Transfer Pricing Times: Volume X, Issue 11
In this Edition: IRS Issues Directive Concerning IDR Enforcement.
On November 4, 2013, the Internal Revenue Service’s (“IRS”) Large Business and International Division (“LB&I”) issued Directive LB&I-04-1113-009 (the “Directive”) concerning (i) requirements for issuing Information Document Requests (“IDRs”) and (ii) new procedures for enforcing IDRs. This Directive reinforces previous guidance (issued June 18, 2013) released to LB&I examiners concerning the process to be followed when issuing and enforcing an IDR. Key points from the Directive include:
New IDR Requirements – Attachment 1 of the Directive lists 13 requirements an LB&I examiner must follow when issuing an IDR. These requirements include, among other things, instructions to (i) discuss the issues related to the IDR with the taxpayer; (ii) discuss how the information requested is related to the issues under consideration; (iii) prepare one IDR for each issue; and, (iv) determine a reasonable timeframe for a response to the IDR with the taxpayer. (Please refer to Attachment 1 available on the IRS’ website for a complete list of the 13 requirements.1)
Collaboration with Taxpayer – One of the most notable points in the Directive is that it relies on extensive collaboration between the taxpayer and the IRS before a final IDR is issued. Taxpayers should take advantage of this opportunity to work with LB&I examiners in tailoring IDRs to clearly define and capture the precise information being requested. In addition, as the Directive does not require multiple LB&I examiners to collaborate with each other, taxpayers are advised to track negotiations with the IRS to ensure that multiple IDRs are not due on the same date and to avoid duplicative information gathering.
Three-Step IDR Enforcement Process – In the event information requested in an IDR is not received by the IDR response date, the LB&I examiner must follow three graduated steps in the new IDR Enforcement Process:
Delinquency Notice – The LB&I examiner is expected to issue the Delinquency Notice within 10 days of the IDR response date. The taxpayer will then be given a maximum of 15 days to comply with the request. However, the Directive does give the IRS Territory Manager discretion to extend this deadline, as warranted.
Pre-Summons Letter – In the event the taxpayer fails to comply with the Delinquency Notice, he Pre-Summons letter is signed by the Territory Manager and is expected to be issued within 14 days of the deadline specified in the Delinquency Notice. The taxpayer has 10 calendar days from the date of the letter to comply. In this instance, the Directive gives the Director of Field Operations the discretion to approve an extension, as warranted. One thing to note is that the Pre-Summons Letter will not be sent to the same employee that received the Delinquency Notice. Instead, the Pre-Summons Letter is directed to that employee’s direct supervisor. Thus, taxpayers are advised to keep their supervisors well-informed of the process and status of an IDR in order to avoid any unwanted surprises.
Summons – This is the final step of the enforcement process. If the taxpayer does not comply by the deadline listed in the Pre-Summons letter, the IRS will prepare a Summons and coordinate its issuance with assigned Counsel. In the event the taxpayer fails to comply with the Summons, the IRS will seek enforcement through the US District Court.
This process is mandatory without exception. Attachment 2 of the Directive provides additional guidance concerning the requirements LB&I examiners must meet when issuing a Delinquency Notice (Letter 5077), a Pre-Summons Letter (Letter 5078), and ultimately a Summons.
Stricter Response Deadlines Imposed – The Directive appears to effectively eliminate an LB&I examiner’s discretion to extend the deadline for responding to an IDR, something that may prove to be particularly problematic for subsidiaries of foreign-based multinational enterprises, who may struggle to obtain responses from their foreign parent company in time.
Pursuant to this Directive, the IDR Enforcement Process is effective beginning January 2, 2014. Taxpayers currently under examination are advised to have a discussion with their LB&I examiner / specialist concerning the new requirements. These discussions should take place as soon as practical, but generally no later than December 15, 2013. Beginning January 2, 2014, IDRs that do not meet the new requirements specified in the Directive will need to be reissued, along with a new response date. However, LB&I examiners have been advised not to issue Delinquency Notices prior to February 3, 2014, in order to allow time for a transition to the new regime.
