Transfer pricing developments were significant in 2022, including refocused IRS scrutiny partially stemming from increased IRS resources included in the Inflation Reduction Act of 2022 and continued and evolving global tax reform (for example, Pillar 2 of the Organization for Economic Cooperation and Development (OECD) framework). As a result, it is crucial for multinational companies to proactively review the framework used for its transfer pricing documentation well in advance of their statutory tax filing dates.
Following are five important considerations to keep in mind to prepare comprehensive, accurate, and compliant transfer pricing documentation:
- Scope. The scope of transfer pricing documentation refers to the extent and coverage of the information included in the documentation. Scope will depend on the specific tax laws and regulations of the country or countries in which a company operates, as well as the size and complexity of the company's related-party transactions. Companies should carefully review the relevant laws and regulations to determine specific documentation requirements (such as transaction thresholds) and should make sure that their documentation sufficiently covers all relevant transactions and entities.
A comprehensive scope for transfer pricing documentation should include a review of all related-party transactions, such as tangible goods transactions, provision of specific services, licensing of intangibles, and financing arrangements. However, including every transaction in transfer pricing documentation can be a costly endeavor. Taxpayers should consider the materiality of their intercompany transactions to make sure that key transactions are covered in the transfer pricing documentation.
Other things to consider when determining the appropriate scope for transfer pricing documentation include:
- Geographical coverage of the related parties
- Cross-border versus domestic transactions
- Outcome of the transaction
Crowe observation
Taxpayers should take steps to outline in their documentation the commercial and business reasons for the outcome of transactions that on their face might not seem to be at arm’s length.
- Depth. Transfer pricing documentation depth focuses on the quality of the analysis and how comprehensive it is. Transfer pricing documentation should provide a detailed explanation of the taxpayer's overall transfer pricing practices, the transfer pricing method used, and the analysis performed to support the arm's-length price determination. Some potential transfer pricing documentation compliance risk areas signaled by IRS frequently asked questions include:
- Industry and company analysis sections
- Functional analysis narratives
- Business risk analysis and consistency with intercompany agreements
- Comparability analysis and explanation of adjustments
- Explanation of best method selection, including the reasoning for rejection of methods
- Support and explanation for the selection of the appropriate profit level indicator
- Inclusion of complete comparability analysis
Crowe observation
Having comprehensive depth will help the documentation be robust enough to withstand scrutiny by tax authorities during an audit.
- Consistency. Transfer pricing documentation should present a consistent story across jurisdictions, across multiple tax years, and with reference to other available documentation (for example, investor reports, intercompany agreements, and valuation studies). With jurisdictions more readily exchanging information and using technology to review financial information, tax authorities can more easily identify inconsistencies.
Some areas to focus on to increase overall consistency include:
- Respective country local files
- OECD master file
- Transfer pricing planning reports
- Internal policy documents
- Legal agreements
- Financial statements
- Other tax or nontax documentation
- Economic substance. An important component of transfer pricing documentation is demonstrating that a company’s transfer pricing policies and practices are aligned with the actual economic activity taking place within the company. Increasingly, tax authorities globally are focused on whether related-party transactions have economic substance and whether the arm's-length principle has been applied in accordance with the underlying economic reality of the transactions. This form-versus-substance argument is used by many foreign tax authorities following the revised transfer pricing guidance from the OECD.
In the U.S., the IRS announced changes to how it applies the economic substance doctrine and listed situations when consideration of the doctrine is appropriate, including situations applicable to transfer pricing. It is critical to explain the economic substance of relevant transactions in transfer pricing studies. In the U.S., taxpayers failing to meet this threshold for economic substance could expose themselves to penalties from a better-funded IRS that has a tighter focus on transfer pricing enforcement as well as penalties relating to failure to document the economic substance of related-party transactions.
- Process. Companies should have clear policies and procedures in place for documenting related-party transactions, including:
- Analysis based on market conditions, business operations, and overall business objectives
- Proper outreach and socialization of the analysis and policies with relevant parties
- A formal confirmation of the analysis by relevant parties or communication to revise the analysis
- A universal buy-in by relevant parties to memorialize the confirmed transfer pricing analysis and policies
- Protocols to organize the relevant items for transfer pricing documentation after the preceding steps are complete
- A system to monitor and adjust transfer prices
Looking ahead
Considering these five key aspects of transfer pricing documentation (scope, depth, consistency, economic substance, and process) can jump-start a company’s efforts to evaluate its transfer pricing documentation and compliance activities. By incorporating these five key aspects of transfer pricing documentation, companies can prepare comprehensive transfer pricing documentation and minimize their risk of penalties, interest, and other adverse consequences in the event of a tax audit.
