Volume No. 14-02
Over the past 15 months, the IRS and the OECD separately published transfer pricing audit and administrative initiatives that will significantly impact the way controlled transactions among related parties are reviewed. These initiatives are consistent with overall concerns raised in the OECD’s Base Erosion and Profit Shifting (“BEPS”) Report. Each stands independently of BEPS and will likely be unaffected by the ultimate action plans implementing the BEPS goals.
View from the U.S.
Congress has not passed any significant transfer pricing legislation in recent years and U.S. transfer pricing regulations remain essentially unchanged. As a result, the U.S. “best method” rule remains the norm.
However, technical rules are now viewed through a lens coated with the political fallout from testimony before the Senate Permanent Subcommittee on Investigations of several large multinational corporations (Apple, Microsoft, Hewlett-Packard and Caterpillar). The IRS continues to expand its team of transfer pricing examiners and is refining its information exchange and advance pricing agreement procedures.
The IRS has significantly changed the U.S. transfer pricing landscape in the absence of legislation by exercising its administrative authority. It concluded that it needs to develop transfer pricing cases more thoroughly at an earlier stage in the audit process in order to identify and resolve issues without resorting to the appeals process. IRS audit teams are spending more time on advance preparation. Audit teams now regularly research a company’s business and industry and adopt a “big picture” approach to a case in lieu of a straightforward application of transfer pricing regulations.
The drive to develop transfer pricing cases more thoroughly at an earlier stage is viewed by some advisers as an attempt to bypass the importance of the appeals process within the IRS by an emphasis on building a litigation file. This approach significantly changes the dynamics of the audit process.
In February, the IRS released its Transfer Pricing Audit Roadmap (the “Roadmap”) which is intended to provide audit techniques and tools to plan, execute and resolve transfer pricing examinations. The Roadmap anticipates up to a 30 month timeline (6 months of planning and 24 months of audit) for the planning, execution and resolution of a Quality Examination Process or QEP. The QEP is based on certain fundamental assumptions. First, up-front planning is essential. Second, transfer pricing cases are usually won or lost on the facts. Third, a reasonable result under the facts and circumstances of any case should be attained. Finally, effective presentation can “make or break” a case.
The QEP emphasizes early identification and prioritization of transfer pricing issues. This will determine proper staffing and scope of the audit given the anticipated complexity of the case. Regarding the existence of facts to justify an adjustment, the QEP notes that the key in is 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. The QEP will be looking for scenarios that it believes are too good to be true. Similarly, the QEP notes that the transfer pricing team should avoid adjustments where the taxpayer’s financial results are reasonable and the taxpayer’s transfer pricing method fits its profile.
The transfer pricing team’s working hypothesis will serve as a guide to further detailed examination, subject to the collection of new data. The QEP discourages fishing expeditions and encourages a commitment by the transfer pricing team to address in full the taxpayer’s analysis. In this way, the QEP acknowledges that the taxpayer may have the more compelling position on the issue.
As to effective presentation, the QEP focuses on the notice of proposed adjustment. The QEP intends that the notice should serve as a persuasive argument for the accuracy of the transfer pricing team’s position over the taxpayer’s position. It should contain all of the relevant facts, both good and bad, and should lead to a conclusion that is self-evident. The QEP assumes that a well presented notice of proposed adjustment will increase the odds of early resolution or a favorable result on appeal. Some advisers believe that, this assumption of the QEP appears to be that the transfer pricing team should prepare a position paper that is at least as good as the transfer pricing report of the taxpayer.
While the QEP process may seem reasonable on its face, further consideration raises two key questions:
- Is this an audit or preparation for litigation? Notable in the QEP detail is an emphasis on documentation of the audit steps taken, facts discovered, preliminary risk assessment, ongoing factual analysis and ongoing coordination with various TPO personnel and counsel. Preparation of a mid-cycle risk assessment to update the initial risk assessment and analysis is considered an important component of the QEP. Finally, participation of the audit team in the appeals process itself with a view towards understanding of the appeals rationale and consideration of future years’ risk assessments could be considered an expansion of normal audit team participation at that level.
