Transfer pricing is and has been the most significant and difficult issue the IRS audits. The audits are typically closed with the IRS agents proposing unreasonably large adjustments and IRS appeals sustaining a very low percentage of the adjustments. The IRS has not been very successful in litigating transfer pricing cases either. As a result, the IRS has changed the way it examines these issues. TIGTA recently addressed this issue in its report entitled Barriers Exist to Properly Evaluating Transfer Pricing Issues.
Transfer Pricing Disputes
Transfer pricing refers to the prices charged (or not charged) between member firms for goods and services. From the IRS’s perspective, taxpayers either manipulate the transfer pricing rules or fail to apply them so that their profits–and income tax due on those profits–are in tax haven or low tax jurisdictions.
In many cases, this involves overpaying an entity or entities set up in foreign countries for the use of intangible assets or for manufacturing or selling goods or services to these entities at inflated prices. If the foreign entity is subject to tax in the U.S., such as a disregarded entity owned by a U.S. parent, it may be just the opposite–where the taxpayers fail to charge or charge too little for goods and services by the foreign entity. The end result is profit being captured in foreign countries and subject to a tax rate that is lower than the U.S. income tax rates.
How the IRS Audits Transfer Pricing Issues
The IRS has changed the way it audits transfer pricing issues over time. Many of these changes were made as part of the IRS’s shift to focusing on international tax issues. The transfer pricing team was initially part of the international audit function. The team was brought into audits by referrals from revenue agents. Then the IRS expanded the international team and it mandated that revenue agents refer cases to the transfer pricing group.
The IRS then stood up a separate transfer pricing audit team. The team still worked on cases by mandatory referral, but it also started working its own audit cases. So large taxpayers typically ended up having three separate IRS income tax audits at the same time, i.e., a domestic income tax audit, an international income tax audit, and a transfer pricing income tax audit.
This overlap of IRS authority often led to disputes between IRS teams working on the audits. It also resulted in confusion as to the chain of command, with IRS management thinking the other function was managing and overseeing the audit and/or not agreeing with decisions made by the other functions. This resulted in IRS agents in the international and transfer pricing groups having little management supervision or oversight by upper management.
It also resulted in unexplained delays where the audits did not have any work done on them. To taxpayers, it was a start-and-stop process punctuated by several months–sometimes up to 6 months–of silence by the IRS agents. Cases were then closed in a rush due to internal politics given the length of time the audits had carried on.
This disorganized audit process resulted in significant delays in the audits and adjustments that did not make a lot of sense from a legal or economic point of view.
These problems have been exacerbated by several high-level personnel changes in the IRS. Initiatives pursued by these leaders have either withered or taken unexpected turns that have reduced their effectiveness. The IRS’s Transfer Pricing Roadmap is one example of this.
Before these high-level personnel changes took place, the IRS authored a document referred to as the Transfer Pricing Roadmap. The roadmap was intended to be a compromise between the IRS and taxpayers that could help speed up the audit process for transfer pricing issues and help the IRS focus on legitimate transfer pricing cases. After the personnel changes, many IRS agents and teams–including higher-level IRS managers–refused to follow or even openly disavowed the Transfer Pricing Roadmap.
The TIGTA Transfer Pricing Report
The primary recommendation in the TIGTA Transfer Pricing Report is that the IRS should require IRS employees to follow the Transfer Pricing Roadmap. As tax practitioners and sophisticated taxpayers know, many of the suggestions in the Transfer Pricing Roadmap are not feasible or realistic.
For example, while limiting the transfer pricing audit to a 24 month period would be nice, it is often not possible to perform a full transfer pricing audit in a 24 month period as suggested by the roadmap. Twenty-four months may sound like a long time, but it is not when the audit and information-gathering process is considered. It can take more than three months for the IRS audit team to complete the audit setup. It can then take six months or more for the IRS team to finish the pre-planning stage where it gathers facts and identifies what issues and sub-issues the IRS will examine. Then the taxpayer has to be afforded time to present information (usually 30 days for each response).
Larger and more complex transfer pricing audits often require 30 or more detailed responses. This is especially true in that transfer pricing adjustments are often based on documents that the taxpayer did not create or develop prior to the audit, as there was no business need to create the documents prior to the audit. And this does not include the time needed to actually write up the transfer pricing report and adjustment and to prepare the paperwork to close the case–which can take another 6 months or more.
The roadmap also pre-supposes that the taxpayer will turn over all information and help the IRS identify the pertinent facts and formulate and make its arguments. It is not clear why a taxpayer would do this, or even why it would be expected during an adversarial audit process that will most likely result in significant tax adjustments.
The IRS’s policy of transparency which its agents and management mention, but often do not follow, is just that–the IRS’s policy. It may or may not be the taxpayers. From the taxpayer’s perspective, their policy is to get all helpful and relevant information into the audit record and try to coax the IRS into closing the case as expeditiously as possible. This is not consistent with the IRS’s Transfer Pricing Roadmap.
It may be that this is the best outcome given the current laws. The IRS is enforcing the laws set by Congress and, to some extent, set by the Treasury Department. Congress and the Treasury Department created the laws that provide taxpayers with the means to, and a significant incentive to, shift income and wealth to foreign countries. They also created laws that discourage taxpayers from repatriating the money.
This presents competing policies of raising revenue versus keeping investments and businesses in the U.S., among other policies. The IRS’s transfer pricing audit function has been assigned the difficult task of balancing these policies and doing so within the established legal framework. Until something changes, time-consuming and resource-intensive audits that result in significant adjustments that are whittled down in the administrative appeals process may be the best way to handle this issue.