IRS Crackdown on Incomplete Transfer Pricing Documentation
IRS May Assert More Penalties for Transfer Pricing Documentation
The IRS looks to assert more penalties in transfer pricing cases, including cases with transfer pricing documentation. Incomplete and insufficient transfer pricing documentation along with improper transfer pricing implementation are now under increased IRS scrutiny.
“We continue to look more closely at cases, even those with transfer pricing documentation, to determine when it’s appropriate to assert penalties,” said Holly Paz, acting commissioner of the IRS Large Business and International (LB&I) Division.
That means taxpayers should expect the IRS to assert penalties more frequently in transfer pricing cases, Paz said November 1st, 2022, at the American Institute of CPAs National Tax Conference. Her comments follow those made September 20th by Brad Anwyll of LB&I’s transfer pricing practice. Anwyll increased penalty assertions allow the IRS to receive better transfer pricing documentation reports. These comments closely follow an improved IRS track record in transfer pricing court cases. Given the IRS’ recent success, it is more confident layering penalties on top of transfer pricing adjustments where taxpayers have missing or incomplete transfer pricing documentation.
Transfer Pricing Documentation Penalty Rules
The IRS can impose transfer pricing penalties if a transfer pricing adjustment results in an understatement of tax that exceeds $5,000 in the case of an individual, S corporation and personal holding companies, or $10,000 in the case of a corporation. Penalties should not be imposed if a taxpayer has contemporaneous transfer pricing documentation as support for its position. Taxpayers who have relied on previous agreements with the IRS, transfer pricing reports that haven’t been updated in years, incomplete documentation such as benchmark studies or transfer pricing studies that do not provide enough detail in the factual sections, may find their documentation unacceptable to avoid penalties when the IRS makes adjustments. Over the last several years, the IRS has highlighted the need for improvement regarding taxpayers’ transfer pricing documentation. A 2018 report published by the IRS Advisory Council Large Business & International Subgroup (Subgroup) found that various stakeholders in the U.S. transfer pricing community believe the quality of transfer pricing has declined over time. The Subgroup recommended that the IRS issue guidance on how taxpayers could improve the documentation quality. In 2020, the IRS attempted to assist taxpayers with a frequently asked questions (FAQs) document regarding transfer pricing documentation in efforts to incentives U.S. taxpayers to improve documentation quality.
Key Information Shared by IRS on Proper Transfer Pricing Documentation
The FAQs states that “transfer pricing reports that comprehensively document the reasonable selection and application of a transfer pricing method help demonstrate low levels of compliance risk and in turn help support early deselection of the transfer pricing issue from further examination.” The IRS pointed to several features of proper documentation that IRS agents should look for to determine whether transfer pricing should be pursued during an IRS examination:
- Perform a self-assessment, a sensitivity analysis of the comparable companies in their data set, e.g., would the removal of one of the comparable companies cause the taxpayer to fall outside the arm’s-length range, or would the data results be dramatically different using alternative profit-level indicators?
- Note whether the segmented financial data tests the arm’s-length nature of the intercompany transaction and explain how it was constructed.
- Explain the allocation of profits between entities involved in the intercompany transaction. Look at the profit realized on both sides of the intercompany transaction, not only the tested party. Is the economic result equitable from the vantage point of both parties?
- Include a description of associated risks and explanation of related-party allocation for each intercompany transaction.
- Include an analysis of any business circumstances that created an atypical result for the intercompany transaction, or any challenges posed in the Economic Analysis due to the business results of that year.
Tackling the Insufficiencies in Transfer Pricing Documentation
The IRS also noted several features of inadequate transfer pricing documentation. The insufficiencies listed below may result in transfer pricing becoming the focus of an IRS examination:
- The Company and Industry Analysis sections should be descriptive enough that the IRS agent understands the business and the industry in which the taxpayer operates.
- The Functional Analysis should not be a checklist; rather, it should be a robust analysis that links facts to the analysis. It should be well supported factually and should not rely on broad-brush assumptions about the business.
- The allocation of risks found in the Functional Analysis should be consistent with those outlined in the intercompany agreements. The allocation of risks in the Functional Analysis should be align with the comparable companies used in the Economic Analysis, and any adjustments to the comparable companies to account for risk should be adequately explained.
- The Best Method Selection Analysis should explain why other potential methods were rejected for analyzing that intercompany transaction.
- Adjustments to comparable data (e.g., working capital adjustments, location savings adjustments, etc.), should be clearly outlined in the Economic Analysis.
The recent comments made by the IRS, the FAQ published on the IRS’ website and the 2018 report published by the IRS Subgroup all point to increased IRS expectations for higher quality of taxpayers’ transfer pricing documentation. Therefore, we recommend taxpayers perform a year-end self-assessment of their transfer pricing documentation for robustness and reexamine their comparable companies for applicability and range sensitivity.
5 Key Transfer Pricing Documentation Questions To Ask Yourself Before Year-End
- Is your transfer pricing documentation current?
- Does your transfer pricing documentation capture “all intercompany transactions,” or have recent supply chain changes to render your documentation obsolete?
- Do intercompany agreements match your transfer pricing documentation?
- Is your Functional Analysis accurate and sufficiently detailed? In many instances, we find the Functional Analysis section more reflective of a taxpayer’s marketing material, as opposed to the legal and economic relationships between related parties.
- Do your accounting records reconcile your transfer pricing documentation?
How Can We Help?
Have more questions or think you have gaps in documentation based on the above questions? Let us help. For assistance or questions regarding transfer pricing documentation, help with year-end planning or other international tax matters, please contact your Cherry Bekaert advisor or a member of the International Tax Pricing group.