Don’t panic, the IRS has laid out a process for examining transfer pricing in its Transfer Pricing Examination Process (TPEP), Publication 5300. The TPEP lays out three phases to a transfer pricing audit. (1) The planning phase determines the scope of the audit. (2) The execution phase is when the IRS develops issues and understanding of the various tax implications of the issues. (3) During the resolution phase, agreement is reached, if possible. Transfer pricing audits can take months, or even years, to resolve. You can prepare for transfer pricing audits by ensuring your transfer pricing documentation and intercompany agreements are current and work with the IRS to hopefully resolve your issues sooner rather than later.
In the planning stage, a transfer pricing audit is much like the planning stage of a financial audit, as the scope of the examination is determined. The IRS and the taxpayer typically work together to establish a plan that identifies the issues, documents audit steps, timelines and communication agreements (i.e., how and when items will be requested and submitted).
If an issue team is assigned to audit your transfer pricing, the issue team is typically made up of the following members:
- Senior Revenue Agent,
- Revenue Agent,
- Economist, and
- Tax Law Specialist.
These members are responsible for coordinating and collaborating with the rest of the IRS exam team. In collecting necessary information, the issue team should coordinate its Information Document Requests (IDRs) with the entire case team to avoid duplications. The issue team may ask for accounting records, organizational charts, financial statements, and other items that it deems necessary.
During the initial transfer pricing risk assessment, the IRS will review prior year workpapers, collaborate with the national level Advance Pricing Mutual Agreement office Analyze the company income tax return, analyze the Country-by-Country report, prepare ratio analysis, research the company’s background and operations, and develop a preliminary working hypothesis.
The preliminary working hypothesis takes into consideration much of what one would expect, such as the following:
- Worldwide effective tax rate, profitability, and the company’s tax structure,
- Industry averages, benchmarks, and reference sets,
- Source of income and tax credits,
- Subpart F issues, and
With its preliminary working hypothesis and the company’s §6662(e) documentation report, the issue team will meet to discuss its finding and at this time will establish an audit timeline with milestone dates for completion of the transfer pricing audit. With all this planning the issue team will be part of the formal opening conference. At the opening conference, the following should include:
- Discussion of the process
- Transfer Pricing Compliance Process
- Preliminary scope of the transfer pricing audit
- Discussion on how, when, why information will be exchanged between the IRS and the company
- Onsite visits and company interviews
- Resolution processes.
Now, this is when the fun begins -- the execution phase of the audit. The key to a successful execution phase is communication and resolution of any factual differences between the IRS and the company. This is your chance to make sure the IRS understands your company’s structure and the functions and risks of the company entities. Your transfer pricing report can go a long way in ensuring the IRS understands your facts.
The first step of the risk assessment is to review the company’s §6662(e) report. The IRS will evaluate the company’s best method selection, determine whether all controlled transactions are covered. as well as analysis whether the documentation meets the requirements §6662(d)(2)(iii). The issue team should be looking to verify that the company documentation is complete and reasonable.
To better understand the company, the issue team may request a financial statement orientation. This your opportunity to do a walk-through of the geographic and functional organization and reporting platforms that the company has in place. This is also when you have the ability to walk the IRS through your Country by Country report (if applicable), and any reconciliations (e.g., between report, tax returns, and trial balance).
Next, the issue team may request a transfer pricing/supply chain audit. You may feel like this is preparing your documentation all over again. The IRS will want to discuss the company’s background and history of intercompany transactions, determine which functional areas should be further reviewed, such as research and development, manufacturing and marketing.
At this point, the issue team will update its risk assessment keeping the audit team up to date on any issues that may have arisen during the execution phase. Now the issue team moves into its fact-finding stage. In coordination with the entire exam team, the team will issue IDRs, review your intercompany agreements (yes, you might want to make sure your intercompany agreements are current), and conduct any additional functional and risk analysis that might be needed.
Once fact gathering is complete, the IRS will begin the issue development. The issue team will work with the exam economist to develop an analysis that is consistent with the working hypothesis. The economic analysis includes evaluation of the taxpayer’s best method, analyzing the facts and data. The economist may even draft an Economist Report. If an adjustment is going to be proposed the IRS will consider whether penalties should be assessed as well.
With the Economist Report and penalties determined, the team then drafts a report and Notice of Proposed Adjustment (NOPA).
At long last, we come to the resolution phase. The team will meet with the company and present its issues and discuss resolution. If the IRS and company agree, the IRS will issue a Revenue Agent Report and a closing agreement is drafted.
If agreement is not reached, the company has many options. Early resolution tools available to the company are early referrals to Appeals or Accelerated Issue Resolution. Other options available to the company include appeals or U.S. Competent Authority.
Remember, there is a process, and an IRS audit is similar to any financial audit. The audit has a planning stage, execution stage, and a resolution stage. If you have strong documentation, and current intercompany agreements, you will get through the examination … with maybe just a few headaches.