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LB&I International Practice Service
Process Unit – Overview
Shelf Business Outbound
Volume 1 Income Shifting Outbound UIL Code N/A
Part N/A N/A Level 2 UIL N/A
Chapter N/A N/A Level 3 UIL N/A
Sub-Chapter N/A N/A
Unit Name Comparability Analysis for Tangible Goods Transactions – Outbound
Document Control Number (DCN) ISO/PUO/V_1_01(2014)
Date of Last Update 09/04/
Note: This document is not an official pronouncement of law, and cannot be used, cited or relied upon as such. Further, this document may not contain a comprehensive discussion of all pertinent issues or law or the IRS's interpretation of current law.
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Table of Contents
(View this PowerPoint in “Presentation View” to click on the links below)
Introduction
Process Overview
Detailed Explanation of the Process
Process Applicability
Summary of Process Steps
Step 1
Step 2
Step 3
Step 4
Step 5
Step 6
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Introduction
Comparability Analysis for Tangible Goods Transactions – Outbound
Both U.S. and Foreign multinational enterprises (MNE) may seek to maximize after tax profits by shifting income from a high tax jurisdiction to a lower tax jurisdiction via controlled party transactions which are not conducted at arms length. Income shifting may be achieved through the sale of tangible goods, provision of services, loans, leases and/or license/transfer of intangibles between related parties at prices that are not arm’s length. This Process Building Block will focus on analyzing the five comparability factors; functions, contracts, risks, economic conditions, and property and services. In addition, this unit looks at the identification and selection of third party transactions comparable to the controlled transactions under examination.
In general, the price of goods in a sales/lease transaction involving two uncontrolled parties is determined by market conditions and is assumed to be at arm’s length. However, in a transaction between controlled parties, the price of goods may not always be determined by market conditions and may be manipulated in order to minimize tax. Both the U.S. IRC 482 rules and the Organization for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines (2010), provide that the price for transactions between controlled parties involving goods, services, intangible property (IP), rents, and loans should be the same as the price for transactions between uncontrolled parties under the same or similar circumstances. Thus, the degree of comparability between a controlled transaction and any uncontrolled comparables is central to the reliability of any transfer pricing analysis.
To determine the degree of comparability between controlled and uncontrolled transactions requires a comparison of the functions performed, contractual terms used, risks borne, economic conditions encountered and the property and services employed by the parties in each transaction. This analysis is a prerequisite to identifying and selecting transactions comparable to the ones under examination. This analysis is not a transfer pricing method and does not itself determine an arm's length result. The purpose and goal of the analysis is to clearly identify and compare the economically significant activities undertaken by each party. A well performed analysis will establish the facts and circumstances needed to properly develop a transfer pricing case.
Comparability Analysis for Tangible Goods Transactions – Outbound
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A comparability analysis, including the functional, risks, contractual and economic analyses, is a tool used to establish the facts and circumstances for IRC § 482 issues. While this analysis is a critical part of any transfer pricing audit, it may also be useful in analyzing a variety of tax issues other than transfer pricing, such as:
Non-income Shifting Transfer of Intangibles Substantial Contribution to Contract Manufacturing (Subpart F exception) Domestic Production Deduction Worthless Stock deductions (under IRC 165(g)(3)) Research and Experimental expenditure identification
This Building Block will not cover the analysis in these above mentioned areas. However, members of the domestic and international audit team and specialists should coordinate information gathering to avoid duplication of work for the exam team and/or making duplicative requests for information from the taxpayer.
Introduction (cont’d)
Comparability Analysis for Tangible Goods Transactions – Outbound
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After completing the comparability analysis and reviewing all the factors that might affect comparability, the examiner can determine if the comparables relied upon by the taxpayer are appropriate or whether they require adjustments or perhaps an alternative set of comparables is necessary.
