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IRS instructs its auditors re taxpayer outbound transfer pricing documentation

Review of Transfer Pricing Documentation by Outbound Taxpayers (ISO/PUO/P_1.7_02(2014)) (Mar. 4, 2016).

In a new International Practice Unit (IPU), IRS outlines the audit steps for its examiners to follow in reviewing the transfer pricing documentation of a U.S. taxpayer that provides tangible property, intangible property, and/or services to foreign affiliates in exchange for payment (i.e., outbound transactions). Such a review is an integral part of an IRS examiner’s analysis of the taxpayer’s transfer pricing risks and its assessment of any transfer pricing penalties under Code Sec. 6662.

Background on IPUs. IPUs generally identify strategic areas of importance to IRS and can provide insight as to how IRS examiners may approach a particular issue or transaction on audit. However, they are not official pronouncements of law or directives and cannot be used, cited, or relied upon as such.

Background on transfer pricing documentation. Transfer pricing generally refers to the methodologies used to price transactions in tangible property, intangible property, and services between related parties. These methodologies must establish a price that is arm’s length—that is, the price that would be agreed upon by unrelated parties.

Under Code Sec. 482 and the regs thereunder, IRS is authorized to adjust the results of certain related-party (i.e., controlled) transactions to clearly reflect the income of the parties in accordance with the arm’s length standard and, in the case of the transfer of intangible property (within the meaning of Code Sec. 936(h)(3)(B)), to be commensurate with the income attributable to the intangible property.

For U.S. multinational enterprises (MNEs), an important element of transfer pricing planning and compliance is the preparation of appropriate documentation of a MNE’s related-party arrangements, including the agreements that document the terms of these arrangements and the economic support for the pricing policy adopted.

In this regard, IRS has been given significant authority to obtain transfer pricing documentation from taxpayers and to impose significant penalties on taxpayers that fail to maintain or provide such documentation. The rate of the transfer pricing penalty under Code Sec. 6662 may be as high as 40%. (Code Sec. 6662(a), Code Sec. 6662(e), and Code Sec. 6662(h))

Contemporaneous transfer pricing documentation (also referred to as Code Sec. 6662(e) documentation) may be provided to IRS to show that a taxpayer’s related-party arrangements are priced in accordance with the arm’s length standard. Such documentation must be in existence by the time that the taxpayer files its U.S. tax return and must be provided to IRS within 30 days of their request in order for the taxpayer to avoid the Code Sec. 6662(e) and Code Sec. 6662(h) penalties. (Code Sec. 6662(e)(3)(B))

If a taxpayer has not maintained contemporaneous transfer pricing documentation, or if its documentation is deemed deficient, the taxpayer may be subject to the aforementioned transfer pricing penalties to the extent that IRS concludes that a transfer pricing adjustment is appropriate. (Code Sec. 6662(a), Code Sec. 6662(b)(3),Code Sec. 6662(e)(1)(B), Code Sec. 6662(e)(2), Code Sec. 6662(e)(3), and Code Sec. 6662(h)) However, meeting certain reasonable cause and good faith requirements may exempt the taxpayer from these transfer pricing penalty provisions. (Code Sec. 6664(c), Reg. § 1.6664-4, Code Sec. 6662(e)(3)(D), Reg. § 1.6662-6(b)(3), and Reg. § 1.6662-6(c)(6)) To meet the reasonable cause and good faith requirements (if the taxpayer is subject to the Code Sec. 6662(e) penalty) or to have amounts excluded from the calculation of the net Code Sec. 482 adjustment (if the taxpayer is subject to the Code Sec. 6662(h) penalty), the taxpayer must maintain and provide IRS with documentation sufficient to establish that the taxpayer reasonably concluded that the chosen transfer pricing method was the best method and its application provided the most reliable measure of an arm’s-length result, given the available data. (Code Sec. 6662(e)(3)(B)(i)(I) and Reg. § 1.6662-6(d)(2)(ii)(A)) In addition, if the taxpayer chooses an unspecified method, but a specified method was potentially applicable, the taxpayer must establish that none of the specified methods was likely to be the best method and provide a more reliable measure of an arm’s length result. (Code Sec. 6662(e)(3)(B)(ii)(I) and Reg. § 1.6662-6(d)(3)(ii)(B))

Review of transfer pricing documentation by outbound taxpayers. The new IPU provides that a taxpayer’s transfer pricing documentation should show that the chosen transfer pricing methodology is reasonable and meets the best method rule—that is, it provides the most reliable measure of an arm’s length result and is the most reliable application of the method. IRS examiners are instructed to consult another IPU, entitled “Overview of IRC 482,” on how to select the best method.

