In a new International Practice Unit, IRS outlines the audit steps for its examiners to follow in reviewing the transfer pricing documentation of a U.S. taxpayer that provides tangible property, intangible property, and/or services to foreign affiliates in exchange for payment (i.e., outbound transactions). This review is an integral part of an IRS examiner’s analysis of the taxpayer’s transfer pricing risks and its assessment of any transfer pricing penalties.
· International Practice Unit (IPU):
IPUs generally identify strategic areas of importance to IRS and can provide insight as to how IRS examiners may approach a particular issue or transaction on audit. However, they are not official pronouncements of law or directives and cannot be used, cited, or relied upon as such.
· Transfer Pricing Documentation:
Transfer pricing generally refers to the methodologies used to price transactions in tangible property, intangible property, and services between related parties. These methodologies must establish a price that is arm’s length—that is, the price that would be agreed upon by unrelated parties.
IRS is authorized to adjust the results of certain related-party (i.e., controlled) transactions to clearly reflect the income of the parties in accordance with the arm’s length standard and, in the case of the transfer of intangible property, to be commensurate with the income attributable to the intangible property.
For U.S. multinational enterprises (MNEs), an important element of transfer pricing planning and compliance is the preparation of appropriate documentation of a MNE’s related-party arrangements, including the agreements that document the terms of these arrangements and the economic support for the pricing policy adopted.
In this regard, IRS has been given significant authority to obtain transfer pricing documentation from taxpayers and to impose significant penalties on taxpayers that fail to maintain or provide such documentation. The rate of the transfer pricing penalty may be as high as 40%.
Contemporaneous transfer pricing documentation may be provided to IRS to show that a taxpayer’s related-party arrangements are priced in accordance with the arm’s length standard. Such documentation must be in existence by the time that the taxpayer files its U.S. tax return and must be provided to IRS within 30 days of their request in order for the taxpayer to avoid the penalties.
If a taxpayer has not maintained contemporaneous transfer pricing documentation, or if its documentation is deemed deficient, the taxpayer may be subject to the aforementioned transfer pricing penalties to the extent that IRS concludes that a transfer pricing adjustment is appropriate. However, meeting certain reasonable cause and good faith requirements may exempt the taxpayer from these transfer pricing penalty provisions.
· Review of Transfer Pricing Documentation by Outbound Taxpayers:
The new IPU provides that a taxpayer’s transfer pricing documentation should show that the chosen transfer pricing methodology is reasonable and meets the best method rule—that is, it provides the most reliable measure of an arm’s length result and is the most reliable application of the method. IRS examiners are instructed to consult another IPU, entitled “Overview of IRC 482,” on how to select the best method.
The IPU instructs IRS examiners to request 10 "principal documentation” items with respect to the taxpayer under audit, via the issuance of an “IRC 6662(e) Mandatory Transfer Pricing Information Document Request” that is included with the initial IRS examination contact letter.
For additional guidance, the IPU asks IRS examiners to consult the “Transfer Pricing Audit Roadmap”, a 26-page set of guidance issued by IRS’s Large Business & International division. The IPU cautions that the use of such guidance requires judgement as every transfer pricing case is unique.
After receiving the requested transfer pricing documentation from a taxpayer, IRS examiners are instructed to compare any related-party information reflected in the following types of U.S. returns to the transfer pricing documentation provided and identify any missing controlled transactions.
In addition, the IPU instructs IRS examiners to confirm that the taxpayer’s financial statements (including income statements and balance sheets) match the transfer pricing documentation provided.
Finally, the IPU spells out additional details and steps for IRS examiners to consider and analyze with respect to each of the 10 principal documentation items received from the taxpayer.
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