Posts Tagged ‘double taxation’

IRS Transfer Pricing Audit Roadmap

May 3, 2014

 

Transfer Pricing NEWS

Dollar Hitch Hiking

The Transfer Pricing Operations (TPO) of the Large Business and International (LB&I) division of IRS released the 26-page Transfer Pricing Audit Roadmap to the public on February 14, 2014.

The Transfer Pricing Audit Roadmap (“Roadmap”) provides audit procedures around an approximate 24-month audit timeline. The stated goals of the roadmap are to assist both the IRS and taxpayer in the discussion and resolution of transfer pricing issues in a timely and orderly fashion, and to resolve issues in the Exam level rather than at Appeals. Also, the Roadmap is intended to provide insight into what to expect during a transfer pricing examination, as well as put a concrete work plan into place for the TPO to execute its transfer pricing audits. The Roadmap is not official guidance; it is a working document for revenue agents in planning their examinations without having to regularly consult the Internal Revenue Manual.

The Roadmap states, “Proper development of a transfer pricing position may take as much as 2-3 years or more.” Given this extended timeline, the Roadmap acknowledges that up-front planning will be essential to the examination process before the IRS commits significant resources to a transfer pricing examination.

There are three phases to the audit process as described in the Roadmap: Planning, Execution, and Resolution.

1. Planning

The Planning phase can last up to 6 months, and starts before the audit cycle begins. The Planning phase consists of a pre-examination analysis, an opening conference (which starts the 24-month examination clock), a transfer pricing orientation meeting (i.e., explanations by the taxpayer of its transfer pricing arrangements and financial information), and the preparation of the initial risk analysis and examination plan.

Company employees involved in the structuring of intercompany transactions will be requested to participate at the transfer pricing orientation meeting. Personnel “responsible for the transfer pricing study” will also be asked to participate. The IRS does not want the transfer pricing orientation meeting to be a high level review of the documentation, but rather a “comprehensive presentation,” according to the Roadmap. Domestic and foreign site visits may also be requested. The transfer pricing orientation meeting is perhaps the most important meeting during the audit, as it gives the taxpayer the opportunity to make its most compelling case for why its transfer pricing methods, analysis, and results are appropriate.

In the Planning phase the IRS will evaluate whether it thinks the taxpayer is shifting income to lower tax jurisdictions using transfer pricing. The Roadmap encourages IRS examiners to assess the functions, assets, and risks of the related parties involved in the intercompany transaction. These functions, assets, and risks should be described in the taxpayer’s transfer pricing documentation, which is reviewed by the IRS examination team. The Roadmap suggests that transfer pricing issues deserve further scrutiny if the taxpayer’s results are “at odds with common sense and economic reality” and if the taxpayer does not provide a convincing transfer pricing documentation report.

2. Execution

In the Execution phase, which can take up to 14 months, the Examiner will request information on the relevant transfer pricing issues from the taxpayer so that the IRS transfer pricing specialist can prepare a report on agreed facts. The IRS team will choose what it thinks is the best method for the intercompany transaction(s) at issue. The IRS team will apply its chosen transfer pricing method to determine an appropriate intercompany price. If this intercompany price is different than the taxpayer’s actual transfer price, and the IRS-determined price is beneficial to the IRS, then the IRS will have arrived at its basis for a proposed Section 482 adjustment.

3. Resolution

In the Resolution phase, which can take up to 6 months, the audit team conducts a pre-Notice of Proposed Adjustment (NOPA) issue presentation, resolution discussions with the taxpayer, and it issues a final NOPA. The taxpayer may disagree with the IRS position and is encouraged to state its reasons for disagreement.

 

