Current Trends in the Administration of International
Transfer Pricing by the Internal Revenue Service
September 2003
Reference Number:
2003-30-174
This report has cleared the Treasury Inspector General for Tax Administration disclosure review process and information determined to be restricted from public release has been redacted from this document.
Redaction Legend:
3(d) = Identifying information - Other identifying information of an individual or individuals
September
15, 2003
MEMORANDUM FOR
COMMISSIONER EVERSON
FROM: Gordon C. Milbourn III /s/ Gordon C.
Milbourn III
Assistant Inspector General
for Audit (Small Business and
Corporate Programs)
SUBJECT: Final Audit Report - Current Trends in
the Administration of International Transfer Pricing by the Internal Revenue
Service (Audit # 200230038)
This report presents the
results of our review of international transfer pricing. The overall objective of this review was to
determine the current trends in the administration of international transfer
pricing by the Internal Revenue Service (IRS).
Transfer pricing is among the most important and complex international
tax issues faced by large Multinational Enterprises (MNE) and the IRS.
In summary, international
transfer pricing is a term commonly used to describe pricing arrangements for
exchanging goods, services, and other property between related entities or
affiliates with operations in the United States (U.S.) and in other
countries. International transfer
prices are significant for both MNE taxpayers and tax administrators because
transfer pricing determines in large part the taxable profits of related
enterprises in different tax jurisdictions.
Therefore, a natural conflict exists between governments and MNEs. The governments seek to ensure that profits
earned within their borders are taxed, and the MNEs seek to minimize their
worldwide tax liabilities.
These intercompany or
“controlled transactions” across borders are increasing as MNEs continue to
globalize their operations. The
Department of Commerce reported for Calendar Year 2001 that related-party
merchandise trade accounted for $526 billion
(46 percent) of the $1.133 trillion in U.S. imports, and $223 billion
(31 percent) of the $731 billion in U.S. exports. Since 1990, imports have increased by 128 percent while exports
have increased 89 percent.
With so much potential tax
at risk, governments have various means to ensure that MNE taxpayers comply
with their tax laws. In the U.S.,
Internal Revenue Code (I.R.C.) Section (§) 482 gives
the IRS the authority to allocate income, expenses, and credits between related
entities. When making these
allocations, the IRS uses the “arm’s length” standard. In a 1999 study, the IRS tentatively
estimated the loss due to transfer pricing at $2.8 billion in income
taxes. An ongoing study being prepared
for the Congress estimates that the use of inflated and undervalued transfer
prices by MNE groups allowed them to avoid paying $53 billion in U.S. income
taxes in Tax Year (TY) 2001. However,
comprehensive and reliable compliance data do not exist; therefore, estimates
of the tax gap due to transfer pricing should be considered tentative.
The determination of whether
MNE taxpayers are paying the proper tax does not come without cost to both the
IRS and the MNE taxpayers. According to
available IRS cost data and estimates, which are incomplete, approximately $22
million was expended on transfer pricing administration in Fiscal Year (FY)
2002. For MNE taxpayers, the cost can
be $100,000 to over $1 million for preparing contemporaneous transfer pricing
documentation needed to avoid penalties.
The tax administration for
international transfer pricing is continuing to evolve as cross-border
transactions increase. Since 1992, the
IRS has implemented a five-part approach aimed at shifting the focus from after-the-fact
examination and litigation of transfer pricing controversies, to encouragement
of upfront taxpayer compliance and advance resolution of transfer pricing
issues. As part of this strategy, the
IRS administers transfer pricing issues through several pre- and post-filing
activities for the 47,716 MNE taxpayers reporting controlled transactions in TY
2000.
The IRS’ two primary
transfer pricing pre-filing activities are publication and guidance and the
Advance Pricing Agreement (APA) Program.
The goal of the publication and guidance activity is the continuing
refinement of the transfer pricing regulations to explain the compliance
requirements. The regulations have
continued to evolve since 1935, when the “arm’s length” standard was first
defined, and were extensively revised in 1994.
While the effect that IRS guidance has on transfer pricing compliance
has not been determined, tax administrators believe that the guidance has a
significant effect on voluntary compliance. The second pre-filing activity is
the APA Program. This Program, which
started in 1991, continues to grow.
From inception through December 31, 2002, a total of 452 APAs were
executed. The number of APAs executed
annually increased from only a few in the early years to an average of 74 in
recent years. The taxpayers that
participate in the APA Program are some of the largest MNEs.
The IRS post-filing transfer
pricing activities include four interrelated activities. The first activity is the Examination
Program. In FY 2002, the IRS
recommended $5.56 billion in transfer pricing adjustments. This was a 34 percent increase from FY 1997,
when the IRS recommended $4.16 billion in transfer pricing adjustments.
When taxpayers do not agree
with the adjustment, there are two subsequent resolution processes. The first subsequent resolution activity is
to protest the transfer pricing adjustment to the Office of Appeals where it
can be conceded in full or substantially reduced. In FY 2002, the Office of Appeals’ data system tracked $899
million in recommended transfer pricing adjustments that were subsequently
reduced to $157.4 million due to hazards of litigation (i.e., the risk of
losing the issue in court) or because information needed to support the
adjustments was not considered adequate in the judgment of the Office of
Appeals. The second subsequent
resolution activity is for the taxpayer to petition the U.S. Tax Court prior to
paying the tax or to pay a disputed tax, file a claim for refund, and when it
is disallowed (or more than 6 months has elapsed without action by the IRS),
initiate a suit in a U.S. District Court or in the Court of Federal
Claims.
A procedure parallel to the
transfer pricing activities exists to ensure that MNE taxpayers are not
burdened by double taxation. MNE
taxpayers may request the assistance of the U.S. Competent Authority for the
relief from double taxation through an international dispute resolution process
called the Mutual Agreement Procedure.
This report contains no
recommendations. The purpose of the
report is to identify trends in transfer pricing tax administration. We discussed the issues contained in the
report with appropriate IRS executives and have incorporated their viewpoints
into this report.
Copies of this report are also being sent to the IRS
managers who are affected by the report issues. Please contact me at (202) 622-6510 if you have questions, or
your staff may call Parker F. Pearson, Director (Small Business Compliance), at
(410) 962-9637.
Appendix I – Detailed Objective, Scope, and Methodology
Appendix II – Major Contributors to This Report
Appendix III – Report Distribution List
Appendix IV – Important Tax Concepts
Appendix VIII – Increasing Globalization Leads to an Increasing Number of Controlled Transactions
Appendix IX – Examination Trends in Transfer Pricing
Appendix X – Advance Pricing Agreement Program Provides Avenue to Encourage Compliance
Appendix XI – Mutual Agreement Procedure Process
Appendix XII – Internal Revenue Code Section 482
International transfer pricing is a term commonly used to describe pricing arrangements for exchanging goods, services, and other property between related entities or affiliates of a Multinational Enterprise (MNE) group with operations in the United States (U.S.) and in other countries. International transfer prices are significant for both MNE taxpayers and tax administrators, because transfer pricing determines in large part the taxable profits of related entities in different tax jurisdictions. Therefore, a natural conflict exists between governments and MNEs. The governments seek to ensure that profits earned within their borders are taxed, and the MNEs seek to minimize their worldwide tax liabilities.
These intercompany or “controlled transactions” across borders are increasing as MNEs continue to globalize their operations, and they represent a significant and growing tax administration challenge to the U.S. and its global trading partners. The Department of Commerce reported for Calendar Year (CY) 2001 that related-party merchandise trade accounted for $526 billion (46 percent) of the $1.133 trillion in U.S. imports, and $223 billion (31 percent) of the $731 billion in U.S. exports. Since 1990, imports have increased 128 percent, from $498 billion, while exports have increased 89 percent, from $387 billion.
The challenge to tax administrators is to determine whether the allocation of income and expenses is done at the “arm’s length” standard. The challenge to the MNE is to minimize its worldwide tax liability. When tax is minimized through improper transfer pricing methods, income shifts to low tax or no tax jurisdictions and expenses shift to high tax jurisdictions.
The following hypothetical example shows how transfer pricing shifts can alter profits and reduce taxes:
A
parent company residing in the U.S. purchases widgets from its wholly owned
subsidiary in Country M. The parent
company agrees to purchase 10,000 widgets from its subsidiary at $35 above the
market price. This increases the
parent’s expenses by $350,000 and lowers its U.S. taxable income by $350,000,
while increasing the subsidiary’s profits by $350,000. With a 35 percent income tax rate in the
U.S., the parent company avoids $122,500 in U.S. income taxes, while the
subsidiary pays $35,000 in Country M income taxes based on a 10 percent income
tax rate, saving $87,500 in worldwide income taxes.
A more comprehensive scenario is provided in Appendix V.
