The IRS recently released informal guidance in the form of “Frequently Asked Questions” discussing its “observations of best practices and common mistakes in preparing transfer pricing documentation” under section 6662. Particularly right now, as many taxpayers find themselves in the throes of drafting and updating annual transfer pricing documentation reports, a review of these FAQs can provide critical insights into the IRS’s thinking that may improve the efficiency of future audits.
Although many of the FAQs reiterate best practices that many sophisticated taxpayers already follow, they also introduce some new concepts that may raise an eyebrow. This post focuses on the most interesting aspects of the FAQs that are applicable to large businesses.
New “Deselection” Incentive
Under the section 6662 regulations, a taxpayer’s incentive to prepare transfer pricing documentation is, of course, to avoid penalties. But the FAQs introduce a new incentive: potential early “deselection” from audit. The IRS has not yet made clear what this precisely means, but the idea of ending an audit early is enticing to companies when resources are stretched thin.
The introduction of “deselection” no doubt stems from a 2018 report by the Internal Revenue Service Advisory Council—a group representing a cross-section of the taxpaying public. (A copy of the report is available online.) The IRSAC report not only recommended that the IRS provide FAQs on transfer pricing documentation, but also suggested that the IRS could provide potential early deselection or more efficient audits in exchange for better quality documentation. But the IRSAC report also recommended that the IRS provide details on how and when deselection could occur, guidance which is lacking in the FAQs.
The answer to FAQ 2 encourages taxpayers to conduct a self-assessment of “potential indicators of transfer pricing non-compliance.” For example, a taxpayer utilizing the CPM might perform a sensitivity analysis by testing whether removing one company from the comparable set pushes the tested party results out of the benchmark range. Or, the taxpayer might perform sensitivity testing on its selection of the profit level indicator, by checking alternative PLIs.
In our experience, these types of sensitivity analyses are important aspects of evaluating the persuasiveness of any documentation study, and we frequently recommend them as part of any effort to prepare for an IRS audit.
Certain aspects of the FAQs might lead a reader to conclude that the IRS thinks time and money are no objects. For example, as will be discussed in more detail below, the FAQs seem to suggest that taxpayers need to disprove the applicability of other methods and need to compile system profits analyses. These can be helpful tools in some cases, particularly issues involved in Advance Pricing Agreements or in litigation, where significant resources can be brought to bear. But in the context of “plain vanilla” documentation, some taxpayers faced with limited budgets to deliver annual documentation on a short timeline may be frustrated with these suggestions to the extent they are meant to suggest a norm, applicable in every case.
Rejecting Other Methods
The answer to FAQ 4 asks that taxpayers describe the methods that are not used and explain why. The IRS acknowledges, for instance, that companies often maintain massive databases of internal contracts that could be mined as sources for potential transactional evidence, while recommending that companies “describe as clearly as possible the internal and external data requested and reviewed in the process of selecting a method.”
This suggestion sounds simple at first blush, but there is some tension here with the best method rule, which provides that the best method is selected based in part on the reasonable availability of the data. Plumbing the depths of a contract database may be prohibitively expensive, which may be the reason why a company selects a method for which data is more reasonably available.
The IRS’s answer to the FAQ seems to be stretching the regulations beyond their original intent. In fact, in the preamble to Treas. Reg. § 1.6662-6, Treasury said the following in direct response to commenters’ concern that effectively disproving all other methods would be onerous: “The comparison to be done under the best method rule will not necessarily entail a thorough analysis under every potentially applicable method. . . . Indeed, in some cases, it might be reasonable to conclude that a particular method is likely to be the most reliable with virtually no consideration of other potentially applicable methods.” 61 Fed. Reg. 4877 (Feb. 9, 1996). How this provision of the FAQs will be interpreted and applied by the IRS’s examination teams in the future remains to be seen, but taxpayers should bear the preamble in mind.
Systems Profits Super-Check
The answer to FAQ 5, subsection “Allocation of Profits Among All Parties,” says that after the application of the taxpayer’s selected method, “one of the parties may end up with returns that may seem too high or too low.” The answer then gives an example of a manufacturer selling to a related distributor, where the taxpayer’s method tested the returns to the distributor (i.e., a one-sided method). But the FAQ admonishes that it is also important to consider whether the manufacturer’s relative activities entitled it to earn its returns (i.e., a two-sided method). In this type of situation, the IRS says that documentation should explain where the excess returns come from and which controlled party is entitled to the returns.
Coupled with the FAQs’ statements about providing segmented financial data (see, e.g., FAQ 2), a fair reading of this language is that, on top of its normal transfer pricing method, a taxpayer’s documentation should also include a system profits analysis to confirm the arm’s length nature of the taxpayer’s selected method. But to the extent LB&I intends to use the system profits test as a mandatory check, meant to be overlaid on top of the taxpayer’s normal method in all cases, then astute historians of section 482 will be checking the calendar, wondering if the year is 2020 or 1992. In the 1992 proposed section 482 regulations, Treasury attempted to overlay an “objective” profit measure over other section 482 transfer pricing methods, and was criticized so mercilessly that it abandoned the notion just a year later when the regulations were issued in temporary form.
Specifically, the 1992 proposed regulations would have required that, whatever method was selected by the taxpayer, the results needed to be confirmed by the application of an objective profits-based test, the comparable profits interval (predecessor to the modern comparable profits method). See, e.g., Prop. Reg. § 1.482-2(f), 57 Fed. Reg. 3586 (January 30, 1992). Commenters screamed bloody murder, pointing out that the creation of a mandatory overlay test was inconsistent with the best method rule and essentially created an uber-method having priority over all others. In the 1993 temporary regulations, Treasury retreated, saying that “in response to comments” the regulations no longer required the “mandatory check on the results obtained under other methods.” T.D. 8470, 58 Fed. Reg. 5265, 5310 (January 21, 1993).
That is not to say, of course, that in appropriate circumstances, a system profit cannot be used as a secondary corroborating method, or even the primary method. But it would be so used only if its application were reliable, in both the theoretical construct and in terms of data availability. To suggest its use as a mandatory one-size-fits-all super-test, irrespective of considerations of reliability, may seem wasteful to some and worrisome to others. After all, for some taxpayers, the segmented financial data necessary to produce a reliable system profits analysis may be readily available. But for other taxpayers who do not maintain segmented financials in their regular business operations, developing reliable data can be an expensive and time-consuming forensic exercise.
Unforeseen Business Circumstances: COVID-19?
In the midst of a global pandemic, the FAQs may offer taxpayers some well-needed solace. It may not be coincidental that the FAQs were posted in April 2020, once the impact of the economic crisis caused by COVID-19 were beginning to surface.
In particular, the answer to FAQ 1 gives an example of a U.S. “heavy machinery” distributor, in which the IRS recognizes that a U.S. distributor may temporarily incur a loss because of unforeseen “business circumstances” and not because its transfer prices were incorrect. The answer encourages taxpayers to thoroughly explain what the climate was like and how that drove the taxpayer’s unexpected economic results. This suggests that if taxpayers provide a thorough explanation of business exigencies (such as a global pandemic’s impact on their business), they may not automatically be penalized.
We will be very curious how these FAQs are operationalized by the IRS’s Exam teams over time. For example, will a “best practice” not spelled out in the regulations somehow be interpreted as a prerequisite for the avoidance of penalties? We hope not.
In any event, for taxpayers that want to maximize the opportunity to avoid expensive, protracted transfer pricing audits, the FAQ may present an opportunity: apply a little bit more effort today to—perhaps—avoid a great deal of effort later. That’s the theory, anyway.