Transfer Pricing INSIGHTS

  • The Roadmap states that “Transfer pricing cases are usually won and lost on the facts,” emphasizing fact gathering as a means of building a case not only for exam, but for successful litigation. There is consistent emphasis in the Roadmap reminding the exam team of the importance of first building a solid understanding of the facts before forming hypotheses and ultimately reaching conclusions. Accordingly, taxpayers are well-advised to ensure that their transfer pricing documentation is robust and presents a factual picture consistent with its tax returns and financial statements.
  • Expect increased involvement of IRS transfer pricing specialists within most audits, particularly during the Planning phase. The IRS developed the Roadmap to ensure that field audit teams use the transfer pricing resources within the Service. A key theme in the Roadmap is that “transfer pricing specialists must be involved in assessing potential transfer pricing issues at the earliest possible stage – ideally before the official audit commencement date.” These specialists will “help weed out issues that are not worth pursuing” and also help identify additional expertise that might be required to evaluate a taxpayer’s transfer pricing.
  • Transfer pricing documentation is the first and best opportunity to prevent a transfer pricing audit. While IRS auditors will know something about a taxpayer from tax return information and the company’s website, transfer pricing documentation reports allow companies to explain the business, including reasonable intercompany pricing results. IRS economists will assess the quality of transfer pricing documentation prior to meeting with the taxpayer. Companies without transfer pricing documentation may be surprised by initial IRS positions when meeting for the first time.
  • The IRS will issue the mandatory transfer pricing documentation information document request (IDR) with the IRS’ initial contact letter, rather than at the opening conference with the taxpayer, which has usually been the case.  Taxpayers therefore should be sure their transfer pricing documentation is complete and on hand (transfer pricing documentation must be prepared contemporaneously and be in existence when the Federal tax return is filed, and must be provided to the IRS within 30 days of receiving the documentation IDR).
  • Taxpayers can expect examiners to review the following documents during the Planning phase: IRC Section 6662(e) documentation (i.e., “transfer pricing documentation” – for penalty protection), forms 5471, 5472, 8833, 8858, 8865, 926, and schedules M-3 and UTP. The IRS team may also issue an IDR requesting worldwide, geographic, and segmented accounting data and financial statements from the taxpayer. If foreign data are important to the IRS team, it may request it from treaty partners – during the Planning phase.
  • To the extent the field team follows the roadmap guidance, taxpayers should expect a more rigorous transfer pricing examination. Taxpayers should be prepared for this process, which in most cases means much more will be required than merely updating comparables data in boilerplate or outdated transfer pricing studies.
  • Multinationals are faced with the prospect of double taxation unless the foreign tax authority agrees with the IRS position. While the Roadmap does not mention the Competent Authority process, any proper resolution should consider getting the IRS and the foreign tax authority to agree to a resolution. When there is not a resolution such disputes are typically handed off by the IRS examination team to either IRS Appeals or the Competent Authority process.

 

 

 

 

Advertisements

Featured Article – Changes to Australia’s Transfer Pricing Rules

December 18, 2012

Australian-flag-waving

Transfer Pricing NEWS:

An exposure draft of legislation was released on November 22, 2012, “Tax Laws Amendment (Cross-Border Transfer Pricing) Bill 2013: Modernisation of transfer pricing rules—proposing changes to Australia’s domestic transfer pricing rules,” to introduce new Australian transfer pricing rules with significant self assessment and documentation requirements. The start date for these new rules has not been announced, but it is expected to be the date of Royal Assent of the amending legislation.

Apparently, these new rules are a response by the Australian Commissioner of Taxation (Commissioner) to recent losses in tax court. The most prominent example is the SNF case last year. In that case the Commissioner unsuccessfully argued for the use of the transactional net margin method of adjusting transfer prices over the comparable uncontrolled price method. It looks like the Commissioner is convincing the Federal Government to legislate the Commissioner’s interpretation of the old rules as the new rules.

The Exposure Draft proposes the repeal of Australia’s existing transfer pricing rules in Division 13 of Part III of the Income Tax Assessment Act 1936 and the insertion of their replacements, as Subdivisions 815-B to 815-E of the Income Tax Assessment Act 1997. Specifically:

  • 815-B: Arm’s length principle for cross-border conditions between entities
  • 815-C: Arm’s length principle for permanent establishments
  • 815-D: Record keeping requirements (Documentation)
  • 815-E: Special rules for trusts and partnerships.

This blog post will only focus on Subdivisions 815-B and 815-D. Of the four, I see these two as having relatively more consequence for taxpayers. For more information on 815-C and 815-E, please refer to the Exposure Draft (link to Exposure Draft at end of posting).

The new transfer pricing rules will operate on a self-assessment basis, unlike the old rules, which required the Commissioner to make a determination of an assessment. This burden has shifted to the taxpayer, who will need to assess its own transfer pricing arrangements to determine whether they comply with the new rules. If a taxpayer identifies that it has a non arm’s-length arrangement creating a ‘tax benefit’ in Australia, it should self-assess a transfer pricing adjustment to increase Australian taxable income to reflect an arm’s-length result (downward adjustments are not permitted under the proposed rules).

