Its introduction starts with an ominous tone that IRS examinations of the transfer pricing policies of any particular multinational under scrutiny are complex projects requiring up-front planning where the “proper development of a transfer pricing position may take as much as two to three years or more”. We shall note, however, that the overarching theme of this Roadmap traces back to very old fashioned and sensible concepts, which should encourage multinationals to properly document the arm’s-length nature of their intercompany policies.
The Roadmap lays out a three-phase process for any inquiry into a multinational’s transfer pricing: (1) planning that includes pre-examination and initial risk analysis; (2) execution that includes information gathering and issue development; and (3) resolution.
In the pre-examination and initial risk analysis, the IRS team is encouraged to form a working hypothesis with respect to the multinational’s worldwide effective tax rate and whether it is indicative of income shifting.
This IRS Roadmap appears to be echoing messages in the OECD’s Action Plan on Base Erosion and Profit Shifting. The 10-K filings often provide information as to the US share of pretax income as well as the ratio of foreign taxes to foreign based income. The IRS team might therefore draw inferences as to the possibility that the multinational has used transfer pricing to shift income to low tax jurisdictions. We should, however, hasten to add that an effective tax rate below the US statutory rate may be precisely the result of arm’s-length pricing when the drivers of a multinational’s profits are in large part due to functions performed abroad.
Breaking down the stages
The planning stage includes having the examination team review any transfer pricing documentation that the multinational has prepared. Taxpayers should be encouraged to provide the IRS team with appropriate documentation lest the IRS team develop a faulty and averse initial working hypothesis.
The introduction to the Roadmap emphasises that transfer pricing issues turn on the facts surrounding the intercompany pricing issue. The Roadmap encourages IRS examiners to construct a compelling story of what drives the multinational’s financials based on the functions, assets and risks of the related party entities involved in the intercompany transactions at issue. If the taxpayer’s financial results are reasonable and if its transfer pricing methodology fits the fact profile, then the Roadmap suggests that IRS examination should not pursue this issue. If, however, the taxpayer’s results are “at odds with common sense and economic reality”, the Roadmap suggests that the transfer pricing issues deserve further scrutiny.
If the taxpayer does not provide a convincing documentation report, then the IRS team may proceed to the next stages.
The execution stage envisions the Examiner requesting information from the taxpayer on the relevant transfer pricing issues so that the transfer pricing specialist can prepare his report based upon what hopefully are agreed facts. Based on its understandings of the facts, the IRS team will choose what it thinks is the most appropriate methodology for the relevant intercompany transactions and then apply its methodology to arrive at a conclusion as to what would represent an appropriate intercompany price. If the IRS’s conclusion as to the appropriate intercompany price differs from the taxpayer’s actual transfer pricing, then the IRS team will have arrived at its basis for a proposed section 482 adjustment based on its understanding of the relevant facts as well as its proposed methodology and application.
The resolution stage follows this execution phase. The taxpayer may disagree with the IRS position and is encouraged to state its reasons for disagreement. At this stage, the taxpayer and the IRS team should consider alternative means of resolving any particular transfer pricing dispute. Multinationals recognise that the IRS is not the only national tax authority involved. Even if they accept the IRS position, they must address the expectations of the tax authority of the foreign affiliate involved in the transfer pricing dispute. Unless the foreign tax authority ultimately agrees with the IRS position, the multinational is faced with the prospect of double taxation. While the Roadmap does not explicitly mention the Competent Authority process, any proper resolution of the issue should consider getting the IRS and the foreign tax authority to ultimately agree to a proper resolution.
Hypothetical examples
Let us consider two hypothetical examples where the IRS’s understanding of the facts differs from what the multinational presented in its documentation report. The first example involves a US distribution affiliate selling products manufactured by its foreign parent.
The documentation report asserts that the foreign parent owns all valuable intangible assets and puts forth a standard application of the comparable profits method to suggest that a modest operating margin is reasonable. The IRS team, however, asserts that the US affiliate owns valuable marketing intangibles and insists that the transfer pricing be evaluated using the residual profit split method.
Our second example of potential disagreement between the taxpayer and the IRS team involves a US parent purchasing goods from a Chinese manufacturing affiliate. The IRS team is very quick to assert that the Chinese affiliate is nothing more than a contract manufacturer that deserves nothing more than a modest return on its tangible assets. The representatives of the multinational, on the other hand, have made two assertions in the documentation report:
· The Chinese affiliate deserves profits over and beyond this modest return to tangible assets as it generates incremental profits through location savings; and
· The intercompany pricing is consistent with market prices for similar goods, which implies that the preferred method of analysis is the comparable uncontrolled price approach.
While multinationals have presented such arguments in their transfer pricing documentation reports, IRS teams at times have rejected such claims preferring to adopt the comparable profits method with the foreign manufacturing affiliate as the tested party. In both examples, the foreign tax authority is likely to assert that the original transfer pricing policy was reasonable.
The IRS Roadmap appears to suggest that, once the IRS examination team has presented its findings, it is up to the multinational to resolve any transfer pricing disagreements with the foreign tax authorities. Unfortunately, this has always been the reality as IRS examination simply hands off the transfer pricing dispute to either IRS Appeals or to the Competent Authority process. This reality also violates the spirit of the IRS team working with the multinational to reach an agreed upon position based upon an agreed upon set of relevant facts.
By James Harold McClure, senior manager of transfer pricing at Thomson Reuters
