Five New Directives on Transfer Pricing Examinations
In a series of memorandums addressed to employees, Commissioner O’Donnell provides instruction and guidance for IRS examiners that cover the following transfer pricing examinations topics:
- Mandatory Information Document Request (IDR) for all LB&I Examinations are Eliminated
- Examiners are Reminded to Assess IRC §6662(e) Penalties where Relevant
- Approval is Required for Examiners/APA Officials before Rejecting Taxpayer’s “Best Method” Selection
- Policy for Reasonably Anticipated Benefits in Certain Cost Sharing Arrangements in Development
- Opening Cases Involving Stock-Based Compensation in Cost Sharing Arrangements are Restricted
While we introduce all five, the first three apply to a wider audience and will be the focus of this article.
1) Interim Instruction on Issuance of Mandatory Transfer Pricing IDR
The mandatory transfer pricing IDR, in effect since January 2003, is no longer required for all examinations where the taxpayer filed Form 5471 or 5472, or is engaged in cross-border transactions. At least on an interim basis. Effective January 12, 2018, only the following cases require a mandatory IDR:
- Examinations arising under approved LB&I campaigns, where there is specific guidance for the mandatory transfer pricing IDR provided within the campaign; and,
- Examinations with an initial indication of transfer pricing compliance risk where Transfer Pricing Practice (TPP) and/or Cross-Border Activities (CBA) Practice Area employees are assigned to the case.
This procedural change attempts to manage the current high volumes of open transfer pricing cases, narrowing in on those cases that are most relevant in terms of magnitude, type, and complexity of the cross-border transaction. It appears that transfer pricing IDRs will no longer be issued by Field Examiners, but by TPP or CBA employees instead. On its surface, this appears to be a positive development for taxpayers since there is no automatic, routine request for transfer pricing documentation with every examination.
However, without specific definition around what constitutes relevance in terms of magnitude/ type/complexity of cross-border transactions, or guidance on how to identify the “initial indication of compliance risk,” it could complicate the audit process. Any LB&I-categorized Multinational Enterprise (MNE) would appear to fall under one of the two cases listed above, which would trigger a mandatory IDR in any event.
Also, while Field Examiners may no longer be required to routinely request, and check off receipt of, transfer pricing documentation, they must now possess the skills to make a determination about whether or not there is a perceived need to do so, or an “initial indication of compliance risk.” Field Examiners are not transfer pricing specialists, so they may be more apt to call in additional resources (such as TPP or CBA employees) earlier into their cases, where they would historically not have a reason for doing so. This could ultimately lead to a transfer pricing IDR in any event for taxpayers, except possibly with far more targeted and specific questions requiring that taxpayers explain the details of their transfer pricing policies, rather than just whether or not they have documentation.
Of the five instructions issued together, this is the only one that does not explicitly state that the directive only applies to examinations of LB&I taxpayers (i.e., assets equal to or greater than $10m). It will be interesting to see if this new procedure also makes its way beyond LB&I to middle market companies with global operations.
2) Instructions for Examiners on Transfer Pricing Examinations – Appropriate Application of IRC §6662(e) Penalties
Regulations require the IRS to apply penalties when the taxpayer fails to create, or to timely provide, IRC §6662(e) transfer pricing documentation contemporaneous to their tax return filings, or when the documentation provided is unreasonable or inadequate. Penalty rules are meant to hold taxpayers accountable for the reasonableness of their tax return positions and to motivate taxpayers (and their advisors) to adequately document these positions.
This new instruction reminds LB&I employees that penalty analysis should always be a part of the transfer pricing analysis, and that failure to apply penalties has adverse consequences. In particular, it provides less incentive for taxpayer compliance and adequate and timely preparation of documentation. Inadequate or incomplete transfer pricing documentation makes it difficult, resource intensive, and time-consuming for the examination team to assess a taxpayer’s reporting position, ultimately increasing taxpayer burden as well.
Appropriate application of penalties when documentation is inadequate maintains accountability and encourages reasonable and well-documented return positions that are assessed more efficiently, saving resources for both the IRS and taxpayers. As penalties become an increased focus, taxpayers have the incentive to have transfer pricing documentation each year, contemporaneous with their tax return filings, as a form of insurance against them.
3) Instructions for LB&I on Transfer Pricing Selection and Scope of Analysis – Best Method Selection
This new directive attempts to streamline LB&I review of the Taxpayer’s transfer pricing and best method selection, with resulting analysis, by imposing an approval process if the Examiner recommends a method other than the taxpayer’s selected best method. The Treaties and Transfer Pricing Operations (TTPO) Transfer Pricing Review Panel must now approve changing the taxpayer’s selection of a Treas. Reg. §1.482 method as the best method before the Examiner moves forward with its own analysis applying a different best method. This applies to both contemporaneous documentation examinations, as well as the Advance Pricing Agreement (APA) process.
There is a long chain of approval process, including an explanation to the review panel of why the taxpayer’s method is unreliable, whether it can be adjusted to make it more reliable, and what method is more reliable, and why. This extensive approval process is not meant to impede IRS examinations, rather it is designed to support the best use of limited LB&I transfer pricing resources.
This is very good news for taxpayers in that IRS Examiner’s cannot just ignore their transfer pricing analysis (and best method selection) in favor of a different one, without presenting a specific and valid reason for doing so that has been reviewed and approved by a committee.
4) Instructions for Examiners on Transfer Pricing Issue Selection – Reasonably Anticipated Benefits in CSA
This directive expects examination teams to temporarily stop developing adjustments to existing Cost Sharing Arrangements (CSAs) where new Intellectual Property needs to be integrated as a platform contribution transaction (PCT). There is inconsistency in how Examiners are interpreting the §1.482-7 regulations on CSAs, so the IRS is developing a consistent, Service-wide position on the appropriate incorporation of subsequent PCTs into the Reasonably Anticipated Benefits (RAB) share of existing CSAs.
5) Instructions for Examiners on Transfer Pricing Issue Selection – CSA Stock-Based Compensation
This directive mandates that IRS officials stop opening cases related to stock-based compensation included in CSA intangible development costs until the Ninth Circuit issues an opinion on the Altera case currently on appeal. Commissioner O’Donnell recently commented that the IRS has received the not-so-subtle messages from the courts and continues to struggle, losing the majority of its transfer pricing legal cases, so this is a way to reconsider opening cases that it historically does not win, at least until there is more guidance on final court rulings.
To navigate these new LB&I directives, implications of new tax reform on transfer pricing examinations, new CbC reporting requirements, or all the other transfer pricing hot topics relevant to your global business, contact Marina Gentile, Lead, Global Transfer Pricing at Withum by filling out the form below.