On January 12, 2018, the IRS Large Business and International (“LB&I”) Division released a set of “Directives” regarding new transfer pricing examination procedures and policies.1 The Directives, which stem from LB&I’s efforts to work smarter with fewer resources, carry important implications for taxpayers undergoing transfer pricing audits. Namely, the Directives:
- Revisit and partially jettison the 15-year-old “Mandatory Transfer Pricing IDR”;
- Provide critical guidance to LB&I on when it may change a taxpayer’s transfer pricing method; and
- Carry strong reminders on the importance of a careful consideration of the so-called automatic section 482 penalties for non-compliance.
Elimination of Mandatory Transfer Pricing IDR
In 2003, LB&I’s predecessor organization issued a now-famous directive making it mandatory for examiners to request transfer pricing documentation at the beginning of an exam that featured cross-border transactions.2 The reasoning behind the directive was twofold—to encourage taxpayers to prepare detailed transfer pricing documentation and, as a corollary, to allow examiners immediate access to thoughtful data upon which to evaluate the arm’s length nature of the taxpayer’s pricing.
The new LB&I Directive revisits the 2003 directive and retains the Mandatory Transfer Pricing IDR only in limited circumstances. First, if an LB&I campaign contains guidance on issuing a Mandatory Transfer Pricing IDR, then such guidance should be observed. Second, for examinations in which there are “initial indications of transfer pricing compliance risk” and for which the exam has been staffed with employees from the IRS’s Transfer Pricing Practice (TPP) or Cross Border Activities (CBA) Practice Area, then the TPP/CBA employees will issue the Mandatory Transfer Pricing IDR. In other examinations, no Mandatory Transfer Pricing IDR will be issued.
Some taxpayers no doubt will view the abandonment of the 2003 directive as a welcome development, but others may review the new Directive and question how it applies to them for at least two reasons. First, the IRS has offered little guidance to taxpayers concerning LB&I’s campaigns. A taxpayer is not likely to know whether there is campaign guidance instructing the field to use the Mandatory Transfer Pricing IDR. Second, a taxpayer may not know whether the exam team has observed any “initial indications” of compliance risk. And if LB&I determines there are initial indications of compliance risk before requesting 6662 documentation, it begs the question of what examiners are using to make this determination. Well-advised taxpayers, of course, will do well to have dialogues with their local exam agents and International Examiners (IEs), but such conversations may not be satisfying; it is now the TPP/CBA personnel who are charged with issuing any Mandatory Transfer Pricing IDRs, not the local agent or IE.
Change in Best Method Selection Requires National Panel Review
The Directive prevents an examiner from departing from a taxpayer’s determined best method unless the change is vetted through a formal approval process. The instructions now mandate that examiners start their transfer pricing evaluation by reviewing the taxpayer’s application of its chosen methodology (set forth in timely produced §6662(e) documentation), rather than, as has often happened in the past, simply disregarding it and developing an entirely new best method analysis.3 Examiners may then make properly documented adjustments or corrections to the application of the taxpayer’s method (e.g., comparable company selection, tested party data, etc.) without higher levels of scrutiny. However, if examiners believe that an altogether different method results in a more reliable measure of an arm’s length result, the examiner must submit a recommendation through the issue manager’s management chain to the applicable Director of Field Operations level for referral to the national TTPO Transfer Pricing Review Panel (Review Panel). The recommendation must include the analysis supporting the alternative method selection and other relevant information. The Directive also requires the Advance Pricing & Mutual Agreement (APMA) Program to seek formal approval through a parallel process to depart from the transfer pricing method proposed in a unilateral APA request (at any time) or a bilateral APA request prior to the commencement of competent authority negotiations.
The Transfer Pricing Review Panel consists of the TPP director,4 a senior advisor to the TTPO director, and the Income Shifting Practice Network manager. Their review of the recommended transfer pricing change will focus on (1) why the taxpayer’s method is unreliable, (2) whether the taxpayer’s method can be adjusted to make it more reliable and if not (3) what method is more reliable, and why. The LB&I instructions do not provide other helpful information regarding the Review Panel, such as how the approval process proceeds, whether taxpayers may submit additional documentation in support of their method, or how disagreements between the Review Panel and the examiners may be resolved.
