Transfer Pricing Audit Roadmap
The Transfer Pricing Operations (TPO) team of the Large Business and International (LB&I) division of the IRS released the 26-page Transfer Pricing Audit Roadmap (“Roadmap”) to the public on February 14, 2014.
The Roadmap provides audit procedures around an approximate 24-month audit timeline. The stated goals of the Roadmap are to assist both the IRS and taxpayer in the discussion and resolution of transfer pricing issues in a timely and orderly fashion, and to resolve issues at the Exam level rather than at Appeals. Also, the Roadmap is intended to provide insight into what to expect during a transfer pricing examination, as well as put a concrete work plan into place for the TPO to execute its transfer pricing audits. The Roadmap is not official guidance; it is a working document to assist revenue agents in planning their examinations without having to regularly consult the Internal Revenue Manual.
The Roadmap states, “Proper development of a transfer pricing position may take as much as two to three years or more.” Given this extended timeline, the Roadmap acknowledges that up-front planning will be essential to the examination process before the IRS commits significant resources to a transfer pricing examination.
There are three phases to the audit process as described in the Roadmap: Planning, Execution and Resolution.
The Planning phase can last up to six months and typically starts approximately four months before the audit cycle begins. The Planning phase consists of a pre-examination analysis, an opening conference (which starts the 24-month examination clock), a transfer pricing orientation meeting (i.e., a presentation and explanations by the taxpayer of its transfer pricing arrangements), and the preparation of the initial risk analysis and examination plan. The opening conference includes the preliminary scope of the transfer pricing examination and general timelines.
The IRS will issue the 30-day letter and information document request (“IDR”) for principal documents and an index for background documents, ideally in time to analyze the information before the transfer pricing orientation. IDRs will also be issued requesting a financial statement orientation to be held within 30 days of the opening conference, and requesting accounting records including the worldwide, geographic and segmented accounting data and financial statements necessary for transfer pricing review. If foreign entity documentation and data are important to the IRS team, it may request it from treaty partners. Documentation may be obtained from Treaty partners using “collateral requests,” “requests for information pursuant to treaties” and the “Simultaneous Examination Program.”
IRS expectations are that a comprehensive transfer pricing orientation should cover business operations, key functions, worldwide structure, title flow, product flow, service flows, transfer pricing policies and documentation. The IRS also expects the transfer pricing orientation to be held soon after the financial statement orientation. Company employees involved in structuring intercompany transactions will be requested to participate at the transfer pricing orientation meeting. Personnel “responsible for the transfer pricing study” will also be asked to participate. Topics to be covered in the transfer pricing orientation include a discussion of the functional analysis (functions performed, assets employed, and risks assumed by each controlled party of the respective intercompany transactions), understanding how the preparer of the transfer pricing study gained knowledge for the functional analysis (the exam team may request information gathering notes, so companies should be proactively prepared for this prospect) and identification of the persons responsible for structuring the transaction from a tax planning perspective.
This makes it clear that the IRS does not want the transfer pricing orientation meeting to be a high level review of the documentation, but rather a “comprehensive presentation.” Following the orientation meeting, the examination team will typically issue additional IDRs related to topics covered during the presentation. These additional requests can include the examination team requesting interviews with certain individuals from a company’s organizational charts. Domestic and foreign site visits may also be requested.
During the Planning phase the IRS will evaluate whether it thinks the taxpayer is shifting income to its benefit using transfer pricing. The Roadmap suggests that transfer pricing issues deserve further scrutiny if the taxpayer’s results are “at odds with common sense and economic reality,” and if the taxpayer does not provide a convincing transfer pricing documentation report.
In the Execution phase, which can take up to 16 months (typically months 3 through 18 or 19), the Examiner will request information on the relevant transfer pricing issues from the taxpayer so that the IRS transfer pricing specialist can prepare a report on agreed facts. The examination team will request that the taxpayer provide written confirmation of the facts developed during the audit. IRS examination teams are instructed to hold a reassessment meeting after the orientation meeting to determine which intercompany transactions need further analysis and development and assess resource and outside expert needs.
The examination team will assess the roles of the related parties involved in the intercompany transactions. The functions, assets and risks of the related parties should be described in the taxpayer’s transfer pricing documentation, which is reviewed by the IRS examination team. The IRS team will choose what it thinks is the best method for the intercompany transaction(s) at issue. Then, the IRS team will apply its chosen transfer pricing method(s) to determine an appropriate intercompany price(s). If this intercompany price is different than the taxpayer’s actual transfer price and the IRS-determined price is beneficial to the IRS, then the IRS will have arrived at its basis for a proposed Section 482 adjustment.
