Week of 10/20/97
Third Party Return Information in the Competent Authority Process
Competent authority representatives from the U.S., the U.K., Japan, Germany and Canada have recently met in a public forum -- at a meeting sponsored by the National Foreign Trade Council Foundation in Washington -- to discuss the competent authority process. These proceedings, as reported in BNA's Daily Tax Report for 10/31/97 (Halloween), noted the following significant potential divergence surfaced between the parties over the use of third party confidential return information in the process of determining transfer pricing:
To set the stage for this discussion, we note in summary the key point we have developed elsewhere that, in asserting a tax liability against a U.S. taxpayer, the IRS is not entitled to use and indeed is prohibited from using third party tax return information. See Townsend, Section 6103 and the Use of Third Party Tax Return Information in Tax Litigation, 46 Tax Lawyer 923 (Summer 1993)). The problem, as developed more fully in the article, is that Section 6103 prohibits IRS disclosure of third party return information and the discovery rules in litigation require that a party disclose all factual information relevant to or used in developing the party's position. As argued in the article, this irreconcilable conflict requires the IRS to forego the U.S. of comparable information developed in third party audits.
For this reason, the U.S. Competent Authority (John Lyons, the Assistant Commissioner (International)), alleged that the IRS does not use such information for transfer pricing purposes. The U.K. and Canada apparently take the same position based on their internal laws. But, the Japanese Competent Authority indicated that it will use such information in appropriate cases.
This becomes particularly nettlesome, for example, in the Bilateral APA process ("BAPA"), but similar problems would also be encountered in the standard competent authority negotiation. The U.S. and U.K. competent authorities said that they would insist upon reviewing the comparable information even if confidential under Japan's (or some other treaty country's) laws. As the U.S. Competent Authority John Lyons is quoted as saying: "It is difficult to conduct effective competent authority negotiations when data is presented as exact comparables but it cannot be examined."
We have no unique insight into the propriety of the Japanese Competent Authority's use of such "secret" comparables, but to the extent that they are used in the negotiation process with the U.S. Competent Authority, they may infect the U.S. position. If then the comparable authorities are unable to negotiate a result that is acceptable to the U.S. taxpayer, the U.S. taxpayer can litigate. In litigation, the U.S. taxpayer can test whether the IRS position has been infected by the use of comparables (during the competent authority negotiations) that the taxpayer is precluded from discovering. In an appropriate case, this might offer some possible alternative arguments against the IRS. Practitioners in the transfer pricing arena should be alert to this opportunity.
Moving to a more fundamental level, it is obvious that the IRS, whether its audit component or its competent authority component, does in fact use third party return information, directly or indirectly, to develop positions on a daily basis. The information IRS personnel learn in one audit is clearly return information and that information, cumulatively, assists the IRS personnel in developing positions in other audits. Specialty teams learn about product pricing practices and methodologies in one audit and then use that information in the next audit, and the next audit, and so on. There is probably no practical way to avoid this type of use, short of assigning new agents to every transfer pricing audit, a wholly unacceptable result. But taxpayer's should be ever alert to the possibility that the agent is using something more than generalized transfer pricing information developed in other audits to support his or her positions in the audit at hand.