Transfer Pricing Audits: With Changes on the Horizon, Upfront Planning Is Key

Transfer pricing policy in the United States is guided by Section 482 of the Internal Revenue Code (and by the Organization for Economic Cooperation and Development under its Base Erosion and Profit Shifting initiative), and its application is not limited to cross-border transactions. In fact, some states, such as New York and New Jersey, have applied the Section 482 regulation during audits. Beyond the federal statute, it’s also true that nearly all states have adopted these regulations in some capacity to apply locally.

Due to the lack of success in many of these audits, states have begun to realize the need to build a mechanism that understands transfer pricing and create a means to successfully conduct audits. As such, the Multistate Tax Commission (MTC) last December furthered its attempt to bring state governments a comprehensive and coordinated program to address interstate income shifting and the loss of state tax revenues – or as project facilitator Dan Bucks described it, a “preliminary design” to build the infrastructure necessary to support state transfer pricing needs going forward.

The intention of the program is to help assist and train states on how to conduct pricing audits, as an alternative to hiring contracted consultants. The specific details around the proposed Arms Length Adjustment Service (ALAS) program are yet to be finalized and are still subject to approval, but the program is scheduled to kick off in July 2015.

If implemented, the initial phase of the ALAS approach consists of a review and analysis of taxpayers’ existing transfer pricing documentation. During this phase, the MTC examines the functions performed, risks assumed, and assets employed (i.e., both tangible and intangible assets) by the related parties involved in the intercompany transaction, in an effort to produce a more rigorous analysis.

If taxpayers do not have a formal transfer pricing documentation study covering cross-state intercompany transactions, they are encouraged to produce one or, at the very least, provide an economic analysis detailing what comparable third-party benchmarks would earn under the same or similar facts and circumstances. Audit services and post-audit services (including legal assistance with litigation) will also be included.

The proposed preliminary design approach will deviate from prior methods used by the states to audit taxpayers (e.g., strictly contract auditors or strictly state-run audits). It will consist of a mix of in-house MTC expertise and contract auditors for cases requiring advanced technical analysis of transfer pricing documentation and positions.

Taxpayers should begin to expect more rigorous state transfer pricing examinations and be prepared to provide documentation supporting their transfer pricing positions across state borders. Strong transfer pricing documentation includes a complete and accurate functional analysis and risk profile, along with a rigorous economic analysis of the intercompany transactions. While state auditors will have information gleaned from state tax returns, as well as publicly available information, transfer pricing documentation will allow companies to explain their business, industry, and transfer pricing policy while presenting analysis that demonstrates how their positions can be characterized as arm’s length.

Transfer Pricing Audit Roadmap

One resource that companies can use to be mindful of transfer pricing considerations is the Transfer Pricing Audit Roadmap. Developed by the IRS, it provides techniques and tools to conduct examinations. This is the first publicly available transfer pricing tool that offers the reader tangible preparation guidelines.

Why would the IRS release a document explaining how it plans to conduct audits? Because the roadmap helps create transparency for both taxpayers and tax professionals. Up until now, the audit process has been a black box, with little transparency for the taxpayer and little structure for the IRS.

Key themes found in the audit roadmap include upfront planning, factual development and presentation, and involvement of transfer pricing professionals. As the development of a transfer pricing statement may take two to three years, planning is key in getting professionals involved early on in the process. It is important to note that the roadmap is not a standardized audit template, but instead a list of best practices – every case is unique and may not fall under the audit guidelines.

With many changes in the transfer pricing world just around the corner, it is prudent that businesses understand transfer pricing audit risks and how to best mitigate them. Staying up-to-date on upcoming changes, maintaining comprehensive documentation, and utilizing available resources is an excellent way to begin.