IRS issues FAQ on transfer pricing documentation

Tax Hot Topics newsletter The IRS recently released frequently asked questions (FAQ) on transfer pricing documentation. The guidelines amount to a listing of documentation best practices and are timely considering the challenges brought on by COVID-19.

The scope of the FAQ is limited to the “net adjustment penalty” described in Section 6662(e)(1)(B)(ii), which applies when a taxpayer’s “net Section 482 transfer price adjustments for the taxable year exceeds the lesser of $5 million or 10% of the taxpayer’s gross receipts.” The IRS appears to be using a carrot-and-stick approach to incentivize taxpayers to create more robust documentation going forward. As the stick, the FAQ reminds taxpayers that having Section 6662(e) documentation does not automatically protect against penalties. The documentation must be adequate and reasonable. Inadequate, incomplete, or untimely production of documentation is also noted to increase the taxpayer’s burden in an audit. As the carrot, the FAQ repeatedly notes that robust documentation increases the chance of an audit deselection while also facilitating more efficient audits.

The IRS recommends that taxpayers conduct “self-assessments” to see if their documentation is robust. Self-assessments might include a sensitivity analysis to determine if removing one company from the comparable set would cause the tested party to fall outside the benchmarked range or comparing a variety of profit level indictors (PLIs) to see if a different conclusion should be drawn.

Areas identified as benefiting from improvement include functional analysis narratives, consistency in risk analysis with intercompany agreements and comprehensive best method selections. For example, robust functional analysis explains how and where value is created, supporting profit allocation. Taxpayers should consider whether their documentation links specific facts to its functional analysis or if it merely relies on broad assumptions about the business.

Risk analysis should be consistent with intercompany agreements, establishing the basis for risk allocation described and analyzed in the documentation. Documentation should not only describe the general business risks of the transaction but also include a more detailed description of how those specific risks are then allocated among the parties. If manufacturing volume is a risk to the profitable operations, “a policy that ‘ensures’ the distributor makes a fixed profit margin allocates more volume risk to the manufacture/supplier.” Between a supplier and distributor, the risk analysis might explain how some risk is shifted to the supplier as a result of the distributor’s right to return all unsold inventory back to the supplier. The analysis should also determine if risk allocations are consistent with the comparables that form the benchmarking set. The focus is on risk allocation, risk documentation and risk explanation. The IRS even recommends a functional and risk analysis for each transaction.

A comprehensive best method selection also explains why other methods were rejected. Documentation should not simply give a generic statement such as, “There are no Comparable Uncontrolled Prices (CUPs), so we did not apply the CUP method.” Robust documentation would include an explanation why such comparable transactions did not exist. The IRS also discourages conclusory statements such as, “We elected the operating margin as the PLI in the application of the comparable profits method, because distributors typically measure their profits as a function of sales.”

A common thread is dealing with unexpected changes in a company’s business. For example, what actions should be taken when, under certain transfer pricing policies, a reduction in sales volume results in losses. If demand unexpectedly drops and results in a loss caused by unexpected changes in the company’s business circumstances, the taxpayer’s documentation should thoroughly explain how the unforeseen business circumstances caused the loss. To deal with such situations, the IRS considers it “counterproductive” for the taxpayer to try and address the loss by manipulating its set of comparable companies.

In light of COVID-19 and the recent emphasis by the IRS calling for more robust transfer pricing documentation, taxpayers should consider how robust their documentation is and how well it stands up to IRS expectations.

David Sites
Washington National Tax Office
T +1 202 861 4104

Steven Wrappe
Managing Director
Washington National Tax Office
T +1 202 521 1542

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