Transfer pricing controversy and risk management
Cindy Hustad and Keith Reams review the general procedures many tax authorities follow to conduct transfer pricing audits and provides specific examples of the transfer pricing audit procedures in the US.
In recent years there has been a flurry of activity around the world involving international tax and transfer pricing, from legislation and new regulatory rule-making to intensified tax audits and controversy. The OECD's tax working group has released new guidance in connection with its base erosion and profit shifting (BEPS) initiative, which by all accounts is expected to result in even more scrutiny, with the possibility of more controversy and likely tax litigation.
Transfer pricing and international tax planning have been in the news recently, with the EUn's Competition Commission bringing claims of unfair state aid against certain member states that have traditionally provided rulings and other fiscal regimes to large multinational organisations.
Parliamentary hearings have been held in Australia and the UK and executives have been asked to testify about their companies' international tax planning. The press has even started running stories about companies that have engaged in what historically has been standard international tax planning – all perfectly within the law – yet suggesting potential anti-competitive or, in some instances, nefarious motives.
In an increasingly large part of the world, and in all of the advanced economies, there is legislation and extensive statutory, regulatory, and administrative guidance governing international tax and transfer pricing, as well as procedures the tax authorities follow in their conduct of transfer pricing audits. While transfer pricing audits are part of the general overall audits of multinational taxpayers, because of their complexity and magnitude, they frequently become the primary focus and a major area of tax controversy.
How the tax authority selects transfer pricing audit cases
The selection of taxpayers subject to audit may be guided by risk factors or may be random. Tax authorities typically classify taxpayers according to revenue, asset size, and other relevant factors. The largest corporations are generally under continuous audit by many tax authorities. This is especially true in the US, where IRS examiners are often stationed at taxpayers' corporate headquarters. Midsize corporations can be chosen for audit at random or after an initial review indicates that some issues are present that warrant specific review. Tax authorities also periodically examine cases from specific economic or industry sectors.
In the US, the IRS recently announced that it will institute issue-focused, strategic audits. Returns will be selected for audit based on the issues they present, and agents will be instructed to focus on specific issues. Continuous audits of corporations will be replaced by audits of specific issues. Transfer pricing, however, may be expected to continue to be an area of focus of tax audits, and will be an issue that tax authorities will continue to select to audit.
How a taxpayer will find out it has been selected for audit and what the official notification process will be
In the US, the IRS notifies a taxpayer that it has been selected for audit by sending out an opening letter. This letter will relate to a specific accounting period and will be issued to the taxpayer. Generally, standard information document requests (IDRs) are attached to the letter. Once the taxpayer receives the letter, the taxpayer and the IRS will establish a date for the opening conference, at which the IRS will explain the audit process. At this point in an audit, the tax authority will also expect the taxpayer to respond to the initial IDRs, if it has not yet done so. Similar procedures are followed in many other countries.
Procedure on notification of transfer pricing audit
The taxpayer should review the standard initial IDRs and begin to gather the requested information, which includes tax work papers, trial balances board of directors' meeting minutes, and financial statements. At the beginning of the audit, many tax authorities will request the taxpayer's contemporaneous transfer pricing documentation as required by local transfer pricing rules. In some countries, that documentation may have been provided at the time of filing the tax return. Time is generally of the essence once a request has been made. In the US, transfer pricing documentation must be provided within 30 days of a request by the IRS. If the documentation is not provided within 30 days, the taxpayer cannot be assured of penalty protection. Under US rules, the documentation must also meet certain requirements under the regulations to confer penalty protection (see discussion below).
