New IRS Directives Issued for Transfer Pricing Examinations
On January 12, 2018, the Large Business and International Division (“LB&I”) of the Internal Revenue Service (“IRS”) issued five directives which provide instructions on how IRS agents should approach an audit examination. These directives will remain in effect through January 12, 2020 (or until the appropriate Internal Revenue Manual and related references are updated).
Prior to the issuance of the new directives, the IRS was required to request contemporaneous transfer pricing documentation at the beginning of an examination of a taxpayer engaged in cross-border transactions. This request is referred to as a mandatory transfer pricing information document request. This documentation is required under Internal Revenue Code Section 6662(e) to provide penalty protection to taxpayers in the event of a transfer pricing adjustment upon audit.
The new directives focus on:
- The issuance of mandatory transfer pricing information document requests (“IDR”);
- The appropriate application of penalties;
- The analysis of the best method selection;
- Reasonably anticipated benefits in the cost sharing arrangements (“CSA”); and
- CSA stock-based compensation.
The integration and implementation of the five directives are aimed at creating more efficiency within the IRS during audit examinations. The directives that will affect most taxpayers with cross-border transactions are the IDR directive and the best method selection directive.
The new IDR directive limits the use of mandatory transfer pricing IDRs to specific situations. While this change appears to reduce the requirement that companies with cross-border transactions provide contemporaneous documentation upon audit, it does not preclude the possibility that such IDRs will be requested during the course of the audit.
Previously, the mandatory transfer pricing IDR required taxpayers to provide a detailed analysis to support the arm’s length nature of the taxpayer’s transfer pricing. Taxpayers with assets equal to or greater than $10 million were potentially subject to penalties if the appropriate documentation was not provided to the IRS within 30 days of the IDR.
In October 2017, the IRS LB&I implemented 13 new campaigns aimed at expanding the focus areas under its issue-based examination, with an emphasis on international issues. The campaign process directs IRS agents to target issues that present risk and require a response. Transfer pricing is one of the focuses under the campaigns.
Under the new IDR directive, the instructions state that there are only two cases where an IDR is required:
- Examinations under approved LB&I campaigns, where there is specific guidance for the mandatory transfer pricing IDR provided within the campaign; and
- Examinations with an initial indication of transfer pricing compliance risk where Transfer Pricing Practice and/or Cross-Border Activities Practice Area employees are assigned to the case.
If neither of those two criteria is met, the mandatory transfer pricing IDR will not be issued. It is more likely than not that the remainder of the audit process will remain the same. Consistent with the prior rules, if a taxpayer is unable to provide accurate documentation within 30 days of being issued an IDR, the taxpayer can face penalties of 20 to 40 percent of any transfer pricing adjustment levied. If the taxpayer is issued an adjustment and penalty, the taxpayer has the right to pursue an appeal.
It would appear that LB&I IRS agents may experience fewer examinations than before the new IDR directive was implemented. However, the new IDR directive does not explicitly state that it exclusively applies to examinations of LB&I taxpayers. This leaves it open to interpretation and potentially means that middle-market companies with global operations may feel the effects of the new IDR directive, in which case more transfer pricing examinations may occur.
Best Method Directive
The directive regarding the best method selection states that an IRS examiner cannot disregard the taxpayer’s transfer pricing analysis and best method selection. Previously, the ruling on a taxpayer’s analysis of the best method selection was at the discretion of the IRS examiner. If the IRS examiner did not see the analysis as favorable, s/he could simply ignore it and draft another analysis, potentially resulting in penalties for the taxpayer. Now, if the IRS examiner wishes to challenge the best method selection, s/he must go through an approval process providing details to the Treaties and Transfer Pricing Operations Transfer Pricing Review Panel as to why the taxpayer’s method is unreliable, whether it can be adjusted to make it more reliable, and what method is more reliable and why.
As a result of the new directives, the IRS is no longer requiring a transfer pricing IDR for each taxpayer and cannot simply ignore the transfer pricing analysis. Despite the new directives, it continues to be in the taxpayer’s best interest to have transfer pricing documentation prepared and ready to hand to the IRS in order to avoid penalties. Taxpayers with cross border transactions may no longer be under the extreme scrutiny of an IRS examiner, but they must remain diligent in keeping their transfer pricing documentation current and accurate.
Should you have questions on these new directives, contact your Marcum tax advisor.