In this third article in our Looming Transfer Pricing Exams & IRS Preparedness Measures series, we highlight and summarize the essential aspects of the IRS’s Transfer Pricing Examination Process (TPEP) Execution Phase.
The Execution Phase immediately follows the opening conference and consists of continued risk assessment, fact finding, information gathering, and issue development. Stages of issue development include determining the facts, applying the law to those facts, and understanding the various tax implications of the issue. The issue team is advised to make every effort to resolve factual differences with the taxpayer.
Although the transfer pricing documentation IDR is no longer mandatory at the beginning of the Planning Phase, issue teams are advised to issue this IDR “early in the audit process” and review and analyze the taxpayer’s transfer pricing documentation before the taxpayer orientation meetings, which occur during the Execution Phase. Generally, the TPEP advises the issue team to determine whether all documentation requirements of Treas. Reg. § 1.6662-6(d)(2) or (d)(3) have been met and whether the documentation and its conclusions are reasonable. In particular, the issue team is instructed to evaluate the taxpayer’s selection and application of the best method for each relevant controlled transaction.
Indeed, the latest TPEP (Rev 9-2020), which was posted to the IRS Forms and Publications (PDF) website on 09/23/2020, lists Internal Revenue Manual (IRM) section 18.104.22.168.12 (12-13-2018) “Selecting the Best Method” as an additional “Helpful Reference” in the Risk Assessment section of the Execution Phase. The key takeaway from IRM 22.214.171.124.12, and subsection 126.96.36.199.12.1 “Transfer Pricing Review Panel (TPRP),” is when the taxpayer has timely provided transfer pricing documentation that both clearly states and analyzes the best method selection, but the issue team determines that an alternative method is the best method to achieve a more reliable measure of the arm’s length result, the issue team must obtain TPRP approval for use of the alternative method. Whereas, TPRP approval is not required when 1) the taxpayer does not definitively identify the selection of a best method or provide sufficient supporting analysis in its transfer pricing documentation and the issue team seeks to use an alternative method, or 2) when the issue team changes the application of the taxpayer’s best method, but not the selection of the best method.
Per IRM 188.8.131.52.12.1(4), “TPRP approval is an additional level of managerial review and is considered an intermediate step in the examination to help ensure transfer pricing cases are fully developed.” The TPRP generally includes a Transfer Pricing Practice (TPP) Director – or an Advance Pricing and Mutual Agreement (APMA) Program Director when the proposed best method change is part of an Advance Pricing Agreement (APA), a Senior Advisor to the TTPO Director, and the Income Shifting Practice Network (ISPN) Manager or other Practice Network manager such as an Economics Practice Network (EPN) manager. Key factors the TPRP will focus on include: 1) Reasons the issue team concludes that the taxpayer’s method is unreliable, and 2) Whether the taxpayer’s method can be adjusted to make it more reliable, and if not, what method is the best method to more reliably achieve an arm’s length result and why. The TPEP additionally instructs the issue team to consult with the IRS APMA Program when a taxpayer transaction involves a U.S. treaty partner country.
Orientation meetings are to be conducted within 30 days of the opening conference. The issue team will prepare IDRs to request a financial statement orientation and then a transfer pricing/supply chain orientation. Each IDR includes an extensive list of items to request from the taxpayer. Additionally, per IRM 184.108.40.206.6(3), a written agenda should be prepared for every taxpayer meeting and shared with the taxpayer in advance.
Generally, the financial statement orientation meeting will cover a walk-through of the Country-by-Country reports; geographic, legal entity, tax, and functional organizational charts; all reporting platforms (e.g., management reporting) that exist; and all relevant aspects of the financial statements such as reconciliations, roll ups to consolidated financial statements, book/tax differences, adjusting and true-up entries, cost centers and profit centers, and any other relevant taxpayer accounting policies and practices.
The transfer pricing/supply chain orientation meeting generally includes: background and business reasons for the intercompany transactions (e.g., rationale for entering into the controlled transactions, value drivers, and whether the intercompany transaction is associated with a change in functions, assets or risks), persons responsible for structuring the intercompany transactions, discussion of the functional analysis of each controlled party and how the transfer pricing report preparer gained knowledge for the functional analysis, total profits or losses associated with each material controlled transaction and each controlled party’s share of the total profits or losses, and the selection and application of the best method.
IDRs or summonses may be issued after the orientation meetings for further factual development and may include requests for interviews and site visits (e.g., plant tours). The TPEP lists IRM 220.127.116.11 “Overview of the Execution Phase” as a Helpful Resource. IRM 18.104.22.168(2) states, “A cooperative and transparent taxpayer will assist in the factual development of each issue.” It also states that IDRs are required to be “issue-focused” and contain a statement of the issue. Further, with the exception of the Initial Transfer Pricing Documentation IDR (which has a 30-day response time as codified by law), a discussion with the taxpayer and/or their representative is required to confirm an understanding of the items requested and to set a reasonable response date for the request.
IRM 22.214.171.124(5) states, “For potentially unagreed issues, the issue team is required to solicit an acknowledgment of facts (AOF) by attaching a draft Form 886-A, Explanation of Items, to the AOF IDR to request the taxpayer’s concurrence on the facts.” IRM 126.96.36.199(7) states, “Although an AOF IDR is not required for agreed issues, a draft 886-A may be issued as a best practice.” Issuing an AOF IDR for all transfer pricing issues (whether potentially agreed or unagreed) is also listed as a Best Practice in the TPEP. The facts in the AOF, acknowledged in writing by the taxpayer, must be consistent with the facts in both the Economist Report and NOPA. Then, the issue team should resolve any factual differences and/or document all disputed facts. Finally, the issue team issues Form 5701, Notice of Proposed Adjustment (NOPA) and the Economist Report (the issue team economist is responsible for drafting the economist report whether an IRC § 482 adjustment is pursued or not). IRM 188.8.131.52.15 lists the major required sections in the Economist Report. The issue team is to discuss a NOPA response date with the taxpayer, and if no agreement is reached then the issue team will set a “reasonable response date.”
The next installment in our series of articles on Looming Transfer Pricing Exams & IRS Preparedness Measures will condense and explain salient aspects of the TPEP’s Resolution Phase, which is the last of the TPEP’s three phases.
If you have any questions or would like more information on the issues discussed in this article, please contact the authors:
 All IRM sections referenced in this article were revised as of 12-13-2018.
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