A Look at IRS’s Transfer Pricing Audit Roadmap

By: Byung Kyu Cho

 Background

There are still a number of corporations which have not fully recovered from the economic downturn, which consequently leads to less tax revenue for tax authorities.  As such, some of the tax authorities around the globe have taken steps to counter the effects of the diminishing revenue by increasing a number of tax audits or performing audits in a more aggressive manner.  However, based on the statistics provided by Internal Revenue Source (“IRS”), the IRS does not fall under this category.  While the total number of business tax returns has slightly increased from 9.5 million in 2008 to 9.9 million in 2013, an examination coverage ratio, calculated by dividing the number of examined returns by the total number of returns, marginally reduced from 0.63% to 0.61%.[1]  It is not surprising to see that enforcement revenue collected during this period decreased from $56.4 billion to $53.3 billion.[2]  At a glance, it may seem that the IRS has remained friendly and not undergone dramatic changes as a whole.

 

However, when it comes to transfer pricing, it’s a different story.  Ever since the IRS settled a landmark case in 2006 in which GlaxoSmithKline Holdings Inc. agreed to pay $3.4 billion to resolve the largest tax dispute in the history of the IRS at that time[3], the IRS has continuously increased its enforcement efforts.  In 2009, the IRS added 1,200 employees to deal with international issues[4] and the following year, it even reorganized the organization structure. More specifically, in October 2010, the IRS created the Large Business & International (“LB&I”) division along with a number of subdivisions including the Transfer Pricing Operations (“TPO”) group to handle transfer pricing issues exclusively.[5]   

 

2013 was an active year in terms of transfer pricing developments.  While Congress did not pass any significant new legislations on transfer pricing and the Section 482 of the Internal Revenue Code remained essentially unchanged, Congress conducted hearings on the international tax practices of several prominent U.S. corporations, most notably Apple, Inc.  In May 2013, senior executives including Timothy D. Cook from Apple testified before the Senate’s Permanent Subcommittee about the company’s profits that had avoided U.S. taxation with its complicated transfer pricing structure.[6]  There is no doubt that the testimony significantly raised public and political awareness of transfer pricing practices in general.

 

Transfer Pricing Audit Roadmap

 

In another sign of this movement, the IRS released the Transfer Pricing Audit Roadmap (“Roadmap”) on February 14, 2014.[7]  The Roadmap provides “the transfer pricing practitioner with a comprehensive toolkit to address the key themes underlying a transfer pricing examination.”[8]  The document has 26 slides identifying steps that an examination team should take in a transfer pricing audit and provides clear direction on the roles of the team members.[9] Also, the Roadmap stipulates that an audit will consist of three phases: the planning phase of up to 6 months; execution phase of up to 14 months; and resolution phase of up to 6 months.  The following is a brief summary of the information for each phase.[10]

 

1) Planning phase[11]

 

The initial planning phase of the Roadmap can last up to six months, and starts before the 24-month audit cycle begins.  In this phase, examiners are encouraged to familiarize themselves with taxpayer’s business operations by reviewing relevant information, for example, 10-K or industry reports and to perform preliminary economic analyses.  They are also expected to review tax returns, with particular emphasis on Forms 5471, 5472, 8833, 8858, 8865, and 926 as well as Section 6662(e) documentation.  In addition, the examiners should prepare mandatory information request for targeted taxpayers and an initial examination contact letter.

 

In addition, the examiners need to prepare for an opening conference, which kicks off the 24-month audit cycle.  Following the opening conference, financial statement/books and records orientation meeting is to be held within 30 days.  Lastly, the examiners should prepare their risk analysis and audit plan, both of which are approved internally before being provided to the taxpayers.

 

2) Execution phase[12]

 

In this phase, the examiners focus on fact finding by delivering necessary additional information request, if any, conducting interviews with relevant employees, and touring the taxpayer’s plants or sites.  After gathering necessary information, they prepare a written statement summarizing material facts found and share it with the taxpayer.  Upon reviewing the statement, the taxpayer needs to provide a written confirmation or explanation of differences between its position and the IRS’s.

 

Next, the examiners start performing economic analysis and later submit to the taxpayer for discussion of inaccuracies and points of disagreement.

 

3) Resolution phase[13]

 

In this last phase, the audit team needs to meet with the taxpayer to discuss its findings on transactions at issue.  The audit team and the taxpayer need to determine whether they could resolve disputed issues.  If they cannot resolve, the audit team will prepare a revenue agent’s report as well as 30-day letter for unresolved issues, hold the Appeals pre-conference meetings, and attend the post-Appeals meetings.

 

Recommendation

 

In the introduction of the Roadmap, the IRS explicitly states that the Roadmap “is not intended as a template – every transfer pricing case is unique, and the team will need to exercise its own judgment about how to best use these guidelines.”[14] However, there is no doubt that taxpayers can take advantage of the Roadmap by going over every step to understand the IRS’s approaches and prepare for potential transfer pricing examination.  Based on the survey of 680 tax directors, vice presidents of tax, and chief tax officers in May 2014, 40 percent of the respondents believed that future transfer pricing audit process would be smoother due to the introduction of the Roadmap.[15]  In addition, 20 percent of the respondents mentioned that the Roadmap would expand taxpayers’ understanding of the IRS’s transfer pricing concerns, and 15 percent anticipated it would provide them with enhanced certainty on tax audits.[16]

 

With up to six months of advance review and planning before the audit actually begins, it seems clear that most part of transfer pricing audits will be preliminarily determined in the planning phase.  As such, taxpayers should prepare thoroughly for all meetings during this phase, since the audit team will be relatively receptive to the taxpayer’s arguments.  This idea is supported by the above survey; 53 percent of the respondents indicated that they would expand their preparation for transfer pricing audits by performing self-assessments, organizing relevant documentation and files in advance, and being more familiar with what is publicly available about their corporations’ profile.[17]     

 

Furthermore, as the Roadmap is still “work in process and [taxpayers] are strongly encouraged to contact the Income Shifting Issue Practice Networks (IPN) with any corrections, proposed additions or deletions, or other suggestions for improvement,” taxpayers should stay focused on any further developments.[18]

 

Conclusion

 

By issuing the Roadmap, the IRS delivered a clear message; it wants the examiners to be more educated and able to conduct audits in consistent, reasonable and careful manner.  At the same time, the Roadmap would allow the taxpayers to have appropriate expectations, better prepare for the audits in advance, and most importantly, avoid unnecessary arguments with the IRS and potential tax liabilities. 

 

At the 2nd Annual International Tax Enforcement Conference on March 18, 2014, the Deputy Commissioner of LB&I Division cited examples of some countries that have moved toward a model of “cooperative compliance” in their interactions with taxpayers.  The Deputy Commissioner added that “it is hard to move aggressively in that direction, but conceptually it’s where we’d like to go.” Supported by the IRS’s encouraging message, it seems possible that the model of “cooperative compliance” would be established in the U.S. someday.  In the end, the IRS might not be an undefeatable enemy but a supportive friend.