The Transfer Pricing Audit Roadmap: What is it and how can it Help Taxpayers?
In February 2014, the Transfer Pricing Operations (“TPO”) of the Large Business and International (“LB&I”) division of the Internal Revenue Service (“IRS”) released the Transfer Pricing Audit Roadmap (“Roadmap”) to the public. The Roadmap is a practical, user-friendly toolkit organized around a notional 24-month audit time-line. The roadmap discusses the timing of transfer pricing examinations, the need for effective factual development during the examination, and the expanded role of the Advance Pricing Agreements (“APA”) program in transfer pricing examinations.
The Roadmap was initially intended to be used by agents but it has since been released to the public and can be used as a tool for taxpayers. The Roadmap is the first publicly available transfer pricing tool that offers taxpayers tangible preparation guidelines.Why would the IRS release a document explaining how it plans to conduct audits? Because, the Roadmap helps create transparency for both taxpayers and tax professionals. Up until now, the audit process has been complex, with little transparency for the taxpayer and little structure for the IRS.
Although, the roadmap does not represent formal guidance, it does incorporate significant portions of the Internal Revenue Manual (“IRM”) and puts them in a more process/timeline-driven format. The IRM is the primary, official source of the IRS's “instructions to staff” (these relate to the administration and operation of the IRS). The IRM ensures that IRS employees have the approved policy and guidance that they need to carry out their responsibilities in administering the tax laws or other agency obligations.
Currently, transfer pricing examinations are beginning to reflect the guidance of the Roadmap. Because transfer pricing issues are complex and expensive, taxpayers must engage in continuous communication from the early stages of the audit. Transfer pricing cases are usually won and lost on the data, so taxpayers should retain good transfer pricing records and must be able to present facts consistent with tax returns and financial statements. Contemporaneous transfer pricing documentation provides the best defense for the taxpayer, the best way for the taxpayer to present the facts and circumstances of the related-party transactions up front, and ultimately, it provides penalty protection for the taxpayer from any adjustments made upon being audited. For the well-intentioned taxpayers prepared to present the relevant information, the efficiency of the Roadmap is a welcome change.
Elements of the Roadmap
The Roadmap includes a defined process for the examination of transfer pricing issues and notes that “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 (e.g., the initial risk assessment) will be essential to the examination process before the IRS commits significant resources to a transfer pricing examination.
Transfer pricing specialists will be engaged in the early stages of the audit and help address transfer pricing issues at the earliest possible stage. Specialists are used to help weed out the issues not worth pursuing and develop an audit plan and timeline.
In previous years, transfer pricing specialists were typically called in once a complicated transfer pricing issue was identified. Now, transfer pricing specialists are encouraged to participate in any audit where a related-party transaction is identified.
The key to transfer pricing cases is to develop a convincing story on what drives the taxpayer's profit based on analysis of functions, assets and risks along with relevant financial information. If the examination team believes the tax result claimed by the taxpayer is at odds with the common-sense conclusions, chances are this will be further scrutinized.
Historically, examiners were often satisfied with the production of transfer pricing documentation by the entity; but now that transfer pricing specialists are involved, the mere representation of documentation may not be enough. Taxpayers need to make sure the documentation accurately reflects the business's functions, assets and risks.
The planning phase establishes the groundwork for the examination team with:
- An opening conference
- Taxpayer orientation
- Preparation of an initial risk analysis and examination plan
The IRS issues a mandatory transfer pricing information document request (“IDR”) with the initial contact letter, allowing the taxpayer 30 days to respond.
The most time-intensive portion of the exam, the execution phase, involves fact-finding, information gathering, and issue development. This phase involves an extensive amount of taxpayer interaction. The fact-finding phase includes additional IDRs, analysis of accounting data, interviews and site visits. The functional analysis will target the economically significant activities associated with the transaction. An economically significant activity is one that materially affects a) the price charged in a transaction and b) the profits earned from a transaction. If taxpayer collaboration and communication results in new information, the IRS will reassess the risk assessment in a mid-cycle assessment.
After completing the initial economic analysis, the IRS provides a draft of the notice of proposed adjustment (“NOPA”) or preliminary analysis, factual findings and conclusions to the taxpayer. At this point in the process the IRS may revise the NOPA and the economist's report to incorporate the taxpayer's input.
Finally, the resolution phase incorporates presentation of issues, issue resolutions and case closing. After meetings with the taxpayer, the exam team will provide a finalized NOPA. The IRS will also conduct a risk assessment to evaluate the strength of their position and consider pre-appeals resolution opportunities. The next step of the resolution phase is the revenue agent's report (“RAR/30-day letter”), followed by a taxpayer protest and IRS rebuttal. If the protest contains new factual information, the IRS will consider re-engaging the examination process.
After examination and the issuance of the 30-day letter, if the taxpayer does not agree with the adjustment, then the final step is the appeals meetings.
If the taxpayer is assessed a NOPA, it has the right to pursue an appeal. IRS Publication 556 outlines taxpayers' rights to appeal a proposed adjustment from the IRS examination team.
It is important to note that penalties under IRC Section 6662(e) and (h) are not applicable if:
- Contemporaneous documentation was provided within 30 days of request by IRS; and
- There is a reasonable basis to conclude that the selected transfer pricing method produced the most reliable measure of an arm's-length result.
With the release of the Roadmap, the TPO is providing the public with insight into what to expect during a transfer pricing examination. This transparency is intended to help improve communications and efficiency, for the benefit of both the IRS and taxpayers. With many changes in the world of transfer pricing just around the corner, it is prudent for businesses to understand transfer pricing audit risks and how to best mitigate them by staying up-to-date on upcoming changes, maintaining comprehensive documentation, and utilizing available resources.The Roadmap is referred to as a “living document” so expect the TPO to continue to review the Roadmap and make changes over time as new techniques arise or additional reference materials become available. Users are encouraged to contact the TPO to provide any input, feedback and suggestions for improvement. This roadmap represents another step by the IRS in its on-going restructuring of the way it interacts with multinational entities, especially those undergoing transfer pricing examinations.