In LB&I-04-0118-001 (the IDR Memo), the Commissioner of the 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-04-0118-003 (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 $10 million or more) that must file (including extensions) Forms 5471 or 5472 with their original annual US tax return.

IDR Memo

Current instructions

Requirements introduced in January 2003 mandated the issuance of an Information Document Request (IDR) to secure the taxpayer's Section 6662(e) documentation on all examinations when the taxpayer 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:

1. For examinations under approved LB&I campaigns (see Tax Alerts 2017-1876 and 2017-0234), the examination team will follow the specific guidance provided within the campaign. If no such guidance is provided, then the next procedure will apply.

2. 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 January 12, 2018, and continues until January 12, 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.

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