The Controls for Examination Processes for Industry Cases With International Transfer Pricing Issues Can Be Improved

 

September 2004

 

Reference Number:  2004-30-133

 

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.

 

September 10, 2004

 

 

MEMORANDUM FOR COMMISSIONER, LARGE AND MID-SIZE BUSINESS DIVISION

 

FROM:     Gordon C. Milbourn III /s/ Gordon C. Milbourn III

                 Acting Deputy Inspector General for Audit

 

SUBJECT:     Final Audit Report - The Controls for Examination Processes for Industry Cases With International Transfer Pricing Issues Can Be Improved (Audit # 200330014)

 

This report presents the results of our review of international transfer pricing documentation.  The overall objective of this review was to determine the impact of the contemporaneous transfer pricing documentation regulations on Industry Case (IC) transfer pricing examinations.

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 of a Multinational Enterprise (MNE) group with operations in the United States (U.S.) and other countries. The Congress and other stakeholders are concerned whether entities with cross-border transactions are reporting and paying the proper amount of taxes.  There is a broad range of estimates regarding the loss of taxes due to transfer pricing noncompliance.  For example, an Internal Revenue Service (IRS) study in 1999 estimated an annual loss of $2.8 billion, while an independent study estimated the annual loss at $53 billion.  If the actual noncompliance is closer to the $53 billion range, it would be a substantial addition to the $311 billion gross tax gap estimate.  To ensure related party cross-border transactions are accurately reported, one of the operating priorities of the IRS Large and Mid-Size Business (LMSB) Division is to implement appropriate strategies to ensure compliance with the transfer pricing rules and documentation provision as enacted by the Congress.

As part of a comprehensive transfer pricing strategy coordinated with the Department of the Treasury Office of Tax Policy, the Commissioner, LMSB Division, issued a Transfer Pricing Compliance Directive on January 22, 2003.  The memorandum directs LMSB Division executives, managers, and revenue agents to request transfer pricing documentation from MNE taxpayers at the beginning of an examination so it may be evaluated by an international examiner and/or economist.  This should occur during the preplanning risk assessment phase of the examination, so a determination can be made as to whether material transfer pricing issues exist, and should be developed as part of the examination plan.

Our analysis identified that transfer pricing documentation was requested for only about 35 percent of the IC cases closed between Fiscal Years 1997 and 2002.  After issuance of the Transfer Pricing Compliance Directive, transfer pricing documentation was requested about 55 percent of the time.  However, this still fell short of the Directive’s requirement to request the documentation in each case.

As an additional concern, we estimate that 470 (56 percent) of 846 returns with potential transfer pricing issues were not referred to an international examiner for evaluation because they were improperly surveyed by domestic revenue agents and team managers and were never opened for examination. Likewise, some returns with potential transfer pricing issues that are opened for examination are also not being referred for review by international examiners.  The established examination procedures are intended to ensure cases with transfer pricing issues are identified, evaluated, and examined by specialists; however, these procedures are not always effective.  We estimate that, by improving the controls that ensure returns with potential transfer pricing issues are referred to international examiners for consideration, Federal Government revenue could increase by approximately $32.3 million annually in additional income taxes or reduction in tax attributes, provided the IRS has the additional international examiner resources to examine the returns.

To improve the use of transfer pricing documentation and transfer pricing examination results, we recommended the Commissioner, LMSB Division, reemphasize to all executives, managers, and revenue agents the requirements in the Transfer Pricing Compliance Directive.  To improve the performance for the requirement to refer the transfer pricing cases to international examiners, the Commissioner, LMSB Division, should encourage Territory Managers to communicate through team meetings, memoranda, and operational reviews the importance of making appropriate specialist referrals and requesting transfer pricing documentation. To better ensure IC cases classified for transfer pricing issues are not improperly surveyed, the Commissioner, LMSB Division, should implement an automated control to prevent returns selected during classification for international examiners from being surveyed without the prior approval of the International District Program Manager. In the long term, to ensure referrals are made to international examiners, the Commissioner, LMSB Division, should have the Specialist Referral System (SRS) modified to automatically generate referrals to international examiners for returns containing the criteria for referral when the returns are opened for examination.

Management’s Response:  The Commissioner, LMSB Division, agreed with three of our four recommendations.  The Commissioner will reemphasize the Directive by issuing a memorandum suggesting that its requirements be communicated through team meetings, memoranda, and operational reviews, and agreed to incorporate the substance of the Directive into the Internal Revenue Manual.  The Commissioner also agreed to issue a memorandum to the field addressing timely specialist referrals and will continue with efforts to modify the SRS to ensure required referrals to international examiners are made timely.