- Is the QEP approach consistent with current transfer pricing law and regulations? Remember that current transfer pricing law and regulations remain the same. The QEP “big picture” view may or may not align with existing transfer pricing regulations that do not necessarily require a focus on overall economic outcomes or financial results.
Nevertheless, the fact that the TPO organization now is the key IRS transfer pricing administrative function and that the QEP represents the TPO’s key transfer pricing enforcement mechanism imply that taxpayers will need to consider the goals and objectives of QEP in managing audits and in establishing or revising their future transfer pricing policies. This is especially true with respect to intangible property. The TPO Director has repeatedly indicated that transfer pricing for intangibles will be the top priority for TPO activities and that the exam approach should consider the overall economic outcomes achieved by the intercompany transactions involving intangibles and not just whether those transactions have complied with specified methods in the regulations. According to the TPO Director, many related party intangibles transactions achieve unrealistic results and would never be observed between independent entities. Whether this view will ultimately prevail may well depend on the quality of the QEP presentation rather than the expectation of the TPO Director.
The IRS appears to be coming around to a new, more modern, strategic approach to tax management involving the systematic assessment of transfer pricing risk and the corresponding targeting of resources and efforts accordingly. The approach is modeled after findings from the OECD’s tax assessment and compliance research over the last 15 years, and programs implemented in Australia and the United Kingdom, thus reflecting the more positive international transfer pricing developments.
This new approach envisions a more engaged, more cooperative style of examination and a greater use of prescriptive tools, including the development of profiles, or templates, of required information and/or outcomes (based on statistical and other metrics), against which taxpayers can be measured and evaluated with prescribed remedial action depending how the company matches up against the profile. Such action ranges from no action, to follow-up questions, and to a more detailed request. The IRS has indicated that they have already developed several profiles.
The expectation, based on experiences in other countries, is that companies that fit the profile in terms of timeliness and completeness will experience a lighter, quicker and less costly IRS examination. On the other hand, the approach is intended to quickly identify issues that can be given greater attention by more resources and more effective resources.
Viewed from a different perspective, the QEP essentially represents a reordering of the decision making process concerning litigation. The effort that will be made in connection with the decision to proceed with a notice of proposed adjustment means that once a decision is made to issue the notice, the role of the appeals officer in resolving transfer pricing controversies will be reduced because the facts gathered by the transfer pricing team will be clear and convincing. The end result is that the risk of litigation assessment by the appeals officer will be perfunctory – a state of affairs well known in Canada.
View from the OECD
Not long before the release of the Roadmap, the OECD released two documents that set out the current guidance to its 34 member states (as well as G20 member states) on pre-audit risk assessment, transfer pricing documentation and country-by-country (“C-b-C”) reporting.
The Draft Handbook on Transfer Pricing Risk Assessment (OECD, April 30, 2013) (the “Draft Handbook”) is a collection of recent country procedures, methods and approaches intended to help tax administrations improve performance. The objective of the Draft Handbook is to promote more efficient audits by tax authorities in order to avoid waste of resources for tax administrators when unsustainable positions result in litigation Competent Authority cases. While there are no mechanical rules prescribed by the Draft Handbook, countries are encouraged to follow regular and structured risk assessment steps. The Draft Handbook is not law, administrative practice, or even necessarily prescriptive in its approach. The OECD makes it very clear that each country will need to develop its own approach to risk assessment.
The intent of risk assessment is to help an OECD member tax authority determine the factual inquiries that it will make during the course of a transfer pricing audit, if a full audit is to be conducted. There is clear reference to the trade-off between the understanding of risk and the extent of information available for review at the risk assessment stage.
The Draft Handbook deals only with recommended pre-audit procedure. Chapter 4 of the OECD Transfer Pricing Guidelines deals specifically with examination practices, albeit briefly.
The January 30 Discussion Draft on Transfer Pricing Documentation and C-b-C Reporting (OECD, January 30, 2014) (“the Discussion Draft”) proposes a working version of a new standard of documentation and country-by-country information reporting that is considerably more extensive than the present Chapter V guidance.
