By Ross B. Newman (CEO and Chief Economist with Altus Economics and Chairman of the Altus Transfer Pricing Network)
The US Internal Revenue Service (IRS) on June 29 issued the Transfer Pricing Examination Process (TPEP), which replaces the 2014 Transfer Pricing Audit Roadmap (Roadmap) and provides a guide to best practices and processes involved in the three phases of a transfer pricing examination: planning, execution, and resolution.
This article presents a critique of some aspects of the TPEP. The most important elements of the TPEP for taxpayers will be discussed in the second part of this two-part article. These steps are the most perilous for taxpayers under examination and they should study these sections and begin to prepare as soon as they find out they are under examination.
Number of positive aspects
The TPEP has numerous positive aspects. It is very comprehensive in identifying the appropriate steps in a transfer pricing examination. It places an emphasis on continuous open communication between the taxpayer and the team throughout the examination and the need for the team to document the steps taken in each examination. It provides an expansive list of other tax issues that may arise in an examination to help ensure a thorough examination. It identifies many Practice Units to help IRS team members master various tax issues, and lets team members know where they can obtain assistance in the IRS for difficult tax issues.
At the same time, there is a fundamental flaw in the order of the steps. The request for a taxpayer’s transfer pricing documentation is the fourth step in the preparation phase, but it should be the first step. This approach of doing research without reading the transfer pricing report will mean audits take much more time than if the transfer pricing report were requested much earlier. Even the Initial Transfer Pricing Risk Assessment is done before the transfer pricing report is requested. The transfer pricing report is a much faster means of getting information on the taxpayer’s background and operations than reviewing a Form 10-K.
An earlier review of the transfer pricing report would greatly help the IRS assess the taxpayer’s risk in audit. If the report shows the taxpayer falls well within the arm’s-length range and the method and comparable companies used to generate the range are appropriate, the IRS will know the risk is much lower than in other cases and can focus more on taxpayers without transfer pricing reports or with bad reports.
Presumably, the team is to identify the controlled transactions by referencing the taxpayer’s information returns filed with the tax return (Forms 5472 or 5471) before requesting the transfer pricing report. It would be far more efficient to review the transfer pricing report at the same time the tax return is examined so the IRS could confirm the controlled transactions analyzed in the transfer pricing report are the same controlled transactions listed on the information returns.
If the numbers are not the same, there may be an error on the information returns or in the report. If the error is in the information returns instead, the IRS can fine the taxpayer USD10,000 per erroneous information return. If the error is in the transfer pricing report, the IRS may be able to deem the transfer pricing report unreasonable or not done in good faith.
The TPEP sets an ambitious goal of having bi-weekly meetings, which seems very difficult for IRS personnel (and for the taxpayer as well). IRS agents often have multiple cases and it is unlikely that there will be much new information every two weeks. A more realistic goal would be to simply call for frequent meetings. The TPEP also places a great burden on the IRS teams involved in transfer pricing examinations.
They are asked to consider Subpart F issues, US trade or business/permanent establishment issues, hybrid entities, and tax treaties in making the preliminary working hypothesis. These are complex international tax issues and there are not many IRS agents that know these areas of tax well. Permanent establishments are an issue of international tax treaties, another area in which IRS training is not extensive.
My last comment is, as a former IRS Industry economist, I was disturbed by the many instances in which the TPEP talks of the team drafting and revising the Economists report. This is an affront to the many IRS economists working in transfer pricing. The team should certainly have input, but the economist should draft the report – that is why they call it an Economists report.