“Hedging” Transfer Pricing Risk
Given the continued globalization of the financial services industry and the increased attention on transfer pricing issues from governments worldwide, hedge fund firms need to understand the potential implications of transfer pricing on their operations. While transfer pricing disputes involving hedge funds may not be prevalent to date, there are indications that tax and transfer pricing issues specific to these organizations are gaining attention worldwide. Notably, the U.K.’s taxing authority, HM Revenue & Customs (“HMRC”), issued a consultation document in May 2013 to address potential misuse of limited liability partnership structures (commonly used by hedge fund firms) that may (1) disguise employment of an individual as a partner to avoid taxes, or (2) manipulate profit/loss allocations among members (including corporations) to realize tax benefits. Moreover, in September the HMRC introduced proposals to amend transfer pricing law by eliminating an individual partner’s ability to claim an adjustment for payments made to service companies employed by the partnership (such as a fund management company) when such payments are determined to be made at less than an arm’s length amount.2
Given this growing attention, hedge funds may be at a higher risk for transfer pricing scrutiny going forward. In particular, funds with multinational operations are not exempt from the transfer pricing rules that apply to any cross-border intercompany transactions. Furthermore, as the concept of “controlled parties” applied under the U.S. and other transfer pricing rules is very broad, transfer pricing regulations under section 482, in theory, can extend to US-only transactions, including transactions between the fund’s management company and the general partner, or compensation programs of individuals that may be both an employee of the management company and a member of the general partner (as is the subject of current attention in the U.K.).
A recent article by Duff & Phelps’ transfer pricing professionals discusses cross-border transfer pricing issues that may be of particular relevance to hedge funds (e.g., provision of corporate services, fund management activities, etc.), and provides straight-forward examples of how the US transfer pricing rules are applied. This article, published in the Hedge Fund Law Review, can be viewed here.
Practical Advice for Implementing Year-end Adjustments
With the end of the year fast approaching, multinational enterprises (“MNEs”) will need to evaluate their intercompany pricing and actual financial results of various group companies in light of the applicable transfer pricing policies. In case of significant deviations, year-end transfer pricing adjustments3 may need to be considered. In this article, we highlight some key factors that MNEs should be aware of when considering such adjustments:
Determining year-end adjustments: Several scenarios can cause deviations between actual financial results and those that would have been expected based on the company’s transfer pricing policies, including budgeting / forecasting inaccuracies, changes in economic circumstances, disconnect between tax and finance departments, etc. Whatever the reasons, there are several practical steps in identifying the need for, quantifying, and executing a potential year-end adjustment:
Testing of the results: The first step is to undertake a comparison of the actual transfer prices or financial results at year-end with the prices / profit margins determined by uncontrolled transactions or companies. For the latter, it is important to use statutory results of the MNE that are segmented to the extent possible according to intercompany transaction, as these serve as the starting point for a tax inspector conducting a review of the corporate income tax return.
Analysis and decision process:Even if prices or margins are outside of their target range, several questions need to be asked before making an adjustment: (i) What is the reason for the deviation; (ii) which party to the transaction is responsible for the deviation (e.g., revenue or cost item); (iii) is there a deviation of results in only one year or multiple years; and (iv) were any adjustments made in prior years (if so, why?). If adjustments must be continuously made year after year, it may be that the transfer pricing policies are either not consistent with the arm’s length standard or difficult to implement efficiently and correctly.
Size of the adjustment: In the event a year-end adjustment is deemed necessary, the company must determine whether the adjustment should be made to the outer bounds of the interquartile range or to the median (or some other point within the applicable range). While a number of taxing authorities typically adjust to the median, we have found that, in practice, most MNEs make adjustments to either the lower or upper quartile of the interquartile range.
Processing of the adjustment: In order to implement a year-end adjustment, the adjustment must be booked in the financial systems and an intercompany invoice should be sent out. The form of the invoice, including its descriptions of the corresponding payment, can be important (see below).
Timing of the adjustments: Year-end adjustments are commonly made before the close of the book year. However, if done at year-end, the company may make a one-off adjustment that is typically booked in “period 13”.4 In practice, however, tax authorities are routinely requesting period 13 information, and large adjustments often give rise to increased scrutiny. A more regular review of the actual financial results versus the transfer pricing policy would result in relatively smaller adjustments throughout the year that could mitigate a large adjustment at year-end. Alternatively, some companies close their yearly books, including transfer pricing calculations, using forecasted financial data, with true ups based on actual numbers perhaps booked in the following tax year.
Impact of post-closing adjustments: If the adjustment results in a downward adjustment to taxable income previously reported on a filed return, this may not be allowable under local tax regulations.
Characterization of adjustments: Companies may choose to re-characterize the year-end adjustment as a different transaction (separate from the original transaction / invoice). In many circumstances, for example, the adjustment is considered as a debit or credit note to the invoices relating to the same intercompany transaction sent previously during the year. The form and language of the invoice could have important Value Added Tax (“VAT”) or Customs implications. However, the characterization of the adjustment may lead to challenges from taxing authorities in the country of the principal company. Companies would need to be prepared to describe exactly what services have been rendered and why the invoiced remuneration is appropriate.
Failure to adhere to transfer pricing policies may result in serious challenges from tax authorities. For financial reporting reasons, this may also result in reporting of uncertain tax positions (e.g., based on ASC 740 for companies reporting under US GAAP). Many MNEs seek to avoid deviations from transfer pricing policies and expected results through end-of-year adjustments. These adjustments, however, should be executed in a transparent and consistent manner or they will (perversely) lead to added transfer pricing scrutiny from tax authorities.