The focus of this Building Block is how to conduct a comparability analysis relating to the transfer of tangible goods between controlled parties and will focus on the use of the Comparable Profits Method (CPM). This analysis is conducted on the entity that engages in routine activities and is the least complex of the controlled taxpayers (tested party). The tested party in a tangible goods transaction is typically the distributor. Distributors generally are the least complex entity in a controlled party enterprise and generally do not own valuable intangibles or unique assets that would distinguish it from potential uncontrolled comparables.
Although this Building Block focuses on comparability analysis for an outbound distributor, a similar analysis can be applied in a situation where a foreign MNE is the manufacturer and a U.S. entity/subsidiary is the distributor. See IPS Unit ISI/PUO/V6.7.1_01(2014): Comparability Analysis for Tangible Goods Transactions – Inbound.
This Building Block does not cover how to select the “best method.” For selecting the best method see the IPS unit entitled Best Method Determination of an Inbound Distributor ISI/9422.09_04. While that unit is for an inbound transaction, the concepts are the same and can also be applied to an outbound transaction.
NOTE: The functional analysis is only one of the five factors of comparability listed in the regulations. In practice, often the term “functional analysis” is used to describe the complete “comparability analysis.” Technically, the regulations describe the functional analysis as limited to the evaluation of the functions performed and resources employed by taxpayers in transactions. Comparability analysis includes all of the five factors listed in Treas. Reg. 1.482-1(d)(3), including the functional analysis.
Process Overview (cont’d)
Comparability Analysis for Tangible Goods Transactions – Outbound
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This Building Block focuses on the functions employed by a foreign subsidiary as a distributor for a US related parent and how to conduct a comparability analysis relating to the transfer of tangible goods between these controlled parties.
US Parent (USP) owns 100% of Controlled Foreign Subsidiary (CFC). USP manufactures tangible goods and sells these to CFC which in turn sells the goods to the third party customers in Europe. USP and CFC have a transfer pricing study prepared by an outside consultant. The method to be evaluated in this process unit is the Comparable Profits Method (CPM) as applied to the distributor (CFC). (Although the same process applies to any tangible goods pricing methodology.)
Note: An assumption will be made that the tested party is the CFC distributor. Generally, an analysis would need to be performed before that assumption becomes fact.
USP
CFC
Tangible
Goods Payment
Process Overview (cont’d)
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A comprehensive comparability analysis generally includes physically touring the taxpayer’s sites of operation. The observations made during a site visit will result in a thorough understanding of the comparability factors and will enable the examiner to identify additional issues. As a result, the examiner’s report will have better descriptions of facts. Prior to an interview or site visit the examiner should: Identify personnel to be interviewed and sites to be visited; Determine which Service personnel will attend and participate in asking questions; Agree and coordinate interviewees (with taxpayer); Prepare a list of topics to be covered and outline of questions in advance; See IRM 4.61.3-1 Exhibit, On-Site Visitations. The Examiner should identify personnel to be interviewed and sites to be visited. Find out who the decision makers are for each of the comparability factors under analysis. Obtain organizational charts for each transacting party. The charts should identify entities, departments, personnel, and the functions they perform and risks they assume and to whom personnel report. Obtain personnel credentials including skill level and education possessed. Obtain personnel compensation levels including salaries, bonuses and stock based compensation. Obtain job descriptions. Request employee performance evaluations if relevant to the transfer pricing analysis.