With so much potential tax at risk, governments have various means to ensure that MNE taxpayers comply with their tax laws. In the U.S., Internal Revenue Code (I.R.C.) Section (§) 482 gives the Internal Revenue Service (IRS) the authority to allocate income, expenses, and credits between related entities. When making these allocations, the IRS uses the “arm’s length” standard. The “arm’s length” standard was developed by the courts and first defined in the Treasury Regulations in 1935.
There is a concern that transfer pricing is a continuing tax compliance risk area; however, comprehensive and reliable compliance data do not exist. Therefore, estimates of the tax gap due to transfer pricing should be considered tentative and subject to substantial revisions when better data become available. In a 1999 study, the IRS tentatively estimated the loss due to transfer pricing at $2.8 billion. An ongoing academic study being prepared for the Congress estimates that the use of inflated and undervalued transfer prices by MNE groups allowed them to avoid paying $53 billion in U.S. income taxes in Tax Year (TY) 2001. The two estimates are arrived at using vastly different techniques. Neither takes into account how prior year corporate losses, tax credits, or other tax return factors might interact to reduce or eliminate the estimated tax losses due to improperly valued transfer pricing. While the true tax loss to the Treasury due to transfer pricing may never be known, it must also be placed in the proper context of the nearly $2 trillion in annual U.S. trade.
This audit was part of our Fiscal Year (FY) 2003 emphasis on the Large and Mid-Size Business (LMSB) Division’s strategic initiatives. The audit was performed in accordance with Government Auditing Standards between August 2002 and February 2003. Onsite work was performed in the LMSB Division’s Headquarters in Washington, D.C. This report contains no recommendations. Its purpose is to identify trends in transfer pricing tax administration.
Detailed information on our audit objective, scope, and methodology is presented in Appendix I. Major contributors to the report are listed in Appendix II.
The tax administration
challenges presented by transfer pricing issues are significant for the
IRS. I.R.C. § 482 regulations are complex, and
proposed adjustments are regularly challenged by MNEs. At the same time, there is concern about the
potential compliance gap widening as MNEs continue to globalize their
operations.
The IRS’ goal in administering I.R.C. § 482 is to ensure that each controlled taxpayer reflects its true taxable income from intercompany transactions as determined under the “arm’s length” standard. Since 1992, the IRS has implemented a five-part approach aimed at shifting the focus from after-the-fact examination and litigation of transfer pricing controversies, to encouragement of upfront taxpayer compliance and advance resolution of transfer pricing issues. The five-part approach includes:
· Issuing guidance on the application of the “arm’s length” standard.
· Promulgating contemporaneous documentation legislation and issuing related guidance.
· Working to build worldwide consensus on the application of the “arm’s length” standard through the Organization for Economic Cooperation and Development and other international groups.
· Encouraging taxpayers to use the Advance Pricing Agreement (APA) Program.
· Developing procedures to coordinate technical and legal support in I.R.C. § 482 matters.
The IRS administers transfer pricing issues through several pre- and post-filing activities for the 47,716 MNE taxpayers reporting controlled transactions in TY 2000. In total, tax administration activities cost the IRS a minimum of $22 million in FY 2002. Following are descriptions of tax administration trends for transfer pricing and the associated costs, to the extent available, to the IRS in administering transfer pricing compliance issues and to MNE taxpayers in complying with the transfer pricing regulations under I.R.C. § 482.
Pre-filing transfer pricing
activities
The IRS’ two primary pre-filing activities in administering transfer pricing are publication and guidance, and the APA Program. Publication and guidance is targeted at a broad spectrum of taxpayers, and the APAs apply to individual MNE taxpayer situations. These activities are both controlled by the Office of Associate Chief Counsel (International) (ACCI), a component of the Office of Chief Counsel.
The goal of the publication and guidance activity is the continuing refinement of transfer pricing regulations to explain the compliance requirements. The regulations have continued to evolve since 1935, when the “arm’s length” standard was first defined. Recently, the IRS published regulations clarifying the treatment of stock options as a cost under the cost-sharing regulations. The IRS is also working on the last part of the larger regulation project, started in the late 1980s, to update the 1968 I.R.C. § 482 regulations by clarifying the rules on the treatment of services, as well as a project updating the 1995 cost-sharing regulations.
The transfer pricing regulations require the MNE taxpayer to select the most appropriate transfer pricing methodology from the various methods described in the regulations. The method selected should provide the most accurate measure of the “arm’s length” result under the facts and circumstances of the transaction. The transfer pricing regulations also encourage the MNE taxpayer to document, at the time the return is filed, the transfer pricing methodology selected, the reasons for its selection, the methods rejected, and the reasons for rejection. If the documentation rules are satisfied, taxpayers can protect themselves from transfer pricing penalties that would otherwise apply.
In FY 2002, ACCI attorneys spent 2,027 hours revising the transfer pricing regulations, at an estimated cost of approximately $110,000. While the effect that IRS guidance has on transfer pricing compliance has not been determined, tax administrators believe that the guidance has a significant effect on voluntary compliance.
The second pre-filing activity is the APA Program. The APA Program is a voluntary and cooperative process that enables MNE taxpayers to enter into prospective agreements with the IRS to achieve certainty regarding the tax results of their transfer pricing for cross-border transactions. The taxpayers that participate in the APA Program are some of the largest MNEs. This Program, which started in 1991, continues to grow. From inception through December 31, 2002, a total of 452 APAs were executed. The number of APAs executed annually increased from only a few in the early years to an average of 74 in recent years. The APA Program has received 676 applications since it began in 1991.
Figure 1 was
removed due to its size. To see Figure
1, please go to the Adobe PDF version of the report on the TIGTA Public Web
Page.
APAs come in two forms: a bilateral agreement and a unilateral agreement. A bilateral APA generally combines an agreement between a taxpayer and the IRS on an appropriate transfer pricing methodology for the transactions at issue, with an agreement between the U.S. and one or more foreign tax authorities that the transfer pricing methodology is correct. With a bilateral APA, the IRS and the foreign tax authority assure the taxpayer that the income associated by the covered controlled transaction will not be subject to double taxation. There have been 224 bilateral and 7 multilateral APAs.
A unilateral APA is an agreement between a taxpayer and the IRS establishing an approved transfer pricing methodology for U.S. tax purposes only. A unilateral APA binds the taxpayer and the IRS but does not prevent foreign tax administrations from taking a different position on the appropriate transfer pricing methodology for a controlled transaction. There have been 221 unilateral APAs.
Obtaining an APA involves both time and a monetary commitment. Filing an APA request requires a user fee that can range between $5,000 and $25,000 and preparation of a transfer pricing study tailored to the taxpayer’s cross-border transaction. As discussed later, the price of these studies varies but can reach upwards of $1 million or more.
In FY 2002, the APA Program reported that it took an average of 24.6 months to complete a new bilateral APA and an average of 21 months to complete a new unilateral APA. In our discussions with the IRS concerning this report, the APA Program staff reported that the time to complete APA requests has improved in the past few years since staffing increases have reduced inventory backlogs (see Table 1).
Table 1: Average Number of Months a |
||
|
|
Bilateral Inventory |
Unilateral Inventory |
|
|
Number of Months in Inventory |
|
June 30, 2000
|
15 |
13 |
|
June
30, 2001 |
18 |
14 |
|
June
30, 2002 |
11 |
12 |
Source: The APA Program.
The APA Program itself still represents a commitment in terms of cost, time, and providing the IRS access to sensitive, proprietary information that can create uncertainty for MNE taxpayers until the Agreement is completed. Some of the costs in connection with an APA are the APA request submission, requests for additional information, and meetings. However, through an APA, MNE taxpayers may achieve certainty for the duration of the prospective multiyear term of the APA, and that resolution may be carried back where appropriate to previously filed years that may be under examination through a rollback. By contrast, resolution of disputes that grow out of an examination may take more than 8 years to resolve.
In FY 2002, the Office of Chief Counsel incurred
costs of approximately $4.3 million in administrating the APA Program.
Post-filing transfer pricing
activities
There are four interrelated IRS post-filing transfer pricing activities. The first activity is the Examination Program. The IRS attempts to assure voluntary compliance with the transfer pricing regulations by using highly trained specialists to conduct post-filing examinations of income tax returns that contain controlled transactions. The primary objective in selecting returns for examination is to promote the highest degree of voluntary compliance on the part of taxpayers. In FY 2002, the IRS recommended $5.56 billion in transfer pricing adjustments. This was a 34 percent increase from FY 1997, when the IRS recommended $4.16 billion in transfer pricing adjustments. From available IRS cost information, we estimate that the direct examination costs were at least $15 million.
When taxpayers do not agree with the adjustment, there are two subsequent resolution processes. The first subsequent resolution activity is to protest the transfer pricing adjustment to the Office of Appeals. An Appeals Officer or an Appeals Team will evaluate the facts and circumstances surrounding the tax issues and attempt to resolve the case.
