The Internal Revenue Service (IRS) Advance Pricing and Mutual Agreement (APMA) program announced recently that it has developed a “functional cost diagnostic model” (FCDM), an Excel-based program, to facilitate its review of certain Advance Pricing Agreement (APA) requests. The APMA Program, which oversees all Advance Pricing Agreement and Competent Authority transfer pricing cases, indicated the FCDM would require the participating taxpayer to provide specified financial information for cases in which “material non-benchmarkable contributions” form a part of the covered transactions in an APA request. That is, for complex cases where both parties are seen to make non-routine contributions to the value chain. APMA believes that the FCDM model may be able to demonstrate more reliable results for such intercompany transactions by applying a profit split methodology rather than a one-sided profitability analysis (e.g., Comparable Profit Method (CPM) / Transactional Net Margin Method (TNMM)).

In January 2018, the IRS updated the transfer pricing examination guide which provided new guidelines in analyzing the method selected by the taxpayer for the documentation and the APA. The new process would allow the examiners to look into the functions, assets and risks of the related parties and use an alternative method if it seems more reliable. Below are the extracts from the instructions released by the IRS.

“To ignore that analysis and conclusion and start the best method selection analysis from scratch protracts the examination timeline and diverts resources. Starting with the taxpayer’s selection of the best method, the examination team should thoroughly analyze the taxpayer’s application of their selected method.

During the course of an examination’s factual development of related party transactions, if information supports a conclusion that a method other than the taxpayer’s chosen method would result in a more reliable measure of the arm’s length result, the approval process under this Directive for the alternative method must be used.”[1]

Similarly, the FCDM focuses on the identification, organization and analysis of “functional” costs. It requires taxpayers to analyze the economic contributions associated with the activity for which the functional costs are incurred. The FCDM also requires companies to consider which controlled taxpayer(s) incur functional costs that may have an economic value that would not be measured reliably by referring to benchmarks and that are expected to last beyond a single accounting period. The IRS does not specify what functional costs may meet this description and notes that these costs will necessarily be specific to the business operations of the proposed covered group and the scope of the proposed covered transactions.

The FCDM seems to be a step forward in facilitating the examiners in re-evaluating the transfer pricing methodology as under the January IRS instructions.

Based on another memorandum issued in February by the IRS — Interim Guidance on Mandatory Issue Team Consultations with APMA for Examination of Transfer Pricing Issues Involving Treaty Countries — coupled with the updated transfer pricing examination process and the FCDM model may have a broader impact on foreign multinational. The memorandum requires the Large Business and International (LB&I) division and the APMA to consult each other in resolving the transfer pricing issues regarding adjustments due to the procedural or substantive matters. Also, it is mandated that such collaboration is independent of the fact whether the taxpayer has an existing APA or mutual agreement procedure (MAP) request. Below are the extracts from the memorandum released by the IRS.

“This memorandum requires collaboration between transfer pricing issue teams (whether staffed from Transfer Pricing Practice (TPP), Cross Border Activities (CBA) or Geographic Compliance Practice Area personnel) and APMA on examinations with the potential to generate transfer pricing adjustments involving a country with which the United States has a double tax treaty. This consultation requirement applies regardless of whether the taxpayer currently has a mutual agreement procedure (MAP) or advance pricing agreement (APA) case in APMA or whether APMA has an active relationship with the treaty partner.”

With the issuance of these recent IRS memorandums and tool, A&M Taxand recommends that companies consider the potential impact of the model on their value chains as part of their transfer pricing compliance processes.