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Documentation and reporting
Rules and procedures
What rules and procedures govern the preparation and filing of transfer pricing documentation (including submission deadlines or timeframes)?
In the United States, the preparation of transfer pricing documentation is not affirmatively required by law or regulation. Instead, ‘contemporaneous’ transfer pricing documentation is prepared to avoid penalties after a transfer pricing adjustment proposed by the Internal Revenue Service (IRS) is sustained.
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.
Transfer pricing penalties may be avoided if the following requirements under Treasury Regulation Section 1.6662-6(d) are met:
- the taxpayer established that the transfer price was determined in accordance with a specified method under the Section 482 regulations and the taxpayer’s use of the method is reasonable;
- the taxpayer has documentation which sets out the determination of the transfer price in accordance with such method and that its use of the method was reasonable; and
- the documentation is contemporaneous to the time that the return was filed and is provided to the IRS within 30 days of its request.
What content requirements apply to transfer pricing documentation? Are master-file/local-file and country-by-country reporting required?
A master file report is not specifically required. However, the 10 principal documents required for a US transfer pricing report will meet most requirements for a master file report.
A country-by-country report that meets the Organisation for Economic Cooperation and Development base erosion and profit sharing standards is required for tax years beginning after June 30 2016 (Treasury Regulation Section 1.6038-4.) The report is filed with the US income tax return on Form 8975 and the schedules included with the form. Pursuant to Revenue Procedure 2017-23, 2017-7 IRB 917, the IRS will accept Forms 8975 filed for tax years beginning before July 1 2016 (for calendar year 2016 taxpayers).
The following 10 categories of ‘principal documents’ are required by the US transfer pricing regulations:
- an overview of the taxpayer’s business, including economic and legal factors that affect pricing of its products or services (Treasury Regulation Section 1.6662-6(d)(2)(iii)(B)(1));
- a description of the taxpayer’s organisational structure, including all related parties whose activities are relevant to transfer pricing (Section 1.6662-6(d)(2)(iii)(B)(2));
- a document explicitly required by the regulations under Section 482 (eg, documentation of non-routine risks or a cost-sharing agreement) (Section 1.6662-6(d)(2)(iii)(B)(3));
- a description of the method selected and the reason why it was selected (Section 1.6662-6(d)(2)(iii)(B)(4));
- a description of the alternative methods that were considered and an explanation of why they were not selected (Section 1.6662-6(d)(2)(iii)(B)(5));
- a description of the controlled transactions, including terms of sale and any internal data used to analyse them (Section 1.6662-6(d)(2)(iii)(B)(6));
- a description of the comparables used, how comparability was evaluated and what adjustments were made (Section 1.6662-6(d)(2)(iii)(B)(7));
- an explanation of the economic analysis and projections relied on in developing the method (Section 1.6662-6(d)(2)(iii)(B)(8));
- a description or summary of any relevant data that the taxpayer obtains after the end of the year and before filing a tax return (Section 1.6662-6(d)(2)(iii)(B)(9)); and
- an index of principal and background documents (Section 1.6662-6(d)(2)(iii)(B)(10)).
What are the penalties for non-compliance with documentation and reporting requirements?
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. 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.
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.
No penalty applies unless the portion of the underpayment for the taxable year attributable to substantial valuation misstatements exceeds $10,000 for most corporations.
Under Section 6662(h) a higher penalty of 40% applies to gross valuation misstatements. This penalty applies:
- 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 the reasonable application of authorised transfer pricing methods. The methods and application of methods chosen by 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 based on all of the facts and circumstances, regardless of whether the method selected is specified in the relevant regulations or an unspecified method.
Treasury Regulation Section 1.6662-6(d) requires taxpayers to maintain sufficient documentation to establish that they reasonably concluded that the transfer pricing method that they selected and applied provides the most accurate measure of an arm’s-length result under the so-called ‘best method’ rule. The documentation must be self-contained and complete, and should be concise in giving the reader an adequate understanding of, and rationale for, the company’s transfer pricing practices. The documentation must be made contemporaneously and must be completed and in existence when the company files the relevant federal income tax return.
Transfer pricing documentation generally needs to be provided to the IRS within 30 days of a request being made.
What best practices should be considered when compiling and maintaining transfer pricing documentation (eg, in terms of risk assessment and audits)?
There are two classic types of transfer pricing case that require special considerations when a taxpayer compiles transfer pricing documentation in the United States. The first classic case is recurring losses or low profits incurred by a foreign-controlled US entity marketing and distributing products on behalf of a foreign-related party. The second classic case is one where high profits are earned by a foreign affiliate of a US entity in a low-tax jurisdiction when the foreign affiliate is a licensee of intangible property licensed from the United States, including cases where the foreign affiliate participates in a cost-sharing arrangement with the US entity.
In the classic foreign-controlled distribution case, IRS economists typically apply comparable profits method (CPM) to impute a normal operating profit (generally 2% or higher) – even in cases where there are consolidated losses on the products being sold. Therefore, taxpayers need to be aware of IRS practices and be prepared to document and explain why low profits of losses are due to arm’s-length market forces and not improper transfer pricing.
In the second type of classic transfer pricing case, taxpayers may rely on licence transactions that their company has with third parties as a comparable uncontrolled transaction (CUT) to apply the CUT method to determine the arm’s length consideration for a licensed intangible. In many cases, IRS economists apply the CPM to treat the foreign affiliate as a contract manufacturer or routine distributor, which has the effect of limiting any upside profit potential from the licence transaction. Accordingly, taxpayers using the CUT method need to be prepared to discuss and justify why the CUT method and not the CPM is the best transfer pricing method.
Finally, it is good practice to establish a process during the tax year for periodically reviewing the results of material intercompany transactions to determine whether the results of the transactions are producing reasonable (ie, arm’s-length) results. If the results are unreasonable, consideration should be given to adjusting the results of the transaction to produce arm’s-length results.
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