Thursday, 7 April 2016

IRS Releases Several Transfer Pricing Related Practice Units

Throughout the month of March, the IRS released several Practice Units that address various areas of transfer pricing. While they are not official announcements of laws or directives, Practice Units are developed internally by the IRS and are meant to act as both job aids and training materials on international tax issues. They also serve as a resource for the IRS’s field teams when conducting audits. For transfer pricing practitioners and taxpayers, Practice Units can shed valuable light on how the IRS views certain transfer pricing issues. The following sections summarize the Practice Units released during March.

Review of Transfer Pricing Documentation by Outbound Taxpayers
Released on March 4, 2016, this Practice Unit gives guidance on how to best review taxpayer transfer pricing documentation (“TPD”) associated with outbound transactions (i.e. tangible goods, intangibles, or services leaving the US). The Practice Unit provides a useful review of the US transfer pricing documentation requirements as outlined by IRC 6662(e). While TPD is not a requirement in the US, TPD done in good-faith can shield taxpayers from penalties imposed on transfer pricing adjustments. The Practice Unit describes ‘good-faith TPD requirements’ as “(T)he taxpayer must maintain and provide the IRS with documentation sufficient to establish that the taxpayer reasonably concluded that the chosen pricing method was the best method and its application provided the most reliable measure of an arm's-length result, given the available data.”

The Practice Unit also provides practical advice to IRS staff that should not be ignored by taxpayers and practitioners. Specifically, the Practice Unit advises that the first step upon receipt of the TPD is to “map Forms 5471, 8858, and 8865 to the TPD.” In practice, the economic analyses presented in a taxpayer’s TPD may often reflect the transfer pricing policies in place rather than the actual year end transfer pricing results. For example, while the TPD may illustrate the case for why a taxpayer’s foreign distributor should earn a fixed level of profit, based on an economic analysis of comparable distributors, the taxing authorities will need to be able to map the economic analysis results from the TPD directly to information reported in tax filings (e.g., Forms 5471, 8858, and 8865). In order to avoid any misunderstandings at the onset of a transfer pricing audit, taxpayers would be well served to perform a reconciliation exercise annually to ensure the economic analysis from their TPD can be directly linked to information on their tax returns. If necessary, taxpayers should consider adding an explanatory addendum to bridge any potential discrepancies.

Outbound Services by US Companies to CFCs
Released on March 4, 2016, this Practice Unit covers one of the most common intercompany transactions for US-based multinationals: the provision of services by US companies to their Controlled Foreign Corporations (“CFCs”). The Practice Unit provides a helpful summary of the Service Regulations under Treas. Reg. 1.482-9, including how the regulations should be applied in practice. This Practice Unit presents an analogous framework to the Practice Unit released last month which covered the analysis of intercompany loans under the Situs Rule. Specifically, the Practice Unit on intercompany loans describes how for any analysis to be done on the arm’s length nature of an intercompany interest rate, it must first be established that the loan itself is classified as bona fide debt. In following a similar framework, the Practice Unit on outbound services states that before any analysis of the arm’s length charge can be analyzed, it must first be established that i) an intercompany service was provided and ii) the recipient received a benefit. This Practice Unit on outbound services serves as a reminder that an analysis of the underlying substance of a services transaction is the first and most important step in any services analysis.

Residual Profit Split Method - Outbound
Released March 7, 2016, this Practice Unit covers the use of the residual profit split method (“RPSM”) for outbound transactions. The Practice Unit makes clear that the RPSM is only applicable when both controlled taxpayers make significant non-routine contributions to the intercompany transaction and if the identification of a market return for those non-routine contributions is not possible. Application of the RPSM consists of two primary steps: 1) compensating any routine contributions made; and 2) allocating the residual profits amongst the participants. In practice, the latter step is the most difficult and contentious.

There are two ways for residual profits to be split under the RPSM: 1) market observations can be used to determine how parties operating at arm’s length and engaged in a comparable division of non-routine functions split their operating profit; or 2) internal data from the taxpayer can be used to estimate the non-routine contributions made by each respective participant (e.g., development costs incurred). The Practice Unit points out what transfer pricing practitioners have long since recognized; in practice, the RPSM generally relies on internal data to allocate residual profit amongst the participants because observations between two arm’s length parties to support a market-based approach are generally unavailable. However, the Practice Unit does make mention, without naming specifics, that in some industries market-based observations of profit splits can be more easily observed. In summary, taxpayers that apply the RPSM should be able to prove that each party makes significant non-routine contributions and that pricing those contributions is not possible with the data available under any other method.

Further information on the IRS’s International Practice Units can be found on their website here.

Source: Duff&Phelps