While we have periodically written about the Transfer Pricing Examination Process, Publication 5300 (TPEP) and its predecessor, the Transfer Pricing Audit Roadmap, for this blog post we revisited the TPEP to determine how well this IRS guidance and our initial insights on it have withstood the test of time relative to our field-based transfer pricing (“TP”) experience since the TPEP’s initial 29 June 2018 release. This blog post is a companion to our article “Impactful FYE Transfer Pricing Examination Preparedness Measures” in the December 2020 TGS Global AMÉRICA Regional Magazine. Following are six TPEP takeaways that we have found to be even more important today than a few years ago.
1. Robust documentation is the first and best line of defense against an IRS TP adjustment and non-deductible penalties and interest.
Contemporaneous TP documentation (“documentation”) offers penalty protection and reduces the resources required to defend a TP position in an IRS TP examination (“Exam”). Further, documentation proactively allows the taxpayer to explain the reasonableness of its TP, increasing its chances of a favorable Exam outcome, and with less time and effort. Taxpayers without quality documentation may be surprised by the aggressive positions the IRS can take – especially in situations where taxpayers rely on “boilerplate” approaches, report low or highly-variable annual operating profit, or have incomplete documentation.
2. Documentation should contain a complete functional analysis.
Contrary to some taxpayer practices, a functional analysis is not optional for documentation that is intended to withstand an Exam. During the TPEP Execution Phase, the issue team is instructed to conduct a functional analysis that identifies the economically significant functions, assets, and risks of the controlled parties. Taxpayers who don’t include a thorough functional analysis in their documentation will not have ground to stand on when the IRS is prepared with its own functional analysis of the taxpayer MNE companies (the functional analysis is a required section of the IRS Economist Report). And as many taxpayers have learned the hard way, once an IRS agent’s mind is made up, it can be very difficult to convince them of an alternative point of view.
3. The TPEP heavily emphasizes the importance of the best method selection and application.
Best method selection is emphasized in four major TPEP sections of the Execution Phase (Risk Assessment, Fact Finding and Information Gathering, Economic Analysis, and Penalties). The Penalties section specifies that documentation does not automatically protect against penalties because it must be assessed for adequacy and reasonableness. To afford penalty protection, documentation should establish how arm’s length results were determined and contain a detailed description of: 1) how the documentation preparer(s) “reasonably” (reliably) selected and applied the best method (including inputs and assumptions), and 2) how they evaluated the potential applicability of various methods.
4. Intercompany agreements should accurately reflect the economic substance of the underlying TP.
During the Execution Phase, the issue team is instructed to perform a review and analysis of relevant intercompany legal agreements (“IC agreements”) in coordination with the IRS Large Business & International Division Counsel. A goal of this review is to determine if the conduct of the parties is consistent with the written agreements. We advise taxpayers to ensure their agreements accurately reflect the functions, assets, and risks of the entities in the controlled transactions, and detail how the roles and responsibilities and contractual risks are assigned among the controlled entities.
5. The TP orientation meeting is the most effective opportunity for a successful resolution.
The TP/supply chain orientation meeting is often the taxpayer’s best opportunity to present its TP positions. This orientation meeting gives the taxpayer the opportunity to make its most compelling case for why its TP methods, analysis and results are appropriate. It is widely considered to be the taxpayer’s best and last chance to convince the IRS to discontinue the Exam.
6. IRS Practice Units allow taxpayers to achieve knowledge parity with issue teams.
The TPEP devotes considerable space to discussing Practice Units, which are IRS reference and training tools that serve as resources for evaluating and developing potential Exam issues. As a best practice, taxpayers should reference relevant Practice Units when planning and evaluating their TP dealings, as an indication of the IRS position on given topics. In practice, IRS issue teams may know significantly less or more than what is contained in the relevant Practice Units, but a taxpayer who does not have this base level of understanding is a taxpayer who invites more prolonged Exams, unfavorable adjustments, potential double taxation, and penalties.
If you have any questions or would like more information on the issues discussed in this article, please contact the authors:
Subscribe to TaxConnections Blog
Enter your email address to subscribe to this blog and receive notifications of new posts by email.