IRS Guidance Signals More Stringent Scrutiny on Transfer Pricing Documentation

On April 14, 2020, the Internal Revenue Service (IRS) issued informal guidance in the form of frequently asked questions (the “FAQs”), urging taxpayers to strengthen their transfer pricing documentation required under Internal Revenue Code (IRC) section 6662(e) and Treasury Regulations § 1.6662-6. IRC section 6662 provides several types of accuracy-related penalties on underpayments of taxes. Pursuant to IRC section 6662(e)(1)(B)(ii), a net adjustment penalty could apply to an intercompany transaction when the net IRC section 482 transfer pricing adjustment exceeds the applicable threshold amount. Taxpayers, however, may avoid a net adjustment penalty by maintaining transfer pricing documentation in accordance with IRC section 6662(e)(3)(B) and Treasury Regulation § 1.6662-6. The IRS indicates that without robust documentation, intercompany transactions may be subject to extensive examination process.

The FAQs provide guidelines for preparing high-quality documentation that could increase the chance of early deselection of transfer pricing issues, thereby substantially facilitating the examination process. First, industry and company analysis sections of the report should be clear and provide context for related party transactions. For example, the report should explain economic downturns or other unforeseen special business circumstances that affect the transfer pricing results. The analysis should also address any differences in risks or functions between the tested party and the comparable companies. Second, functional analysis narratives should be robust and link facts to analysis, and risk analysis should be consistent with intercompany agreements. Finally, detailed analysis should be provided to support (i) the best method selection (as well as the rejection of specified methods, if applicable); (ii) the profit-level-indicator conclusion; (iii) the satisfaction of the comparability criteria enumerated in the regulations and (iv) proposed adjustments to the application of a specified method, if selected. Taxpayers are encouraged to conduct a “self-assessment” of the potential indicators of transfer pricing non-compliance to strengthen their transfer pricing documentation reports.

The FAQs also identify some of the most helpful features in a transfer pricing report.  These features include (i) a full explanation of the data used in the transfer pricing analysis; (ii) descriptions of the general business risks of the transaction and detailed descriptions of how these risks are allocated among the controlled participants to the transaction based on the intercompany policies/agreements and (iii) detailed explanations of how profits are allocated among all parties, especially where a party is allocated profits that are disproportionate to its relative contributions. High-quality transfer pricing documentation may also include useful features such as reports of a functional and risk analysis for each transaction, an analysis of special business circumstances that may have affected profitability, descriptions of challenges of the analysis and any user-friendly features such as a summary of information.

These guidelines are consistent with  recent IRS efforts to encourage taxpayers to improve the quality of transfer pricing documentation, and suggest that the IRS may apply a higher standard in future examination when reviewing the documentation.

Practice Point: The IRS is signaling that there are some persistent deficiencies in taxpayers’ contemporaneous transfer pricing documentation. It may be a good idea to review your documentation practices in the hope of avoiding a protracted IRS audit. If you have the same basic report year after year (other than changing the numbers), we highly suggest a critical analysis of your documentation. It is easy to get into the “same as last year” rut, but when the IRS comes knocking, you will be happy you did not fall into that bad habit!

AvatarAlex Cheng-Yi Lee
Alex Cheng-Yi Lee focuses his practice on US and international tax matters. He also has a strong background in material science and engineering. Read Alex Cheng-Yi Lee's full bio.


Andrew R. RobersonAndrew R. Roberson
Andrew (Andy) R. Roberson focuses his practice on tax controversy and litigation matters. He represents clients before the Internal Revenue Service (IRS) Examination Division and Appeals Office and has been involved in more than 50 matters at all levels of the federal court system, including the US Tax Court, several US courts of appeal and the Supreme Court. Andy has experience settling tax disputes through alternative dispute resolution procedures, including Fast Track Settlement and Post-Appeals Mediation, and in representing clients in Compliance Assurance Process (CAP) audits. He also represents individuals in Global High Wealth Industry Group audits and in connection with offshore disclosure programs. Read Andy Roberson's full bio.


Kevin SpencerKevin Spencer
Kevin Spencer focuses his practice on tax controversy issues. Kevin represents clients in complicated tax disputes in court and before the Internal Revenue Service (IRS) at the IRS Appeals and Examination divisions. In addition to his tax controversy practice, Kevin has broad experience advising clients on various tax issues, including tax accounting, employment and reasonable compensation, civil and criminal tax penalties, IRS procedures, reportable transactions and tax shelters, renewable energy, state and local tax, and private client matters. After earning his Master of Tax degree, Kevin had the privilege to clerk for the Honorable Robert P. Ruwe on the US Tax Court. Read Kevin Spencer's full bio.

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