IRS Draws Map for Transfer Pricing Audits: An Article Authored by Paul Oliveira, CPA from KLR - Accounting Firm Boston, Massachusetts, Providence, Rhode Island

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IRS Draws Map for Transfer Pricing Audits

posted Jun 16, 2014 by Paul Oliveira, CPA

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The IRS Large Business and International (LB&I) Division has developed a Transfer Pricing Audit Roadmap to provide IRS examiners with audit techniques and tools to assist in the planning, execution and resolution of transfer pricing examinations. The roadmap isn’t intended to be a template for examiners, because every transfer pricing case is unique. But it provides some valuable clues to multinational companies about what might draw IRS scrutiny if they’re audited.

Key themes

The roadmap identifies four key themes:

  1. Upfront planning is essential. Proper development of a transfer pricing position may take two to three years or more, and transfer pricing specialists should be involved in assessing potential transfer pricing issues at the earliest possible stage, preferably before the official audit begins.
  2. Transfer pricing cases are usually won and lost on the facts. There should be a thorough analysis of functions, assets and risks, and an accurate understanding of the relevant financial information. Exam teams should explain the taxpayer’s value chain, competitive position in its industry, and financial results “in a clear and compelling fashion.”
  3. The objective in a transfer pricing audit is to determine a reasonable result under the facts and circumstances of the case. Effective enforcement of the arm’s-length standard requires judgment. An early “working hypothesis,” based on initial basic fact development, is a necessary guide to further detailed examination. The process of developing the facts and evaluating the hypothesis should be documented as the examination advances.
  4. Effective presentation can make or break a case. Even a strong position may not be sustained on review if it isn’t presented clearly and persuasively. All of the relevant facts — good and bad — should be addressed.

Audit phases

The roadmap divides a transfer pricing audit into three phases: 

  1. Planning. Taking up to six months, this includes a pre-examination analysis (that is, a preliminary assessment, a Section 6662(e) documentation review and planning meetings); an opening conference, which starts the 24-month cycle the roadmap uses to demonstrate how milestones and audit phases are sequenced; taxpayer orientations; and preparation of an initial risk analysis and examination plan, including timelines and key milestones.
  2. Execution. This can take up to 14 months. It includes fact finding and information gathering and consists of information document requests (IDRs), functional analysis and a midcycle assessment. It also involves issue development, economic analysis and a preliminary report and findings.
  3. Resolution. This phase of up to six months includes issue presentation, issue resolution, a risk assessment review (RAR) and case closing. The roadmap emphasizes that continuous communication with the taxpayer and the team throughout the execution and resolution phases is critical.

The IRS considers the roadmap a “work in process” and encourages examiners to submit corrections, additions or deletions, or other suggestions for improvement.

Scrutiny and Changes Ahead

Here are just a few things that are likely to be scrutinized in an IRS audit:

  • Publicly available documents such as SEC Form 10-K,
  • R&D activity and location; descriptions of patents, trademarks and other intellectual property; a company’s geographic and organizational structure; its segmented operational and profitability levels, and
  • Other tools that may be helpful in understanding a company’s overall operation and profit drivers, such as Capital IQ (CIQ) and Compustat (information databases about global businesses).

The release of the roadmap suggests that multinationals may see major changes in the transfer pricing audit process. This, in turn, might affect their strategic moves to ensure that their transfer pricing documents are solid, factual and in line with their income tax returns and financial statements.

SIDEBAR: IRS announces 2014 housing cost allowances for those working abroad

The IRS announced the 2014 adjustments to the housing cost exclusion limits for specific locations. Under Internal Revenue Code Section 911, a qualified individual may elect to exclude from U.S. gross income his or her foreign earned income and housing cost amount. The maximum excludable housing cost amount is calculated using a complex formula.

Notably, the IRS slashed by more than $21,000 (to $96,000 from $117,100) the amount that U.S. employees living in Tokyo can claim under the exclusion for 2014.

The change is drastic compared with generally modest revisions for other areas. The full list of 2014 housing cost limits is contained in IRS Notice 2014-29: http://www.irs.gov/pub/irs-drop/n-14-29.pdf