In a new International Practice Unit (IPU), the IRS charted audit steps its examiners should follow in reviewing the transfer pricing documentation of U.S. taxpayers that transfer and provide tangible property, intangible property, and service to foreign affiliates in exchange for payments (that is, outbound transactions).
The review is an integral part of an IRS examiner’s analysis of transfer pricing risks and the assessment of any transfer pricing penalties.
The IPU notes that transfer pricing documentation should show that the pricing methodology is reasonable and meets the best method rule — that is, it provides the most reliable measure of an arm’s-length result and is the most reliable application of the method.
Auditors should request the following “principal documentation”:
- An overview of the taxpayer’s business, including an analysis of the economic and legal factors that affect the pricing of its property or services,
- A description of the taxpayer’s organizational structure (including an organization chart) covering all related domestic and foreign parties engaged in potentially relevant transactions, including foreign affiliates whose transactions directly or indirectly affect the pricing of property or services in the U.S.,
- A description of the transfer pricing method selected and an explanation of why it was selected, including an evaluation of whether any regulatory conditions and requirements for application of that method were met,
- A description of any alternative transfer pricing methods that were considered and an explanation of why they weren’t selected,
- A description of the related party (controlled) transactions and any internal data used to analyze those transactions,
- A description of the transfer pricing comparables that were used, how comparability was evaluated, and any adjustments made,
- An explanation of the economic analysis and projections relied upon in developing the transfer pricing method,
- A description or summary of any relevant data that the taxpayer obtained after the end of the tax year and before filing a tax return that would help determine if a specified method was selected and applied reasonably, and
- A general index of the principal and background documents and a description of the recordkeeping system used for cataloging and accessing those documents.
The IPU notes that “complete documentation may not require all principal documentation to be provided.” Instead, IRS examiners should analyze whether the documentation provided gives a complete understanding of a taxpayer’s controlled transactions. Supplying all the principal documentation wouldn’t necessarily preclude the IRS from assessing the aforementioned transfer pricing penalties for a variety of reasons — for example, deficient documentation.
For additional guidance, the IPU asks IRS examiners to consult the Transfer Pricing Audit Roadmap (https://www.irs.gov/pub/irs-utl/FinalTrfPrcRoadMap.pdf), but cautions that the use of such guidance requires judgment, as every transfer pricing case is unique.
After receiving the requested transfer pricing documentation, IRS examiners are instructed to compare any related-party information reflected in the following types of U.S. returns to the transfer pricing documentation provided and identify any missing controlled transactions:
- Schedules C, F, and M of Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations”;
- Schedules C and F of Form 8858, “Information Return of U.S. Persons With Respect To Foreign Disregarded Entities”; and
- Schedules B, L, and N of Form 8865, “Return of U.S. Persons With Respect to Certain Foreign Partnerships.”
In addition, the IPU instructs IRS examiners to confirm that the taxpayer’s financial statements (including income statements and balance sheets) match the transfer pricing documentation provided.
In summary, the overall objective is to encourage taxpayers to document their transfer pricing transactions and provide the documentation to the IRS in a timely manner.
Sidebar: Limits on Housing Expenses
The IRS issued a notice of 2016 adjustments to the limitation on housing expenses for individuals working abroad. The notice recognizes that some taxpayers may elect to apply the 2016 limitation to tax years beginning in 2015.
Qualified individuals may elect to exclude from U.S. gross income their foreign earned income and housing cost amount. The maximum excludable housing cost amount is calculated by way of a complex formula.
The notice contains a table that:
- Identifies locations within countries with high housing costs relative to U.S. housing costs, and
- Provides an adjusted annual maximum and daily housing expense limitation for a qualified individual incurring housing expenses in one or more specified high-cost localities in 2016 to use (instead of the otherwise applicable annual housing expense limitation of $30,390, or the prorated daily amount) in determining his or her housing expenses.
A qualified individual who incurs housing expenses, in one or more of the high-cost localities identified in the table for the year 2016, may use the adjusted limit provided in the table (rather than $30,390 or the prorated daily amount) in determining the housing cost amount. This is reported on Form 2555, “Foreign Earned Income.”
While the high-cost area amounts for most cities didn’t change dramatically, there were large drops for some Canadian cities. For example, the amount for Toronto dropped to $41,400 from $49,700 in 2015, and the amount for Montreal fell to $43,900 from $52,000.
The full notice can be found at https://www.irs.gov/pub/irs-drop/n-16-21.pdf.