Arm’s Length Conditions

The draft legislation focuses on the ‘conditions’ that exist between entities and whether these are consistent with the ‘arm’s length conditions’. Arm’s length conditions are the conditions that may be expected between independent entities dealing wholly independently with one another in comparable circumstances. In identifying arm’s length conditions, regard must be had to the economic substance of what was actually done. Where the economic substance of what was done does not match the legal form, it is the economic substance that determines the ‘arm’s length conditions’.

The arm’s length conditions are to be determined using the most appropriate and reliable method. The method must be selected based on the comparable data available, and a comparability analysis must be performed. Five comparability factors (the comparability factors in the OECD Transfer Pricing Guidelines) must be considered in this analysis. The five comparability factors are:

  1. Characteristics of property or services
  2. Functional analysis
  3. Contractual terms
  4. Economic circumstances
  5. Business strategies

An arrangement could be considered non-arm’s length if it does not contain a condition that third parties would have normally included in a comparable arrangement. Likewise, if a related party arrangement contains a condition that third parties would not normally agree to, this may also constitute a non-arm’s length arrangement. Note: There is great uncertainty as to how the Commissioner will apply this test in practice.

Transfer Pricing Benefit

There will be a ‘transfer pricing benefit’ where arm’s length conditions are applied and one of the following three outcomes would arise:

  1. The Australian entity’s taxable income for the income year is greater than actual conditions
  2. The Australian entity’s loss is less than actual conditions
  3. The Australian entity’s tax offsets are less than actual conditions

 Reconstruction

The draft Explanatory Memorandum states that the Commissioner can substitute actual dealings or arrangements if “independent entities would not have done what was actually done given the options that are realistically available to them.” Basically, the Commissioner is granted broad power to reconstruct transactions when the arrangements are not considered “substantially similar” to what would have occurred between independent parties, given the options realistically available to the Australian taxpayer. This statement in the Explanatory Memorandum is somewhat of a departure from the OECD Guidelines, which state:

“[r]estructuring of legitimate business transactions would be a wholly arbitrary exercise the inequity of which could be compounded by double taxation created where the other tax administration does not share the same views as to how the transaction should be structured.”

Unlike the OECD guidelines, the proposed rules do not require the existence of ‘exceptional circumstances’ before undertaking a reconstruction.

‘Optional’ Transfer Pricing Record Keeping (aka Documentation)

While the Exposure Draft does not make “transfer pricing ‘record keeping’” mandatory, it is in effect mandatory if the taxpayer wants to have a reasonably arguable position. Subdivision 815-D imposes burdensome self-assessment documentation requirements in order for a taxpayer to obtain a RAP. A RAP limits penalties to 10% (non deductible) versus 25% or more otherwise.

Where Taxpayers prepare robust transfer pricing documentation in accordance with the prescribed process, they should be deemed to have a RAP.

Records to satisfy 815-D:

  • Must be contemporaneous
  • Must explain how 815-B applied or did not apply to the entity
  • Must explain why applying 815-B best achieves consistency with the OECD Guidelines
  • Must identify both the ‘actual conditions’ and the ‘arm’s length conditions’
  • Must detail the method used and comparable circumstances relevant to identifying the ‘arm’s length conditions’
  • Must detail the difference, if any, between the ‘arm’s length conditions’ and the ‘actual conditions’

If documentation does not meet the RAP, taxpayers would be subject to a minimum penalty of 25% of the tax shortfall if the Commissioner makes an adjustment, subject to de minimis thresholds (generally $10,000 or 1% of taxable income). The potential penalty with a RAP is 10%.

Transfer Pricing INSIGHTS:

