US IRS limits use of mandatory transfer pricing IDR and instructs examiners on penalties in transfer pricing cases

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1 24 January 2018 Global Tax Alert News from Transfer Pricing US IRS limits use of mandatory transfer pricing IDR and instructs examiners on penalties in transfer pricing cases EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Executive summary In LB&I (the IDR Memo), the Commissioner of the Internal Revenue Service (IRS) Large Business and International Division (LB&I) provided interim instructions on when to issue the mandatory transfer pricing information document request (IDR), which changes the process for issuing such IDRs. Concurrently, in LB&I (the Penalties Memo), the LB&I Commissioner instructed LB&I examiners on the appropriate assertion of penalties in certain transfer pricing examinations. The Penalties Memo applies only to examinations of LB&I taxpayers (i.e., assets of US$10 million or more) that must file (including extensions) Forms 5471 or 5472 with their original annual US tax return. Detailed discussion IDR Memo Current instructions Requirements introduced in January 2003 mandated the issuance of an Information Document Request (IDR) to secure the taxpayer s Internal Revenue Code 1 Section 6662(e) documentation on all examinations when the taxpayer

2 2 Global Tax Alert News from Transfer Pricing filed Form 5471 or 5472, or when the taxpayer engaged in cross-border transactions. This IDR is known as the Mandatory Transfer Pricing IDR. Interim instructions The Mandatory Transfer Pricing IDR is no longer required for all cases. The following procedures now apply: For examinations under approved LB&I campaigns, the examination team will follow the specific guidance provided within the campaign. If no such guidance is provided, then the next procedure will apply. For examinations with initial indications of transfer pricing compliance risk (considering the volume and type of transactions), Transfer Pricing Practice (TPP) and/or Cross Border Activities (CBA) practice area employees will issue the Mandatory Transfer Pricing IDR, if assigned to the case. If TPP or CBA resources are not assigned to the case, the Mandatory Transfer Pricing IDR will not be issued. Implications Transfer pricing issues make up a substantial portion of the LB&I inventory. As a result, significant LB&I resources are devoted to transfer pricing issues. The IDR Memo is an acknowledgement by LB&I that, given its shrinking resources, it needs to better manager transfer pricing examinations and such changes are consistent with other recent efforts by LB&I with respect to IDRs, campaigns and other enforcement efforts. Effective date and duration The IDR Memo is effective from 12 January 2018, and continues until 12 January 2020, or until the appropriate Internal Revenue Manual and related references are updated. Penalties Memo The Penalties Memo reminds examiners that the IRS must apply penalties when the taxpayer fails to create or to timely provide Section 6662(e) documentation or when the documentation provided is unreasonable or inadequate, assuming the net adjustment penalty thresholds are met. The Penalties Memo notes that having Section 6662(e) documentation does not automatically protect against penalties; the documentation must also be assessed for adequacy and reasonableness. In addition, if the documentation does not explicitly include an analysis and conclusion that the method used is the best method, penalties would apply if adjustments to tax exceed the penalty regulation threshold. As with all other penalties, the manager s written approval is required before assertion of the penalty; documentation of that approval must be maintained in the case file. Once the taxpayer has timely provided an analysis and conclusion selecting a specified method as the best method, the Penalties Memo continues, examiners should use that method as the starting point for their examination of the reasonableness of the selection and application of the method. If the examiner determines the taxpayer s best method selection is not reasonable and receives approval to apply an alternative method as the best method, subject to the best method guidance, penalties would apply if the resulting adjustments exceed the threshold amount. Whether the threshold is met for the net adjustment penalty is determined on an aggregate basis (the sum of all increases in the taxable income of the taxpayer for the tax year under Section 482, netted against decreases for collateral adjustments), with the total reduced by adjustments for which the taxpayer had adequate contemporaneous documentation. Even if the IRS position is not fully sustained, the final resolution may result in a tax adjustment that is higher than the penalty thresholds. In addition, if the Section 6662(e) documentation is inadequate on its own, a taxpayer generally may not protect against penalties by supplementing with documents that were prepared after the date of filing of the return or that were not provided to the IRS within the 30-day deadline. Implications Companies should aim to create or to timely provide Section 6662(e) documentation supporting a reasonable and adequate economic analysis. They should also anticipate a thorough review of their transfer pricing documentation based on the transfer pricing penalty rules. Lastly, companies should expect to see more penalties being raised by LB&I if the examiner finds the Section 6662(e) documentation to be inadequate or unreasonable.

3 Global Tax Alert News from Transfer Pricing 3 Endnote 1. All Section references are to the Internal Revenue Code of 1986, and the regulations promulgated thereunder. For additional information with respect to this Alert, please contact the following: Ernst & Young LLP, US Transfer Pricing Controversy Services, Washington DC Ken Christman kenneth.christmanjr@ey.com Dick McAlonan richard.mcalonan@ey.com Thomas Vidano thomas.vidano@ey.com Dave Canale david.canale@ey.com Carlos Mallo carlos.mallo@ey.com Ernst & Young LLP, Tax Policy and Controversy, Washington DC Heather Maloy heather.maloy@ey.com Linda Kroening linda.kroening@ey.com Frank Ng frank.ng@ey.com

4 Global Tax Alert News from Transfer Pricing 4 Ernst & Young LLP, International Tax Services US Transfer Pricing Controversy Services David Arnold david.arnold@ey.com David Canale david.canale@ey.com Paul Chmiel paul.chmiel@ey.com Ken Christman kenneth.christmanjr.com David Farhat david.farhat@ey.com Hiro Furuya hiroaki.furuya@ey.com Peter Griffin peter.griffin@ey.com Ameet Kapoor ameet.kapoor1@ey.com Dan Karen dan.karen@ey.com Carlos Mallo carlos.mallo@ey.com Dick McAlonan richard.mcalonan@ey.com Mike McDonald michael.mcdonald4@ey.com Tom Ralph thomas.l.ralph@de.ey.com Craig Sharon craig.sharon@ey.com Tom Vidano thomas.vidano@ey.com Miller Williams miller.williams@ey.com Transfer Pricing leaders Ernst & Young LLP, Minneapolis Peter Griffin Ernst & Young LLP (Canada), Ottawa Tom Tsiopoulos Mancera, S.C., Mexico City Enrique Gonzalez Ernst & Young Ltda., Bogota Andres Parra Kost Forer Gabbay & Kasierer, Tel Aviv Lior Harary-Nitzan Ernst & Young LLP, US Area Leaders Larry Eyinla, Atlanta Colleen Warner, Chicago Lonnie Brist, Houston Tracee Fultz, New York Barbara Mace, New York (Financial Services) Anne Welsh, Seattle David Canale, Washington, DC (National Tax) Dick McAlonan, Washington, DC (National Tax)

5 EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. About Ernst & Young s International Tax Services practices Our dedicated international tax professionals assist our clients with their cross-border tax structuring, planning, reporting and risk management. We work with you to build proactive and truly integrated global tax strategies that address the tax risks of today s businesses and achieve sustainable growth. It s how Ernst & Young makes a difference. Transfer Pricing 2018 EYGM Limited. All Rights Reserved. EYG no Gbl NY ED None This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com