How much is enough? Lessons on transfer pricing documentation from the recent IRS report

Tax Executive, The, Sept-Oct, 2002 by Michael C. Durst, Robert E. Culbertson

Introduction

In May 2002, the IRS released its report to Congress on the effectiveness of the "contemporaneous documentation" that the Code and Regulations have, since 1994, required multinational companies to prepare in order to avoid exposure to penalties in the event of transfer pricing adjustments under section 482. (1) The report is based on a study by IRS examiners of documentation that had been submitted by 25 different taxpayers, as well as a survey of taxpayers conducted on behalf of the IRS by an independent consultant, Schulman, Ronca & Bucuvalas, Inc. (SRBI). Although it can be questioned whether the survey was truly representative, the report nevertheless provides useful information for tax executives seeking a cost-effective approach to documentation. In particular, the report supports the following practical conclusions:

(i) Contemporaneous documentation has become part of the fabric of tax practice, and IRS examiners expect documentation to be available at the start of large case examinations. Companies that do not maintain documentation with respect to their significant intercompany transactions are a conspicuous minority and face a much-heightened risk of penalties.

(ii) The IRS report indicates that documentation is removing some difficulty from the early stages of examinations by reducing the number of IDRs that are issued. The report does not suggest, however, that documentation is reliably reducing the contentiousness of examinations once the IRS identities a transfer pricing issue. Even the best documentation is not likely to eliminate controversy if the IRS otherwise is inclined to inquire into pricing.

(iii) Documentation is proving costly to multinational companies. Indeed, companies may be spending more than necessary on the documentation that they are producing, and could consider reducing costs by avoiding unnecessarily extensive analysis, and by doing more of the necessary work in-house.

Background of the Report

The recent report seems to have originated in the longstanding concern of Senator Byron Dorgan that the arm's-length standard cannot serve as the basis of an effective transfer pricing system. At Senator Dorgan's request, (2) the Senate Finance Committee included, in its version of what later became the fiscal year 2000 Treasury-IRS appropriations legislation, a requirement that the IRS conduct a study of the extent to which taxpayers are preparing documentation, and the quality of the documentation that is being submitted. (3) The conference committee later deleted this requirement, but the IRS decided nevertheless that the report should be provided. (4)

Methodology

SRBI conducted its taxpayer survey primarily during 2001, by initial telephone contact followed by an Internet-based questionnaire. (5) The IRS took pains to reassure companies that no data identifiable with particular taxpayers would be given to the IRS. (6) Despite these precautions, however, when the survey firm began contacting taxpayers with its questionnaire, the tax executives of many companies faced conflicting considerations concerning whether to participate. Notwithstanding the precautions taken by the IRS to ensure confidentiality, some potential participants thought it undesirable to record in an unprivileged setting observations concerning their companies' relative degree of compliance with documentation rules. (7)

On the other hand, it seems likely that some tax executives did not want, by declining to participate in the survey, to send Congress an implicit message that the arm's-length standard as currently implemented is not working. Given the history of the survey, it was natural to view the effort as a "report card" on the operation of current transfer pricing rules. As it turned out, of those companies that the survey firm identified as potentially eligible for participation in the survey, about 70 percent actually participated. Of the 30 percent that opted out, about half explicitly declined to take part, and the other half simply did not send in completed forms. (8)

This rate of nonparticipation does not in itself cast doubt on the validity of the sampling, but it seems likely that the self-identification of the 70 percent who did choose to participate was not entirely random. Those who did participate probably represent disproportionately companies that both (i) felt that their own documentation was in particularly good order, and (ii) desired to demonstrate for the benefit of Congress the effectiveness of current transfer pricing rules. (9) Thus, this possible skewing suggests that the report may present a somewhat rosier picture of documentation practice today than would be revealed by a more rigorously representative sampling.

Similarly, the IRS's own study of 25 taxpayers' documentation must unavoidably be seen more as an approximate survey than as a statistically rigorous exercise. The process used to select the 25 taxpayers was not designed (and probably could not practically be designed) to select a fully representative sampling. (10) Moreover, there is no quantitatively precise way to judge the quality of documentation. Examiners therefore were asked to grade documentation into four categories--excellent, good, moderate, and poor--and there can no assurance that the standards applied by the different examiners that conducted the survey were consistent. Nevertheless, given the limitations on the precision that any survey of the quality of documentation could achieve, the IRS effort was conducted carefully and provides a useful body of information.