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Review and adjustments

Review and audit

What rules, standards and procedures govern the tax authorities’ review of companies’ compliance with transfer pricing rules? Where does the burden of proof lie in terms of compliance?

No special rules, standards or procedures apply to the review of transfer pricing issues.

The burden of proof in a transfer pricing tax examination or in litigation rests with the taxpayer, unless the Internal Revenue Service (IRS) alleges fraud, in which case the burden of proving fraudulent conduct lies with the IRS. The taxpayer has the following two-fold burden of proof in transfer pricing cases:

  • it must show by clear and convincing evidence that any IRS proposed transfer pricing adjustment is “arbitrary, capricious, unreasonable amounting to an abuse of discretion”; and
  • it must show by a preponderance of evidence (greater than 50% probability) the correct arm’s-length result.

When a taxpayer meets the threshold burden of proof (ie, arbitrary or capricious), but not the second burden of proof (ie, proving the arm’s-length result), the court reviewing the transfer pricing dispute has the authority to determine the arm’s-length result independently.

In practice, most courts litigating transfer pricing cases have found the IRS proposed adjustment to be arbitrary, capricious and unreasonable, but have generally not agreed with the taxpayer’s determination of the arm’s-length result. For example, see Medtronic Inc v Comm’r (TC Memo 2016-112) and Amazon.com, Inc v Comm’r (148 TC No 8, 2017).

Do any rules or procedures govern the conduct of transfer pricing audits by the tax authorities?

No special statutory or regulatory rules govern the conduct of transfer pricing examinations. The IRS set up a special group within the National Office to coordinate and in some cases lead major transfer pricing examinations. This group is referred to as Transfer Pricing Operations (TPO).

In 2014 the TPO published a transfer pricing audit roadmap, which provides a suggested timeline and framework for transfer pricing examinations. The roadmap outlines IRS examination best practice procedures for identifying, examining and resolving transfer pricing issues.

The IRS has also established a quality examination process, which is a systematic approach for engaging and involving large business and international division taxpayers in the tax examination process – from the earliest planning stages through to resolution of all issues and completion of the case. The IRS publication Achieving Quality Examinations through Effective Planning, Execution and Resolution, outlines the large business and international division examination process from start to finish.

Penalties

What penalties may be imposed for non-compliance with transfer pricing rules?

In the United States, contemporaneous transfer pricing documentation is prepared to avoid the imposition of penalties after a transfer pricing adjustment proposed by the IRS is sustained. Penalties are avoided if the taxpayer had reasonable cause to believe at the time the tax return was filed that the transfer pricing positions that reflected on the US income tax return produced arm’s-length results. The transfer pricing penalty provisions under Internal Revenue Code Sections 6662(e) and 6662(h) are triggered when taxpayers fail to reasonably comply with the documentation requirements. The documentation requirements state that taxpayers must be able to demonstrate that their related-party pricing was arm’s length. The amount of the penalty is directly correlated to the taxpayer’s divergence from what is determined to be the arm’s-length price.

Under Internal Revenue Code Section 6662(e), a 20% penalty applies for substantial valuation misstatements. Namely:

  • a transactional penalty applies where the arm’s-length price of any property or service or use of property, claimed on a return in connection with any transaction between members of a related group is 200% or more or 50% or less than the amount ultimately determined by the IRS under Section 482 to be the correct price and
  • a net Section 482 adjustment penalty applies where the net effect for an entire taxable year of all of the Section 482 adjustments in the price for any property or services or for the use of property results in an increase in taxable income for the year in excess of the lesser of:
    • $5 million; or
    • 10% of the taxpayer’s gross receipts.

There is no penalty unless the portion of the underpayment for the taxable year attributable to substantial valuation misstatements exceeds $10,000 for most corporations.

The second penalty under Section 6662(h) is a 40% penalty for gross valuation misstatement. This penalty may apply instead of the 20% substantial valuation penalty if either of the following situations apply:

  • where the price for any property or services, or the use of property, claimed on any income tax return in connection with any transaction between members of a controlled group is 400% or more or less than 25% of the amount ultimately determined to be the correct price under Section 482 (transactional penalty); and
  • where the net effect for an entire taxable year of all the adjustments under Section 482 in prices for property and services is an increase in taxable income for the year greater than the lesser of $20 million or 20% of gross receipts (net Section 482 adjustment penalty).

Penalties are avoided if the taxpayer had reasonable cause to believe at the time that the tax return was filed that the transfer pricing positions reflected on the US income tax return produced arm’s-length results through reasonable application of authorised transfer pricing methods. The methods and application of methods chosen based on the taxpayer are reasonable if they provided the most reliable measure of an arm’s-length result. Under Treasury Regulation Section 1.6662-6(d), reasonableness is determined by all of the facts and circumstances, regardless of whether the method selected is a method that is specified in the relevant regulations or an unspecified method.

Adjustments

What rules and restrictions govern transfer pricing adjustments by the tax authorities?

In general, are no restrictions specifically govern transfer pricing examinations or adjustments.

Challenge

How can parties challenge adjustment decisions by the tax authorities?

In the United States, in the absence of unusual circumstances (referred to as ‘jeopardy assessments’), the IRS must follow deficiency procedures before assessing a disputed income tax adjustment, including an income tax adjustment attributable to transfer pricing. Taxpayers may challenge proposed adjustments before the assessment of the disputed tax through:

  • administrative review procedures during the examination process;
  • an administrative appeals process within the IRS; or
  • litigation in the Tax Court.

Taxpayers may also challenge IRS adjustments after an assessment of the disputed tax through refund litigation in the US District Court of the US Court of Federal Claims.

Appeal rights are set out in IRS Publication 5, Your Appeal Rights and How To Prepare a Protest If You Don’t Agree.

Mutual agreement procedures

What mutual agreement procedures are available to avoid double taxation arising from transfer pricing adjustments? What rules and restrictions apply?

The United States has entered into approximately 40 income tax conventions treaties. US income tax treaties all contain an article that provides mutual agreement procedures to resolve potential economic double taxation caused by transfer pricing adjustments made by one of the parties to the treaty.

A complex set of US procedural requirements apply to requesting mutual agreement procedure relief, which are outlined in Revenue Procedure 2015-40, IRB 2015-35.

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