(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.)

E. Issue Development

1. Economic Analysis
The issue team should work with the economist to perform an economic analysis consistent with the working hypothesis to:

• Evaluate the taxpayer’s best method analysis
– Consider whether the taxpayer’s method, as applied, or whether the method with adjustments, would reflect an arm’s length result. If not, refer to Revised Instructions for LB&I on Transfer Pricing Issue Selection and Scope of Analysis – Best Method Selection
• Analyze the facts, including accounting data, to determine the applicable legal analysis
• Prepare a draft Economist Report, as appropriate. Arrange a meeting with the taxpayer to discuss the economic analysis to date

• When the transaction involves a treaty partner, the issue team will regularly coordinate regarding the economics of the transaction with APMA
• If the taxpayer asserts an IRC Section 482 setoff:
– Issue additional IDRs for information, as necessary
– Request a comparability and economic analysis that supports the potential setoff, as appropriate
– Request the taxpayer’s support of the setoff. Generally, the taxpayer should be able to support the setoff in the same manner as the original controlled transaction under examination
– Consider how a setoff will affect the examination plan, timeline, and ECD, if applicable

Helpful Reference:
APMA Program Contact Information
Rev. Proc. 2005-46 – setoff procedures

2. Penalties
Penalties should be considered whenever adjustments are made to a tax return. The determination whether to assert penalties, identify the appropriate penalties, and calculate the penalty amount accurately is primarily the issue team’s responsibility and should take place throughout the examination process. Workpapers must support the analysis and conclusion. Issue teams should consult with LB&I Division Counsel and Associate Chief Counsel International (ACCI), as appropriate.

One potential penalty is the IRC 6662(e) penalty. Regulations require the IRS to apply penalties when the taxpayer fails to create or to timely provide IRC §6662(e) documentation or when the IRC §6662(e) documentation provided is unreasonable or inadequate, assuming the net adjustment penalty thresholds are met. IRC §6662(e) documentation does not automatically protect against penalties because the IRC §6662(e) documentation must be assessed for adequacy and reasonableness. To meet the reasonable cause exception of the penalty regulations, taxpayers must document they reasonably selected the best method for their analysis and they reasonably applied that best method. Factors to consider in evaluating the adequacy of a taxpayer’s transfer pricing documentation are outlined in the regulations.

Other penalties may also apply. The Penalty Practice Network can provide assistance to issue teams in evaluating and applying penalties. As with all penalties, the manager’s written approval is required before assertion of the penalty (ideally when the penalty is
initially raised and, if not completed earlier, before the issuance of a 30-day letter or notice of deficiency). Documentation of that approval must be maintained in the case file.

Best Practice: The issue team should discuss the imposition of penalties at the same time as the primary adjustment. Do not wait until the end of the examination process.

Helpful References:
IRM 20.1.5.9 – IRC Section 6662(e) Substantial Valuation Misstatement IRM Exhibit 20.1.5-3 – IRC Section 6662 penalty flowchart IRM 4.46.4.10 – Penalty Consideration
Instructions for Examiners on Transfer Pricing Issue Examination Scope – Appropriate
Application of IRC 6662(e) Penalties
Practice Unit on IRC 6662(e): Calculating the Net Adjustment Penalty for a Substantial Valuation Misstatement

3. Drafting Reports
The issue team continues to build the Economist Report and NOPA collaboratively, as a team, based on the functional analysis that was performed. The Economist Report should include:
• Executive Summary
• Factual Background and Functional Analysis of the Taxpayer and the Transaction(s) at Issue
• Summary of Taxpayer’s Proposed Economic Analysis for the Transaction at Issue
• Critique Taxpayer’s Methodology and Analysis for the Transaction at Issue
• IRS Determination of Arm’s Length Allocation of Income/Pricing
• Summary and Conclusion

The issue team should utilize Transfer Pricing NOPA Best Practices. The NOPA should include:
• Adjustment Table
• Issue Statement
• Executive Summary of Issue
• Facts
• Law
• Taxpayer’s Position
• Analysis – Government’s Position
• Conclusion

Best Practices: The facts of the case should be agreed upon with the taxpayer whenever possible. Continuous open communication between the taxpayer and the issue team throughout the examination is critical. Consider whether an issue presentation meeting with the taxpayer would be beneficial at this point in the
examination. Coordinate with LB&I Division Counsel regarding the analysis presented in the reports.

Helpful References:
IRM 4.46.6 – Workpapers and Reports Resources
NOPA Preparation – Training Materials Economist Report Template on the Economics Practice Networks SharePoint Website

4. Acknowledgement of Facts IDR
The issue team members are responsible for documenting all facts have been secured to ensure examiners reach correct conclusions. All relevant facts, including those from the taxpayer’s response to the acknowledgement of facts (AOF) IDR or facts in the taxpayer’s favor, should be considered before issuing a final NOPA and Economist Report. The facts of the case must be consistent in the Economist’s Report, NOPA, and AOF IDR.

• Coordinate legal issues with LB&I Division Counsel, ACCI, TPP and the Practice Networks
• Ensure communication and collaboration with Case Managers and Territory Managers throughout the examination process
• Issue a statement of facts requesting taxpayer’s acknowledgement following current procedures
• Resolve any factual differences and/or document factual disputes
Best Practice: An AOF IDR should be issued for all transfer pricing issues (whether potentially agreed or unagreed). The issue team should revise the Economist’s Report and NOPA based on additional taxpayer input, as appropriate. An issue team review of
the facts and findings is strongly encouraged. This review should include the issue team and applicable managers.

Helpful References:
IRM 4.46.4.9 – Written Acknowledgment of the Facts (AOF)
IRM Exhibit 4.46.4-3 – Pro-Forma IDR for Acknowledgment of Facts on Unagreed Issues

(This Is Part VI of VIII On Department of Treasury – Transfer Pricing Examination Process And Updates. Click To Part V)