IRS revises cookbook for transfer pricing audits.

On June 14, 1994, the IRS issued the revised Internal Revenue Manual relating to transfer pricing audits for years beginning after Apr. 21, 1993. The revisions expand this manual from six pages to 70 pages of "how to" guidelines. The transmittal letter included with the revised manual indicate that the methodologies cable to years currently under examination. The revised manual reflects the Service's broad new powers under Secs. 482, 603 8A and 6662 to set pricing rules, require documentation and assess penalties for noncompliance.

Introduction

Transfer pricing is the determination of prices of goods and services in related-party transactions. Although the emphasis has been on international audits, the manual applies equally to domestic cases, such as related C and S corporations.

The introduction to the manual states that the temporary regulations under Sec. 482 reflect three basic concepts: comparability, flexibility and documentation. The introduction also emphasizes the fact that, even though the temporary regulations replaced the priority of methods with a "best method" rule, in many cases there is no correct single transfer price, but rather a range of arm's-length results. The manual makes clear that if the taxpayer does not produce a transfer pricing report that was in existence when the tax return was filed, the examiner is to engage in a lengthy series of interviews and document analysis to arrive at the transfer prices that the Service thinks are appropriate. Therefore, every affected taxpayer should seriously consider whether to prepare its own transfer pricing study.

The introduction also contains a comment that, if the Coordinated Examination Program (CEP) case and a transfer pricing issue is present, the use of an IRS economist is mandatory. For non-CEP audits, a referral for economic assistance is mandatory if the potential deficiency is over $500,000.

Approaching a transfer pricing audit

The manual provides agents with several starting points with which to begin a transfer pricing examination. One of the starting points given is review of Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, and/or Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business (Under Sections 6038A and 6038C of the Internal Revenue Code), to determine the extent of intercompany transactions. Therefore, it is very important that Schedule M, Transactions Between Controlled Foreign Corporation and Shareholders or Other Related Persons, of Form 5471, if included, is completed correctly. This also holds true for the completion of Form 5472 regarding disclosure of related-party transactions. The manual also mentions the use by examiners of a computer program that analyzes Form 5471, called the International Issue Identification Expert System. Failure to present interest paid/received on amounts borrowed/loaned, to disclose amounts charged/paid for services, purchases or sales in the correct location on these forms could be costly.

Another area given as a starting point is the computation of various financial ratios by the agent. The manual lists the following as key financial ratios: gross profit/net sales; net profit/net sales; operating expenses/net sales; and gross profit/operating expenses. This statement differs somewhat from Regs. Sec. 1.482-5(b)(4)(ii), which provides that financial ratios that may be appropriate include net profit/net sales and gross profit/operating expenses. Regs. Sec. 1.482-5(b)(4)(iii) further provides that "other" unspecified ratios can be considered. However, no examples are given. Then, using the Standard Industry Classification (SIC) code of the taxpayer, the manual instructs the agent to compare the computed ratios of the taxpayer to standard industry ratios found in such services as Robert Morris Associates, Dun & Bradstreet and Moody's. As can be inferred, proper use of SIC codes by taxpayers will be critical in the future.

The agent is also advised to review minutes of meetings from different departments within the taxpayer's organization (such as those from executive committees and departmental meetings). Copies of the taxpayer's brochures, price lists, pamphlets or any other types of data that will provide information regarding intercompany pricing should also be obtained. The manual advises agents to obtain a listing of policy and procedural manuals (such as accounting, finance, intercompany transactions, personnel and telecommunications).

Examination of transactions

After the agent has gained some understanding of the taxpayer's business and industry, the detailed examination of specific transactions can be started. This is the area of the manual that addresses the new requirements of contemporaneous documentation (as provided in the Sec. 6662 penalty regulations). The manual instructs the agents to keep in mind the factors of comparability: functions performed, risks assumed, contractual terms, economic conditions, products produced and services performed.