The Commissioner did not concur with our recommendation to implement an automated control that will prevent a return with international features from being improperly surveyed prior to approval of the International District Program Manager and to detect this occurrence.  The Commissioner believes the preferred approach is to ensure returns are referred timely and will continue efforts to develop and test either an automated referral system or a system which will efficiently provide information regarding returns awaiting referral.  Management’s complete response to the draft report is included as Appendix V.

Office of Audit Comment:  We agree with the Commissioner that the preferred approach is to ensure returns with international features are referred timely. As the report indicates, the intent of the recommendation is to implement an automated control that would ensure all required returns are referred to an international examiner within a short period of time. While we still believe our recommendation is worthwhile, we do not intend to elevate our disagreement concerning it to the Department of the Treasury for resolution.

In responding to our draft report, the Commissioner, LMSB Division, also included numerous comments regarding our work that we believe need to be clarified.  First, the Commissioner expressed concern about references to the estimates on transfer pricing noncompliance developed by Doctors Pak and Zdanowicz.  Our purpose for using these figures in the report was to illustrate the range of estimates of transfer pricing noncompliance in recent studies.

Second, the Commissioner indicated the IRS subsequently conducted an independent survey of International Territory Managers to determine the rate of request for transfer pricing documentation and determined it to be higher than the 55 percent described in our report.  We are pleased it appears that examiners are requesting transfer pricing documentation more consistently, which indicates to us that our review activities had a positive impact.  However, we cannot comment on the reliability of the LMSB Division survey results because they were provided subsequent to our audit work.

Third, while the Commissioner expressed no specific disagreement with the outcome measure described in our report, concern was expressed over our assumptions and the fact that our projection is contingent on the premise that the LMSB Division has the international examiner resources to examine the additional returns that should be referred.  Specifically, the Commissioner noted that transfer pricing examinations frequently lead to the dispute resolution processes where significant issues are resolved at amounts substantially less than those originally proposed.  As we indicate in the report, we took these factors into consideration.  Our assumption that additional international examiner resources may be required was based on the unstated assumption that current international examiner resources are already fully employed and therefore unavailable.

Copies of this report are also being sent to the IRS managers affected by the report recommendations.  Please contact me at (202) 622-6510 if you have questions or Philip Shropshire, Acting Assistant Inspector General for Audit (Small Business and Corporate Programs), at (215) 516-2341.

 

Table of Contents

Background

Examiner Requests for Transfer Pricing Documentation Increased After the Compliance Directive, but Opportunities for Improvement Still Exist

Recommendation 1:

Many Income Tax Returns With Potential Transfer Pricing Issues Never Received Consideration by International Examiners

Recommendations 2 and 3:

Recommendation 4:

Appendix I – Detailed Objective, Scope, and Methodology

Appendix II – Major Contributors to This Report

Appendix III – Report Distribution List

Appendix IV – Outcome Measures

Appendix V – Management’s Response to the Draft Report

Background

One of the Internal Revenue Service (IRS) Large and Mid-Size Business (LMSB) Division’s top priorities since its standup in June 2000 has been to build a tax administration organization to deal effectively with globalization.  The LMSB Division’s Strategy and Program Plan Fiscal Year (FY) 2004 – 2005 describes this challenge:

As the business world continues to globalize, tax planning is increasingly focused on worldwide effective tax rate minimization.  As a result, taxpayers often have an inherent incentive to adopt structures or arrangements that maximize U.S. [United States] expenses or shift income abroad.  While many cross-border transactions are clearly contemplated and addressed under U.S. domestic law or treaty provisions, others involve emerging issues that may constitute unacceptable tax avoidance or evasion.

One of the operating priorities of the LMSB Division is to implement appropriate strategies to ensure compliance with the transfer pricing rules and documentation provision as enacted by the Congress.

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 U.S. and other countries.  The Congress and other stakeholders are concerned whether entities with cross-border transactions are reporting and paying the proper amount of taxes.  There is a broad range of estimates regarding the loss of taxes due to transfer pricing noncompliance.  For example, an IRS study in 1999 estimated an annual loss of $2.8 billion, while an independent academic study estimated the annual loss at $53 billion.  If the actual noncompliance is closer to the $53 billion range, it would be a substantial addition to the $311 billion gross tax gap estimate.

One factor that historically hindered the IRS’ effective administration of Internal Revenue Code (I.R.C.) Section  (§) 482 and international transfer pricing was limited access to the information necessary to establish the proper transfer pricing methodology and transfer prices under the “arm’s length” standard.  As a result, international transfer pricing has historically been one of the most contentious issues leading to protracted disputes between the IRS and MNE taxpayers.

In response, the Congress in 1993 amended I.R.C. § 6662(e) to encourage MNE taxpayers to contemporaneously document their transfer pricing methodology and transfer prices when they file their returns and provide that documentation to the IRS within 30 days of a request.  In exchange, the MNE taxpayers would not be assessed the substantial valuation or gross valuation penalties if a transfer pricing adjustment resulted from an examination.

