Recent Congressional and Treasury focus on perceived U.S. earnings stripping transactions continues to fuel an increasing number of transfer pricing audits by the Internal Revenue Service. In response, the IRS (including the newly restructured national LB&I Division discussed below) is retooling its transfer pricing examination activities at the national level with the appointment of a new transfer pricing director and a chief economist.
On the ground, we are seeing more and more transfer pricing challenges arising in cases where transfer pricing policies have been in place and unchallenged by the IRS for years. In some cases, the IRS is resorting to nontraditional analyses to challenge pricing policies, including ignoring the rights of the parties under existing contracts or imputing arrangements where no contract exists. Some of the more questionable IRS rationales appear to be designed simply to inflate the adjustment. We have seen some success in overturning poorly reasoned transfer pricing adjustments in Appeals, particularly where an Appeals economist has agreed that the IRS analysis was flawed. Surprisingly, we have not seen many cases returned to IRS examination by Appeals for further development, which is always a concern when choosing to protest a case under the administrative Appeals process.
Significant strategy decisions are involved in determining whether a taxpayer seeks competent authority in lieu of, or simultaneously with Appeals, or dockets the case and attempts to invoke competent authority. Any strategy formulation requires a good understanding of the strengths and weaknesses of the case and the interests of the United States and the foreign competent authority involved. As we know from the Glaxo experience, competent authority is not a panacea in every case, especially high-ticket cases. As more transfer pricing disputes increase, there will be increased pressure on the countries with which the United States has a treaty, which includes a mandatory arbitration clause. In the past, the conventional wisdom was that a mandatory binding arbitration provision would serve more as a stick to ensure that taxpayers get some relief from double taxation. Certain competent authorities have openly declared that no cases would likely reach the mandatory arbitration stage because competent authorities would hammer out some agreement in order to avoid yielding sovereignty to an arbitrator in a baseball arbitration proceeding. These incentives may produce unsatisfactory results for taxpayers faced with significant U.S. initiated transfer pricing adjustments. In this regard, the best defense is always an offensive strategy as a taxpayer prepares its transfer pricing documentation. The lesson from Xilinx is that transactional documentation still reigns supreme in establishing what constitutes an arm’s-length price.
Finally, the state governments are not immune from the transfer pricing fever. This rush to augment government treasuries with transfer pricing adjustments has also been tapped by some enterprising individuals who are selling their transfer pricing services to some state governments on a contingent fee basis. (One such organization, Chainbridge was actually issued a patent for its “computer-implemented method” software in May 2010.) State governments (such as the District of Columbia and possibly New Jersey) have engaged these transfer pricing service providers to run a transfer pricing analysis and proposed state tax adjustment wholly based on publicly available data. Some of these reports are void of any detailed functional and factual analyses of the taxpayer and its actual activities in the relevant state although such analyses purport to follow section 482 arm’s-length principles. Many companies experiencing these adjustments have determined that, as a practical matter, they must fight these seriously flawed transfer pricing adjustments (no matter how small) or else more states will start to contract these service providers.