Transfer pricing examinations can be an intensive process. IRS commissioners speak openly about the drain on their limited budgets and continuously declining resources. In an effort to increase efficiency, the Internal Revenue Service (IRS) released a new manual titled Transfer Pricing Examination Process ( TPEP), replacing its Transfer Pricing Audit Roadmap issued in 2014.
The TPEP provides a best practices framework and guide—consistent with the Large Business & International Examination Process—to determine an arm’s length result of a taxpayer’s activity, given the facts and circumstances of a case. Transfer pricing examinations require a laborious review of the functions, assets, and risks of a taxpayer, in addition to the facts and relevant financial information to the intercompany transfers under review. Being resource-constrained, this TPEP manual will help the IRS target areas with the most significant risk for non-compliance so that productivity can be maintained during a transfer pricing examination. Further, it will help to keep examiners, taxpayers and practitioners on the same page, organizationally, as an examination progresses.
The Transfer Pricing Examination Process manual is divided into three distinct phases: planning, execution and resolution.
Phase 1: Planning
The planning phase determines scope of audit, identification of issues, steps to be taken and a timeline to completion. Every transfer pricing case will be assigned an “issue team” comprised of revenue agents, senior revenue agents, transfer pricing economists, and/or tax law specialists. The issue team coordinates to issue an information document request (“IDR”) for the taxpayer. The initial transfer pricing risk assessment involves a series of 8 steps:
- Review prior year work papers (e.g. taxpayer’s transfer pricing documentation, functional analysis, etc.);
- Collaborate with Advance Pricing Mutual Agreement (“APMA”) program when the controlled transaction involves a tax treaty country;
- Analyze the income tax return, including Form 926, Form 4797, Form 5471, and Form 5472 (among others);
- Analyze the Country-by-Country Report (Form 8975) to gauge high-level transfer pricing risk and Base Erosion and Profit Shifting risk;
- Prepare a ratio analysis using the taxpayer’s financials for multiple years and making industry comparisons using a variety of sources (e.g. Capital IQ, Compustat, ktMINE, and various other industry standard databases);
- Research the taxpayer’s history, background, operations, and profit drivers through its website, Form 10-K, Form 20-F, or other taxpayer-specific information;
- Develop a preliminary working hypothesis with an issue statement to be proved or disproved; and,
- Complete a risk analysis that will be continuously updated throughout the transfer pricing audit.
During the planning phase, the IRS will request IRC Section 6662(e) documentation and conduct internal planning meets to review the IDR process and key milestone dates. The formal opening conference with the taxpayer will discuss expectations regarding the audit process.
Phase 2: Execution
The execution phase involves interactive discussions with the taxpayer to determine the facts, apply the law to those facts, and assess any tax implications. The issue team will review the taxpayer’s transfer pricing documentation to consider if the requirements of Treas. Reg. § 1.6662 are satisfied, determine if all material controlled transactions are covered, and evaluate whether the conclusions reached are reasonable. An IDR requesting both a financial statement orientation and a transfer pricing/supply chain orientation meeting will then be issued.
Arguably the most important aspect to the execution phase is the course of fact-finding and information gathering. It is this phase of the examination where the intercompany agreements are reviewed and a full functional analysis is conducted, analyzing the functions performed, risks incurred, and assets employed. Weekly or bi-weekly discussions are called to be maintained between the examination team and the taxpayer, and the issue team may schedule several meetings with the taxpayer to confirm material facts of the business.
After completing the functional analysis, the issue team will use professional judgment to decide if the issues originally specified in the planning phase should still be examined, or perhaps modified in scope as new facts are developed. This is completed in a mid-cycle risk assessment and may warrant a change to the working hypothesis. With all controlled transactions reviewed and confirmed, the issue team will work with a transfer pricing economist to perform an economic analysis pursuant to the best method rule. It is at this time that adjustments and penalties will be considered based upon the results of the economic analysis.
To complete the execution phase, an acknowledge of facts (“AOF”) IDR will be issued to the taxpayer. With the taxpayer’s response, the Economist Report and Notice of Proposed Adjustments (“NOPA”) will be drafted in consideration of all facts of the case.
Phase 3: Resolution
The objective of the resolution phase is to reach an agreement on the tax treatment of each issue examined. Before finalizing the Economist Report and NOPA, the issue team will meet with the taxpayer to discuss the results. If the taxpayer is in agreement with the conclusions reached by the issue team, the case is closed.
However, if the taxpayer is not in agreement, and field resolution is not reached, a Revenue Agent Report (“RAR”) will be issued to the taxpayer and the case will close. To refute the conclusions reached, the taxpayer will build a Protest and the IRS will respond with a Rebuttal, leading into the Appeals process.
The taxpayer is allowed to file a U.S. Competent Authority (“CA”) request after a proposed adjustment is communicated to the taxpayer in writing. Competent Authority evaluates the case and issues a tentative resolution. If ataxpayer accepts the CA resolution, the case will be closed. If taxpayer rejects the CA resolution, and AMPA or the foreign CA is unwilling to consult further, the AMPA will formally close the case and return jurisdiction to the examination.
The Transfer Pricing Examination Process can be downloaded from the IRS website https://www.irs.gov/pub/irs-utl/P5300.pdf.
How Can We Help?
For questions or to speak with a member of Withum’s International Tax Services Group, please contact us by filling out the form below.