As part of a comprehensive transfer pricing strategy coordinated with the Department of the Treasury Office of Tax Policy, the Commissioner, LMSB Division, issued a Transfer Pricing Compliance Directive on January 22, 2003.  The memorandum directs LMSB Division executives, managers, and revenue agents to request transfer pricing documentation from MNE taxpayers at the beginning of an examination so it may be evaluated by an international examiner and/or economist.  This should occur during the preplanning risk assessment phase of the examination, so a determination can be made as to whether material transfer pricing issues exist, and should be developed as part of the examination plan.

If contemporaneous documentation is not available or is provided more than 30 days after the IRS’ request, the taxpayer may be subject to the substantial valuation penalty of 20 percent or the gross valuation penalty of 40 percent of the portion of the tax deficiency arising from transfer pricing-related adjustments.

The audit was performed in accordance with Government Auditing Standards as part of our FY 2004 emphasis on the LMSB Division’s strategic initiatives.  The review was performed at the LMSB Division Headquarters in Washington, D.C., and in Examination function groups in the LMSB Division field offices in the Los Angeles, New York City, and Philadelphia metropolitan areas during the period May 2003 through March 2004. Detailed information on our audit objective, scope, and methodology is presented in Appendix I.  Major contributors to the report are listed in Appendix II.

Examiner Requests for Transfer Pricing Documentation Increased After the Compliance Directive, but Opportunities for Improvement Still Exist

Our analysis of sample cases with transfer pricing issues closed on the International Case Management System (ICMS) between FYs 1997 and 2002 (prior to issuance of the Transfer Pricing Compliance Directive) showed that in only 35 percent (20 of 57) of the cases did the revenue agent request transfer pricing documentation from the MNE taxpayer.  After issuance of the Directive, transfer pricing documentation was requested for Industry Cases (IC) about 55 percent of the time (12 of 22 open cases reviewed). However, this still fell short of the Directive's requirement to request the documentation in each case.

In 8 (36 percent) of the 22 cases, the examiner or team manager indicated that the request was not issued because the transfer pricing issues were de minimis, the related party transactions were not material, or the transfer pricing issues had little potential. Thus, in these cases a decision was made regarding materiality without requesting the transfer pricing documentation, which negates one of the primary objectives contained in the Directive.

In 2 (9 percent) of the 22 cases, transfer pricing documentation was not warranted.  In one case, the team manager indicated that the request was not made because the case was a limited-scope examination based on “continuing compliance issues” identified from the prior examination. In the other case, the team manager indicated that the request was not made because of the extremely remote possibility of a transfer pricing issue being present on interest transactions on loans between the U.S. branch office of a foreign bank and the bank’s home office.

In the 12 cases for which the documentation was requested, MNE taxpayers responded timely with transfer pricing documentation in 4 cases.  In another 4 cases, MNE taxpayers provided transfer pricing documentation or studies more than 30 days after the initial requests.  In the final 4 cases, the taxpayers did not provide the documentation.  In summary, in only two-thirds (8 of 12) of the cases did the MNE taxpayers provide some form of study or documentation describing their transfer pricing methodologies.

One cause of the problem with requesting transfer pricing documentation was that the issue was not addressed by LMSB Division Territory Managers during operational reviews of their teams.  Our review of a judgmental sample of the documentation for 18 operational reviews conducted by 9 Territory Managers after issuance of the Transfer Pricing Compliance Directive showed that the requirements of the Directive were not addressed in any of the operational reviews.

When transfer pricing documentation is available but not requested, the benefits that would be derived from its use are lost.  To better understand the benefits of having the documentation early in the decision-making process, we surveyed the 11 International function team managers that controlled the international portion of the open examination cases to determine the effectiveness of the Transfer Pricing Compliance Directive and transfer pricing documentation when it is present.  Ten of these International function team managers provided responses to the following issues.

Use of documentation allows for more efficient examinations

Nine of 10 International function team managers believed documentation allowed international examiners to more quickly identify transfer pricing issues.  In addition, the IRS reported in a study to the Congress that the transfer pricing documentation significantly reduced the time and effort necessary to obtain information to analyze transfer prices.  The IRS report states:

In many examinations, documentation saved significant IRS resources. Documentation permitted the IRS to determine at an early stage of the examination process . . . whether to devote personnel and other resources to transfer pricing issues.  In several cases, the examiner’s initial review of the documentation enabled a reasoned judgment to be made to devote scarce examination resources to other issues.  In contrast, in several other cases, the initial review revealed significant issues that required additional scrutiny.  Under prior practice, in contrast, the IRS could not allocate appropriate resources to transfer pricing issues until it conducted preliminary inquiries, which often consumed lengthy periods of time.

Use of documentation allows for more effective understanding of the taxpayer’s point-of-view and facilitates more open communication

Seven of 10 managers see the documentation as beneficial because it defines the taxpayer’s position and transfer pricing methodology.  The IRS report also made this point:

. . . By placing the taxpayer’s transfer pricing analysis in a clear framework and stating the taxpayer’s position regarding the arm’s length price for the controlled transactions, it provides a basis for the IRS examination of these issues.  Examinations conducted with the benefit of documentation tend to be quicker and more focused than examinations conducted under the ad hoc approach to transfer pricing that many taxpayers used prior to the enactment of section 6662(e).

Use of documentation reduces the time and resources needed to resolve disagreed cases

Seven of 10 managers believe when transfer pricing issues are proposed to the taxpayer, access to transfer pricing documentation improved the quality of the transfer pricing issues developed.  The improved quality in the development of transfer pricing issues should improve the IRS’ ability to prevail on these issues in postexamination administrative appeals and court actions.  This should eventually lead to more agreements on these issues at the examination level, thereby reducing the time and resources needed to resolve disagreed issues.

Recommendation

1.      The Commissioner, LMSB Division, should reemphasize the Transfer Pricing Compliance Directive and incorporate it into the Internal Revenue Manual (IRM).  Additionally, the Commissioner should encourage Territory Managers to communicate the requirements of the Directive through team meetings, memoranda, and operational reviews.  This increased emphasis at the executive and manager level should communicate the importance of requesting the documentation at the onset of an examination.

Management’s Response:  The Commissioner, LMSB Division, will issue a memorandum to the field reemphasizing the Transfer Pricing Compliance Directive and suggesting that requirements of the Directive be communicated through team meetings, memoranda, and operating reviews. The Commissioner also plans to incorporate the substance of the Transfer Pricing Compliance Directive into the IRM.

Office of Audit Comment:  In the response to our draft report, the Commissioner, LMSB Division, also included numerous comments regarding our work that we believe need to be clarified. First, the Commissioner expressed concern about references to the estimates on transfer pricing noncompliance developed by Doctors Pak and Zdanowicz.  Our purpose for using these figures in the report was to illustrate the range of estimates of transfer pricing noncompliance in recent studies.

Second, the Commissioner indicated the IRS subsequently conducted an independent survey of International Territory Managers to determine the rate of request for transfer pricing documentation and determined it to be higher than the 55 percent described in our report.  We are pleased it appears that examiners are requesting transfer pricing documentation more consistently, which indicates to us that our review activities had a positive impact.  However, we cannot comment on the reliability of the LMSB Division survey results because they were provided subsequent to our audit work.

Many Income Tax Returns With Potential Transfer Pricing Issues Never Received Consideration by International Examiners

Requests for transfer pricing documentation and the subsequent review of the information provided by the MNE taxpayers can occur only if the returns are opened for examination and the information, once obtained, is referred to an international examiner or economist with the proper technical training to evaluate it. However, tax returns with international features selected for examination are not always being opened, and the returns with international features that are opened are not always being referred to an International function group for evaluation and possible examination.

We estimate that, in FY 2002, 470 (56 percent) of 846 returns with potential transfer pricing issues were not referred to an international examiner for evaluation because they were improperly surveyed by domestic revenue agents and team managers and were never opened for examination.  The estimate was based on a case review of an attribute sample of 106 returns from a population of 2,489 Tax Years (TY) 1999 and 2000 returns containing potential transfer pricing issues that were surveyed.  The sample had a 95 percent confidence level, ±7.3 percent precision margin, and 18.9 percent expectation of finding returns that were surveyed without proper approval.

Likewise, some returns with potential transfer pricing issues that are opened for examination are also not being referred for review by international examiners.  A computer analysis showed that 146 (27 percent) of 547 TYs 1999 and 2000 returns opened for examination with potential transfer pricing issues as of August 2003 were not referred to international examiners for evaluation as required.

The LMSB Division reported similar results concerning all returns surveyed in FY 2003 in an internal study released on March 4, 2004.  The study of a statistical sample of 380 surveyed returns found that 126 (33 percent) of the returns reviewed contained material issues worthy of examination.  We also reported this condition in our report on Foreign Controlled Corporations.

The LMSB Division also reported in February 2004 that mandatory referrals to specialists, including international examiners, continue not to be made, declining another 14 percent between FYs 2001 and 2003.  In FY 2001, the LMSB Division reported that referrals to specialists were made in only 64 percent of the cases for which guidelines required a specialist referral to be made; this declined to 50 percent by FY 2003.

The IRM provides the procedural guidelines on the criteria for surveying cases with potential transfer pricing issues and for referring cases to international examiners once the cases are opened.  The established examination procedures are intended to ensure cases with transfer pricing issues are identified, evaluated, and examined by specialists; however, these procedures are not always effective.  Therefore, the control system to ensure compliance needs improvement.

The Government Accountability Office (formerly the General Accounting Office) Standards for Internal Control in the Federal Government specify that control activities are policies, procedures, techniques, and mechanisms that enforce management’s directives.  Control activities are an integral part of an entity’s planning, implementing, reviewing, and accountability for stewardship of Federal Government resources and achieving effective results.  When these control activities are ineffective to enforce management’s directives, significant losses can occur because risks were not minimized.

There are at least two causes for not following the referral requirements.  First, Territory Managers do not uniformly include an evaluation as to whether proper referrals to specialists were made during their operational reviews.  Our review of a judgmental sample of 43 team operational reviews conducted by 12 LMSB Division Territory Managers in Dallas, Houston, Los Angeles, and New York between September 1, 2000, and November 24, 2003, showed that only 11 (26 percent) discussed and evaluated the manager and team on the need for making specialist referrals. The remaining 32 provided no evidence that the referrals to specialists were discussed or evaluated.

Second, the current procedures rely simply on the procedures themselves to achieve the control objective. However, there are no controls to prevent noncompliance or to detect when there has been no compliance. Therefore, the control system could be improved to minimize the risk that returns with potential transfer pricing issues miss being referred for evaluation.

We estimate that, by improving the controls that ensure returns with potential transfer pricing issues are referred to international examiners for consideration, Federal Government revenue could increase by approximately $32.3 million annually in additional income taxes or reduction in tax attributes.  This projection is contingent on the premise that the LMSB Division has the international examiner resources to examine the additional returns that should be referred.  The $32.3 million is composed of estimates of $24.7 million currently lost due to the improper surveying of cases with potential transfer pricing issues, and $7.6 million currently lost due to open cases with potential transfer pricing issues not being referred to international examiners for consideration. Details of our analysis are included in Appendix IV.

Recommendations

2.      In the short term, the Commissioner, LMSB Division, should strengthen controls by encouraging Territory Managers to communicate through team meetings, memoranda, and operational reviews the importance of making appropriate referrals.

Management’s Response:  The Commissioner, LMSB Division, agreed to issue a memorandum to the field addressing timely specialist referrals. 

3.      In the long term, the Commissioner, LMSB Division, should have the Specialist Referral System (SRS) modified to automatically generate referrals to international examiners for returns containing the criteria for referral that can currently be identified through the Business Return Transaction File (RTF) when the returns are opened for examination. Additional automatic criteria for referral can be added to the SRS as the information becomes available with the electronic filing of corporation income tax returns.

Management’s Response:  The Commissioner, LMSB Division, agreed to continue the development and testing of modifications to the SRS to achieve automatic referral of returns meeting international mandatory referral requirements and to deploy the system developed, provided it is both efficient and cost-effective.  The Commissioner will also continue the development and testing of information systems that will efficiently provide information with respect to returns with international features awaiting referral.

4.      In the long term, the Commissioner, LMSB Division, should implement an automated control that, when a return is selected during classification for international examiners, prevents the return from being improperly surveyed without the prior approval of the International District Program Manager and detects this occurrence so the team’s Territory Manager can take appropriate corrective action.

Management’s Response:  The Commissioner, LMSB Division, did not concur with this recommendation, stating that the suggested approach has been attempted in the past and has had mixed results.  A primary weakness is that, if a return is not referred and sufficient time is allowed to elapse, the International function will not have the time necessary to identify and develop substantive issues, such as issues under I.R.C. § 482.

The Commissioner believes the preferred approach is to ensure returns are referred timely and will continue efforts to develop and test either an automated referral system or a system which will efficiently provide information regarding returns awaiting referral.

Office of Audit Comment:  We agree with the Commissioner that the preferred approach is to ensure returns with international features are referred timely.  As the report indicates, the intent of the recommendation is to implement an automated control that would ensure all required returns are referred to an international examiner within a short period of time. 

The Commissioner, LMSB Division, also included numerous comments regarding our work that we believe need to be clarified.  The Commissioner expressed no specific disagreement with the outcome measure described in our report, but did express concern with the assumptions and the fact that our projection is contingent on the premise that the LMSB Division has the international examiner resources to examine the additional returns that should be referred.  Specifically, the Commissioner noted that transfer pricing examinations frequently lead to the dispute resolution processes where significant issues are resolved at amounts substantially less than those originally proposed.  As we indicate in the report, we took these factors into consideration.  Our assumption that additional international examiner resources may be required was based on the unstated assumption that current international examiner resources are already fully employed and therefore unavailable.

 

Appendix I

 

Detailed Objective, Scope, and Methodology

 

The overall objective of this review was to determine the impact of the contemporaneous transfer pricing documentation regulations on Industry Case (IC) transfer pricing examinations.  To achieve this objective, we extensively relied on internal management reports and computer-processed data contained in the Audit Information Management System (AIMS), Examination Return Control System (ERCS), Foreign Information System (FIS), International Case Management System (ICMS), and Specialist Referral System (SRS).  We did not establish the reliability of these data because extensive data validation was outside the scope of this audit.

The specific tests included the following:

I.                   Determined the extent of use of the contemporaneous transfer pricing documentation described in Internal Revenue Code (I.R.C.) Section (§) 6662(e) and Treas. Reg. § 1.6662-6(d)(2)(iii).

A.    Through a closed case review, determined the number of cases requesting transfer pricing documentation prior to issuance of the January 22, 2003, Transfer Pricing Compliance Directive using a judgmental sample.  We used a judgmental sample because location and travel factors associated with the selection of a random sample would have been cost-prohibitive.  We identified a population of 2,782 post-Tax Year (TY) 1995 non-Coordinated Industry Case (non-CIC) tax returns with transfer pricing issues that were closed on the AIMS and ICMS between Fiscal Years (FY) 1997 and 2002 and reviewed 57 complete cases.

B.     Through an open case review, determined the number of cases requesting transfer pricing documentation after issuance of the Transfer Pricing Compliance Directive.  We identified a population of 109 cases (114 returns) with potential transfer pricing issues through matching Transactions Between Controlled Foreign Corporation and Shareholders or Other Related Persons (Schedule M) of the Information Return of U.S. Persons With Respect to Certain Foreign Corporations (Form 5471) and Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business (Form 5472) information for TYs 1999 and 2000 from the FIS to referrals open on the ICMS as of October 15, 2003, that were started between October 1, 2002, and July 31, 2003.  We selected a judgmental sample of 50 cases (54 returns) located in the metropolitan areas with the greatest concentration of cases open during this period – Los Angeles, New York, and Philadelphia.  We selected a judgmental sample because a statistical sample was impractical due to cost, time, staffing, and travel considerations associated with such a sample.  Forty-three open cases were available for review in November and December 2003.  We determined that, in 22 of the cases, taxpayer contact took place subsequent to issuance of the Transfer Pricing Compliance Directive, based on the issuance date of the first information document request.

C.     Through computer analysis, determined the number of open cases with potential transfer pricing issues that were not being referred.  We identified a population of 503 open cases (547 open returns) with potential transfer pricing issues by matching Form 5471 Schedule M and Form 5472 information for TYs 1999 and 2000 from the FIS to the open return examination information on the ERCS as of August 2003.  We ran the ERCS and FIS match of 503 open cases against the ICMS and SRS databases and identified 366 cases (73 percent of open cases involving 401 open returns) that were referred and 137 cases (27 percent of open cases involving 146 open returns) that were not referred for consideration by international examiners.

D.    Determined the number of non-CIC surveyed returns with potential transfer pricing issues that were improperly closed without approval of the International District Program Manager.  We identified a population (N) of 3,099 surveyed returns with potential transfer pricing issues through matching Form 5471 Schedule M and Form 5472 information for TYs 1999 and 2000 from the FIS to return information on the nonexamined AIMS database for FY 2002 with survey before assignment (Disposal Code 31) and survey after assignment (Disposal Code 32).  We selected and requested from files a random attribute sample (n) of 132 returns.  The sample, when selected, had a 95 percent confidence level (Z) with ±5 percent tolerable sampling error (E).  The expected percentage (p) of returns with the attribute of being selected for examination by the International function and being improperly surveyed was 10 percent, based on a pilot sample conducted in our audit of Foreign Controlled Corporations.  Twenty-six (20 percent) of the 132 sample returns were unavailable for review, reducing the effective sample size (n') to 106 returns.  Because no data were available on these 26 returns, we assumed these returns may behave differently from the returns reviewed, preventing projection of results to 610 (20 percent) of the 3,099 returns in the population.  The effective sample of 106 returns allows projection to 2,489 (80 percent) of the 3,099 returns.

Because of changes in the effective sample size, from 132 to 106 returns, and the actual value of p exceeding the expected value of p (18.9 percent compared to an expected value of 10 percent), the tolerable sampling error was adjusted to ±7.3 percent.  Projecting these results into the population of surveyed returns with a 95 percent confidence level, we estimate that 846 returns [(36/106) × 2,489] were originally selected for examination (with a range between 572 and 1,119 returns) and that 470 returns [(20/106) × 2,489] were improperly surveyed (with a range between 244 and 695 returns).

II.                Reviewed the criteria associated with transfer pricing documentation and the identification, selection, and referral of returns with potential transfer pricing issues for evaluation and potential.

A.    Reviewed I.R.C. § 482 and I.R.C. § 6662(e) along with the associated regulations, internal operating procedures in the Internal Revenue Manual (IRM), and the Transfer Pricing Compliance Directive of January 22, 2003.

B.     Reviewed the IRM for the internal procedures concerning the identification, selection, and referral of returns with international features.

III.             Assessed the causes for not requesting transfer pricing documentation on IC cases and for not referring IC cases with potential transfer pricing issues to the International function for evaluation through surveys, reviews of operational reviews and official memoranda, and responses to case reviews.  The review of the operational reviews was from a judgmental sample consisting of 12 Territory Managers selected from a population of 62 LMSB Territory Managers.  These 12 Territory Managers conducted 43 operational reviews between September 1, 2000, and November 24, 2003.  The population of operational reviews conducted during this period is not readily available.  A judgmental sample was used because the population of operational reviews was not readily available and location and travel factors associated with the selection of a random sample of Territory Managers would have been cost-prohibitive. Eighteen of the 43 operational reviews were conducted by 9 Territory Managers after issuance of the Transfer Pricing Compliance Directive.

IV.             Determined the effects of transfer pricing documentation not being requested and returns with potential transfer pricing issues not being referred for evaluation and potential examination.

A.    Determined the benefits lost when the Internal Revenue Service does not request transfer pricing documentation from the taxpayer and the taxpayer has prepared the documentation.  We submitted questionnaires to the 11 International function team managers that controlled the international portion of the open examination cases and obtained and analyzed questionnaires from 10 International function team managers whose cases were included in the open case review to determine anecdotally the benefits received when transfer pricing documentation is provided by the taxpayer.

B.     Estimated the approximate revenue lost as a result of returns with potential transfer pricing issues being improperly surveyed.

C.     Estimated the approximate revenue lost as a result of returns with potential transfer pricing issues that were opened for examination but not referred to international examiners.

 

Appendix II

 

Major Contributors to This Report

 

Phil Shropshire, Acting Assistant Inspector General for Audit (Small Business and Corporate Programs)

Frank Dunleavy, Audit Manager

Earl Charles Burney, Lead Auditor

Carole Connolly, Senior Auditor

Debra Mason, Auditor

Ali Vaezazizi, Auditor

 

Appendix III

 

Report Distribution List

 

Commissioner  C

Office of the Commissioner – Attn:  Chief of Staff  C

Deputy Commissioner for Services and Enforcement SE

Deputy Commissioner, Large and Mid-Size Business Division  SE:LM

Director, Field Specialists  SE:LM:FS

Director, International  SE:LM:I

Director, Strategy, Research, and Program Planning  SE:LM:SR

Chief Counsel  CC

National Taxpayer Advocate  TA

Director, Office of Legislative Affairs  CL:LA

Director, Office of Program Evaluation and Risk Analysis RAS:O

Office of Management Controls  OS:CFO:AR:M

Audit Liaison:  Commissioner, Large and Mid-Size Business Division  SE:LM

 

Appendix IV

 

Outcome Measures

 

This appendix presents detailed information on the measurable impact that our recommended corrective actions will have on tax administration.  These benefits will be incorporated into our Semiannual Report to the Congress.

Type and Value of Outcome Measure:

  • Increased Revenue – Potential; $24.7 million in additional recommended taxes or reduced tax attributes annually; $123.5 million over 5 years (see page 7).

Methodology Used to Measure the Reported Benefit:

To estimate the increased revenue that could result from examining returns with potential transfer pricing issues that are currently being improperly surveyed, we began by identifying the population of 3,099 returns with potential transfer pricing issues surveyed in Fiscal Year (FY) 2002.  We selected a random attribute statistical sample of 132 returns from the population with a 95 percent confidence level, ±5 percent tolerable sampling error level, and 10 percent attribute of finding returns that were surveyed without proper approval.  Because 26 of the 132 returns were unavailable, the effective sample size was reduced to 106 returns, allowing projection to 2,489 returns [3,099 ´ (106/132)] in the population.  We identified 20 of 106 sample returns (18.9 percent) with potential transfer pricing issues that were surveyed without evidence of approval by the International District Program Manager.  The tolerable error level of the sample was adjusted from ±5 percent to ±7.3 percent because of changes in the effective sample size and because the actual percentage of returns surveyed without proper approval exceeded the expected percentage. Projecting the sample into the population of 2,489 returns, we estimate that 470 returns with potential transfer pricing issues [2,489 ´ (20/106)] were improperly surveyed.

To determine the amount of additional recommended taxes or reduced tax attributes that could be generated from examination of the 470 improperly surveyed returns with potential transfer pricing issues in the future, we assumed that:

·         Fifty international examiners would be available to evaluate and possibly examine these returns.

·         The returns, when referred to International function groups, are rejected for examination at the FY 2002 historical rate of 32.56 percent because of workload considerations or indications that no significant tax adjustments exist.

  • The remaining returns, when examined, would have the same profile of no changes and changes as returns examined and reported on the International Case Management System (ICMS) over the last 5 years with transfer pricing issues under Internal Revenue Code (I.R.C.) Section (§) 482 (see Table 1).

