It’s inevitable that the IRS will audit significant intercompany transactions, particularly those at large multinational companies. These audits can take years to resolve and often consume significant resources to defend—but they’re survivable. We suggest some considerations for anticipating or defending a transfer pricing audit.
Strong, well-written Section 6662(e) documentation allows a taxpayer to control the narrative in an IRS audit. Documents should be viewed as having two purposes: penalty protection and the first line of audit defense. For penalty protection purposes, the documents must contain the relevant “principal documents” and must demonstrate that the taxpayer was “reasonable” in concluding that the method applied was the best method.
But the documents may need to go beyond these minimum requirements to provide a strong first line of audit defense. This more robust documentation typically would:
- Explain the transaction in the context of the taxpayer’s overall value chain and industry;
- Contain a robust analysis of the functions and risks of each relevant related party (not just the tested party) and a robust economic analysis;
- Fully explain the data used in the analysis; and
- Explain the best method selection including reasons for not selecting other potential methods.
We recognize that such documentation may be cost-prohibitive for most intercompany transactions, but it should be considered for the most material or significant transactions that are likely to face audit.
Taking the time to create an “audit defense file” long before an audit begins will also help. In-house professionals often have to move onto the next project as soon as one is finished (if not before) and may deprioritize less pressing administrative matters. But it’s worthwhile to create an audit defense file while entering transactions or updating documents.
They should include background workpapers, interviews that support the documentation, internal notes, notes about confirming methods, and other documents that could shed light on the transactions and pricing. This will help your controversy colleagues understand what and why something was done, giving them a head start in preparing for the audit.
The IRS essentially has unlimited time to conduct the audit. Taxpayers should recognize that any timeline presented by the IRS is aspirational, especially if transfer pricing issues are being examined. Transfer pricing audits routinely take years to resolve.
The IRS begins a transfer pricing audit with a working hypothesis formed through data analytics and publicly available information. The taxpayer often can present an overview of the intercompany transaction and pricing methodology to the exam team at the beginning, and typically a few times throughout, as exam personnel changes. Taxpayers should take advantage of these opportunities but not be surprised when they have to explain their business multiple times over the course of an audit.
Taxpayers also generally can meet with the exam team weekly or bi-weekly. These meetings are geared toward transparency, but it often is only the taxpayer who’s transparent. Examiners are unlikely to share information about their hypothesis or concerns with the taxpayer’s method until near the end. Examiners may use these informal meetings to ask for information from a taxpayer. These requests should be turned into information document requests before responding.
Taxpayers also should use these informal meetings to raise any concerns with the examiners, whether about specific IDRs or bigger-picture concerns about the process, scope, transparency, or length and pace of the audit. If these concerns can’t be resolved through informal meetings, they may still provide a springboard for escalation within the Large Business and International Division.
Perseverance Is Key
The IRS uses IDRs to gather information to support a working hypothesis. IDRs can be voluminous and numerous. In one transfer pricing audit, examiners issued more than 400 IDRs—with subparts. T
axpayers have little ability to push back on requests for “relevant” information but should use the draft IDR process to negotiate the scope of the requests and reasonable deadlines for responses. IDR responses should be timely and complete but limited to the specific information requested—and specific as to any limitations, such as the documents provided are those that the taxpayer identified after a reasonable search.
Taxpayers should carefully identify whether any responsive documents are subject to the attorney-client, Section 7525, or other applicable privileges, and assert those privileges where appropriate prior to responding to IDRs. This is important but often difficult, given the prevalence of dual purpose documents within tax departments.
The IRS also uses interviews to test its working hypothesis. Although interviews can help the IRS to understand the business, they’re also disruptive. Taxpayers should be prepared to negotiate the number, length, date and time, location, format, and topics of interviews, as well as the specific employees to be questioned. Often, proposed interviewees won’t have the best firsthand knowledge of the sought-after information, so taxpayers should be prepared to suggest alternative interviewees. Many employees aren’t focused on transfer pricing in their day-to-day lives. But often, after understanding the objectives of the audit process, they can provide pertinent insights about the business’s functions and risks.
Toward the end of the audit, the exam team will issue an acknowledgment-of-facts IDR. While the best response strategy depends on the nature of the audit, transaction, and issue, the response may be one of the last opportunities to introduce relevant facts or dispute facts as stated prior to resolution discussions—or barring that, filing a protest or request for competent authority assistance.
After the AOF IDR, the audit typically will proceed to the resolution phase, which includes a final notice of proposed adjustment and an economist’s report. While some taxpayers continue to have success resolving transfer pricing issues with their exam teams, in our experience, these audits are typically less contentious than perhaps others.
After the IRS has spent years auditing a transfer pricing issue, the taxpayer’s journey to tax certainty often is only just beginning when the audit ends. Nevertheless, many of the same best practices that will help taxpayers survive a transfer pricing audit will leave them well-positioned to seek resolution through appeals, the mutual agreement procedure, an advance pricing agreement with rollback or, as a last resort, litigation.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Jenny Austin is a partner in Mayer Brown’s Chicago office and a member of the global tax practice. She concentrates her practice on federal tax controversy and litigation and has significant experience advising multinationals on transfer pricing issues from the IRS audit through litigation.
Jason Osborn is a partner in Mayer Brown’s Washington, D.C., office and co-leader of the firm’s international tax and transfer pricing team. He advises multinationals in a range of industries in APA negotiations, competent authority matters, IRS transfer pricing audits and planning and structuring related party transactions.
May Chow is an associate in Mayer Brown’s Chicago office and a member of the global tax practice. She represents taxpayers at all levels of federal tax controversy, including IRS audits, administrative appeals, competent authority, and litigation.
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