In FY 2002, the Office of Appeals’ data system tracked $899 million in recommended transfer pricing adjustments that were subsequently reduced to $157.4 million due to hazards of litigation (i.e., the risk of losing the issue in court) or because information needed to support the adjustments was not considered adequate in the judgment of the Office of Appeals.
The number of closed returns with transfer pricing issues tracked by the Office of Appeals increased from 94 returns in FY 2000 to 97 returns in FY 2002. Our analysis shows that approximately 30 percent of the 1,078 returns with transfer pricing adjustments closed by international specialists in FY 1997 were settled by the Office of Appeals. The Office of Appeals has no management information to determine the costs associated with settling transfer pricing cases. We did not attempt to estimate these costs.
The second subsequent resolution activity is litigation. In this activity, the taxpayer may petition the U.S. Tax Court prior to paying the tax or pay a disputed tax, file a claim for refund, and when it is disallowed (or more than 6 months has elapsed without action by the IRS), initiate a suit in a U.S. District Court or in the Court of Federal Claims. The Office of Chief Counsel has no available summary data regarding resolution of I.R.C. § 482 cases. The Office of Chief Counsel until recently had no ability to identify the specific provision of the I.R.C. at issue in a specific case in litigation, and there is no requirement that the amounts of specific adjustments be recorded in the databases. However, in a 1999 study, the IRS described the importance of litigation as a tool in the administration of I.R.C. § 482 cases:
Because these cases typically
revolve around complex factual valuation issues, they require the devotion of
enormous amount of resources on the part of the IRS, the courts, and the
taxpayers. …Nevertheless, the cost of
litigation cannot be a controlling factor when deciding whether to
litigate. Otherwise, tactical delay in
producing information until a case has reached the Court should yield enormous
advantage to uncooperative taxpayers.
Several recent cases illustrate the difficulty faced by the IRS in
determining an appropriate reallocation and defending such reallocation when
information is not forthcoming until after a controversy reaches court. Although the reallocations sustained by the
Court were greatly reduced from those initially determined by the IRS,
substantial adjustments to the position taken on the return were sustained
nevertheless.
This litigation does not come without cost. In the same study, the IRS described the costs of preparing and litigating two I.R.C. § 482 cases. The cost of 1 case was over $4.6 million, and the cost of the other case was over $2 million.
A procedure parallel to the transfer pricing activities exists to ensure that MNE taxpayers are not burdened by double taxation. MNE taxpayers may request the assistance of the U.S. Competent Authority for the relief from double taxation when a disputed transaction involves the taxing jurisdictions of the U.S. and one or more of its treaty partners through an international dispute resolution process called the Mutual Agreement Procedure (MAP). In the U.S., the MAP process is performed by the LMSB Division’s Office of the Director, International, who is the U.S. Competent Authority for all tax treaty matters. When a transfer pricing adjustment is made during an examination on a related entity that is under the jurisdiction of a U.S. treaty partner, the taxpayer has the option of invoking Revenue Procedure 2002-52 to secure relief from double taxation.
In the MAP process, the competent authorities of the U.S. and the treaty partner meet in an effort to resolve by mutual agreement any difficulties or doubts arising as to the interpretation or application of a tax treaty. With respect to transfer pricing issues, the goal of the MAP process is avoidance of double taxation or taxation not in accordance with the applicable treaty. The U.S. Competent Authority reported that, in FY 2002, the MAP process eliminated potential double taxation in 92 percent of the adjustments (by providing correlative relief 38 percent of the time, withdrawing the adjustment 27 percent of the time, and providing partial relief through foreign tax credit 27 percent of the time).
Between FYs 1997 and 2002, the U.S. Competent Authority reported no clear trends with regard to the length of the MAP process. Depending upon the year, the length of the process averaged 679 days to 948 days. During the same period, the U.S. Competent Authority also reported that it can take up to 484 days on average to secure a Mutual Agreement, depending upon the year a bilateral APA case was closed. Though the MAP process can run concurrently with an ongoing examination or appeal in consideration of an issue, in some cases it can present a potential delay to the completion of transfer pricing examination cases, Office of Appeals cases, and APA cases that involve U.S. treaty partners. In FY 2002, the MAP process cost approximately $1.8 million related to the administration of transfer pricing.
MNE taxpayers can incur substantial costs to document
transfer pricing methods
In Ernst & Young surveys of international tax issues, transfer pricing ranks as the number one concern of MNE tax managers. One reason is that MNE taxpayers can protect themselves from significant transfer pricing penalties by satisfying the transfer pricing documentation rules. Under I.R.C. § 6662(e), an MNE can avoid penalties associated with an examination transfer pricing allocation if it provides contemporaneous transfer pricing documentation within 30 days after the IRS requests it. Failure to maintain and provide the documentation timely can result in penalties for the MNE of up to 40 percent of the tax deficiency.
The costs to prepare the transfer pricing documentation can appear quite substantial, but need to be evaluated in the context of the IRS’ upfront compliance effort in the administration of the transfer pricing process. In 2001, the IRS commissioned a study of 1,529 MNE taxpayers and received substantially complete responses from 696. From a sampling of 567 responses, 176 (31 percent) showed that the respondents were spending from $100,000 to over $1 million preparing the required contemporaneous transfer pricing documentation (see Table 2). In a response to a discussion draft of this report, the Office of Chief Counsel commented that $1 million spent on transfer pricing documentation by a taxpayer that has over $1 billion in annual gross receipts may be relatively inexpensive considering the taxpayer’s total gross receipts and the potential costs and hazards of the examination, appeals, and litigation processes.
Table 2: Amount Spent on Preparing Transfer Pricing
Documentation |
|||||||
|
|
Gross Receipts |
||||||
|
Amount Spent |
$10-$61 Mil. |
$62-$124 Mil. |
$125-$249 Mil. |
$250-$499 Mil. |
$500 Mil. -$1 Bil. |
Over $1 Bil |
Total |
|
Sample
Size |
N=27 |
N=58 |
N=68 |
N=101 |
N=80 |
N=233 |
N=567 |
|
$0 |
11% |
7% |
7% |
3% |
3% |
3% |
4% |
|
$1 |
56% |
64% |
63% |
66% |
63% |
37% |
53% |
|
$100,001 to |
4% |
10% |
12% |
13% |
18% |
18% |
15% |
|
$200,001 to |
7% |
-% |
3% |
8% |
6% |
23% |
12% |
|
$500,001 to |
-% |
-% |
-% |
-% |
1% |
6% |
3% |
|
More than |
-% |
-% |
-% |
-% |
-% |
2% |
1% |
|
Declined to |
22% |
19% |
15% |
10% |
10% |
12% |
13% |
Source: IRS data.
The same survey found that 60 percent of the MNE taxpayers were committing the resources of 1 to 10 full-time employees for handling transfer pricing issues and documentation. The survey also reported that MNE taxpayers spent over 18 percent of their total annual tax compliance budgets to address transfer pricing issues. In discussions about this audit report, the IRS officials responsible for transfer pricing issues stated that while MNE transfer pricing contemporaneous documentation costs can appear very significant, the costs need to be viewed in the overall context of encouraging upfront compliance with the transfer pricing regulations.
As MNEs continue to expand their global operations, the costs to document the controlled transactions are likely to continue to increase. Beyond this, different nations can require different documentation. While there is some agreement among nations on documentation standards, differences do exist. These differences add to the MNEs’ documentation costs.
Conclusion
The tax administration challenges for international transfer pricing will continue as globalization continues. The transfer pricing compliance approaches in place are evolving processes to address transfer pricing in a comprehensive manner that benefits both the IRS and MNEs.
Appendix I
Detailed Objective, Scope,
and Methodology
The objective of the review was to determine the current trends in the administration of international transfer pricing by the Internal Revenue Service (IRS). Onsite tests were performed in the Large and Mid-Size Business (LMSB) Division Headquarters. Information was obtained from the LMSB Division, the Office of Appeals, and the Office of Associate Chief Counsel (International).
To achieve the audit objective, we extensively relied on internal management reports and computer-processed data contained in the Foreign Information System (FIS), International Case Management System (ICMS), Audit Information Management System, Appeals Centralized Data System (ACDS), and Case and Issue Reports System (CIRS). We did not establish the reliability of these data because extensive data validation tests were outside the scope of this audit. The specific tests included the following:
I. Using IRS information systems and reports, determined the trends in the administration of international transfer pricing under Internal Revenue Code (I.R.C.) Section (§) 482.
A. Using the FIS database for Tax Years 1996 through 2000, determined the number of Information Returns of U.S. Persons With Respect To Certain Foreign Corporations (Form 5471) and Information Returns of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business (Form 5472) filed, the number of entities filing these forms, and the categories and amounts of controlled transactions reported.
