Risk Transfer Valuation in Advance Pricing Agreements Between Multinational Enterprises and Tax Authorities

Abstract

Advance pricing agreements (APAs) are long-term contracts between multinational taxpayers and tax authority(ies), according to which the taxpayer consents to use the agreed upon transfer price for its related transactions for a fixed period of time. We argue that for such an agreement to be based on the principle of arm’s length, the specified transfer price(s) should include a premium that captures the risk transferred from one entity to another. When this risk is not accounted for, the long-term transfer pricing policy specified in the agreement (although supported by tax authorities) is not arm’s length. We present a pricing model that can be easily applied to value such risk by incorporating it to the transfer price determined by the APA.