On April 14, 2020, the IRS released transfer pricing documentation FAQ and best practices (herein referred to as “IRS TP FAQ”). This article discusses the main topics covered in the IRS TP FAQ and provides initial observations and implications under the current economic environment in the face of the COVID-19 pandemic.
Transfer Pricing Documentation and Related Party Rules
The U.S. Treasury regulations § 1.6662-6(d)(2)(iii)(B) outline the 10 principal documents that must be maintained to prepare transfer pricing documentation. Such documentation must be prepared and completed contemporaneously with the filing of the U.S. tax return and provided to the IRS within 30 days of a request during an examination. Generally speaking, a taxpayer can reduce the risk of tax penalties if this documentation is prepared in a timely manner. However, the IRS TP FAQ emphasizes that the mere preparation of transfer pricing documentation does not protect taxpayers against penalties. Transfer pricing documentation must be assessed for “adequacy and reasonableness,” which includes the requirement to apply the U.S. transfer pricing regulations in an adequate and timely manner for a taxpayer to take advantage of penalty reductions.1
Context for Transfer Pricing Documentation Frequently Asked Questions
The IRS TP FAQ is a result of a 2018 directive sent by the IRS Large Business and International Division (LB&I) to incentivize taxpayers to improve the quality of transfer pricing documentation. Further, the Internal Revenue Service Advisory Council (IRSAC) released in its 2018 Public Report that the quality of transfer pricing documentation has declined and recommended that the IRS provide best practices to U.S. taxpayers.
The IRS TP FAQ reminds taxpayers that the transfer pricing documentation rules motivate taxpayers to prepare adequate and timely documentation, and gives the IRS helpful tools to evaluate and, if necessary, correct transfer prices. Sufficient documentation also, in the IRS’s view, reduces audit time and taxpayer burden.
Transfer Pricing Documentation Best Practices
The IRS has laid out six FAQ with their corresponding answers, which we have listed below. These questions and answers are based on the IRS’ observations of best practices and common mistakes in preparing documentation.
- What benefit(s), in addition to potential protection against penalties pursuant to IRC § 6662(e)(3)(B), might there be for taxpayers who invest in robust transfer pricing documentation?"
The IRS states that high-quality transfer pricing documentation facilitates a more efficient risk assessment for both taxpayers and examiners because it allows the IRS to rely on the taxpayer’s analysis of functions, risks, value drives, etc. and to ask more focused and targeted questions that could be addressed in a much shorter time frame. It provides an example where a U.S. distributor purchases heavy machinery from its foreign parent and earned significant losses during the year it was audited. These losses will be seen as an initial indicator that transfer pricing may have had an impact on the U.S. distributor’s losses and it will be expected that transfer pricing documentation thoroughly explaining the taxpayer’s business circumstances impacted the U.S. taxpayer’s financial results and how it is not a result of transfer pricing.
This example is especially relevant under the current economic environment where taxpayers will be facing extraordinary results due to the COVID-19 pandemic.
- How can a “self-assessment” help to anticipate questions and prepare better 6662(e) documentation?
The IRS believes that taxpayers can anticipate and proactively address concerns by performing basic sensitivity analyses. Examples provided by the IRS include: a) evaluating the strength of comparable companies used in benchmarking; b) comparing tested party results to multiple profit level indicators (PLIs) and being ready to address potential inconsistencies; and c) evaluating the reasonableness of how system profits are shared between related parties based on their relative contributions.
- What is the IRS’s guiding principle in establishing arm’s-length prices were charged in intercompany transactions?
The IRS’s guiding principle is to ensure taxpayers comply with the U.S. transfer pricing regulations; related taxpayers should report income based upon intercompany prices that third parties would have charged under similar circumstances.
As many of us in transfer pricing are keenly aware, the evaluation of intercompany transactions will more often than not contain imperfect comparables. The IRS TP FAQ reminds taxpayers and practitioners that comparability adjustments should be applied rationally and consistently and follow basic economic principles, as outlined in the transfer pricing regulations. Further, transfer pricing documentation is required to outline the reason comparability adjustments were performed, and detail how these adjustments were applied to comparable company results.
The IRS’s reminder on the requirement to consider and explain comparability adjustments is important for two reasons. First, this is required by taxpayers to prepare adequate and reasonable transfer pricing documentation and take advantage of penalty reductions. Second, taxpayers will more likely need to consider comparability adjustments in 2020 to account for the business impact caused by the COVID-19 pandemic.
- What are some areas the IRS has identified in transfer pricing documentation reports that could benefit on improvement?
The IRS outlined specific areas that could be improved. These include: a) industry and company analyses that provide context to the related party transactions; b) a robust functional analysis rather than a checklist of which party performs each function; c) better support for the best method selection including internal and external data reviewed in concluding on each method; d) effects of discrepancies between transfer pricing policies and the method used in documentation; e) explanation of year-end adjustments; and e) impact of differences in functions/risks between the tested party and comparable companies.
- What are some features of the most useful transfer pricing documentation reports?
The IRS identified features that may result in a more efficient audit process. These include a) full explanation of data used in the analysis, including files that preserve calculations; b) allocation of system profits among parties; and c) an analysis of special business circumstances that may have affected profitability.
- Can you provide an example of a presentation of a company’s intercompany transactions that would be a helpful summary for examiners to use in a risk assessment?
The IRS attached a sample intercompany transaction summary that was recommended to be included in an executive summary of transfer pricing documentation. The transaction summary would include information such as: foreign related party and the jurisdiction and location in documentation where transaction is analyzed; and, if an Advanced Pricing Arrangement (APA) is in place, amount reported in tax form, transfer pricing policy, transfer pricing method selected, benchmarking results and actual results of the tested party.
More information on the IRS TP FAQ can be found here.
Read Transfer Pricing Times – Second Quarter 2020
Sources
1.The U.S. transfer pricing regulations is also referred to as Internal Revenue Code (IRC) Section 482.