B. Using extracts of the closed cases from the ICMS database for Fiscal Years (FY) 1997 through 2002, determined the total number of returns, cases, issues, and length of international examination for Coordinated Industry Cases (CIC) and Non-CICs containing I.R.C. § 482 transfer pricing issues conducted by International Examiner Revenue Agents for each fiscal year.
C. Using the Coordinated Examination Management Information System database for FYs 1997 through 2001, determined the total number of returns, cases, issues, and length of examination for CICs having I.R.C. § 482 transfer pricing issues for each fiscal year.
D. Using the ACDS/CIRS database for FYs 2000 through 2002, determined the total number of returns, cases, issues, average length of appeals, amount of recommended examination adjustments, amount of the sustained Office of Appeals adjustment, and sustention rate for each fiscal year.
E. Reviewed and analyzed reports from the Office of Chief Counsel concerning its transfer pricing activities for FYs 1997 through 2002 derived from the Counsel Automated System Environment and Counsel Automated Tracking System for trends in the administration of transfer pricing.
F. Reviewed and analyzed tables made available by the United States Competent Authority on the IRS web site describing its activities in the Mutual Agreement Procedure process to determine program trends.
G. Reviewed and analyzed the Advance Pricing Agreement (APA) Program annual reports submitted to the Congress for Program trends.
II. Reviewed criteria associated with the administration of international transfer pricing under I.R.C. § 482.
A. Reviewed I.R.C. §§ 482 and 6662(e) along with the associated regulations, revenue procedures, and internal operating procedures found in the Internal Revenue Manual.
B. Reviewed and analyzed the model tax conventions of the United Nations and the Organization of Economic Cooperation and Development (OECD) for provisions specifying use of the “arm’s length” standard. We also reviewed and analyzed the OECD’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (dated July 1995).
C. Reviewed the mission statements, performance, and diagnostic measures used by the IRS units (LMSB Division, Office of Appeals, and Office of Chief Counsel) in the administration of transfer pricing.
III. Reviewed the decline in personnel resources available to conduct transfer pricing examinations.
IV. Determined the effects of the current trends in the administration of international transfer pricing.
A. Obtained the time it takes to complete an APA and a post-filing transfer pricing examination.
B. Obtained estimates of the cost of transfer pricing documentation on taxpayers.
C. Determined the time and costs associated with the APA Program and the Post-Filing Examination Program for FY 2002.
Appendix
II
Major Contributors to This Report
Parker F. Pearson, Director
Phil Shropshire, Director
Frank Dunleavy, Audit Manager
Earl Charles Burney, Senior Auditor
Stanley M. Pinkston, Senior Auditor
Lawrence
Smith, Senior Auditor
Appendix III
Chief Counsel CC
Deputy Commissioner for Services and Enforcement N:SE
Commissioner, Large and Mid-Size Business Division LM
Commissioner, Small Business/Self-Employed Division S
Chief, Appeals AP
National Taxpayer Advocate TA
Associate Chief Counsel (International) CC:INTL
Division Counsel/Associate Chief Counsel (Large and Mid-Size Business) CC:LMSB
Deputy Commissioner, Large and Mid-Size Business Division LM
Acting Deputy Commissioner, Small Business/Self-Employed Division S
Deputy Chief,
Appeals AP
Director, Field Operations – East, Office of Appeals AP:FO – East
Director, Field Operations – West, Office of Appeals AP:FO – West
Director, International LM:I
Director, Strategy, Research, and Program Planning, Large and Mid-Size Business Division LM:SR
Director, Office of Legislative Affairs CL:LA
Director, Office of
Program Evaluation and Risk Analysis
N:ADC:R:O
Office of Management Controls N:CFO:AR:M
Audit Liaisons:
Chief Counsel CC
Deputy Commissioner for Services and Enforcement N:SE
Commissioner, Large and Mid-Size Business Division LM
Commissioner, Small Business/Self-Employed Division S
Chief, Appeals AP
Appendix IV
Concept of Related Entities
Related entities in the context of transfer pricing are
entities that are controlled by a common economic interest directly or
indirectly. These entities may take the
form of corporations, partnerships, or some other business formation. The common economic interest may be an
individual, a group of individuals such as shareholders, a corporation,
partnership, or some other business formation.
Two of the most common forms of related entities are the
parent-subsidiary form and the brother-sister form. See illustration in Figure 1. Figure 1 was removed
due to its size. To see Figure 1,
please go to the Adobe PDF version of the report on the TIGTA Public Web Page. In the parent-subsidiary form as illustrated, the common
economic interest are the stockholders that own the United States (U.S.) parent
corporation that directly controls the subsidiary corporation in Country
X. The subsidiary corporation in this
case is a Controlled Foreign Corporation (CFC). The stockholders of the U.S. parent corporation may be an
individual, group of individuals, other corporations, partnerships, trusts,
estates, or a combination. The U.S.
parent corporation would file U.S. Corporation Income Tax Return (Form 1120). In the brother-sister form as illustrated, the common
economic interest of non-U.S. stockholders may be an individual, group of
individuals, corporations, partnerships, or some other business formation that
controls two corporations directly. The
brother corporation is one incorporated in the U.S. The sister corporation is one incorporated outside the U.S and is
therefore a Foreign Corporation (FC) that is taxable by the U.S. only on its
effectively connected U.S. income, while the brother corporation is taxable on
its worldwide income. The sister
corporation, an FC, owns and controls a subsidiary, a U.S. domestic corporation
known as a Foreign Controlled Corporation.
The two U.S. corporations, the brother and the U.S.-based subsidiary,
would file Form 1120. The FC, the sister
corporation, would be required to file only if it had effectively connected
U.S. income; it would file Form 1120F. Concept of Control Control in the context of transfer pricing is de facto
or effective control and can be either direct or indirect. The Internal Revenue Code requires that the
entities in question be owned by the same economic interest. The regulations further expand the term
control to include any kind of control (i.e., direct or indirect), whether
legally enforceable, and however exercisable or exercised. It is the reality of control which is
decisive, not its form or the mode of its exercise. For purposes of this meaning of control, one must differentiate
between statutory control and de facto control. Statutory control as it relates to corporations in general
means the ownership of stock possessing at least 50 percent of the total
combined voting power of all classes of stock entitled to vote, or at least 50
percent of the total value of all classes of stock. For partnerships, control means owning directly or indirectly
more than 50 percent of the capital interest or the profits interest. De facto control has been defined in two court
decisions and takes precedence over statutory control. In B. Forman Co., Inc., the Second Circuit
reversed the U.S. Tax Court decision that 50 percent ownership of a corporation
by 2 unrelated partners was not control.
In the decision, the Second Circuit held that the two partners were a de
facto partnership or joint venture working in concert in making loans
without interest to a corporation. In
another case, the Fifth Circuit upheld an allocation of income among four
organizations, noting that it was immaterial that the ownership of stock and
partnership interests were not identical persons at the same time. Control could be inferred from the actions
of the parties. The regulations state that a presumption of control arises
if income or deductions have been arbitrarily shifted. The taxpayer is thus placed in the position
of proving that, if the mechanical standards of statutory control are not
satisfied, the de facto control also does not exist. Appendix V A
Simple Illustration of How Transfer Pricing Can Be Used to Improperly Shift
Income and Reduce Taxes To establish transfer prices between related entities, the
“arm’s length” standard has been developed.
The goal of this approach is to distribute income in the same way that
the market would distribute income; therefore, related parties should earn the
same return that unrelated parties would earn under similar circumstances. This approach is implemented through
separate accounting in which an individual transfer price is determined for
each transaction. Figure 1 and the example that follows illustrate one method
of how transfer pricing can be used to shift income and erode the United States
(U.S.) tax base. Figure 1 was removed due to its size. To see Figure 1, please go to the Adobe PDF
version of the report on the TIGTA Public Web Page. Fsub Corporation is located in Country M, a country not
contiguous to the U.S., and is a wholly owned foreign subsidiary (Controlled Foreign
Corporation, CFC) of a U.S. corporation, USP Corporation. Fsub Corporation manufactures Product X, an
unbranded widget, for a cost of $50 a unit, that it sells at a transfer price
of $90 a unit to USP Corporation. USP
Corporation then sells Product X to unrelated customers at the U.S. market
price of $100 a unit. Unrelated and
independent companies A, B, C, D, and E, also located in Country M, sell an
unbranded widget similar to Product X for the market price of $55. The corporate tax rates in the U.S. and in
Country M are 35 percent and 10 percent, respectively. In 200X, USP Corporation imported and sold
10,000 units of Product X. (See Table 1
for details of computations.) Based on this scenario and assuming for purposes of the
example that gross profit is equal to taxable income, USP Corporation would
underreport its worldwide income tax liability by $87,500 ($162,500 – $75,000)
by shifting $350,000 of taxable income to its controlled foreign subsidiary,
Fsub Corporation, by using a transfer price of $90 per unit instead of the
market price of $55 per unit. USP
Corporation would underreport its U.S. tax liability by $122,500 ($157,500 –
$35,000) and Fsub Corporation would overreport its Country M Tax Liability by
$35,000 ($40,000 – $5,000). Table 1
was removed due to its size. To see
Table 1, please go to the Adobe PDF version of the report on the TIGTA Public
Web Page. If the
example above was examined and an Internal Revenue Code Section 482 adjustment
made to the taxable income of the members of the controlled group, there would
be additional side effects of double taxation on the allocated amounts, changes
in the amount of allowable foreign tax credit, and severe penalties. Appendix VI Historical Information on
International Transfer Pricing and the “Arm’s Length” Standard The antecedents of Section (§) 482 predate the Internal Revenue Code (I.R.C.). The history of I.R.C. § 482 was briefly discussed in A
Study of Intercompany Pricing, dated October 1988, that is commonly
referred to as the “White Paper.”
