Taxing authority and tax law
Tax authority: Internal Revenue Service (IRS)
Tax law: Internal Revenue Code (IRC) §§482, 6038A, 6038C and 6662
Relevant regulations and rulings
- Treasury Regulations (Treas. Regs.) §§1.482, 1.6662, 1.6038A, 1.6038C
- Revenue Procedure (Rev. Proc.) 2006-54, Rev. Proc. 99-32, and Rev. Proc. 2006-9
- Final regulations (TD 9088) on compensatory stock options under IRC §482, released on 26 August 2003, maintain that stock-based compensation must be taken into account in determining operating expenses for qualified cost-sharing arrangements (CSAs) under Treas. Reg. §1.482-7
- Audit checklist on CSAs issued in August 2005
- In April 2007, CSA buy-ins were designated by the IRS as a “Tier I” issue, and thus susceptible to intensified audit scrutiny
- A Coordinated Issue Paper was released on 27 September 2007 providing internal IRS guidance for examiners in developing CSA exam positions
The Department of Treasury and the IRS released temporary CSA regulations with an effective date of 5 January 2009 (TD 9441, 74 FR 340). These regulations revise the proposed regulations issued in 2005 and replace the existing CSA regulations from 1995. The temporary regulations provide the IRS with discretion to make periodic adjustments and formalize other new requirements for compliance.
New final, temporary, and proposed regulations related to services were issued on 31 July 2006. The new rules were effective 1 January 2007, and apply to tax years beginning after 31 December 2006. In conjunction with the new regulations, the IRS also issued Announcement 2006-50, which contained a proposed list of “specified covered services” that relate to a specific cost-based method. The new services regulations require stock-based compensation to be considered in total costs. On 20 December 2006, the IRS released Notice 2007-5 and Revenue Procedure 2007-13, which extended the effective date of the Services Cost Method until 1 January 2008 and added to the list of “covered services.”
OECD guidelines treatment
The IRS considers its transfer pricing laws and regulations to be wholly consistent with OECD guidelines. For domestic use, the OECD guidelines do not provide support, and would not be directly relevant, to the application of any pricing methods. However, if taxpayers pursue competent authority relief from double taxation or a bilateral APA, the OECD guidelines would be important and may be used to demonstrate compliance with international principles.
Priorities/pricing methods
For tangible goods, the IRS accepts the CUP, Resale Price, Cost Plus, CPM, Profit Split, and unspecified methods. For intangible goods, the IRS accepts the Comparable Uncontrolled Transaction (CUT), CPM, Profit Split, and unspecified methods. The new services regulations provide for the following methods: Services Cost Method, Comparable Uncontrolled Services Price, Gross Services Margin, Cost of Services Plus, CPM, Profit Split, and unspecified methods.
The Coordinated Issue Paper related to CSAs advises IRS auditors that unspecified methods are appropriate for valuing buy-ins (such as the “income method” and the “acquisition price method”). The regulations provide a “best method rule” for determining the appropriate method to be applied by the taxpayer for each intercompany transaction.
Transfer pricing penalties
Taxpayers may be liable for either a 20% or 40% penalty for underpayment of tax (IRC §6662), as a percentage of the underpayment, or the penalty may apply to a valuation misstatement. There is not a US penalty for failure to have documentation, but documentation may help to avoid a penalty.
Penalty relief
Penalties may be avoided by adequate disclosure on IRS Form 8275 for disregarding rules or regulations and for a substantial understatement of income tax. Penalties for negligence and for a valuation misstatement are not avoided by disclosure. No penalties apply, however, if there was reasonable cause and the taxpayer acted in good faith with respect to the transaction. The regulations provide guidance for establishing reasonable cause and good faith, for example, by preparing documentation or by obtaining an APA.
Documentation requirements
Transfer pricing documentation is not required by law. However, in practice, it is recommended that taxpayers maintain contemporaneous documentation in order to avoid penalties. Documentation must be provided to the IRS within 30 days of a request during an IRS examination. To be considered contemporaneous, the documents must be in existence when the return is filed, but their existence does not need to be disclosed with the tax return and they do not need to be provided with the return.
For penalty avoidance purposes, a taxpayer is considered to have satisfied the documentation requirement if it maintained sufficient documentation to establish that the taxpayer reasonably concluded that, given the available data and the applicable pricing methods, the method (and its application of that method) provided the most reliable measure of an arm’s length result under the principles of the best method rule.
- A method determined as part of an APA is a consideration for whether the taxpayer’s method was reasonable. The principal documents required by regulations are:
- An overview of the taxpayer’s business and an analysis of legal and economic factors affecting pricing
- A description of the organizational structure
- Any documents explicitly required by regulations (e.g., CSA documents)
- A description of the pricing method and reasons why the method was selected (a best method analysis)
- A description of alternative methods and why they were not selected
- A description of controlled transactions and any internal data used to analyze them
- A description of comparables used, how comparability was evaluated and any adjustments
- An explanation of any economic analysis and any projections used to develop the pricing method
- Any material data discovered after the close of the tax year but before filing the tax return
- A general index of the principal and background documents and a description of the recordkeeping system
Documentation deadlines
If documentation is prepared to help protect against penalties, then it must be in place by the filing date of the US tax return. Taxpayers must provide documentation to the IRS within 30 days of an examiner’s request.
Statute of limitations on transfer pricing assessments
A general statute of limitations applies, which is three years from the later of either the tax return due date or the date the return was actually filed. For substantial understatements of income, the statute is extended to six years. For fraud, there is no statute of limitations.
Return disclosures/related-party disclosures
Taxpayers are required to file Forms 5471 and 5472 regarding transactions with related parties, and they may also need to file Form 8275 (regarding disclosure). Under new regulations issued in 2010, certain taxpayers will have to disclose their uncertain tax positions (UTPs) on Schedule UTP, and provide information such as the ranking of the positions by the sizes of their reserves, and concise descriptions of the tax positions. There is a phase in period so that by 2014, the UTP disclosures will be required by corporations with assets of US$ 10m or more.
Audit risk/transfer pricing scrutiny
The risk of transfer pricing scrutiny during a tax audit is high. Transfer pricing is extensively regulated. The designation of CSAs and intellectual property transactions as a Tier I (high-risk transaction) issue for IRS auditors increases the risk for those transactions. This has been borne out in practice, where documentation is requested at the start of any international-issues audit.
APA opportunity
The IRS has an APA Program Office dedicated to analyzing and negotiating unilateral APAs, as well as bilateral and multilateral APAs with competent authority, as provided in Rev. Proc. 2006-9. The revenue procedure has strict case management procedures, disclosure requirements, and detailed guidance for taxpayers and the IRS in submitting APA requests and processing the analyses. Competent authority guidance is provided in Rev. Proc. 2006-54, which complements the requirements of Rev. Proc. 2006-9.
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