Internal Revenue Service (IRS); Internal Revenue Code (IRC) § 482, § 6038A, § 6038C and § 6662.
Treasury Regulations (Treas. Regs.) § 1.482; § 1.6662; § 1.6038A; § 1.6038C; Revenue Procedure (Rev. Proc.) 2006-54; Rev. Proc. 99-32; and Rev. Proc. 2006-9. Final regulations (T.D. 9088) on compensatory stock options under IRC § 482 released on 25 August 2003, maintain that stock-based compensation must be taken into account in determining operating expenses for qualified cost sharing arrangements (CSAs) under Treas. Reg. § 1.482-7. Audit checklist on CSAs issued in August 2005. Proposed regulations on CSAs (REG- 144615-02) issued 22 August 2005 introducing new methods for determining buy-in payments, providing the IRS with discretion to make periodic adjustments and formalizing other new requirements for compliance. In April 2007, CSA buy-ins were designated by the IRS as a “Tier I” issue, and thus susceptible to intensified audit scrutiny. A Coordinated Issue Paper was released on 27 September 2007 providing internal IRS guidance for examiners in developing CSA exam positions.
New final, temporary and proposed regulations related to services were issued on 31 July 2006. The new rules were effective 1 January 2007, and apply to tax years beginning after 31 December 2006. In conjunction with the new regulations, the IRS also issued Announcement 2006-50, which contained a proposed list of “specified covered services” that relate to a specific cost-based method. The new services regulations require stock-based compensation to be considered in total costs. On 20 December 2006, the IRS released Notice 2007-5 and Revenue Procedure 2007-13, which extended the effective date of the Services Cost Method until 1 January 2008 and added to the list of “covered services.”
The IRS considers its transfer pricing laws and regulations to be wholly consistent with OECD guidelines. For domestic use, the OECD guidelines do not provide support, and would not be directly relevant to the application of any pricing methods. However, if taxpayers pursue competent authority relief from double taxation or a bilateral APA, then the OECD guidelines would be important and be used to demonstrate compliance with international principles.
The IRS accepts the CUP, Comparable Uncontrolled Transaction (CUT), Resale Price, Cost Plus, CPM, Profit Split or other unspecified methods. Taxpayers must use the best method under the regulations. New services regulations provide for methods: Services Cost Method, Comparable Uncontrolled Services Price, Gross Services Margin, Cost of Services Plus, CPM, Profit Split and unspecified methods. The Coordinated Issue Paper related to CSAs advises IRS auditors that unspecified methods are appropriate for valuing buy-ins (such as the “income method” and the “acquisition price method”).
Taxpayers may be liable for either a 20% or 40% penalty for underpayment of tax (IRC § 6662), as a percentage of the underpayment, or the penalty may apply to a valuation misstatement. There is not a US penalty for failure to have documentation, but documentation may help to avoid a penalty.
Penalties may be avoided by adequate disclosure on IRS Form 8275 for disregarding rules or regulations and for a substantial understatement of income tax. Penalties for negligence and for a valuation misstatement are not avoided by disclosure. No penalties apply, however, if there was reasonable cause and the taxpayer acted in good faith with respect to the transaction. The regulations provide guidance for establishing reasonable cause and good faith, for example, by preparing documentation or by obtaining an APA.
Documentation is not required by law. However, in practice, it is recommended that taxpayers maintain contemporaneous documentation in order to avoid penalties. Documentation must be provided to the IRS within 30 days of a request for an examination. The documents must be in existence when the return is filed, but their existence does not need to be disclosed with the tax return and they do not need to be provided with the return. For penalty avoidance purposes, a taxpayer is considered to have satisfied the documentation requirement if it maintained sufficient documentation to establish that the taxpayer reasonably concluded that, given the available data and the applicable pricing methods, the method (and its application of that method) provided the most reliable measure of an arm’s length result under the principles of the best method rule.
A method determined as part of an APA is a consideration for whether the taxpayer’s method was reasonable. The principal documents required by regulations are:
If documentation is prepared to help protect against penalties, then it must be in place by the filing date of the US tax return. Taxpayers must provide documentation to the IRS within 30 days of an examiner’s request.
A general statute of limitations applies, which is three years from the later of either the tax return due date or the date the return was actually filed. For substantial understatements of income, the statute is extended to six years. For fraud, there is no statute of limitations.
There are no return disclosure requirements except those required in statutory accounts and in annual reports filed in compliance with any current APAs. The absence of disclosure requirements wil typical y leave prior years open to discovery assessments.
The risk of transfer pricing scrutiny during a tax audit is high. Transfer pricing is extensively regulated, and a 2003 IRS directive on enforcing contemporaneous documentation violations indicates that scrutiny will increase. The designation of CSAs and intel ectual property transactions as Tier I issue for IRS auditors increases the risk for those transactions. This has been borne out in practice, where documentation is requested at the start of any transfer pricing audit.
Unilateral, bilateral and multilateral APAs are available under Rev. Proc. 2006-9. The revenue procedure was released in December 2005 and updated Rev. Proc. 2004-40. There is a higher fee scale for filing the APA request with the IRS. The IRS implemented the fol owing changes to the APA Program including:
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