Prepared by the Department of the Treasury’s Office of International Tax
Counsel and Office of Tax Analysis, and the Internal Revenue Service’s (IRS)
Office of Assistant Commissioner (International) and Office of Associate Chief
Counsel (International), the paper describes that the IRS Commissioner was
generally authorized to allocate income and deductions among affiliated
corporations in 1917. The earliest
direct predecessor of I.R.C. §
482 dates to 1921, when legislation went beyond the authority to require
consolidated accounts and authorized the Commissioner to prepare consolidated
returns for commonly controlled trades or businesses to compute their “correct”
tax liability. This legislation was
passed partly because possession corporations, ineligible to file consolidated
returns with their domestic affiliates, offered opportunities for tax
avoidance. As early as 1921, the
Congress perceived the potential for abuse among related taxpayers engaged in
multinational transactions. In the 1928 Revenue Act, the Congress removed the provision
from the expiring consolidated return provisions and significantly expanded it
as § 45, the predecessor to the
current I.R.C. § 482. The provision gave the Commissioner the
authority to make adjustments expressly predicated on the duty to prevent tax
avoidance and to ensure the clear reflection of the income of related parties. For many years prior to the 1960s, the small number of
United States (U.S.) companies with multinational affiliates meant that I.R.C. § 482 had little impact in the
international context. Regulations
issued in 1935 remained substantially unchanged until 1968. These regulations set forth the “arm’s
length” standard as the fundamental principle underlying I.R.C. § 482, stating “The standard to be
applied in every case is that of an uncontrolled taxpayer dealing at arm’s
length with another uncontrolled taxpayer.”
However, the regulations did not mandate any particular allocation
method. The case law interpreting I.R.C. § 482 and its predecessors took a broad approach. The concepts of “evasion of taxes” and
“clear reflection of income” were developed into far-reaching weapons to attack
a variety of tax abuses. The courts
applied a number of different standards for determining when transactions were
conducted at arm’s length. Transactions
were scrutinized to determine if related parties received full, fair value; a
fair and reasonable price; or a fair price including a reasonable profit. In 1961, the Department of the Treasury recommended that
significant changes be made in the taxation of U.S. enterprises with foreign
affiliates. In particular, the
Department of the Treasury contended that I.R.C. § 482 was not effectively protecting the U.S. taxing
jurisdiction. However, the Congress, in
the Conference Committee reports to the 1962 Revenue Bill, thought
otherwise: The conferees on the part of both the House and the Senate
believe that the objectives of Section 6 of the bill as passed by the House can
be accomplished by amendment of the regulations under present Section 482. Section 482 already contains broad authority
to the Secretary of the Treasury or his delegate to allocate income and
deductions. It is believed that the
Treasury should explore the possibility of developing and promulgating
regulations under this authority which would provide additional guidelines and
formulas for the allocation of income and deductions in cases involving foreign
income. The result was that the Department of the Treasury
promulgated new I.R.C. § 482
regulations that were issued in final form in 1968. These regulations were extensively revised and updated again in
1994. The Department of the Treasury is
currently working on providing additional I.R.C. § 482 guidance in the areas of cross-border services and cost
sharing along with the recently issued regulations on stock option
compensation. Appendix VII Internal Revenue Service Initiatives Currently Underway to
Help Improve Voluntary Compliance and the Administration of the Transfer Pricing
Regulations In Fiscal Year (FY) 2002, the Advance Pricing Agreement
(APA) Program opened its second West Coast office in Laguna Niguel, California
(south of Los Angeles), to complement its Northern California office in San
Francisco and to better serve taxpayers.
The APA Program had determined that approximately 25 percent of the APA
Program case load comes from taxpayers west of the Mississippi River, with the
majority in California. The APA Program
determined that having western cases served from California would benefit both
the taxpayers and the APA Program staff by reducing travel time, costs, and
time zone complications, and by having closer relationships with western
taxpayers and taxpayer organizations. For similar reasons, the Office of Director, International,
Large and Mid-Size (LMSB) Division, opened a second West Coast Tax Treaty
office in El Segundo, California, to provide service on APA Program and
Competent Authority cases. The staff of
the Tax Treaty Division was increased by four tax treaty analysts in the West
Coast office and four in the Washington, D.C., office in FY 2002. Transfer pricing is a key focus of the LMSB Division’s
Globalization Strategic Initiative. The
LMSB Division’s Strategy and Program Plan FY 2003-2004, dated September
2002, describes several initiatives underway, related to transfer pricing
administration, due to concerns about the movement of business profits and
highly appreciated assets offshore. One initiative is to evaluate compliance with the transfer
pricing regulations, including issues emerging from application of the
cost-sharing provision, and to develop appropriate strategies for addressing
issues identified. Among the measures
associated with the initiative are the percentage of open Coordinated Industry
Cases (CIC) with time planned for transfer pricing and the percentage of CICs
with pricing adjustments sent to the Internal Revenue Code (I.R.C.) Section (§) 6662(e) Penalty Screening
Committee. A second initiative is to support the Outside Expert Program
that is occasionally used to administer the transfer pricing regulations. The Outside Expert Program is extremely
critical to the development and defense of tax issues that are subject to
litigation. A third initiative is to provide training to agents and
managers in the new Limited Issue Focused Examination model, as well as a new
risk assessment analysis tool. This
model, along with the examination standards and quality criteria, will allow
agents and managers to focus on the most significant issues. The new risk assessment analysis tool
balances the development of new issues against cycle time considerations. The new risk assessment training will
include the new currency definition, criteria, risk assessment of employment
taxes, and transfer pricing issues. In addition to the initiatives mentioned in the Strategy
and Program Plan FY 2003-2004, the LMSB Division’s Economist Program,
consisting of approximately 80 economists stationed in 18 key United States
(U.S.) cities, has established national workgroups led by 1 of the
8 economist managers that are focusing on establishing consistency in the
development of transfer pricing issues across the country. The economists in the Program are primarily
located in proximity to both major Internal Revenue Service (IRS) International
Examiner group concentrations and the U.S. headquarters of Multinational
Enterprises (MNE). The Economist
Program supplies economists that are experts in the field of transfer pricing
and the “arm’s length” principle. Nearly
all of these economists hold a graduate degree and about 60 percent hold
doctorates. The Economist Program,
which is part of the Field Specialist Program, is also participating in an
initiative with the Office of Appeals.
According to officials, experienced economists will be reassigned to the
Office of Appeals and will receive appeals resolution training as Appeals
Economists to maintain the independence of the Office of Appeals. The LMSB Division, the Office of Chief Counsel, and the
Department of the Treasury continue to work on three significant regulation
projects addressing transfer pricing issues.
