Transfer pricing audits can be better navigated via IRS audit road map
Global connectivity plays a key role
Working with a small boutique accounting firm on the West Coast had served this international accessories distribution company well−until they found themselves embroiled in a taxable income audit by the IRS. Knowing this audit was beyond the capabilities of the smaller firm, the company’s chief financial officer turned to RSM to assist him with this challenging task.
The IRS claimed the company was overcharged for product purchases from their foreign parent company by approximately $3 million in one tax year. At the same time, the foreign country tax authority was auditing the parent company for the same transfer pricing concerns. Clearly, there was a dispute over which entity was entitled to the profits and which government had the right to collect the associated taxes. Members of RSM’s international tax team provided extensive documentation to the IRS, but the case eventually went to appeals.
In an effort to stop the dispute, RSM proposed that the company negotiate a bilateral advance pricing agreement with the IRS and foreign country tax authority. An advance pricing agreement (APA) is a prospective agreement between a taxpayer and a taxing authority on an appropriate transfer pricing methodology for a set of transactions at issue over a fixed period of time. The law firm representing the accessories company disagreed with the proposed approach, and the company chose to pursue resolution through the Competent Authority process, whereby the IRS and the foreign country tax authority would negotiate the position and come to an agreement on how to share the profits. Unfortunately, the law firm’s position and subsequent 50-page legal opinion did not have the desired effect and ultimately restarted the IRS examination, which ensued for nearly two years.
The accessories company might have avoided this result by taking a more proactive and fact-based approach to its transfer pricing documentation. This fact-focused approach is emphasized and elaborated in the transfer pricing audit road map released by the IRS in February 2014, which should be referenced by taxpayers for insight into how the IRS is proposing to approach transfer pricing audits in the future. RSM recommends that taxpayers facing a transfer pricing examination prepare for it by:
- 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, responding to a Notice of Proposed Adjustment, and preparing a protest)
- Preparing to discuss their documentation in detail and to explain specific controlled transactions
- Identifying and gathering key documents and preparing personnel in advance of an examination
- Using the information document request process affirmatively to tell the taxpayer’s story
The IRS appeal was finally settled in favor of the accessories company. Had the IRS been successful, similar proposed adjustments were anticipated for the following four years. Therefore, the dispute resolution allowed the taxpayer to avoid nearly $12 million in total additional proposed adjustments. Often, companies find themselves unprepared for an audit of this size and scope, and using skilled advisors with deep experience in tax controversy matters is critical. The newly issued transfer pricing audit road map provides insight on what taxpayers should expect when faced with a transfer pricing audit and is a useful tool for developing an examination strategy. RSM works with clients to prepare robust documentation in advance, helping to mitigate the tangled web of an IRS transfer pricing examination.