Five new transfer pricing Directives are released in the US
On January 12th, 2018, the Internal Revenue Service (IRS) Large Business and International (LB&I) Division released a set of five Directives, addressing how it approaches examination when auditing a taxpayer’s transfer pricing practices. They revisit and adapt the mandatory transfer pricing information document request (IDR), which was introduced in January 2003, the best method selection and penalty application practices.
The main points of the Directives are as follows:
- The IDR is not automatically used for LC&I examinations – it is only issued in certain scenarios.
- Examiners need to carefully assess whether penalties are appropriate for each transfer pricing matter.
- If examiners want to reject a taxpayer’s choice of best transfer pricing method, they must first gain approval through a national panel review.
The five Directives are as follows:
- Interim Instructions on Issuance of Mandatory Transfer Pricing Information Document Request (IDR) in LB&I Examinations
- Instructions for LB&I on Transfer Pricing Selection and Scope of Analysis – Best Method Selection
- Instructions for Examiners on Transfer Pricing Examination Scope – Appropriate Application of IRC 6662(e) Penalties
- Instructions for Examiners on Transfer Pricing Issue Selection – Reasonably Anticipated Benefits in Cost Sharing Arrangements
- Instructions for Examiners on Transfer Pricing Issue Selection – Cost-Sharing Arrangement Stock Based Compensation
What did the previous guidance require?
The mandatory transfer pricing IDR, which preceded the Directives, involved an automatic, routine request for a taxpayer’s transfer pricing documentation. This approach was designed to encourage taxpayers to produce clear and in-depth transfer pricing documentation and make it quick and easy for examiners to access this information. The downside of the existing guidelines was that examiners could reject a taxpayer’s chosen method of transfer pricing analysis without the need for approval or review, which meant that the taxpayer may not have been wrong but could still incur a rejection of complex and costly analysis performed initially. Such situations often resulted in a time-consuming and expensive dispute between the taxpayer and the IRS.
Why have the new Directives been released?
The new Directives aim to reduce the number of open transfer pricing cases and just focus on the most relevant ones (with relevancy referring to magnitude, type and complexity of cross-border transaction). They acknowledge that transfer pricing disputes often arise because the taxpayer and examiner have different opinions on the best method for determining arm’s length transfer pricing. Previously, such circumstances would mean that the taxpayer was at a disadvantage because the examiner could simply reject the taxpayer’s chosen transfer pricing method and replace it with their own chosen method. With the new Directives, examiners cannot reject the taxpayer’s chosen transfer pricing method without first gaining approval from a national panel review.
How do the new Directives affect taxpayers?
Under the new Directives, the IDR may only be used in certain scenarios. These are: 1) if the LB&I campaign suggests that an IDR should be issued; and 2) if the taxpayer shows “initial indications of transfer pricing compliance risk” and is being examined by employees from the IRS’s Transfer Pricing Practice (TPP) or Cross Border Activities (CBA) Practice Area. It has been noted, however, that the taxpayer is unlikely to know whether the campaign features guidance for issuing an IDR, or the examiner has identified “initial indications” of compliance risk, so there is a chance that these regulatory changes could complicate the audit process.
The local exam agents and international examiners that some well-informed taxpayers may have previously spoken to for guidance about such topics are no longer in charge of issuing IDRs. This is now up to the TPP and CBA staff conducting the transfer pricing examination.
The new Directives give taxpayers greater control over the transfer pricing method that they use, and make it harder for the analysis to be dismissed due to choosing an option that the examiner doesn’t agree with. If the examiner does not agree with the method that the taxpayer has chosen, they must go through a formal approval process to be able to reject and change it.
Why can an examiner reject a taxpayer’s chosen transfer pricing method?
Under the new Directives, the examiner is allowed to adjust the application of the taxpayer’s chosen transfer pricing method – for example, the use of comparables data – without the need for formal approval. However, if the examiner wants to reject the method completely, they must submit a recommendation, including an analysis of the methods in question. They can only do this if they determine that a different method would produce a more reliable arm’s length result. This recommendation will be reviewed by the Treaties and Transfer Pricing Operations (TTPO) Transfer Pricing Review Panel. The review will focus on three things: 1) why the taxpayer’s chosen method is not suitable; 2) whether the method can be adjusted to make it more reliable; and 3) if step 2 is not possible, which method would be better for the study.
How can taxpayers benefit from the new Directives?
To get the most from the new Directives, taxpayers need to assess the clarity, accuracy and detail of their transfer pricing study. The study must clearly outline the taxpayer’s chosen transfer pricing method, and explain in detail why they identified it as the best method. This ensures that, if an IDR is issued, or an examiner seeks to reject the taxpayer’s chosen transfer pricing method, the taxpayer is in a better position to show that they “adequately searched for, considered and applied the relevant body of information and […] adequately incorporated and addressed that data” when developing its transfer pricing documentation. Given that examiners can still relatively easily make corrections to the application of the taxpayer’s method, e.g. selection of comparables, taxpayers need to make sure to use the most recent highest quality comparables data from sources such as RoyaltyRange.
When will penalties be enforced for taxpayers?
The Directives provide guidance to examiners on when it is appropriate to penalize a taxpayer for their choice of transfer pricing. It suggests that penalties should only apply when transfer pricing adjustments go over a certain monetary threshold. The examiner must decide whether the transfer pricing method that the taxpayer selected was unreasonable or if the taxpayer made a reasonable choice based on the comparables data they had access to. The Directives are not entirely clear about when penalties can be applied, but it seems that the chosen method must be deemed unreasonable for a taxpayer to be penalized – not simply that the examiner has identified a more suitable method.
Accessing comparables data for your transfer pricing analysis
Organizations around the world use RoyaltyRange’s premier-quality royalty rates, loan interest rates and service fees databases to access high-quality comparables data for their transfer pricing documentation. With our data, you can make more informed and accurate decisions about your transfer pricing analysis, and keep clear and in-depth records that will support you in the case of a transfer pricing audit. Contact us at RoyaltyRange to find out more, or simply request a subscription.
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