IRS Transfer Pricing Audit Roadmap Provides Guidance to Agents and Taxpayers Alike
February 2014The IRS released its Transfer Pricing Audit Roadmap on February 14, 2014. The document is described as a “toolkit that is organized around a basic audit time-line and that provides advice and links to useful reference material.” The roadmap is a first in the area of transfer pricing. With the included links, the roadmap is a significant document that should be reviewed by any multinational with controlled transactions involving U.S. companies in its group.
Although many U.S. practitioners are knowledgeable about the IRS’s audit process in general, the roadmap is novel in that it sets out in a detailed, systematic process that IRS agents are expected to follow in auditing transfer pricing issues. It also reveals some changes in the IRS’s audit policies.
Understanding the roadmap is useful for companies in setting and documenting transfer prices as well as for anticipating and responding to the government’s requests during a transfer pricing audit. The roadmap is useful for taxpayers for another reason as well. It will help ensure that both the taxpayer’s and the government’s resources are expended constructively and that an agent's concerns about transfer pricing issues can be addressed and resolved promptly. We discuss some highlights of the roadmap below.
Transfer Pricing Operations
The roadmap is the handiwork of a relatively new IRS group, Transfer Pricing Operations (or TPO). As part of its ongoing enhancement of resources devoted to transfer pricing issues, LB&I recently established TPO as a team of transfer pricing specialists. Some of these specialists have been hired from the private sector recently, while others were already with the IRS. TPO encompasses professionals in LB&I’s APMA (Advance Pricing and Mutual Agreement) Program and its TPP (Transfer Pricing Practice). There are about 60 individuals in total. These personnel (and other experts) are available to IRS agents to assist in developing transfer pricing issues during audits. Given the large number of transfer pricing audits, however, TPO is not expected to be involved in the majority of these audits. Taxpayers should be aware, nevertheless, of TPO’s expertise because personnel from TPO may be helpful in resolving transfer pricing issues raised by international examiners.
The audit work streams and timeline
The audit timeline specified in the roadmap covers 24 months, although the roadmap cautions that it may take 2 to 3 years, or more, to properly develop the government’s position on a transfer pricing issue. The roadmap has three phases, Planning, Execution and Resolution, which include nine overlapping work streams. Each work stream is described in significant detail in the in roadmap. The work streams in order, with anticipated end date are:
- Pre-examination Analysis (ending 2nd month)
- Opening Conference, Transfer Pricing Orientation (ending 6th month)
- Preparation of Initial Risk Analysis, Exam Plan and Key Milestones (ending 6th month)
- Fact Finding and Additional IDRs, Functional Analysis (ending 17th month)
- Mid Cycle Risk Assessment (ending 17th month)
- Issue Development and Preliminary Reports (ending 18th month)
- Pre-NOPA Issue Presentation (ending 19th month)
- Resolution Discussions (ending 20th to 23rd month)
- Final NOPA and Case Closing (ending 24th month)
Some key points
Understanding the approach of the examining agent can allow the taxpayer to take some practical steps to prepare for the audit and to prepare responses to agents’ requests for information and analysis. These are some key points from the roadmap:
- Open communication: A major theme of the roadmap and IRS management is open communication by the IRS with the taxpayer during the audit. The roadmap was released to the public in order to facilitate a more transparent audit. The roadmap details the various meetings and briefings that should occur during the transfer pricing audit. The expectation is that enhanced transparency will help avoid unpleasant surprises, increase mutual trust and lead to identification and resolution of issues more rapidly.
- Mandatory documentation IDR accelerated: The IRS will issue the mandatory 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.
- More detailed transfer pricing orientation: The taxpayer should provide the IRS with a “transfer pricing orientation” in the planning phase of the audit. This is expected to be more than a mere review of the taxpayer’s transfer pricing documentation. The list of items to be covered include (i) a discussion of the functions performed, assets employed, and risks assumed by each controlled party of the respective intercompany transactions, (ii) understanding how the preparer of the transfer pricing study gained knowledge of each controlled party’s functions performed, assets employed and risks assumed, and (iii) identifying the persons responsible for structuring the transaction from a tax planning perspective. A theme of the roadmap is to build a story of the taxpayer’s transfer pricing. The orientation is a critical opportunity for the taxpayer to tell its story to the examining agent so this presentation should be well considered and rehearsed.
- Request for interview notes: Examining agents should meet with the taxpayer to understand how the preparer of the taxpayer’s transfer pricing study developed his knowledge of assets, risks and functions and request supporting documents (interview minutes and notes). Taxpayers should review these documents and be prepared to address any inconsistencies. (For example, interview notes often contain overly optimistic statements by internal sponsors of R&D projects.) Going forward, corporate personnel being interviewed should be informed that their responses generally will be requested by the IRS. Some taxpayers may wish to consider entering into Kovel arrangements or develop arguments as to why these materials may be privileged if disclosure of these materials could be adverse to the taxpayer’s reporting position.
- Information Returns Tool: The IRS has developed a tool for agents to use to review and analyze certain common international returns (Forms 5471, 5472, 8858 and 8865) – the International Information Returns (IRR) Tool. For this reason, taxpayers should ensure there are no inconsistencies between the pricing of their controlled transactions and the information on these forms. The roadmap also recommends analyzing other forms including, Form 926, Schedule UTP and Forms 926.
- Financial ratio analysis: Examining agents should use tax return information and “available research tools” to compute financial ratios for multiple years to determine whether cross border income shifting is occurring. The road map cautions that even if an analysis of ratios suggests potential transfer pricing issues, a rigorous development of the issues, facts and circumstances must be developed. Taxpayers should perform their own ratio analysis and be prepared to explain any apparent anomalies.
- Foreign coordination: Examining agents should consider obtaining foreign based documentation from treaty partners under the various programs now available, e.g., the Simultaneous Examinations Program and the Exchange of Information article of U.S. tax treaties (if applicable). APMA should also be notified if the transfer pricing issue involves a treaty partner. US tax personnel should notify foreign affiliates that such documentation may be requested and should be prepared to explain any inconsistencies between the US and foreign documentation. For many taxpayers this should not be an issue, as the well-advised multinational strives for global consistency. However, as a result of settling overseas audits, inconsistencies among jurisdictions can develop over time.
- IDR enforcement: The roadmap describes the process agents should follow in developing IDRs and following up in the event the taxpayer is delinquent in responding to an IDR. The roadmap references the “IDR Enforcement Directive.” This document sets forth an aggressive timeline for compliance with IDRs. The roadmap instructs agents to coordinate with counsel “when drafting IDRs with potential to summons.”
- Site tours: The roadmap directs agents to identify key personal for interviews and site tours. It also instructs agents to “consider and evaluate the need for foreign travel.” In the author’s experience, foreign travel by examining is rare in all but the largest audits. Perhaps this signals a change in policy.
Overall the transfer pricing roadmap will enhance transfer pricing audits by increasing transparency and allowing taxpayers to anticipate and respond to agents’ questions more rapidly than in the past. The hope is that issues can be resolved sooner and save the IRS and the taxpayer time and effort. However, taxpayers with aggressive transfer pricing positions may find that the IRS now will be more effective at identifying and prevailing on transfer pricing issues than in the past.
 The Large Business & International Division of the IRS. Information Document Request.KEYWORD: Transfer Pricing
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