the dates, upon which all Parties execute this APA. The Parties may execute this APA in counterparts, with each counterpart constituting an original.

WITNESS,

The Parties have executed this APA on the dates below.

[Taxpayer Name in all caps]

By: Date: , 20 Jane Doe Sr. Vice President (Taxes)

IRS

By: Date: , 20 Matthew W. Frank Director, Advance Pricing Agreement Program

APPENDIX A

COVERED TRANSACTIONS AND TRANSFER PRICING METHOD (TPM)

1. Covered Transactions .

[ Define the Covered Transactions .]

2. TPM .

{Note: If appropriate, adapt language from the following examples.}

• CUP Method

The TPM is the comparable uncontrolled price (CUP) method. The price charged for must equal between and (the Arm’s Length Range). Taxpayer must realize, recognize, and report results on its U.S. Returns that clearly reflect such pricing.

• Resale Price Method (RPM)

The TPM is the resale price method (RPM). Taxpayer must realize, recognize, and report results on its U.S. Returns that clearly reflect a gross margin (defined as gross profit divided by sales revenue as those terms are defined in Treasury Regulations sections 1.482–5(d)(1) and (2)) of between % and % (the Arm’s Length Range) for the Covered Transactions.

• Cost Plus Method

The TPM is the cost plus method. Taxpayer must realize, recognize, and report results on its U.S. Returns that clearly reflect a ratio of gross profit to production costs (within the meaning of Treasury Regulations sections 1.482–3(d)(1) and (2)) of between % and % (the Arm’s Length Range) for the Covered Transactions.

• CPM with Berry Ratio PLI

The TPM is the comparable profits method (CPM). Taxpayer must realize, recognize, and report results on its U.S. Returns that clearly reflect a gross profit to operating expenses ratio (as those terms are defined in Treasury Regulations sections 1.482–5(d)(2) and (3)) of between and (the Arm’s Length Range) for the Covered Transactions.

• CPM using an Operating Margin PLI

2005–16 I.R.B. 952 April 18, 2005

The TPM is the comparable profits method (CPM). The profit level indicator is an operating margin. Taxpayer’s reported operating profit (within the meaning of Treasury Regulations sections 1.482–5(d)(5)) must clearly reflect an operating margin (defined as the ratio of operating profit to sales revenue as those terms are defined in Treasury Regulations section 1.482–5(d)(1) and (4)) of between % and % (the Arm’s Length Range) for the Covered Transactions.

• CPM using a Three-year Rolling Average Operating Margin PLI

The TPM is the comparable profits method (CPM). The profit level indicator is an operating margin. Taxpayer’s Three-Year Rolling Average operating margin is defined as follows for any APA Year: the sum of Taxpayer’s reported operating profit (within the meaning of Treasury Regulations section 1.482–5(d)(5)) for that APA Year and the two preceding years, divided by the sum of Taxpayer’s sales revenue (within the meaning of Treasury Regulations section 1.482–5(d)(1)) for that APA Year and the two preceding years. Taxpayer’s Three-Year Rolling Average operating margin must be between % and % (the Arm’s Length Range.)

• Residual Profit Split Method

The TPM is the residual profit split method. Taxpayer must realize, recognize, and report results on its U.S. Returns that clearly reflect the following: [ insert description of profit-split mechanism ].

[ Insert additional provisions as needed .]

3. Adjustments.

{For use with a CPM}

For each APA Year, if Taxpayer’s year-end [Three-Year Rolling Average] {specify PLI used} for the Covered Transactions is not in compliance with the TPM, Taxpayer will make an adjustment that brings its [Three-Year Rolling Average] {specify PLI used} to {if the TPM specifies a point value, use that; if the TPM specifies an Arm’s Length Range, use the nearest edge of the Arm’s Length Range or a point such as the median within the Arm’s Length Range} .

[ Insert additional provisions as needed .]

APPENDIX B

CRITICAL ASSUMPTIONS

This APA’s critical assumptions are:

1. The business activities, functions performed, risks assumed, assets employed, and financial and tax accounting methods and classifications [and methods of estimation] of Taxpayer in relation to the Covered Transactions will remain materially the same as described or used in Taxpayer’s APA Request. A mere change in business results will not be a material change.

[ Insert additional provisions as needed. ]

APPENDIX C

APA RECORDS AND ANNUAL REPORT

APA RECORDS

The APA Records will consist of:

1. All documents listed below for inclusion in the Annual Report, as well as all documents, notes, work papers, records, or other writings that support the information provided in such documents.

2. [Insert here other records as required.]

ANNUAL REPORT

The Annual Report will include a cover sheet and a table of contents. The cover sheet will specify:

i. the Parties to the APA;

ii. the APA Term (defined in section 3 of this APA);

iii. the APA’s effective date (defined in section 14 of this APA);

iv. whether the APA is a renewal, and if so the term of the prior APA;

April 18, 2005 953 2005–16 I.R.B.

v. whether the APA has been amended, and if so the amendment’s effective date;

vi. any information needed to distinguish the APA at issue from any other APAs involving the same parties;

vii. any changes to the Taxpayer notice information in section 13 of this APA.