These projects include transfer pricing regulations addressing
cross-border services and cost sharing, along with the recently issued
regulations on stock option compensation. The LMSB Division’s Director, International, completed a
study entitled Effectiveness of Internal Revenue Code Section 6662(e),
dated December 2001. This study
was a response to a request by the Senate Committee on Appropriations that had
expressed concern about the effectiveness of legislative changes affecting
administration of I.R.C. § 482. The Committee asked the IRS to provide
information on three specific areas of interest: ·
Whether taxpayers are preparing contemporaneous transfer
pricing documentation as anticipated by I.R.C. § 6662(e). ·
The quality of the documentation. The study found that most taxpayers prepare documentation
for a substantial portion of controlled transactions, and taxpayers that
prepare documentation for fewer than all transactions generally do so based on
a cost-benefit analysis. The study also
indicated that most taxpayers made substantial efforts to prepare
documentation, particularly for controlled transactions deemed to have the
greatest potential for scrutiny under I.R.C. § 482. The quality of
documentation in individual cases varied widely. IRS examination teams surveyed as part of the study concluded
that the documentation was very useful in the examination of transfer pricing
issues by allowing early identification of key issues. On January 22, 2003, the LMSB Division issued a memorandum
to all its executives, managers, and agents instructing them to begin
requesting contemporaneous transfer pricing information pursuant to I.R.C. § 6662(e) when opening cases with
controlled transactions. The memorandum
was effective immediately. The proper
application of the procedures in this memorandum should permit the
International Examiners and Economists to begin and complete their risk
assessment analysis of transfer pricing issues on the returns in the case early
in the examination, so that they can make a decision as to whether further
examination of the transfer pricing issues is warranted. On March 12, 2003, the IRS announced an agreement of the
members of the Pacific Association of Tax Administrators (PATA). The members agreed on principles under which
MNE taxpayers can prepare one set of documentation that will meet the transfer
pricing documentation provisions of each PATA member country, eliminating the
need to prepare separate documentation for each country. The PATA Documentation Package is intended
to reduce taxpayer burden and provide certainty that an otherwise applicable
transfer pricing documentation-related penalty will not be imposed if
documentation is maintained and submitted in accordance with the Package. The PATA Documentation Package is voluntary in nature and
does not preclude PATA member tax administrations from making transfer pricing
adjustments and assessing any interest due on those adjustments. The Package is consistent with the general
principles outlined in Chapter V of the Organization for Economic Cooperation and
Development’s (OECD) Transfer Pricing Guidelines for Multinational
Enterprises and Tax Administrations (dated July 1995). Appendix VIII Increasing Globalization Leads to an
Increasing Number of Controlled Transactions The Department of Commerce, Bureau of Economic Analysis
(BEA) reports that, for Calendar Years (CY) 1997 through 2001, direct private
United States (U.S.) investment overseas increased 29 percent, from $5.158
trillion to $6.647 trillion. During the
same period, direct private foreign investment in the U.S grew at an even greater
rate, 53 percent, from $5.341 trillion to $8.150 trillion (see Figure 1). Between CYs 1998 and 2001, U.S. trade also
increased. U.S. imports grew from $908
billion to $1.133 trillion, up 25 percent, and U.S exports increased from $680
billion to $731 billion, up over 7 percent. Figure 1 was removed
due to its size. To see Figure 1,
please go to the Adobe PDF version of the report on the TIGTA Public Web Page. The increasing globalization of the economy evidenced by the
increasing amount of private U.S. investment abroad and private foreign
investment in the U.S., as well as the increasing amount of U.S. trade,
directly affects the volume and amount of controlled transactions among
Multinational Enterprise (MNE) groups.
These controlled transactions are required to be reported to the
Internal Revenue Service (IRS) at the time the taxpayer’s U.S. income tax
return is filed. The Information Return of U.S. Persons With Respect To
Certain Foreign Corporations (Form 5471) is used by U.S. citizens and residents
who are officers, directors, or 10 percent shareholders in certain foreign
corporations. Schedule M is used to
report a summary of transactions between the Controlled Foreign Corporation
(CFC) and the shareholder or other related entities grouped by category. One of the consequences of the increase in
U.S. direct foreign investment abroad is the increase in the number of Forms
5471 with Schedule M filed by U.S. MNE groups.
The number of Forms 5471 with Schedule M grew 42 percent, from 71,897 in
Tax Year (TY) 1996 to 102,124 in TY 2000.
While the growth in the number of return filings is impressive, the
number of U.S. entities filing those returns grew more modestly. The U.S. entities filing a Form 5471 with
Schedule M grew 27 percent, from 11,408 entities in TY 1996 to 14,461 in TY
2000 (see Figure 2). One reason for the
disparity between filings and entities was explained in a recent planning
document from the Large and Mid-Size Business Division. ****3d**** Figure 2 was removed
due to its size. To see Figure 2,
please go to the Adobe PDF version of the report on the TIGTA Public Web Page. The Information Return of a 25% Foreign-Owned U.S. Corporation
or a Foreign Corporation Engaged in a U.S. Trade or Business (Form 5472) is
filed by a 25 percent or more foreign-owned U.S. corporation or a foreign
corporation with reportable transactions.
One of the results of the increase in foreign direct investment into the
U.S. is the increase in the number of Forms 5472 filed by foreign MNE
groups. Form 5472 filings grew 5.5
percent, from 67,633 in TY 1996 to 71,352 in TY 2000, while the entities filing
Forms 5472 grew nearly 7 percent, from 31,140 FCCs and Foreign Corporations
(FC) in TY 1996 to 33,255 FCCs and FCs in TY 2000 (see Figure 3). Figure 3 was removed
due to its size. To see Figure 3,
please go to the Adobe PDF version of the report on the TIGTA Public Web Page. The effect of this is that the value and complexity of the
summary of controlled transactions reported on these information returns
continues to grow. The value of the
summary of controlled transactions reported on Forms 5471 with Schedule M grew
10 percent, from $3.9 trillion in TY 1996 to $4.3 trillion in TY 2000, while
during the same period the value of the summary of controlled transactions
reported on Forms 5472 by FCs and FCCs declined 16 percent, from $910 billion
in TY 1996 to $761 billion in TY 2000 (see Figure 4). Figure 4 was removed
due to its size. To see Figure 4,
please go to the Adobe PDF version of the report on the TIGTA Public Web Page. The Form 5471 Schedule M and Form 5472 information indicates
that the potential population of MNEs with transfer pricing issues in the U.S.
taxpayer population is far more concentrated than first indicated by the number
of filings of Forms 5471 and Forms 5472.
In TY 2000, only 47,716 business entities filing U.S. income tax returns
reported that they had controlled transactions. This represents 0.31 percent of the 15.5 million business returns
filed (2.5 million corporate returns, 2.1 million partnership returns, 2.9
million S corporation returns, and 8 million sole proprietorship returns) for
that year. However, the Form 5471 and
Form 5472 information reports business receipts from related transactions in TY
1999 of $638 billion compared to the business receipts of $16.3 trillion
reported for all corporation filings, or 4 percent. Appendix IX Examination
Trends in Transfer Pricing The Internal Revenue Service (IRS) has historically
attempted to assure voluntary compliance with the transfer pricing regulations
by conducting post-filing examinations of income tax returns that contain
controlled transactions. The primary
objective in selecting returns for examination is to promote the highest degree
of voluntary compliance on the part of taxpayers. The consequences of this
strategy were protracted disputes lasting years and limited access to
information. To alleviate these
problems, according to a 1999 IRS report, the agency began implementing in 1992
a five-part strategy aimed at shifting the focus from after-the-fact
examination and litigation of transfer pricing controversies, to encouragement
of upfront taxpayer compliance and advance resolution of transfer pricing
issues. The effect was to reduce the
reliance on examinations as a tool for ensuring compliance of controlled
taxpayers with the “arm’s length” standard in determining their true taxable
income on controlled transactions, while emphasizing upfront compliance tools
such as guidance, Advance Pricing Agreements, and contemporaneous
documentation. The population of United States (U.S.) income tax returns
with controlled transactions reported represents a small percentage of all
business returns filed each year. For
example, in Tax Year (TY) 1999, there were 15.1 million business income tax
returns filed (2.5 million corporations, 2.8 million S corporations, 2 million
partnerships, and 7.8 million sole proprietorships), but only 0.4 percent, or
59,432 U.S. business returns, reported containing controlled transactions based
on the Information Return of U.S. Persons With Respect To Certain Foreign
Corporations (Form 5471) or the Information Return of a 25% Foreign-Owned U.S. Corporation
or a Foreign Corporation Engaged in a U.S. Trade or Business (Form 5472) (see
Figure 1). Business entities filing
U.S. income tax returns reported $3.598 trillion in controlled transactions on
Forms 5471 and $657 billion on Forms 5472, for total controlled transactions of
$4.255 trillion. This represented
nearly 12 percent of the $36.859 trillion in transactions reported by
corporations filing U.S. income tax returns in TY 1999. Figure 1 was removed
due to its size. To see Figure 1,
please go to the Adobe PDF version of the report on the TIGTA Public Web Page. One measure of the IRS’ overall Examination Program is the
“Examination coverage rate,” commonly known as the “audit rate,” which is
figured by dividing the number of returns examined by the total number of tax
returns filed in the previous calendar year.
Using this description, a rough estimate of the “Examination coverage
rate” of U.S. entities filing U.S. income tax returns reporting controlled transactions
can be developed. It shows the
“Examination coverage rate” of returns with controlled transactions fell 27
percent between Fiscal Years (FY) 1997 and 2001, from 2.6 percent to 1.9
percent. During this same period, the
overall number of U.S. income tax returns reporting controlled transactions
grew 12 percent, from 42,548 to 47,716, while the number of transfer pricing
examinations fell 16 percent, from 1,083 to 906 returns examined (see Figure
2). In comparison, over the same
period, the income tax return “Examination coverage rate” for all return
categories fell 56 percent, from 1.27 percent of all income tax returns filed
to 0.56 percent. In our discussions,
the IRS also pointed out that during this period the IRS underwent a
significant restructuring that had a broad impact on the assignment of work to
Examination personnel and affected case closures. Figure 2 was removed
due to its size. To see Figure 2,
please go to the Adobe PDF version of the report on the TIGTA Public Web Page. While the transfer pricing Examination coverage rate of
controlled transactions declined, the amount of total transfer pricing
adjustments made to taxable income by International Examiner (IE) Revenue
Agents reported on the ICMS between FYs 1997 and 2002 peaked, then declined,
then recovered, and then increased over its 1997 level. Total transfer pricing adjustments increased
34 percent in FY 2002 over the FY 1997 level, from $4.15 billion to $5.56
billion. Transfer pricing adjustments
in the Coordinated Industry Case (CIC) Program paralleled the trend in total
transfer pricing adjustments and increased 39 percent in FY 2002 over the FY
1997 level, from $3.3 billion to $4.6 billion.