Update: Further Developments in Global Transfer Pricing
Highlights of recent developments in transfer pricing are outlined below:
India Issues Final Safe Harbor Rules: Subsequent to the release of its draft of proposed safe harbor rules (see Duff & Phelps Transfer Pricing Times, Volume X, Issue 9), the Indian Central Board of Direct Taxes (“CBDT”) issued its final rules on September 18, 2013, after considering comments received from transfer pricing practitioners, multinational enterprises operating in India, and other interested parties. The key changes to the draft as a result of these comments are as follows:
The safe harbor rules shall be applicable for five assessment years, beginning with the 2013-2014 assessment year.
An assessee can determine the term of the safe harbor. However, this term cannot exceed five assessment years and can only be exercised by filing Form 3CEFA, as prescribed in the rules.
For routine Information Technology / Information Technology Enabled Services (“ITES”), the initial ceiling of 1 billion rupees has been removed. The final rules provide for a safe harbor margin of 20 percent for transactions up to 5 billion rupees and 22 percent for transactions above 5 billion rupees.
For transactions involving a corporate guarantee, the ceiling of 1 billion rupees has also been removed. The final rules provide that the safe harbor specified in the draft will be available for transactions above 1 billion rupees if the wholly-owned subsidiary has been rated to be of adequate to highest safety by a rating agency registered with the Securities and Exchange Board of India (“SEBI"). Furthermore, the safe harbor margin has been reduced from two percent (as specified in the draft) to 1.75 percent (as specified in the final safe harbor rules) of the amount guaranteed.
The final rules attempt to provide a reasonable distinction between knowledge process outsourcing (“KPO”) and routine business process outsourcing (“BPO”). However, several practitioners have expressed their concern that this clarification remains ambiguous. The safe harbor operating margin applied for KPO activity was reduced from 30 percent (draft) to 25 percent (final), and the transactional volume ceiling has been removed.
Taxpayers electing to apply a safe harbor will have the ability to “opt out” by furnishing a statement to this effect to the Assessing Officer.
Additional details pertaining to the changes made as a result of the comments received on the draft may be found on the CBDT website.5
US Finalizes Reserved Portion of 2011 US Cost Sharing Regulations: On August 26, 2013, the IRS and the US Department of the Treasury (“Treasury”) issued Internal Revenue Bulletin 2013-38, finalizing cost sharing guidance concerning the use of discount rates under an income method analysis. At the time the US Cost Sharing Regulations were finalized (December 22, 2011, through Federal Register (76 FR 80082)), certain guidance regarding the application of the differential income stream approach6 was reserved and issued as “temporary cost sharing regulations” (76 FR 80249 and 76 FR 80309) because the IRS and Treasury felt that public discussion of this matter was appropriate. While the temporary cost sharing regulations were finalized without change, the final rules do solidify the guidance and testing around the selection and use of discount rates with respect to two alternatives generally considered in an income method approach: (i) the cost sharing alternative, and (ii) the licensing alternative. Specifically, the final regulations are designed to combat the practice of using a relatively low licensing discount rate and a relatively high cost sharing discount rate, without sufficiently considering the appropriate interrelationship of the discount rates and financial projections. This practice gave rise to material distortions and the potential for Platform Contribution Transaction (“PCT”) payments (for which buy-in payments are due from other participants) to be made that were not in accordance with the arm’s length standard. As a result, the final regulations incorporate the determination of the discount rate as a consideration to assessing the best method for analyzing transfer pricing issues surrounding intangible assets.
Given the finalization of the last portion of the cost sharing regulations, taxpayers should be prepared for increased scrutiny around the use of discount rates and be ready to defend the assumptions and parameters used in their application of the income method.
2See technical discussion, available here.
3Such adjustments can be made just before or after year end. More rarely, they can be made after the financial books for the year have been closed. It should also be noted that some MNEs make adjustments during the year, e.g. on a quarterly basis.
4Period 13 refers to an accounting method in which an artificial month is created to make year-end adjustments. This is done so as not to skew the financial reporting for any particular period. Instead, bad debts, other write-offs, and adjustments are booked in the 13th month and then flow through for year-end accounting purposes.
5The CBDT press release concerning the final safe harbor rules can be found on its website (http://www.incometaxindia.gov.in/archive/PressRelease_SafeHarbourRules_19092013.pdf). The actual rules will be available on the CBDT website at a later date.
6The differential income stream approach refers to the difference between the undiscounted income streams under the cost sharing and licensing alternatives. For further guidance related to its application, please refer to Treas. Reg. Section 1.482-7(g)(v)(B)(2) – (vi)(F)(2).