Legislative, regulatory, or other procedures applicable to taxpayers subject to a transfer pricing audit
There are a number of legislative, regulatory, and other procedures applicable to taxpayers subject to a transfer pricing audit. Some of the more significant procedures include the following:
At the time the taxpayer files its tax return, as a general matter, the taxpayer must have, and maintain, the information necessary to support its return filing position, including its transfer pricing results. To avoid the imposition of transfer pricing-specific penalties, the taxpayer must have prepared, by the time it files its tax return, documentation and must provide this documentation typically within 30 days of a request. The transfer pricing documentation must include:
An overview of the relevant business, including an analysis of the economic and legal factors that affect the pricing of its property or services;
A description of the taxpayer's organisational structure (including an organisation chart) covering all related parties engaged in transactions potentially relevant under transfer pricing regulations, including affiliates in one country whose transactions directly or indirectly affect the pricing of property or services in another country;
Any documentation explicitly required by the regulations;
A description of the method selected and an explanation of why that method was selected;
A description of the alternative methods that were considered and an explanation of why they were not selected;
A description of the controlled transactions (including the terms of sale) and any internal data used to analyse those transactions;
A description of the comparables that were used, how comparability was evaluated, and what (if any) adjustments were made; and
An explanation of the economic analysis and projections relied on in developing the method.
In addition, the taxpayer usually must maintain and be able to provide the following items:
A description or summary of any relevant data the taxpayer obtains after the end of the tax year and before filing a tax return, which would help determine if a taxpayer selected and applied a specified method in a reasonable manner; and
A general index of the principal and background documents, and a description of the record-keeping system used for cataloguing and accessing those documents.
Once the audit begins, there are typically guidelines and various directives that the tax examiners must follow in auditing transfer pricing issues. For instance, in the US, the IRS's Transfer Pricing Audit Roadmap provides detailed guidance to agents for the conduct of a transfer pricing audit. The roadmap anticipates that the agents will engage in extensive factual development, including interviews of company and non-company personnel.
In addition to the primary agents on the audit, the tax examiners will often request assistance from transfer pricing specialists with experience reviewing such issues. In the US those specialists are now generally part of the Transfer Pricing Practice (TPP). The TPP is comprised of economists and tax law specialists who focus on transfer pricing. The economist, with the tax law specialist's guidance, will develop the facts necessary to perform a functional analysis and develop the economist's transfer pricing methodology. For potentially large cases, the IRS may also seek the guidance of IRS counsel.
How the tax authority compiles information on a taxpayer for a transfer pricing audit
Tax examiners typically gather information from a number of sources, including tax returns, financial statements, transfer pricing documentation, websites, and other public information. The tax examiners will also request additional documentation and information during the course of a transfer pricing audit. In the US examiners gather information from the taxpayer and seek interviews and site visits during the audit through IDRs. The IRS, in February 2014, released a directive on issuing IDRs that calls for the IRS to discuss the requests and timing of responses to those requests with the taxpayer before issuing them. Generally, the IRS expects a response to its requests within 15 to 30 days. If the IRS does not receive responses, the directive requires the IRS to take steps that can lead to the judicial enforcement of administrative summonses if the taxpayer does not provide the information voluntarily.
In some countries, the taxpayer may withhold documents based on assertions of privilege. Several types of potential privilege exist, including attorney-client privilege, taxpayer-adviser privilege, and work product privilege. Generally, for a document to be privileged, the client must be seeking legal or tax advice, with the intent that the communication be kept confidential. The privilege can be waived if the client discloses the information to another who is not in a privileged relationship to the client. The privilege can also be waived if the taxpayer puts the advice in issue. In the US, this issue has recently arisen in situations where the client uses the Internal Revenue Code section 6662 documentation report as a defence against the IRS's imposition of a transfer pricing penalty. If the taxpayer acted with reasonable cause and in good faith in using the transfer prices claimed in its tax return it would not be subject to a section 6662 penalty.
With respect to the section 6662 transfer pricing penalty, however, the taxpayer must show that it had the contemporaneous transfer pricing report prepared at the time it filed its return. In Eaton Corp. v. Commissioner, Dkt. No. 5576-12, the US Tax Court ruled in July 2015 that by relying on documentation reports as a defence to the section 6662 transfer pricing penalty, the taxpayer had placed its subjective belief concerning its transfer pricing at issue. Therefore, it had waived the privilege with respect to other advice it had received concerning the transfer pricing. This order has potentially wide-ranging ramifications.
