On February 14, 2014, the Transfer Pricing Operations office of the Internal Revenue Service (IRS) released the Transfer Pricing Audit Roadmap (the Roadmap). The Roadmap is intended to provide IRS exam teams with the tools and guidance necessary to identify early in the examination those transfer pricing issues that merit pursuing, and then to assist the teams in developing more defensible adjustments. The Roadmap also provides taxpayers with insight into what they can expect during transfer pricing examinations. This article identifies the key themes of the Roadmap, summarizes the proposed phases of the transfer pricing audit, and considers ways in which taxpayers can use it to prepare for transfer pricing audits.
Key Roadmap concepts
The Roadmap sets forth the following four key concepts:
Additionally, under the Roadmap, transfer pricing audits should be conducted with increased transparency. Exam teams also are encouraged to involve experts within the IRS to provide guidance and assistance, as appropriate, during the exam.
While not mandating a two-year cycle for all transfer pricing examinations, the Roadmap suggests that complex transfer pricing issues may typically take 24 months to resolve, with the cycle consisting of three discrete phases: (1) planning (months 1 through 6), (2) execution (months 3 through 17), and (3) resolution (months 18 through 24).
Phase 1: Planning
In the planning phase, IRS examiners develop a working hypothesis of the case and perform an initial risk assessment, which should be shared with the taxpayer. Developing the initial risk assessment is fundamental to the audit process under the Roadmap; before proceeding with a potentially protracted examination, agents must first determine whether a case is worth pursuing.
Because transfer pricing cases are generally "won or lost on the facts," the Roadmap encourages examiners to focus on the facts and economics of intercompany transactions—as opposed to legal interpretation of the Regulations—and to develop what it refers to as an "effective story" early in the exam to explain the taxpayer's value chain, competitive position in the industry, and financial results. "If indications are that the tax result claimed by the taxpayer is at odds with common sense and economic reality—'too good to be true'—chances are it is a good candidate for further scrutiny," according to the Roadmap. Conversely, if the economics are reasonable, the case may not be worth pursuing. The IRS believes by narrowing the audit focus to those cases in which it has a chance of prevailing, it will better conserve its resources.
Also notable, in this phase—and all other phases—the Roadmap instructs examiners to document the process by which they develop facts and create (and later adjust) their hypotheses. It is the IRS's hope that increased documentation will support adjustments later on should the taxpayer choose to go to IRS Appeals or to litigate.
Phase 2: Execution
During this phase, IRS examiners continue to develop the facts and perform economic analyses, including comparability and functional analysis of the relevant transactions. This entails reviewing accounting data and identifying economically significant activities performed in connection with such transactions.1 Based upon the fact finding and analyses performed during the execution phase, examiners are expected to narrow the focus of the examination by determining which, if any, transactions need further scrutiny. An examiner will then draft a preliminary statement of the facts to provide to taxpayers for feedback, along with a preliminary economic report critiquing the taxpayer's chosen method, tested party, comparables, etc.
Phase 3: Resolution
During this phase, IRS examiners finalize their analysis and propose adjustments. Before issuing a final NOPA, however, examiners are instructed to meet with the taxpayers and to assess the risks of moving forward.
How to prepare for transfer pricing examinations
The IRS believes that early risk assessment by an examiner during the planning phase should lead to fewer lengthy examinations that would ultimately result only in nominal adjustments, if any. This will conserve resources of both the IRS and the taxpayer. Furthermore, the Roadmap should lead to a more transparent application of transfer pricing rules and more consistent examination outcomes.
Taxpayers should familiarize themselves with the Roadmap to assess its possible effect on transfer pricing examinations. Up-front planning works both ways, and prepared taxpayers who are able to readily substantiate the arm's-length nature of their intercompany transactions are more likely to see their examinations concluded in the planning phase. To that end, taxpayers should consider conducting their own risk analysis before an examination begins:
Once the audit begins, taxpayers can strategically invoke the Roadmap to enhance the examination process. For example, the Roadmap recommends increased transparency of the process, with the exam team providing certain documents, such as the risk assessment and draft statement of facts, to the taxpayer for feedback. Taxpayers should request that they do so. Also, the Roadmap suggests that the exam team involve—sooner rather later—other IRS transfer pricing experts to improve audit processes. A taxpayer may also benefit from this approach and should consider, for example, requesting involvement from the Advance Pricing and Mutual Agreement Program when an adjustment may be raised that would require competent authority assistance. In addition, the Roadmap provides that agents should involve chief counsel early and often, and taxpayers too should consider requesting the involvement of chief counsel when the issues or the process becomes more complex than originally anticipated.
The IRS believes that applying the Roadmap should result in more efficient and standardized transfer pricing examinations. Additionally, early risk assessment can allow the IRS to dispose of cases that it is not likely to win early in the process. Taxpayers that are familiar with the goals and objectives of the Roadmap will be better prepared to navigate future audits.
1. To facilitate an IRS agent's ability to gather information in a timely manner, the Roadmap refers to the IRS's new IDR response policy three separate times, thereby underscoring its importance to transfer pricing examinations. See Dolan, Michael P., "IRS Changes Document Requests and Appeals Rules for Large Taxpayers," KPMG TAX DISPUTE RESOLUTION QUARTERLY, Issue No. 7 (Summer 2013).
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The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the authors only, and do not necessarily represent the views or professional advice of KPMG.