Is Your Transfer Pricing Documentation up to IRS Standards?
Is your transfer pricing documentation up to IRS standards, and what makes transfer pricing documentation acceptable to them? The IRS attempted to answer these questions in a recently published frequently asked questions (FAQ) document regarding transfer pricing documentation. The IRS released the FAQ to incentivize U.S. taxpayers to improve the quality of their documentation. This was in response to a 2018 Public Report published by the IRS Advisory Council Large Business & International Subgroup (Subgroup), which found that various stakeholders in the U.S. transfer pricing community believe the quality of transfer pricing has declined over time. The Subgroup recommended that the IRS issue guidance on how taxpayers could improve the quality of their documentation.
In the U.S., transfer pricing documentation as described in Internal Revenue Code (IRC) Section 6662(e) is needed for penalty avoidance in the event of an IRS examination. Such transfer pricing documentation needs to be in place at the time the tax return was filed. If transfer pricing documentation is found not to exist at the time the tax return was filed and the IRS makes an adjustment to the taxpayer’s transfer prices, which trigger certain thresholds attributed to the adjustment, penalties of either 20 percent or 40 percent of the additional tax due could be imposed. Therefore, it is imperative to have robust transfer pricing documentation to avoid these penalties. The overall theme of the FAQ is that transfer pricing documentation should thoroughly meet all transfer pricing documentation requirements outlined in U.S. Treasury Regulation §1.6662-6(d)(2) and that any anomalies to transfer prices historically used should be well-explained in the transfer pricing analysis.
The FAQ indicates that “transfer pricing reports that comprehensively document the reasonable selection and application of a transfer pricing method help demonstrate low levels of compliance risk and in turn help support early deselection of the transfer pricing issue from further examination.” The IRS pointed out several features of proper documentation that IRS agents should look for to determine whether transfer pricing should be pursued during an IRS examination. A summary of the noted features of the FAQ is below.
- Taxpayers should consider performing a self-assessment, which is essentially a sensitivity analysis of the comparable companies in their data set, e.g., would the removal of one of the comparable companies cause the taxpayer to fall outside the arm’s-length range, or would the results of the data set be dramatically different using alternative profit-level indicators?
- If segmented financial data is used to test the arm’s-length nature of the intercompany transaction, be sure this is noted and include an explanation of how it was constructed.
- Explain the allocation of profits between entities involved in the intercompany transaction. Look at the profit realized on both sides of the intercompany transaction, not only the tested party. Is the economic result equitable from the vantage point of both parties?
- The Functional Analysis should include a description of risks associated with each of the intercompany transactions and how they are allocated between the related parties involved in each of the subject intercompany transactions.
- Include an analysis of any business circumstances that created an atypical result for the intercompany transaction or any challenges posed in the Economic Analysis because of business results for that year.
The IRS also noted several features of inadequate transfer pricing documentation. The insufficiencies listed below may result in transfer pricing becoming the focus of an IRS examination. Please note this is not a complete summary of the deficiencies listed in the IRS’ FAQ.
- The Company and Industry Analysis sections should be descriptive enough that the IRS agent understands the business and the industry in which the taxpayer operates. The Functional Analysis should be well supported factually and should not rely on broad-brush assumptions about the business.
- The Functional Analysis should not be a checklist; rather, it should be a robust analysis that links facts to the analysis.
- The allocation of risks found in the Functional Analysis should be consistent with those outlined in the intercompany agreements. The allocation of risks in the Functional Analysis should be compared to the comparable companies used in the Economic Analysis, and any adjustments to the comparable companies to account for risk should be adequately explained.
- The best method selection analysis also should include why the other potential methods were rejected for analyzing that intercompany transaction.
- Adjustments to the comparables’ data, e.g., working capital adjustments, location savings adjustments, etc., should be clearly outlined in the Economic Analysis.
The above is a high-level summary of what the IRS expects from taxpayers during an examination where transfer pricing documentation is requested. Reach out to your BKD Trusted Advisor™ or use the Contact Us form below to discuss a review of your current transfer pricing documentation or if you are interested in establishing transfer pricing documentation for IRC §6662(e) penalty protection.