In many countries, if the tax examiner does not receive the information requested, it may issue an administrative summons. In the US, such summonses are not self-enforcing; if the taxpayer does not comply with a summons, the IRS must enforce the summons in federal district court. Generally, the bar to enforcing a summons is low: The IRS must show that the information requested is relevant, that it complied with the administrative steps for issuing the summons, that the information is not in its possession, and that the summons was not issued for an improper purpose. The IRS cannot force a taxpayer to create a document through the summons process, but it can summon witnesses to give testimony.
Tax authorities often issue summonses to third parties to gather information. They can summon former employees or third parties to a contract, as well as bank and other relevant records from third parties. In recent years, the IRS has used third-party summonses more frequently to interview former employees of taxpayers.
Tax examiners typically have tools to obtain information from foreign parties. In recent years, the IRS has been using the information-gathering tools provided in treaties. In addition, the IRS can ask a US corporation to act as an authorised agent for a foreign corporation that owns at least 25% of the US corporation. In essence, the US corporation becomes an agent for acceptance of service for IRS requests for information and documents from the foreign parent and for any administrative summons for the parent's records. If the US corporation does not agree to be the foreign parent's agent, the IRS may impose significant monetary penalties on the US corporation, and determine the appropriate transfer price based on the information already in the IRS's possession. The US corporation will not be allowed to introduce any additional information.
The IRS has another powerful tool at its disposal, which it has begun to use more frequently. The IRS can require the taxpayer to provide information by issuing an administrative summons pursuant to section 7602 of the Internal Revenue Code. In addition, the IRS can issue one designated summons during the course of an audit of a corporation, which will suspend the running of the statute of limitations during any judicial enforcement proceeding of that summons. The IRS can also issue summonses related to that designated summons within 30 days of the issuance of the designated summons. If any one of those summonses is subject to judicial enforcement, the statute of limitations is suspended. This is a powerful enforcement tool, which the IRS has recently used in its examination of corporate taxpayers.
The recently released OECD guidance on documentation, particularly regarding country-by-country, master file, and local file requirements, is intended to provide local tax authorities, particularly outside the US, with increased access to information that was historically available only to tax examiners in the company's headquarters country.
Issues that may trigger a transfer pricing audit by the tax authorities
Items in corporate tax returns that might trigger a transfer pricing audit include cost sharing arrangements, licensing of intangibles, transfers of intangibles, business restructurings, and management charges. Many tax authorities have stated that they look for transfers of intangibles from high-tax jurisdictions to low-tax jurisdictions.
In the US, the IRS continues to focus on cost sharing arrangements, advocating the use of the income method and particularly focusing on the life of the platform contributions. In the case of business restructurings, the tax authorities focus generally on the substance of the operations in the foreign jurisdictions, as well as on the pricing of management services fees. This continues to be the case in many areas of the world, particularly in Latin America and in some parts of Asia, where management fees are particularly frowned upon and deductions for which are routinely denied.
Tax authorities are also increasingly focusing their attention on supply chain restructurings of multinational businesses, whereby some or all of the headquarters activities are transferred to a foreign jurisdiction. In those instances, the tax authorities not only focus on the transfer price for any intangible property the foreign entity receives, but typically they also examine the substance of the foreign operations. More specifically, the tax authorities inquire as to whether the foreign entity can provide, and in fact does provide, the services and supervision claimed. To support its position, the taxpayer may be asked to provide personnel to be interviewed in the foreign jurisdiction, as well as performance evaluations, job descriptions, and other contemporaneous evidence of the foreign entity's direct involvement and supervision of foreign activities.
Tax authorities also continue to audit local subsidiary corporations of foreign parent entities, examining closely the services they perform on behalf of the foreign parent. In recent audits, the tax authorities have attempted to determine if such services may be in effect creating intangibles, such as marketing or brand intangibles, in the local country for which the local entity should be compensated beyond a routine return. Similarly, concepts such as location savings are appearing in many tax audits, particularly in places such as China and India.
Documents by the tax authorities from the taxpayer during a transfer pricing audit
In addition to the information that would be included in the transfer pricing documentation discussed above, tax authorities often will request any documents and information that may be relevant to the taxpayer's transfer pricing. The actual information requested will be dictated by the facts and circumstances of the transactions being audited. Tax authorities may request documents and information supporting the assumptions, conclusions, and positions in the transfer pricing documents. They also may request presentations by the corporate board of directors, audit committee reports, or other documents that may concern the transactions under audit, including any meeting notes and interviews with individuals involved in those transactions. Tax authorities also frequently request documents and interviews to perform a functional analysis with respect to the transactions. Some examiners may even request information and interviews from third parties.
In the US, the IRS also examines closely any set-off claims the taxpayer may assert against proposed transfer pricing adjustments. Generally, the taxpayer must file its set-off claim under Revenue Procedure 2005-46 within 30 days of receiving the examination report. However, the IRS is generally requiring earlier notification, so that it may fully examine the basis for the claimed set-off. Therefore, taxpayers who wait until after receiving the examination report to file a set-off claim may risk extending the IRS audit.
Restrictions on a company's business during a transfer pricing audit
Generally there are no restrictions on a company's business during audit. However, for publicly traded companies that are traded on public exchanges, significant potential audit adjustments and/or risk may be subject to disclosure by regulatory authorities. In addition, in some countries, the tax authorities may seize files and computers of taxpayers during the audit process, which can have the effect of temporarily shutting down company operations.
Restrictions on the taxpayer's advisers during a transfer pricing audit
Taxpayers' representatives are generally subject to rules governing their practice before the local tax authorities. In the US, practice before the IRS is set forth in IRS Circular 230. Generally, the rules require that advisers exercise due diligence in responding to information document requests, and that they provide all information requested by the tax authority, unless the information is subject to privilege. Failure to do so can subject a practitioner to discipline for violating Circular 230. In addition, if the adviser knows that information has been omitted from a response, he or she must inform the client of the omission and possible penalties and, if necessary, withdraw from the case. Sanctions for violating Circular 230 include censure, suspension, or disbarment from practice before the IRS.
Length of a transfer pricing audit
Timing can vary depending on the tax jurisdiction and the complexity of each case. Typically, a transfer pricing audit may last from six months to four or more years. The length depends on the scope of the issues and whether the taxpayer will agree to an extension of the statute of limitations. In the US, after the IRS Examination Division issues Notices of Proposed Adjustments (NOPAs) and the Revenue Agent's Report (RAR), the taxpayer may appeal the Examination Division's adjustment to the IRS administrative Appeals division. Generally, the taxpayer files a written protest setting forth its facts and position. Other countries have similar appeals processes. In the US, the formal appeals protest is often a lengthy, complete, and highly technical document. After a protest is filed, the taxpayer will meet with the appeals officer on one or more occasions to discuss settlement. An appeal can typically take anywhere from six months to three years to reach resolution.
On close of an audit
If the tax authority agrees with the taxpayer's position, it will issue a no change letter and/or accept the taxpayer's return as filed. If the tax authority proposes adjustments with which the taxpayer disagrees, the taxpayer has several options. If a tax treaty exists between the country where the dispute arises and the country of the affiliate on the other side of the intercompany transaction, the taxpayer may seek double tax relief through a mutual agreement procedure (MAP).
The taxpayer may also appeal transfer pricing adjustments administratively, exercising care to protect the taxpayer's ability to obtain full double tax relief through any tax treaty MAP if such relief applies, and if the administrative appeal results in a reduction but not elimination of the proposed adjustment.
Another alternative is for the taxpayer to challenge the adjustment judicially. If seeking judicial redress, care must be taken to protect the taxpayer's ability to obtain full double tax relief through a tax treaty MAP if the relief applies and if the administrative appeal results in a reduction but not elimination of the proposed adjustment.
Most taxpayers choose to appeal the audit adjustment through the local country's administrative appeals process. In the US, this process requires the taxpayer to submit a written protest to the Appeals Office, setting forth the facts and the taxpayer's technical position. The appeals officer has the ability to apply a hazards of litigation standard to resolve the issues. Recently, the IRS has instituted the Appeals Judicial Approach and Culture programme, which reinforces Appeals' role as a settlement body, not a fact-finder. If the taxpayer introduces new facts at Appeals, the case will be returned to the Examination Division to review those facts. If the taxpayer introduces new legal theories, the Examination Division will generally be provided an opportunity to comment. In practice, this has resulted in longer examinations as the Examination Division strives to develop cases more fully.