The manual states that the agent should ask the taxpayer how the transfer price was determined. This appears to be the point at which the taxpayer is required to present the nine-part report provided by Temp. Regs. Sec. 1.6662-6T(d)(2)(iii)(b). The manual clearly states that "he taxpayer must establish the economic justification for its transfer price at the time the transaction occurs (not years later when the examiner arrives)." This supports Temp. Regs. Sec. 1.6662-6T(d)(2)(iii), which provides that the taxpayer will provide to the IRS, within 30 days of a request, documentation to support pricing methods. The manual goes on to state that, if the documentation requested is not provided within the time provided by the regulations, consideration should be given to the application of appropriate penalties. This would be the 20% and 40% penalties provided by Temp. Regs. Sec. 1.6662-6T(a)(1).

The manual then goes on to list the methods that the agent must use in determining the "best method" for the transfer of tangible property. The IRS manual and Regs. Sec. 1.482-3(a) provide the same five "best methods" available for use: comparable uncontrolled price (CUP), resale price, cost plus, comparable profits method (CPM), and other. The final regulations added the profit-split method, which will undoubtedly be added to the audit manual. Although the regulations do not provide a hierarchy and simply state that the "best method" must be selected, the IRS manual states that "... all factors of comparability cited in Regulation [sections]1.482-1T(c)(1)(ii)[regs. Sec. 1.482-1(d)(3)] must be considered. However, if a CUP exists, it will be the best method."

The manual discusses the transfer pricing methods available for the transfer of intangible property: comparable uncontrolled transaction (CUT) and CPM. The audit manual also states that the regulations refer to both routine and nonroutine intangibles, but that no definition is given in the regulations; therefore, the agents have no guidance as to what constitutes a routine or nonroutine intangible. Unfortunately, the manual provides no definition either.

Comparability

Comparability is discussed in detail and how agents go about determining whether comparability exists. The manual advises agents to first develop a functional analysis. This is the same requirement placed on the taxpayer by Regs. Sec. 1.482-1(d)(3). The manual describes this functional analysis as determining who does what, when, where, why and how. The manual goes on to instruct the agent that to perform a proper analysis, the agent must go outside the taxpayer's tax department. The manual suggests that the agent take plant and office tours, and conduct interviews of key personnel. This will be facilitated by the documentation requirement of Temp. Regs. Sec. 1.6662-6T(d)(2)(iii)(B)(2), which provides that a description of the taxpayer's organizational structure, including organizational charts, must be included in the documentation. The manual then goes on to discuss the scope and depth of the functional analysis.

Analysis of the risks associated with the transaction and how to go about determining which party is assuming the risk is covered next. Again, this is the same requirement placed on the taxpayer by Regs. Sec. 1.482-1(d)(3)(iii). The manual cautions agents to exercise care to assure that the allocation of risk has not been artificially manipulated. The manual instructs agents to make sure that the risk agrees with the substance of the transaction (such as whether the party assuming the foreign currency risk has the financial ability to withstand losses that may occur). The manual also advises agents on the steps necessary to analyze the remaining factors: the contractual terms, economic conditions, products produced and services performed.

Regarding third-party comparables, the manual advises agents to consult annual financial statements of similar companies, electronic databases such as Compustat, Standard & Poor's services and various other publications. The manual also informs agents that the IRS and U.S. Customs have entered into a joint program under which Customs will provide information pertaining to the importation of goods into the United States. This information includes units imported, description of merchandise, value, country of export, duty paid (and more). However, this information is only available to the Service, not to the taxpayer trying to comply with these regulations.

The manual also discusses obtaining third-party information from comparable unrelated entities that have had no other transactions with the taxpayer. The manual advises the agent to contact the unrelated party's tax director by telephone and follow up the conversation with a letter confirming what agreed on information will be provided. (However, it seems unlikely that a company will divulge information about itself to agents auditing a competitor.

Finally, the manual discusses the authority the Service has to obtain records from foreign entities (as provided by Secs. 6038A and 6038C), as well as the procedure to follow while conducting an on-site visit of the taxpayer's facilities.

Conclusion

The IRS is indeed gearing up its agents for a transfer pricing assault. The revised audit manual closely follows the temporary regulations on the importance of properly analyzing the functions, risks and other factors of a transaction, as well as the documentation required. Those taxpayers who do not have the required documentation are likely to be in for a long siege.

From Mark E. Kral, CPA, Schaumburg, Ill., and Roger D. Lorence, J.D., LL.M., New York, N.Y.