  1. Taxpayers should review their intercompany legal agreements to assess whether legal form and economic substance are aligned, and whether the terms and conditions are consistent with third party agreements.
  2. The Exposure Draft implies that a single set of arm’s-length conditions will exist. In practice, there is rarely a single arm’s-length price or outcome; taxpayers and tax authorities typically seek to identify a range of arm’s-length outcomes. The use of a range is not directly acknowledged in the Exposure Draft. While this is an area of uncertainty, taxpayers could attempt to refer to the OECD Guidelines to support the use of a range.
  3. Subdivision 815-B applies whether the entities are related or not, allowing the Commissioner to attack collusive behavior between unrelated parties, and potentially requiring the taxpayer who wants a Reasonably Arguable Position to document unrelated party transactions to show they are indeed unrelated party transactions.
  4. The Exposure draft gives the Commissioner great power with regard whether or not to make, and how to make, consequential adjustments. Although Subdivision 815-B operates on a self-assessment basis for the primary taxpayer, it does not operate on a self-assessment basis for any other ‘disadvantaged entity’ taxpayer that might be affected by ‘arm’s length conditions’ replacing the ‘actual conditions’. In such cases, the disadvantaged entity will need to ask the Commissioner to make a determination such as reducing its taxable income, increasing its loss, increasing a tax offset, or reducing the withholding tax payable in respect of interest or royalties. The Commissioner is only required to make such a determination where the Commissioner considers it is fair and reasonable to do so.
  5. The proposed de minimis rule does not provide much relief for taxpayers, since it will be necessary for taxpayers to calculate the value of potential transfer pricing adjustment exposures before they can identify whether their dealings fall below the threshold. A simpler approach – which would have been less onerous to the taxpayer – would have been to provide an exemption from penalties for transactions that fall below a certain threshold.
  6. In future transfer pricing cases, the Commissioner may be able to argue that a significant difference between results produced by a transactional method used by the taxpayer (e.g., the comparable uncontrolled price method), and a profit-based method (e.g., the transactional net margin method), suggests there are factors specific to the taxpayer’s situation that are not taken into account by the transactional method. Then, the Commissioner could rely on a profit-based method to defend an assessment of a ‘transfer pricing benefit’ even where the taxpayer is able to use a transactional method to establish that no such benefit exists (as the Commissioner attempted to do in the SNF case).
  7. For certain large and complex intercompany arrangements, I think the added uncertainty for taxpayers resulting from the Exposure Draft, and the additional documentation burden, increases the appeal of APAs.

Links to the Exposure Draft and Explanatory Memorandum:

Exposure Draft

Explanatory Memorandum

Pros and Cons of Safe Harbors, and Advice to Tax Authorities

December 14, 2012

Galveston, TX

Why is it worth weighing pros and cons of safe harbors*? Because the OECD’s June 6, 2012 draft endorses safe harbors and presents three sample memoranda that countries may use to negotiate bilateral safe harbors. Also, most would say that the IRS has been successful with instituting safe harbors on interest rates for intercompany loans, and safe harbors for certain routine services. The trend is toward the adoption of more safe harbors, not fewer.

PRO: 

  • Less likely to result in double taxation (for bilateral and multilateral safe harbors)
  • Less burdensome on taxpayers, tax authorities, and courts (lower compliance and administrative costs)
  • Safe harbors on routine situations allow taxpayers and tax authorities to focus resources on more complex situations (resource rationalization)
  • Increased taxpayer compliance
  • Provides taxpayers with greater certainty

CON:

  • May not be compatible with the arm’s-length principle
  • Transactional methods (e.g., CUP) when properly applied, are more precise and more accurate than a profit based methodology safe harbor
  • Potential for adverse selection if safe harbors are not arm’s length
  • Unilateral safe harbors could result in some taxpayers over reporting income in the safe harbor country
  • Some amount of tax revenue erosion
  • Published safe harbors may create rules of thumb for arm’s-length analyses, potentially biasing the results

ADVICE:

  • Safe Harbors should emulate arm’s-length results
  • Bilateral (or multilateral) safe harbors are more effective than unilateral ones in preventing double taxation
  • Safe harbors should be elective, not mandatory (a pro and a con of elective safe harbors is a general reduction in tax liability)
  • Mandatory safe harbors would be akin to formulary apportionment, which is not generally accepted nor is it arm’s length
  • Require taxpayers to commit to the safe harbor for a certain number of years, or require an advance notice of election to use the safe harbor (otherwise, taxpayers will electively choose the safe harbor only when it provides a better tax answer)
  • Use ranges to lessen chances of double taxation
  • Allow mutual agreement procedures to mitigate the risk of double taxation
  • Bilateral and multilateral safe harbors should be updated periodically to account for market changes

* The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (2010), in Chapter IV, Section E, defines a safe harbor as “a statutory provision that applies to a given category of taxpayers and that relieves taxpayers from certain obligations otherwise imposed by the tax code by substituting exceptional, usually simpler obligations.”


%d bloggers like this: