(The Transfer Pricing Examination Process was recently updated by the Department of Treasury – June 2018. TaxConnections posts this valuable eight part a series to keep you informed of these changes.)

C. Initial Transfer Pricing Risk Assessment

1. Review Prior Year Workpapers

Risk assessment includes the review of prior year workpapers, if applicable, to identify potential controlled transactions. The issue team should analyze prior year documents including, but not limited to:

• Initial and mid-cycle risk analysis
• Taxpayer’s transfer pricing documentation
• Revenue Agent Reports and closing agreements
• Notice of Proposed Adjustments (NOPA)
• International Examiner’s Report
• Economist’s Report
• Other specialist’s reports
• Functional analysis
• Appeals Case Memorandum (ACM)

Best Practice: Workpapers are used to document the audit procedures performed, information gathered, analysis performed, and conclusions reached over the course of the examination. To promote efficiency, workpapers must be prepared on a timely
basis. The issue team will begin documenting workpapers at the inception of the examination and continue to update the file throughout the examination process.

Helpful References:
IRM 4.10.9.7 – Workpapers

2. Collaborating with Advance Pricing Mutual Agreement Program

The issue team will collaborate with the Advance Pricing Mutual Agreement (APMA)program when the transaction involves a tax treaty country. Also, the issue team will consider obtaining information or foreign-based documentation from treaty partners using collateral requests, information requests pursuant to treaties, and the Simultaneous Examination Program (SEP).

Helpful References:
IRM 4.60.3 – Tax Treaty Related Matters United States Income Tax Treaties – A to Z APMA Program Contact Information

3. Analyze the Income Tax Return
The issue team will access the CAS website for a variety of tools to conduct analysis on e-filed income tax returns. Tutorials are available for instructions and training. The Auditor’s Workbench tool will be used to analyze data from Forms 1120, 1065, 1120S,4797, 5471, 5472, 8858, and 8865. In addition to the potential for transfer pricing issues, the examiner should collaborate with CBA to identify any Subpart F or U.S. trade or business/permanent establishment issues related to the controlled transaction.

Forms to analyze include, but are not limited to:
• Form 926 – Return by a U.S. Transferor of Property to a Foreign Corporation
• Form 4797 – Sales of Business Property
• Form 5471 – Information Return of U.S. Persons With Respect To Certain Foreign Corporations
• Form 5472 – Information Return of Foreign Owned Corporation
• Form 8858 – Information Return of U.S. Persons With Respect To Foreign Disregarded Entities
• Form 8865 – Return of U.S. Persons With Respect to Certain Foreign Partnerships
• Form 8833 – Treaty-Based Return Position Disclosure
• Schedule M-3 analysis
• Schedule UTP – Uncertain Tax Positions (UTP Disclosures)

Helpful References:
IRM 4.61.3 – Development of IRC section 482 Case
LB&I Schedule UTP Guidance
Auditor’s Workbench Tutorials
Auditor’s Workbench Income Shifting Outbound Custom Queries
Auditor’s Workbench Income Shifting Inbound Custom Queries
CAS and Examiner Analysis Tools

4. Analyze the Country-by-Country Report
The issue team should utilize the Form 8975, Country-by-Country (CbC) Report. It is a tool intended to provide useful information to analyze high level transfer pricing risk, Base Erosion and Profit Shifting (BEPS) related risk, and where appropriate, conduct
further economic and statistical analysis. Before analyzing the CbC report, the issue team members will complete the required training. Guidance for foreign parent CbC reports will be available on the Income Shifting Practice Network SharePoint websites under Audit Tools and Reference Resources.

Helpful References:
IRM 4.61.3 – Development of IRC § 482 Case
LB&I Country-by-Country Guidance and Procedures for Large Business and International (LB&I) Division
ELMS 67517 Country-by-Country Report Training

5. Prepare Ratio Analysis
The issue team will compute key financial ratio analysis for multiple years, make industry comparisons, and consider whether there is potential cross border income shifting by using tools, such as:

• Financial ratio analysis of both the U.S. party and the foreign related parties to the transaction
• Tax Information Gateway (TIG) Report – company financial data, worldwide profitability analysis, and historical information
• Capital IQ (CIQ) – database to compare results to available industry information
• Compustat – database to compare results to available industry information
• Bureau Van Dijk – international database of available industry information
• Auditor’s Workbench – ratio analysis reports (building custom queries as needed)
• ktMINE – for publicly available information on intangible property and analytics
• Moody’s Analytics RiskCalc – analysis tools for financial transactions
• Thomson Reuters LoanConnector – analysis tools for financial transactions
• Campaign and Case Built File (CBF) data provide issue-focused financial ratios and analysis

Caution: Financial ratio analysis must be used carefully. Financial ratios may be useful as a diagnostic tool to help focus the audit; however, they do not provide a definitive indication of the arm’s length nature of a taxpayer’s controlled transactions. Whether
financial ratios indicate potential non-arm’s length transfer pricing issues, the team needs to complete rigorous development of the relevant facts and circumstances to support a transfer pricing adjustment, a Subpart F adjustment, or both.

6. Research Taxpayer’s Background and Operations
The issue team will obtain an understanding of the taxpayer’s history, background, overall core business operations, and profit drivers. Perform a review the taxpayer’s website, Form 10-K or Form 20-F filed with the Securities and Exchange Commission
(SEC), and complete an internet search of the taxpayer’s name. This information may include the following:

• Overview of a taxpayer’s business, including operations in various countries
• Geographical, legal, and tax organizational structure information
• Financial statements
• Segmented operational and profitability levels
• Functional activities and their locations
• Significant transactions
• Descriptions of patents, trademarks, and other intangibles
• Industry and competitor information
• Value drivers
• Merger, acquisition, and other reorganization activity

Helpful References:
SEC Website (Edgar)
United States Patent and Trademark Office
IRM 4.46.6 Workpapers and Reports Resources

7. Develop a Preliminary Working Hypothesis
The purpose of the risk assessment is to identify specific transactions between the U.S. taxpayer and its affiliates warranting examination. The goal is to gather and analyze information relevant to those transactions. The development of a preliminary working
hypothesis is a fluid concept. It will include an issue statement that will be proved or disproved as additional information is obtained. The issue team will develop a preliminary working hypothesis taking into consideration the:

• Worldwide effective tax rate, profitability, and whether the taxpayer’s overall tax position benefits from income shifting from a financial accounting/cash flow standpoint
• Industry averages, benchmarks, or reference sets, if available
• Source of income and tax credit availability
• Subpart F issues and need to collaborate with CBA
• Hybrid entities and how the taxpayer uses hybrid entities within its structure
• Net operating losses (NOLs)
• Collateral adjustments and other impacting factors
• Tax treaties and the need to collaborate with relevant APMA personnel

Caution: Treasury Regulation Section (Treas. Reg. Sec.) 1.482-1(d)(2) states that “unadjusted industry average returns themselves cannot establish arm’s length results.” Therefore, unadjusted industry average returns should only be used to assess transfer
pricing risk and on their own should not be used to make a transfer pricing adjustment.

Helpful References:
IRM 4.60.3 – Tax Treaty Related Matters
United States Income Tax Treaties – A to Z
APMA Program Contact Information

8. Complete Risk Analysis
The issue team will complete the risk analysis using the current Form 13744-I, as recommended. However, Forms 4764, 4764-A, 4764-B, 4764-IC, and 13745 can still be used, as appropriate:

• Submit the initial risk analysis for approval by the Issue Manager and Territory Manager (TTM)
• Update and document the risk assessment at various stages of the examination.
Risk assessment is a continuous process that occurs throughout the audit. Document the audit steps taken, facts discovered, and the initial risk assessment in the audit file. Begin to outline and document the facts that will be updated throughout the examination process

Caution: When a transfer pricing adjustment is made, a deemed distribution or other conforming adjustment(s) may result and potentially be subject to withholding or have other tax consequences. Ensure that the Form 1042 statute remains open. Also, see Treas. Reg. Sec. 1.482-1(g)(3) and Revenue Procedure 99-32 for a discussion of conforming adjustments.

Helpful Reference:
IRM 4.46.3.2 – Risk Analysis Process

(This Is Part II of VIII On Department of Treasury- Transfer Pricing Examination Process And Updates. Click To Part I, Click To Part III)