As one of 15 BEPS Action Plan steps taken in a time of fiscal crisis, the Discussion Draft recalls the approach to serious crime in occupied North Africa taken by Captain Renault in the classic film Casablanca: “Realizing the importance of the case, my men are rounding up twice the usual number of suspects.” The volume and utility of the information requested in the Discussion Draft, as well as information security and confidentiality, has been roundly criticized by the tax community. The Discussion Draft states that information submitted to tax authorities (either documentation or the new C-b-C factual and financial reporting) can be used in either the pre-audit or case selection phase of a transfer pricing audit, or can be used in the early stages of an audit for the purpose of focusing such audits on the most important issues. Irrespective of how or if the information will be used, the Discussion Draft calls for more C-b-C reporting information that can be obtained by a tax authority before review of the transfer pricing documentation.
The U.S. developments with QEP have been independent of the C-b-C dialogue and, in fact, U.S. officials have expressed some reservation as to the logic of certain aspects of the C-b-C reporting requirements. This is easy for the U.S. to say, as the U.S. already has in place a robust reporting regime for international business operations of U.S. taxpayers. This regime is an integral part of QEP planning phase which contemplates a detailed tax return review including (i) Forms 5471 and 5472 regarding information on intercompany transactions, (ii) Form 8833, regarding treaty based return positions, (iii) Form 8858, regarding information on disregarded entities, (iv) Form 8865, regarding U.S. controlled foreign partnerships, (v) Schedule UTP, regarding uncertain tax position disclosures, and (vi) worldwide book to taxable income reconciliation Schedule M-3 of the Form 1120. Examination of the overall data requests required by these forms would reveal that a material amount of the information requested in the C-b-C reporting has been compiled. Note though that these forms demand the greatest amount of information from U.S.-based groups. The question arises whether the same degree of information should be demanded of local subsidiaries.
But also at issue are the usual suspects. Rather than setting out a risk-assessment process framework like the Audit Roadmap, the Draft Handbook places emphasis on company and transaction fact patterns that are likely to increase transfer pricing risk. The usual suspects are (among others): (a) transactions with related parties in low-tax jurisdictions, (b) intra-group services, (c) excessive debt and/or interest expense, and the transfer or use of intangibles to/for related parties.
The Audit Roadmap sets out the audit process as means of organizing fact gathering and formation of a theory of a case (facts seeking a theory) rather than a theory seeking facts. We believe this is generally the correct way conduct a transfer pricing examination. To some extent, the increased information requirements of the proposed OECD C-b-C reporting and the prescriptive issues lists in the Draft Handbook promote a theory seeking facts approach to transfer pricing risk assessment. We expect double tax issues between the IRS and the tax authorities of its treaty partners will require further effort and time to align the fact development and robustness to the theory of the case where the treaty partner has reassessed tax based on a usual suspects approach.
From the IRS perspective, whether the glass is half full or half empty, there will be an expanded access to the IRS audit team and other administrative personnel. Taxpayers may want to closely examine their tax situations in 2014 both historically to open years and prospectively to future years so that they may measure the anticipated effect of the IRS initiatives described above. A robust transfer pricing report that tells a complete factual story and supports the transfer pricing method selected and applied may ultimately provide a quicker, more cost-effective means to resolve transfer pricing issues.
From the OECD perspective, we anticipate that there may be information shortages in certain OECD member countries, but expect that the matter will be solved with the introduction of more focused foreign reporting forms. In a sense, the OECD’s emphasis on information requirements is understandable. Reliable information is required to assess risk and responsibly, select taxpayers, and further select particular tax positions for a robust examination. As the Draft Handbook remains in draft while other BEPS Action Plan items receive attention from the OECD Centre for Tax Policy and Administration, we hope that the Audit Roadmap and other procedural developments will be finalized with double tax minimization in mind.
Multinational businesses with a taxable presence in both the United States and in other OECD and G20 member states should be mindful of the similarities and differences between OECD guidance and IRS field guidance. Areas of difference are relevant to exam approaches, documentation approaches, and differences in the perspective of tax authorities conducting Simultaneous Examination Program audits and Competent Authority negotiations.
Tax authorities and the politicians to whom they report have determined that it is time for countries to take control of their tax borders. Transfer pricing examinations of a new and ambitious sort are to be expected.
Michael Peggs, Cadesky & Associates LLP
Robert Rinninsland, Ruchelman PLLC
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