This Directive seems to recognize that the most time-consuming and expensive transfer pricing disputes are those in which the taxpayer and the IRS have markedly divergent views as to the best method for determining an arm’s length result. That the Directive admonishes LB&I personnel not to lightly discard a taxpayer’s chosen method should therefore be a welcome development. Note, however, that in order to enjoy the benefits of this Directive, it is critical that the taxpayer’s transfer pricing study (i) articulates clearly the taxpayer’s method, and (ii) explains its selection as the best method. It remains unclear how LB&I will react to a study that identifies more than one method as best or identifies one method supported by one or more “corroborative” methods.
Exam Teams Are Reminded to Consider Imposing Transfer Pricing Penalties
As an appendage to the other Directives, a third LB&I Directive now also encourages examiners to thoroughly evaluate whether the imposition of penalties is appropriate in every transfer pricing matter. Unlike many penalties, section 6662(e) and (h) penalties may apply automatically when transfer pricing adjustments eclipse a certain dollar threshold unless the taxpayer maintains adequate contemporaneous transfer pricing documentation and provides it to the IRS within 30 days of a request for it. The new LB&I Directive reminds examiners that merely having a study is not enough. Rather, the study must meet the strictures of section 6662(d) and its regulations. This includes an inquiry into whether taxpayers “reasonably selected the best method for their analysis and [that] they reasonably applied that best method.” Stated indications of when taxpayers may have acted “unreasonably” in this regard include taxpayer use of “inaccurate inputs,” the failure to “adequately search for or consider material information” or “follow [the] best method rule in selecting and applying the method,” or the appearance of “results that different significantly from the arm’s length result and that are sizable in relation to the controlled transaction.” The LB&I instructions also encourage examiners to probe what data and information the taxpayer had access to (or reasonably could have had access to) to determine whether the “taxpayer adequately searched for, considered and applied the relevant body of information and whether the taxpayer adequately incorporated and addressed that data” in its transfer pricing documentation.
This penalty Directive should be considered together with the separate Directive discussed above on the approval process for changing the best method. It is unclear, for example, if an examiner receives approval to change the best method, and the penalty thresholds are exceeded, it is a foregone conclusion (as a technical or practical matter) that penalties will be imposed. There is language in the penalty Directive that might suggest automatic penalty assertion. The penalty Directive states in part: “If the examiner determines the taxpayer’s best method selection is not reasonable and receives approval to apply an alternative method as the best method, subject to the best method guidance referenced above, penalties would apply if the resulting adjustments are in excess of the threshold amount” (emphasis added). In our view, however, the Directives read in context mean that penalty assertion is only possible if the examiner can positively conclude that the taxpayer’s choice of methods was unreasonable, not simply that there was another method ultimately sustained as the best method.
1 LB&I issued five Directives, each a “Memorandum for LB&I Division Employees” from Douglas W. O’Donnell, Commissioner LB&I Division. In this Legal Update, we address three of the five that are of general application: “Interim Instructions on Issuance of Mandatory Transfer Pricing Information Document Request (IDR) in LB&I Examinations,” LB&I-04-0118-001 (January 12, 2018); “Instructions for LB&I on Transfer Pricing Selection and Scope of Analysis – Best Method Selection,” LB&I-04-0118-002 (January 12, 2018); and “Instructions for Examiners on Transfer Pricing Issue Examination Scope – Appropriate Application of IRS§6662(e) Penalties,” LB&I-04-0118-003 (January 12, 2018).
The other two Directives concern procedures related to cost sharing arrangements—specifically cases with stock-based compensation and certain disputes over reasonably anticipated benefit issues: “Instructions for Examiners on Transfer Pricing Issue Selection – Reasonably Anticipated benefits in Cost Sharing Arrangements,” LB&I-04-0118-004 (January 12, 2018), and “Instructions for Examiners on Transfer Pricing Issue Selection – Cost-Sharing Arrangement Stock Based Compensation,” LB&I-04-0118-005 (January 12, 2018).