Section 6.04 of Rev. Proc. 2015-41 requires taxpayers to sever a competent authority issue from a case in appeals (or use the simultaneous appeals procedure) in order to preserve its ability to request competent authority assistance under MAP.
Managing audit risk
The best way to manage audit risk is to establish and follow effective, sustainable transfer pricing policies, prepare annual contemporaneous transfer pricing documentation establishing the appropriateness of transfer pricing results, and provide transfer pricing documentation within 30 days of a tax authority request. To further mitigate audit exposure, companies should confirm that they are fully compliant with the relevant tax laws, file tax returns within the prescribed time limits, pay tax on time, and monitor their transfer pricing results, including key indices, such as industry margin profiles, on an ongoing basis during the year. In the US, a taxpayer can review the Transfer Pricing Audit Roadmap or its equivalent in other tax jurisdictions and maintain the documentation often requested during an audit to confirm that it can support its transfer pricing policies and results. Finally, in an increasing number of countries taxpayers may enter into an advance pricing agreement (APA) with the local tax authority to manage their overall tax examination risk.
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Cindy Hustad is a director in the San Francisco office of Deloitte Tax. She is the West Region tax controversy competency leader and represents corporate clients before the IRS.
During her 16-year tenure at Deloitte, Cindy has successfully represented many large and small clients, both at the examination and appeals levels, focusing on transfer pricing and international issues. Before joining Deloitte, Cindy was a special trial attorney with the IRS Chief Counsel's Office, where she represented the IRS in US Tax Court in more than 50 litigated cases. During her period at the IRS, Cindy advised large-case agents, international examiners, and appeals officers in some of the largest examinations undertaken by the IRS involving a wide range of complex international and domestic corporate issues. Cindy also represented the government in litigating several large corporate tax and transfer pricing cases, including DHL v. Commissioner. Cindy has held the position of law clerk at the US Court of Appeals for the Ninth Circuit, as well as acting assistant professor at the New York University Law School.
Cindy is admitted to the state bar of California, holds admission to practice at the US Tax Court, and is a past president of the San Francisco Tax Litigation Club. She was also the recipient of the IRS Chief Counsel National Litigation Award.
Cindy holds a BA from the University of Wisconsin, a JD from the University of Wisconsin Law School, and an LLM (tax) from the New York University Law School.
555 Mission Street
San Francisco, CA 94105-0920
Tel: +1 415 783 6088
Keith Reams is a principal in the Sacramento office of Deloitte Tax, and the US and global leader for clients and markets for Deloitte's global transfer pricing practice. He has advised clients around the globe on intercompany pricing transactions with respect to income tax regulations in Argentina, Australia, Belgium, Brazil, Canada, Chile, China, Colombia, Czech Republic, Denmark, France, Germany, India, Ireland, Israel, Italy, Japan, Korea, Luxembourg, Malaysia, Mexico, the Netherlands, Norway, Peru, Poland, Singapore, South Africa, Spain, Switzerland, Taiwan, Thailand, the UK, and the US.
Keith has assisted numerous multinational companies with international valuation and economic consulting services involving mergers and acquisitions activity, international tax planning, and restructuring and reorganization of international operations. Keith is on the global tax management team for Deloitte's technology, media, and telecommunications practice and is a leader in the area of transfer pricing for newly emerging industries, such as electronic commerce and cloud computing, where he has extensive experience around the world in helping clients extend their business models into new territories.
Keith has testified as a qualified specialist in numerous valuation and transfer pricing disputes. In addition, he is one of only three economists in the US approved by the New York State Department of Taxation and Finance to provide transfer pricing knowledge and testimony in cases involving cross-border transactions within commonly controlled affiliated groups. He has also helped many clients to successfully resolve valuation and transfer pricing disputes before they reach trial.
Keith completed course requirements for a PhD in international finance from New York University. He holds a MA in economics from California State University Sacramento and a BS degree in chemical engineering from Stanford University.