Transfer pricing adjustments in the Non-CIC Program declined from FYs
1997 to 2000 before recovering and increasing over the FY 1997 level in FY
2001. Transfer pricing adjustments in
the Non-CIC Program increased 13 percent in FY 2002 over the FY 1997
level, from $861 million to $969 million (see Figure 3). Figure 3 was removed
due to its size. To see Figure 3,
please go to the Adobe PDF version of the report on the TIGTA Public Web Page. The examination of transfer pricing issues takes place in
two components of the IRS field Examination Program by IEs in the Large and
Mid-Size Business (LMSB) Division. The
two components are: ·
The Non-CIC Program, a field Examination Program
formerly known as the General Examination Program. It is operated by both the Small Business/Self-Employed and LMSB
Divisions and conducts examinations of income tax returns using a single Income
Tax Revenue Agent. The CIC Program, in comparison to
the Non-CIC Program, examines fewer returns with controlled transactions but
accounted for over 81 percent of the proposed transfer pricing adjustments
during FYs 1997 to 2002. Thirty-two
percent of the transfer pricing examinations completed from FYs 1997 to 2002
involved large multinational corporations in the CIC Program. In a 1999 report, the IRS estimated that
transfer pricing examinations consumed about one-half the time of their staff
of approximately 650 IEs. While
the return from transfer pricing adjustments appears high at the close of the
examinations, the adjustments can be subsequently conceded in full or reduced
through three methods that MNE taxpayers can use separately or in
combination. MNE taxpayers can (1)
challenge adjustments in the IRS Office of Appeals, (2) petition the U.S. Tax
Court, or (3) pay the tax associated with the adjustments and sue for a refund
in a U.S. District Court or in the Court of Federal Claims. A
U.S.-initiated transfer pricing adjustment may also be reduced as a result of a
U.S. Competent Authority proceeding with a U.S treaty partner in an effort to
eliminate double taxation pursuant to Revenue Procedure 2002-52. For additional information on invoking
Revenue Procedure 2002-52 as a means to secure relief from double taxation
through the Mutual Agreement Procedure Process, see Appendix XI. Appendix X Advance
Pricing Agreement Program Provides Avenue to Encourage Compliance The Advance Pricing Agreement (APA) Program operated by the
Associate Chief Counsel (International) is one of the methods used by the
Internal Revenue Service (IRS) to encourage compliance with the transfer
pricing regulations. The APA Program is
a voluntary process. The Program is
designed to resolve actual or potential transfer pricing disputes in a
principled, cooperative manner, as an alternative to the traditional
post-filing examination process. The taxpayer submits an application for an APA together with
a user fee as set forth in Revenue Procedure 96–53. The process is broken down into five phases: (1) application, (2) due diligence, (3)
analysis, (4) discussion and agreement, and (5) drafting and execution. An APA is a binding contract between the IRS
and a taxpayer by which the IRS agrees not to seek a transfer pricing
adjustment under Internal Revenue Code (I.R.C.) Section (§) 482 for a covered transaction if
the taxpayer files its tax return for a covered year consistent with the agreed
upon transfer pricing method. An APA generally combines an agreement between a taxpayer
and the IRS on an appropriate transfer pricing methodology for the transactions
at issue with an agreement between the United States (U.S.) and one or more
foreign tax authorities that the transfer pricing methodology is correct. With such a bilateral APA, the taxpayer is
assured that the income associated by the covered transaction will not be
subject to double taxation by the IRS and the foreign tax authority. A unilateral APA is an agreement between a taxpayer and the
IRS establishing an approved transfer pricing methodology for U.S. tax purposes
only. A unilateral APA binds the
taxpayer and the IRS but does not prevent foreign tax administrations from
taking a different position on the appropriate transfer pricing methodology for
a transaction. APAs are negotiated with the taxpayer by an IRS team headed
by an APA team leader. As of December
31, 2001, the APA Program had 22 team leaders, of whom 21 were attorneys and 1
was a former International Examiner (IE).
The APA team generally includes an economist and an IE. In a bilateral case, a “competent authority
analyst,” who leads the discussions with the treaty partner, will be
included. The APA team may also include
Large and Mid-Size Business (LMSB) Division field counsel, other LMSB
Examination personnel, and an Appeals Officer. The APA Program reported to the Congress that it has
received 676 applications over the life of the Program and has entered into 452
new and renewed APAs, consisting of 221unilateral APAs (49 percent), 224
bilateral APAs (50 percent), and 7 multilateral APAs (1 percent) (see
Figure 1). The Program has also
reported that 5 APAs have been canceled and 80 APAs have been withdrawn during
the life of the Program. Figure 1 was removed
due to its size. To see Figure 1,
please go to the Adobe PDF version of the report on the TIGTA Public Web Page. Most of the APAs made by the Program have been with foreign
Multinational Enterprises (MNE) operating U.S. subsidiaries or branch offices
in the U.S. The Program reported to the
Congress that of 444 APAs, 253 APAs (57 percent) have been with foreign MNEs
and 163 APAs (37 percent) have been with U.S. MNEs (see Figure 2). Figure 2 was removed
due to its size. To see Figure 2, please
go to the Adobe PDF version of the report on the TIGTA Public Web Page. The APA Program reports that the most frequently controlled
transaction that is the subject of an APA is the sale of tangible property into
the U.S. The most frequently applied
transfer pricing methodology used by the APA Program is the Comparable Profits
Method (CPM). The 2001 APA Program
annual report describes the benefits of this method: The CPM is frequently applied in APAs. This is because reliable public data on
comparable business activities of independent companies may be more readily
available than potential CUP [Comparable Uncontrolled Price] data and
comparability of resources employed, functions, risks and other relevant
considerations is more likely to exist than comparability of product. The CPM also tends to be less sensitive than
other methods to differences in accounting practices between the tested party
and comparable companies.… In addition,
the degree of functional comparability required to obtain a reliable result
under the CPM is generally less than required under the resale price or cost
plus methods, because differences in functions performed often are reflected in
operating expenses, and thus taxpayers performing different functions may have
very different gross profit margins but earn similar levels of operating
profit. Figure 3 shows the frequency of the various transfer pricing
methodologies used in the APA Program. Figure 3 was removed
due to its size. To see Figure 3,
please go to the Adobe PDF version of the report on the TIGTA Public Web Page. The heavy use of the CPM by the APA Program may be
indicative of the methods being used by the taxpayers when filing their returns
and also by the IRS when making an I.R.C. §
482 allocation during a transfer pricing dispute in a post-filing
examination. Appendix XI Mutual
Agreement Procedure Process Taxpayers may obtain assistance from the United States
(U.S.) Competent Authority under the provisions of an income, estate, or gift
tax treaty to which the U.S. is a party by invoking Revenue Procedure
2002-52. The Large and Mid-Size
Business Division’s Director, International, acts as the U.S. Competent
Authority in administering the operating provisions of tax treaties and in
interpreting and applying these treaties.
The U.S. Competent Authority assists taxpayers with respect to matters
covered in the Mutual Agreement Procedure (MAP) provisions of tax treaties in
the manner specified in those provisions.
A tax treaty generally permits taxpayers to request competent authority
assistance when they consider that actions of the U.S., the treaty country, or
both, result or will result in taxation that is contrary to the provisions of a
treaty. There is no authority for the
U.S. Competent Authority to provide relief from U.S. tax or to provide
assistance due to taxation arising under the tax laws of the foreign country or
the U.S., unless such authority is granted by a treaty. If a taxpayer’s request for competent authority assistance
is accepted, the U.S. Competent Authority generally will consult with the
appropriate foreign competent authority and attempt to reach an agreement that
is acceptable to all parties. The U.S.
Competent Authority may also initiate competent authority negotiations in any
situation deemed necessary to protect U.S. interests. Such a situation may arise, for example, when a taxpayer fails to
request competent authority assistance after agreeing to a U.S. or foreign tax
assessment that is contrary to the provisions of an applicable tax treaty or
for which correlative relief may be available.
