Reporting Form Gives IRS Auditors New Lens for U.S. Groups

The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.

By Kevin A. Bell

Internal Revenue Service international examiners and economists will soon have an additional tool to help them select cases for audit, as U.S. multinationals later this year will begin to file a detailed reporting form with their tax returns.

Final IRS regulations (T.D. 9773, RIN:1545-BM70) issued in June 2016 require companies with annual revenue of at least $850 million to report information including the amount of revenue, profit or loss, capital and accumulated earnings for each country of operation, consistent with OECD recommendations designed to combat tax base erosion and profit shifting. Tax practitioners noted that reporting requirements will yield a fuller picture of the company’s value chain in including foreign-to-foreign transactions not currently required under the U.S. transfer pricing documentation regime.

However, opinions varied about how useful that information would be. In addition, some business representatives worried that foreign auditors will use the information to make transfer pricing adjustments—something that the U.S. rules and the rules from the Organization for Economic Development on which they are based expressly prohibit.

The first required reporting period is the 12 months beginning on or after the first day of a tax year of the ultimate parent entity that begins on or after June 30, 2016. The reporting form and accompanying schedule on which the data will be recorded currently exist in draft.

Whole Value Chain

The information in the country-by-country reports goes beyond the current U.S. transfer pricing documentation requirements in providing information on all of a company’s international transactions, not just those involving a U.S. entity.

Barbara Mantegani of Mantegani Tax PLLC in McLean, Va., told Bloomberg BNA March 4 that examiners, in reviewing the form, might focus first on the distribution of global revenue “to get a feel for where the company is earning money.” Because the U.S. documentation rules don’t require taxpayers to list transactions that are entirely outside the U.S., the country-by-country report would give auditors some country-level income information “that they probably would not have otherwise.”

IRS examiners already get U.S.-related transactional information from Forms 5471 and 5472, but the country-by-country report might give them something to compare the transactional information with, “and could reveal significant foreign-to-foreign transactions,” Mantegani said. Those transactions might not create a U.S. audit risk, “but knowing, for example, that the taxpayer has five constituent entities in a certain country where the company recognizes a significant amount of income with 10 employees might make an auditor want to ask some questions.”

Peter Barnes, a former tax counsel for General Electric Co. and a professor at Duke University School of Law, agreed that if a taxpayer shows significant income in a low-tax jurisdiction, with limited employees and limited physical assets, then the examiner can explore whether the taxpayer’s operations in the examiner’s home country are making payments to that low-taxed jurisdiction.

“Royalties? Interest? Service fees? The mere fact that payments are being made to the low-taxed jurisdiction does not mean there is abuse, but the examiner can focus good questions to the taxpayer,” he told Bloomberg BNA in an e-mail March 6.

Barnes said the reverse is also true—if an examiner sees that a taxpayer “has substantial operations—employees, assets—in his or her jurisdiction, but relatively little income,” the examiner can ask why.

Finally, if the taxpayer has significant operations in a nearby, low-tax jurisdiction—for example, Germany or Luxembourg—the examiner in the higher-tax jurisdiction can ask why, and what the relationship is between operations in the two countries.

Not a Game-Changer

Still, Barnes noted, examiners can already ask these kinds of questions. He said he saw the country-by-country report as a useful tool, but not a game-changer.

Meanwhile, David Ernick, a principal at PricewaterhouseCoopers LLP in Washington, saw no use for the information from the country-by-country reports in a transfer pricing context.

“Unfortunately, for all the time and expense businesses will spend preparing CBC reports, they provide no relevant information for assessing transfer pricing risk,” Ernick told Bloomberg BNA March 6.

Transfer Pricing Adjustments?

U.S. officials have said repeatedly that the country-by-country data shouldn’t be used to make transfer pricing adjustments, and that the IRS will refuse to exchange the information with governments that use the information to do so.

Thus, a U.S. examiner would never devise a transfer pricing adjustment directly from the country-by-country report, Matnegani said. “The U.S. has said that it will not sign a bilateral competent authority agreement to exchange CBC reports with any country that uses the data in that way, so it will not be possible for a U.S. examiner to just run some sort of formula and calculate an adjustment and get anybody in the field to sign off on it,” she said.

“The more cynical among us might think that is a naive view,” Mantegani, a former manager in the IRS’s Advance Pricing and Mutual Agreement Procedure office, acknowledged. However, she added, “having worked with field auditors I feel pretty confident that nobody is going to start creating equations from the CBC data without following standard audit procedures.”

Barnes said that any examiner—U.S. or foreign—that makes an assessment solely from the country-by-country report is abusing their authority. “I don’t think that will happen,” said the professor, who is also of counsel with Caplin & Drysdale Chartered.

Further, using information from country-by-country reports to make a transfer pricing adjustment would be risky for an auditor because the adjustment could be hard to support with information legitimately at the auditor’s disposal.

“No examiner wants to waste time chasing an adjustment that will not stand up,” Barnes said.

Ernick, on the other hand, predicted that as a result of the OECD’s BEPS recommendations on transfer pricing, foreign tax authorities will use the information “to make creative transfer pricing adjustments to help themselves to a larger share of the global profits of U.S. companies.”

The practitioner, a former Treasury official, said foreign auditors likely “will resort to a simple ratio analysis,” considering information such as “which countries show revenue per employee, or profits per employee, significantly higher than the average. Then they’ll back into a transfer pricing adjustment, with varying justifications for why more of the profits sitting in low-tax jurisdictions should be shifted to their jurisdiction.”

Ernick said some countries will argue they should get a larger share of global profits based on the number of employees in their country, others will argue for a larger share based on the size of the market and the fact that a larger proportion of sales occurs in their country. “When I was at Treasury we resisted calls for CBC reporting for several years because we recognized it for what it was—a stalking horse for formulary apportionment.”

Reining in Foreign Auditors

U.S. companies worry that Chinese and Indian tax auditors in particular will use U.S. country-by-country reports to pull more profit into their respective jurisdictions for transfer pricing purposes.

A former Treasury official involved in the BEPS project said the OECD peer review process on the BEPS Action 13 work is likely to be successful in preventing foreign auditors from misusing the country-by-country report.

“One of the things the OECD can do extremely well is to work together on rules that we can all agree to, and then through peer review processes, ensure that the countries are kind of living up to implementing the rule in the way we had all agreed to it,” said Robert Stack, former Treasury deputy assistant secretary for international tax affairs. (An edited transcript of Stack's remarks appears in the Interview section.)

Stack told Bloomberg BNA that country-by-country reporting is a good example of that process. Part of the review process will be whether countries adopted country-by-country reporting to begin with, and then, whether they did it “the way that we all agreed, like the United States has done.”

Countries well understand the U.S. position on misuse of the reported information, Stack said. For example, he noted that India is looking at ways to ensure that the information is received by offices that can help conduct a risk assessment without necessarily sending all the information down to the auditor.

“India, I think, wants the information and wants very much to abide by the global agreement game, so personally, this is not, for me, a huge concern,” Stack said. “But it will play out in practice.”

To contact the reporter on this story: Kevin A. Bell in Washington at kbell@bna.com

To contact the editor responsible for this story: Molly Moses at mmoses@bna.com

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