·         The returns resulting in changes when examined would yield the same average dollars per return as examined returns reported on the ICMS over the last 5 years with transfer pricing adjustments under I.R.C. § 482 (see Table 1).

·         The recommended assessments would be sustained at the FY 2002 historical rate of 17.5 percent in postexamination appeals.

Table 1:  Analysis of Non-Coordinated Industry Case (CIC) Transfer Pricing Return Examinations
FYs 1999 - 2003

 

 

 

Fiscal Year

 

Total Returns Examined

Return Examinations Resulting in No Change

Return Examinations Resulting in Adjustment

Total Transfer Pricing Adjustments

1999

1,012

499

513

$  562,148,003

2000

796

389

407

405,575,391

2001

639

290

349

1,203,537,437

2002

524

228

296

969,291,816

2003

479

233

246

1,264,033,712

     Summation

3,450

1,639

1,811

$4,404,586,359

Divisor

3,450

3,450

3,450

1,811

     5-year average percentage

100%

47.51%

52.49%

 

     5-year average of transfer pricing adjustment per return

$2,432,129

 

 

Source:  Treasury Inspector General for Tax Administration analysis of the dispositions and adjustments on

non-CIC transfer pricing return examinations on the ICMS for FYs 1999 - 2003.

Based on these assumptions, we estimate the referral of 470 returns in the future would result in 153 (470 × 32.56 percent) returns being rejected because of indications of no significant adjustment or workload considerations.  The remaining 317 returns would yield 151 (317 ´ 47.51 percent) no change return examinations and 166 (317 ´ 52.49 percent) return examinations with transfer pricing adjustments to taxable income averaging $2.43 million per return, or $403 million in total (166 ´ $2.43 million).  This $403 million in adjustments could increase recommended examination tax assessments or reduce tax attributes attributable to net operating loss carryforwards by about $141 million ($403 million ´ 35 percent marginal corporate tax rate). The $141 million in recommended tax assessments or reductions in tax attributes would be further subject to postexamination appeals, which would further reduce the amount of revenue. Therefore, taking into account the sustention rate on transfer pricing issues in the Office of Appeals for FY 2002, the potential increased revenue would be about $24.7 million ($141 million × 17.5 percent) per year.

Type and Value of Outcome Measure:

·         Increased Revenue – Potential; $7.6 million in additional recommended taxes or reduced tax attributes annually; $38 million over 5 years (see page 7).

Methodology Used to Measure the Reported Benefit:

To estimate the increased revenue that could result from examining returns with potential transfer pricing issues that are currently open but not being referred, we began by identifying the population of 547 open return examinations with potential transfer pricing issues in FY 2003.  We matched this population against the ICMS and the Specialist Referral System (SRS), identifying 401 open returns that were referred to international examiners for evaluation and possible examination while the remaining 146 open returns were not.

To determine the future amount of additional recommended taxes or reduced tax attributes that could be generated from examination of the 146 open returns with potential transfer pricing issues that were not referred, we assumed that:

·         Sixteen international examiners would be available to evaluate and possibly examine these returns.

·         The returns, when referred to International function groups, are rejected for examination at the FY 2002 historical rate of 32.56 percent because of workload considerations or indications that no significant tax adjustments exist.

  • The remaining returns, when examined, would have the same profile of no changes and changes as returns examined and reported on the ICMS over the last 5 years with transfer pricing issues under I.R.C. § 482 (see Table 1).
  • The returns resulting in changes when examined would yield the same average dollars per return as examined returns reported on the ICMS over the last 5 years with transfer pricing adjustments under I.R.C. § 482 (see Table 1).

·         The recommended assessments would be sustained at the FY 2002 historical rate of 17.5 percent in postexamination appeals.

Based on these assumptions, we estimate the referral of 146 returns in the future would result in 48 (146 × 32.56 percent) returns being rejected because of indications of no significant adjustment or workload considerations.  The remaining 98 returns would yield 47 (98 ´ 47.51 percent) no change return examinations and 51 (98 ´ 52.49 percent) return examinations with transfer pricing adjustments to taxable income averaging $2.43 million per return, or $124 million in total (51 ´ $2.43 million).  This $124 million in adjustments could increase recommended examination tax assessments or reduce tax attributes attributable to net operating loss carryforwards by about $43.4 million ($124 million ´ 35 percent marginal corporate tax rate). The $43.4 million in recommended tax assessments or reductions in tax attributes would be further subject to postexamination appeals that would further reduce the amount of revenue. Therefore, taking into account the sustention rate on transfer pricing issues in the Office of Appeals for FY 2002, the potential increased revenue would be about $7.6 million ($43.4 million × 17.5 percent).

 

Appendix V

 

Management’s Response to the Draft Report

 

The response was removed due to its size.  To see the response, please go to the Adobe PDF version of the report on the TIGTA Public Web Page.