The failure of the taxpayer to request competent authority assistance or
to take appropriate steps, as necessary to maintain availability of the remedy,
may cause a denial of part or all of any foreign tax credits claimed. A request for competent authority assistance may be filed at
any time after an action results in taxation not in accordance with the
provisions of the applicable treaty. In
a case involving a U.S.-initiated adjustment of tax or income resulting from a
tax examination, a request for competent authority assistance may be submitted
as soon as practicable after the amount of the proposed adjustment is
communicated in writing to the taxpayer on a Notice of Proposed Adjustment
(Form 5701). When a request for competent authority assistance is
accepted with respect to a U.S.-initiated adjustment, the Internal Revenue
Service (IRS) will postpone further administrative action with respect to the
issues under competent authority consideration. However, the normal administrative procedures continue to apply
to all other issues not under the U.S. Competent Authority consideration. Taxpayers who disagree with a proposed U.S. adjustment may
either pursue their right of administrative review with the Office of Appeals
before requesting competent authority assistance or request competent authority
assistance immediately. The Office of
Appeals’ consideration of potential competent authority matters will be made
without regard to other issues or considerations that do not involve potential
competent authority matters. Taxpayers
that are pursuing their rights with the Office of Appeals may contact the U.S.
Competent Authority if they believe they have potential competent authority
issues. If a taxpayer decides to make a
competent authority request, it may choose to make a request pursuant to the
Simultaneous Appeal procedures. In
Fiscal Year (FY) 1997, the U.S. Competent Authority received 218 cases for
competent authority assistance with a tax treaty provision. In FY 2002, the U.S. Competent Authority
received 212 cases, a decline of nearly 3 percent from the FY 1997 level. The number of cases received during this
period ranged from a high of 228 in FY 2000 to a low of 178 cases in FY 1998. The
U.S. Competent Authority disposed of 228 cases in FY 2002, a 20 percent
increase from the 1997 level of 190 cases.
The disposition of cases ranged from a low of 175 cases in FY 2000 to a
high of 228 cases in both FYs 1999 and 2002 (see Figure 1). Figure 1 was removed
due to its size. To see Figure 1,
please go to the Adobe PDF version of the report on the TIGTA Public Web Page. These cases included: ·
Allocation
cases where the taxpayer sought relief from double taxation due to transfer
pricing adjustments under Internal Revenue Code (I.R.C.) Section (§) 482. ·
Advance
Pricing Agreement (APA) cases where the taxpayer sought a bilateral or
multilateral APA to eliminate potential double taxation on its proposed
transfer pricing methodology. ·
Nonallocation
cases and limitation of benefits cases where the taxpayer sought competent
authority to resolve issues of fiscal residence or to allow a competent
authority to make a discretionary determination that a taxpayer is entitled to
the benefits of a treaty under specific limitation on benefits provisions. Allocation cases result when taxpayers request assistance
under a tax treaty to relieve economic double taxation arising from an
allocation under I.R.C. § 482 or
an equivalent provision under the laws of a treaty country. With respect to a request for competent
authority assistance involving allocation of income and deductions between a
U.S. taxpayer and a related person, the U.S. Competent Authority and its
counterpart in the other treaty country will be bound by the “arm’s length”
standard provided by the applicable provisions of the relevant treaty. The U.S. Competent Authority will also be
guided by the “arm’s length” standard consistent with the regulation under
I.R.C. § 482 and the
Organization of Economic Cooperation and Development’s Transfer Pricing
Guidelines for Multinational Enterprises and Tax Administrations (dated
July 1995). When negotiating Mutual
Agreements on the allocation of income and deductions, the U.S. Competent
Authority will take into account all of the facts and circumstances of the
particular case and the purpose of the treaty to avoid double taxation. In FY 1997, the U.S. Competent Authority closed 104
allocation cases, or 55 percent of the 190 cases it disposed of, composed of 65
U.S.-initiated cases and 39 foreign-initiated cases. However, by FY 2002, the number of allocation cases closed
remained at the same level of 104 cases, composed of 60 U.S.-initiated cases
and 44 foreign-initiated cases. The
allocation cases declined in percentage terms by 16 percent, to only 46 percent
of the 228 cases closed by the U.S. Competent Authority (see Figure 2). Figure 2 was removed
due to its size. To see Figure 2,
please go to the Adobe PDF version of the report on the TIGTA Public Web Page. Between
FYs 1997 and 2002, the U.S. Competent Authority reported no clear trends with
regard to the length of the MAP process.
Depending upon the year, the length of the process averaged 679 days to
948 days (see Figure 3). Figure 3 was removed
due to its size. To see Figure 3,
please go to the Adobe PDF version of the report on the TIGTA Public Web Page. With respect to transfer pricing issues, the goal of the MAP
process is the avoidance of double taxation or taxation not in accordance with
the applicable treaty. Figure 4 shows the percentage of the type of relief granted
for the total adjustments closed by the U.S. Competent Authority for FYs
1997-2002. For example, in FY 2002: ·
A correlative adjustment was provided in 38 percent of
the adjustments closed by the U.S. Competent Authority, thus eliminating the
potential for double taxation. In these
cases, a corresponding decrease in income was provided by the non-initiating
country. Figure 4 was removed
due to its size. To see Figure 4,
please go to the Adobe PDF version of the report on the TIGTA Public Web Page. As
previously discussed in Appendix X, the U.S. Competent Authority is also
involved in the negotiation of bilateral APAs.
A bilateral APA is a contract between a taxpayer and the IRS on an
appropriate transfer pricing methodology for the transaction at issue, with an
agreement between the U.S. and one or more foreign tax authorities that the
transfer pricing methodology is correct.
In a bilateral case, the discussions proceed in two parts and involve
two IRS offices: the APA Program and
the U.S Competent Authority. In the
first part, the APA Program team will attempt to reach a consensus with the
taxpayer regarding the position that the APA Program office recommends the U.S.
Competent Authority take in negotiations with its treaty partner. The APA Program and the U.S. Competent
Authority report that APA Program negotiations are likely to proceed faster
with the foreign competent authority if the taxpayer fully supports the
recommended U.S. negotiating position.
This recommended U.S. negotiating position is a paper drafted by the APA
Program team leader and signed by the APA Program Director that provides the
APA Program’s view of the best transfer pricing method for the covered
transaction, taking into account I.R.C. § 482 and the
regulations thereunder, the relevant tax treaty, and the U.S. Competent
Authority’s experience with the treaty partner. Once
the APA Program completes the recommended U.S. negotiating position, the APA
Program process shifts from the APA Program to the U.S. Competent
Authority. The U.S. Competent Authority
analyst assigned the APA takes the recommended U.S. negotiating position and
prepares the final U.S. negotiating position, which is then transmitted to the
foreign competent authority. The
negotiations with the foreign competent authority are conducted by the U.S.
Competent Authority analyst, most often in face-to-face negotiating sessions
conducted periodically throughout the year. Between
FYs 1997 and 2002, the U.S. Competent Authority received requests for bilateral
and multilateral APAs ranging from a low of 33 cases in FY 1998 to a high
of 61 cases in FY 2002. The 61 cases
received in FY 2002 were a 56 percent increase over the FY 1997 level of 39
cases received. During the same period,
the U.S. Competent Authority completed Mutual Agreements on 55 cases in FY
2002, an increase of 57 percent over the FY 1997 level of 35 cases. During this period, bilateral APAs completed
by the U.S. Competent Authority ranged from a low of 31 cases in FY 1998 to a
high of 55 cases in FY 2002 (see Figure 5). Figure 5 was removed
due to its size. To see Figure 5,
please go to the Adobe PDF version of the report on the TIGTA Public Web Page. The U.S. Competent Authority tracks time on an APA case from
the date a tax treaty analyst is assigned to a case to the date the final
Mutual Agreement is concluded with a treaty partner or partners. Between FYs 1997 and 2002, the U.S.
Competent Authority reported that it can take up to 484 days on average to
secure a Mutual Agreement, depending upon the year a bilateral APA Program case
was completed (see Figure 6). Figure 6 was removed
due to its size. To see Figure 6,
please go to the Adobe PDF version of the report on the TIGTA Public Web Page. Appendix XII Internal
Revenue Code Section 482 Sec. 482. Allocation of income and deductions among
taxpayers. In any case of
two or more organizations, trades, or businesses (whether or not incorporated,
whether or not organized in the United States, and whether or not affiliated)
owned or controlled directly or indirectly by the same interests, the Secretary
may distribute, apportion, or allocate gross income, deductions, credits, or
allowances between or among such organizations, trades, or businesses, if he
determines that such distribution, apportionment, or allocation is necessary in
order to prevent evasion of taxes or clearly to reflect the income of any of
such organizations, trades, or businesses.
In the case of any transfer (or license) of intangible property (within
the meaning of section 936(h)(3)(B)), the income with respect to such transfer
or license shall be commensurate with the income attributable to the
intangible.