The table of contents and the Annual Report will be organized as listed below. Taxpayer must include the following items in its Annual Report for each APA Year.

1. Statements that fully identify, describe, analyze, and explain:

a. All material differences between any of Taxpayer’s business operations (including functions, risks assumed, markets, contractual terms, economic conditions, property, services, and assets employed) during the APA Year and the description of the business operations contained in the APA Request. If there have been no material differences, the Annual Report will include a statement to that effect.

b. All material changes in Taxpayer’s accounting methods and classifications, and methods of estimation, from those described or used in Taxpayer’s request for this APA. If there have been no such material changes, the Annual Report will include a statement to that effect.

c. Any failure to meet any critical assumption. If there have been no failures, the Annual Report will include a statement to that effect.

d. Any change to any entity classification for federal income tax purposes (including any change that causes an entity to be disregarded for federal income tax purposes) of any Worldwide Group member that is a party to the Covered Transactions or is otherwise relevant to the TPM.

e. Any changes to Taxpayer’s financial accounting methods that were made to conform to U.S. GAAP changes and that affect the Covered Transactions.

f. The amount, reason for, and financial analysis of any compensating adjustments under paragraph 5(f)(ii) of this APA for the APA Year, including but not limited to:

i. the amounts paid or received by each affected entity;

ii. the character (such as capital, ordinary, income, expense) and country source of the funds transferred, and the specific affected line item(s) of any affected U.S. Return; and

iii. the date(s) and means by which the payments are or will be made.

g. The amounts, description, reason for, and financial analysis of any book-tax differences relevant to the TPM for the APA Year, as reflected on Schedule M–1 of the U.S. Return for the APA Year.

2. The Financial Statements, and any necessary account detail to show compliance with the TPM, with a copy of the independent certified public accountant’s opinion required by paragraph 5(d) of this APA.

3. A financial analysis that reflects Taxpayer’s TPM calculations for the APA Year. The calculations must reconcile with and reference the Financial Statements in sufficient account detail to allow the IRS to determine whether Taxpayer has complied with the TPM.

4. An organizational chart for the Worldwide Group, revised annually to reflect all ownership or structural changes of entities that are parties to the Covered Transactions or are otherwise relevant to the TPM.

2005–16 I.R.B. 954 April 18, 2005

APPENDIX D

DEFINITIONS

The following definitions control for all purposes of this APA. The definitions appear alphabetically below:

April 18, 2005 955 2005–16 I.R.B.

ATTACHMENT B

FORMULAS FOR BALANCE SHEET ADJUSTMENTS

Definitions of Variables:

AP = average accounts payable

AR = average trade accounts receivable, net of allowance for bad debt

cogs = cost of goods sold

INV = average inventory, stated on FIFO basis

opex = operating expenses (general, sales, administrative, and depreciation expenses)

PPE = property, plant, and equipment, net of accumulated depreciation

sales = net sales

tc = total cost (cogs + opex, as defined above)

h = average accounts payable or trade accounts receivable holding period, stated as a fraction of a year

i = interest rate

t = entity being tested

c = comparable

Equations:

If Cost of Goods Sold is controlled (generally, sales in denominator of PLI):

Receivables Adjustment (“RA”): RA = {[(AR ) x sales ] - AR } x {i/[1+(i x h )]} t / salest c c c

Payables Adjustment (“PA”): PA = {[(AP ) x sales ] - AP } x {i/[1+(i x h )]} t / salest c c c

Inventory Adjustment (“IA”): IA = {[(INV ) x sales ] - INV t / salest c c } x i

PP&E Adjustment (“PPEA”): PPEA = {[(PPE ) x sales ] - PPE } x i t / salest c c

If Sales are controlled (generally, costs in the denominator of PLI): ⁸

Receivables Adjustment (“RA”): RA = {[(AR ) x tc ] - AR } x {i/[1+(i x h )]} t / tct c c c

Payables Adjustment (“PA”): PA = {[(AP ) x tc ] - AP } x {i/[1+(i x h )]} t / tct c c c

Inventory Adjustment (“IA”): IA = {[(INV ) x tc ] - INV t / tct c c } x i

PP&E Adjustment (“PPEA”): PPEA = {[(PPE ) x tc ] - PPE } x i t / tct c c

Then Adjust Comparables as Follows:

adjusted sales RA c = salesc +

adjusted cogs c = cogsc + PA - IA

adjusted opex c = opexc - PPEA

8 Depending on the specific facts, the equations below may use total costs (“tc”) or cost of goods sold (“cogs”).

2005–16 I.R.B. 956 April 18, 2005