IRS releases transfer pricing audit roadmap
TAX ALERT |
On Feb. 14, 2014, the IRS released a transfer pricing audit roadmap. The roadmap was developed by a team at the Large Business and International Division and provides its examiners with audit techniques and tools to assist with the planning, execution and resolution of transfer pricing examinations. The roadmap’s on-line toolkit is organized around a basic three-phase, 24-month audit timeline. Cautioning that the roadmap is not intended as a template and every case is unique, the IRS indicated that examination teams will need to exercise judgment about how to best use these new guidelines.
The pricing of intercompany transactions within a multinational group is one of the most important factors in determining taxable profits across the various countries or tax jurisdictions where a company operates. As a result, the IRS and tax authorities around the world frequently examine the taxable income reported by multinationals. The IRS has the authority to make allocations between the entities of a controlled group if a taxpayer has not reported its true taxable income. In making such allocations, the IRS applies what is known as the arm’s length standard to clearly reflect the income of the controlled taxpayer it is auditing.
The roadmap provides insight on what taxpayers should expect upon a transfer pricing audit and is a useful tool for developing a strategy should a company face an examination.
The roadmap presents the following key themes, which the IRS advises its examination teams to keep in mind when conducting transfer pricing audits:
- Up-front planning. Transfer pricing specialists will be relied upon at the earliest possible stage—ideally, before the audit commencement date. The goal is to ensure that the audit plan and timeline are appropriate given the complexity of the case and to enlist transfer pricing specialists’ help in weeding out issues not worth pursuing.
- Fact development. The IRS also directs its auditors to keep in mind that transfer pricing cases are usually won and lost on the facts. The IRS refers to fact development as the “bread and butter” of its examination teams. Thus, the examination teams are instructed to put together a compelling story of what drives the taxpayer’s financial success, based on a thorough analysis of functions, assets, and risks and an accurate understanding of the relevant financial information. If the facts indicate that the tax result claimed by the taxpayer is at odds with common sense and economic reality (i.e., “too good to be true”), chances are the taxpayer is a good candidate for further scrutiny.
- A working hypothesis. The roadmap is also intended to eliminate “fishing expeditions” (i.e., theories in search of facts). The notion of a working hypothesis, which is to be updated and well-documented during the fact-finding process, is heavily stressed. Members of the examination team are encouraged remain open minded to new information that comes to light and to adjust their hypothesis accordingly. The IRS emphasizes it is critical in every case that the team address in full the taxpayer’s analysis, acknowledging that the taxpayer may well have the more compelling position on an issue.
- Effective presentation can make or break a case. The roadmap stresses the presentation of clear and persuasive arguments. A conclusion in an IRS notice of proposed adjustment (NOPA) should come across as “inevitable.” The IRS asserts that presenting its case logically, while weaving the facts, circumstances and other relevant economic and legal principles together, is critical. The examination team should compile a complete case. All of the relevant facts, good and bad, should be addressed. The IRS advises its examiners that this type of presentation lends credibility to the proposed adjustment and increases the odds of early resolution or of the adjustment being sustained on review.
The IRS transfer pricing audit quality examination process or audit cycle is presented in the roadmap over a 24-month timeline, from pre-examination analysis to the final NOPA and case closing. While not every step will be necessary in every audit and the timeline may be shorter (or perhaps longer) depending on the particular case, the message from a practical perspective is clear−the roadmap illustrates the importance of factual development and the documentation of a multinational’s transfer pricing processes. Thus, taxpayers should ensure that current and future documentation is substantial enough to withstand audit scrutiny.
In addition, while the roadmap was prepared to assist IRS auditors, taxpayers should use the roadmap to their advantage in developing a strategy for managing an examination. To this end, taxpayers facing a transfer pricing examination should prepare for it by 1) preparing to discuss their documentation in detail and to explain specific controlled transactions, 2) identifying and gathering key documents and preparing personnel in advance of an examination, 3) organizing the facts in a way that tells a compelling story (e.g., through early development of a statement of facts that can be used as a guide in responding to information document requests , developing position papers, and responding to the NOPA and preparing a protest), and 4) using the IDR process affirmatively to tell the taxpayer’s story.
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