In accordance with Reg. § 1.6662-6(d)(2)(iii)(B), the IPU instructs IRS examiners to request the following “principal documentation” items with respect to the taxpayer under audit, via the issuance of an “IRC 6662(e) Mandatory Transfer Pricing IDR” (i.e., an Information Document Request) that is included with the initial IRS examination contact letter:

1. An overview of the taxpayer’s business, including an analysis of the economic and legal factors that affect the pricing of its property or services;
2. A description of the taxpayer’s organizational structure (including an organization chart) covering all related parties (domestic and foreign) engaged in transactions potentially relevant under Code Sec. 482, including foreign affiliates whose transactions directly or indirectly affect the pricing of property or services in the U.S.;
3. Any documentation specifically required by Code Sec. 482 and the regs thereunder (e.g., when a taxpayer uses a cost-sharing arrangement under Reg. § 1.482-7);
4. A description of the transfer pricing method selected and an explanation as to why that method was selected, including an evaluation of whether the regulatory conditions and requirements for application of that method (if any) were met;
5. A description of the alternative transfer pricing methods that were considered and an explanation of why they were not selected;
6. A description of the related party (i.e., controlled) transactions and any internal data used to analyze those transactions;
7. A description of the transfer pricing comparables that were used, how comparability was evaluated, and what (if any) adjustments were made;
8. An explanation of the economic analysis and projections relied upon in developing the transfer pricing method;
9. A description or summary of any relevant data that the taxpayer obtained after the end of the tax year and before filing a tax return, which would help determine if a taxpayer selected and applied a specified method in a reasonable manner; and
10. A general index of the principal and background documents and a description of the recordkeeping system used for cataloging and accessing those documents.

The aforementioned 30-day response period starts with the issuance of the IDR requesting these ten principal documentation items. However, the IPU notes that “complete documentation may not require all principal documentation to be provided,” but rather, IRS examiners should analyze whether the documentation provided gives a complete understanding of a taxpayer’s controlled transactions. For a variety of reasons (e.g., deficient documentation), the fact that a taxpayer supplies all ten principal documentation items would not necessarily preclude IRS from assessing the aforementioned transfer pricing penalties.

For additional guidance, the IPU asks IRS examiners to consult the “Transfer Pricing Audit Roadmap” (see Weekly Alert ¶  59  2/20/2014), a 26-page set of guidance issued by IRS’s Large Business & International division. The IPU cautions that the use of such guidance requires judgement as every transfer pricing case is unique.

After receiving the requested transfer pricing documentation from a taxpayer, IRS examiners are instructed to compare any related-party information reflected in the following types of U.S. returns to the transfer pricing documentation provided and identify any missing controlled transactions:

  • Schedules C, F, and M of Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations;
  • Schedules C and F of Form 8858, Information Return of U.S. Persons With Respect To Foreign Disregarded Entities; and
  • Schedules B, L, and N of Form 8865, Return of U.S. Persons With Respect To Certain Foreign Partnerships.

In addition, the IPU instructs IRS examiners to confirm that the taxpayer’s financial statements (including income statements and balance sheets) match the transfer pricing documentation provided.

Finally, the IPU spells out additional details and steps for IRS examiners to consider and analyze with respect to each of the ten principal documentation items received from the taxpayer.

References: For transfer pricing rules, see FTC 2d/FIN ¶  G-4000  et seq.; United States Tax Reporter ¶  4824  et seq.; TaxDesk ¶  175,060; TG ¶  6450  et seq.

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