In the Resolution phase, which can take up to seven months, the audit team conducts a pre-Notice of Proposed Adjustment (NOPA) issue presentation and resolution discussions with the taxpayer. Discussions focus on understanding the taxpayer’s position, understanding the nature of disagreements (facts or interpretations of law) and determining whether the taxpayer agrees with the facts and would agree to any issues. Prior to the issuance of a final NOPA, the examination team can share its draft NOPA and draft economist report with the taxpayer for input. The IRS will also conduct an internal risk assessment to evaluate the strength of their position and consider pre-appeals resolution opportunities. The Roadmap ends with the final NOPA and case closing. The case closes with either agreement on the issues or the examination team’s rebuttal of the taxpayer NOPA response and the issuance and rebuttal of the response to the Revenue Agent’s Report.
WTP Advisors Insights
Importance of robust and accurate documentation. The Roadmap states that “Transfer pricing cases are usually won and lost on the facts” (as opposed to legal interpretation of the Regulations), emphasizing fact gathering as a means of building a case not only for exam, but for successful litigation. There is consistent emphasis in the Roadmap reminding the exam team of the importance of first building a solid understanding of the facts before forming hypotheses and ultimately reaching conclusions. Accordingly, taxpayers are well-advised to ensure that their transfer pricing documentation is robust and presents a factual picture consistent with their tax returns and financial statements. Transfer pricing documentation is the first and best opportunity to prevent a transfer pricing audit. While IRS auditors will know something about a taxpayer from tax return information and the company’s website, transfer pricing documentation reports allow companies to explain the business, including reasonable intercompany pricing results. IRS economists will assess the quality of transfer pricing documentation prior to meeting with the taxpayer. Companies without transfer pricing documentation may be surprised by initial IRS positions when meeting for the first time.
Increased involvement of IRS transfer pricing specialists. The IRS developed the Roadmap to ensure that field audit teams use the transfer pricing resources within the Service. A key theme in the Roadmap is that “transfer pricing specialists must be involved in assessing potential transfer pricing issues at the earliest possible stage – ideally before the official audit commencement date.” These specialists will “help weed out issues that are not worth pursuing” and also help identify additional expertise that might be required to evaluate a taxpayer’s transfer pricing.
More rigorous examinations. To the extent the field team follows the Roadmap guidance; taxpayers should expect a more rigorous transfer pricing examination. Taxpayers should be prepared for this process, which in most cases means much more will be required than merely updating comparables data in boilerplate or outdated transfer pricing studies.
Earlier requests for transfer pricing documentation. The IRS will issue the mandatory transfer pricing documentation IDR with the IRS’s initial contact letter, rather than at the opening conference with the taxpayer, which has usually been the case. Taxpayers therefore should be sure their transfer pricing documentation is complete and on hand (transfer pricing documentation must be prepared contemporaneously and be in existence when the Federal tax return is filed, and must be provided to the IRS within 30 days of receiving the documentation IDR).
Importance of the transfer pricing orientation meeting. The transfer pricing orientation meeting gives the taxpayer the opportunity to make its most compelling case for why its transfer pricing methods, analysis and results are appropriate. The orientation meeting is the taxpayer’s last chance to convince the IRS to discontinue its audit.
Consistency with other tax return information. Taxpayers can expect examiners to review the following documents during the Planning phase: IRC Section 6662(e) documentation (i.e., “transfer pricing documentation” – for penalty protection), forms 5471, 5472, 8833, 8858, 8865, 926, and schedules M-3 and UTP. The IRS has developed the International Information Returns (“IRR”) Tool for agents to use to review and analyze certain common international returns. For this reason, taxpayers should ensure there are no inconsistencies between the pricing of their controlled transactions, their documentation and the information on these forms.
Implications for non-US jurisdictions. Multinationals are faced with the prospect of double taxation unless the foreign tax authority agrees with the final IRS position. After receiving the final NOPA, the taxpayer may request that the U.S. competent authority assist in eliminating any double taxation, if the United States has a tax treaty with the other country that could be affected by the proposed adjustment (the international examiner is required to notify the taxpayer by letter of the potential double taxation and the taxpayer’s right to request competent authority assistance). While the Roadmap does not mention the Competent Authority process, any proper resolution should consider getting the IRS and the foreign tax authority to agree to a resolution. When there is not a resolution such disputes are typically handed off by the IRS examination team to either IRS Appeals or the Competent Authority process.
Most importantly, the Roadmap can and should be used by taxpayers to their benefit. It is an excellent tool that can be used to conduct an internal assessment to determine their preparedness to respond to transfer pricing inquiries from the IRS.