Detailed Explanation of the Process (cont’d)
Comparability Analysis for Tangible Goods Transactions – Outbound
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Detailed Explanation of the Process (cont’d)
Comparability Analysis for Tangible Goods Transactions – Outbound
Analysis In some instances, it may be necessary for the examiner to interview personnel no longer employed by the taxpayer. The purpose of an interview and on-site visitation is to identify the functions performed, contractual terms, risks assumed, economic conditions and property or services provided. The Service personnel responsible for identifying and developing issues should attend interviews and site visits including: the examiner; the economist assigned to the case; and the manager responsible to the issue. If the taxpayer’s operations are highly technical, an engineer should attend the site visits and interviews. Consider inviting Counsel to attend any interviews or site visits. The Service personnel attending interviews and site visits should choose a primary interviewer in advance. Usually an experienced team member is chosen as a primary interviewer. Service personnel not acting as the primary interviewer should plan on taking notes. Notes should be compared among team members. The Examiner should coordinate interview and site visits with the taxpayer. The examiner and the taxpayer should agree: Who will be interviewed, Which sites will be toured; A timetable for the interviews and site visits; and The length of time allowed for each interview; allowing enough time for note taking and follow-up questions. A site visit may involve a tour of various facilities. The examiner should get a description of what will be toured and know which taxpayer personnel they will be meeting with beforehand. It may be convenient to interview personnel the same day the facilities are being toured. Therefore, obtaining a list of personnel and their work location can prove helpful.
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Process Applicability
Comparability Analysis for Tangible Goods Transactions – Outbound
Taxpayer’s documents may not provide enough information to adequately analyze the comparability factors in connection with uncontrolled transactions. Information provided by the taxpayer may need to be verified as part of the examination process.
Criteria Resources
The examiner has identified significant controlled transactions.
Review Form 1120 - Schedule M-3, and Uncertain Tax Positions (UTP) Disclosures. Tie the financials to the tax return and note any differences. Review prior exam cycle files. Review Sch B of Form 5471 for the CFC.
The examiner has identified economically significant activities performed in connection with the controlled transaction.
Review the Transfer Pricing Study to understand the MNE structure, the activities performed, transaction materiality, and general risks of the transaction.
Review the company websites for additional discussions about the taxpayer’s activities.
The examiner has reviewed the general ledger and financial statements for expenses relating to the production of goods, such as manufacturing costs, depreciation of plants, R&D expense, warranty expenses etc.
Review USP’s and CFC’s Annual Reports/Financial Statements for confirmation that the information matches the transfer pricing study. Review the CFC’s income statement and balance sheet for expenses that confirm its status solely as a distributor. Perform ratio analysis based on the financial information.
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Summary of Process Steps
Comparability Analysis for Tangible Goods Transactions – Outbound
Process Steps The key factors that determine comparability (functions, contractual terms, risks, economic conditions, and property or services) should all be addressed as part of the comparative analysis. After performing the first five steps it will be possible to evaluate in Step 6 whether the controlled transaction is comparable to transactions between unrelated parties in order to establish whether the controlled transactions are priced at arm’s length.
Step 1 How to conduct a functional analysis
Step 2
How to conduct a contractual terms analysis.
Step 3
How to conduct a risk analysis.
Step 4 How to conduct an economics conditions analysis.
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Step 1: Functional Analysis
Comparability Analysis for Tangible Goods Transactions – Outbound
Step 1 Functional analysis involves tracing the flow of products at various stages from the conceptualization to final sale to understand what entities perform which functions
Considerations Resources
Functional Analysis involves tracing the flow of products at various stages from the conceptualization to its final sales. The stages may include: Conceptualization R&D Various stages of production Testing and quality control Assembly, packaging and labeling Inventory management Transportation and warehousing Marketing and promotion Sales or internal use Warranty administration Various stages of financing the production and inventory
Treas. Reg. 1.482-1(d)(3)(i), Functional analysis Transfer Pricing Roadmap [Plan the audit timeline and discuss the timeline with your manager and team coordinator.] IRM 4.61.3-4 Functional Analysis Questionnaire Checklist - IRC 482 Transfer Pricing Case Development Tool Transfer Pricing Study Intercompany Agreements
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Step 1: Functional Analysis (cont’d)
Comparability Analysis for Tangible Goods Transactions – Outbound
Step 1 Functional analysis involves tracing the flow of products at various stages from the conceptualization to final sale to understand what entities perform which functions.
Considerations References / Resources
In order to understand specific processes performed by USP and CFC, inquires need to be made into : Manufacturing; Selling and distribution; Assets, including intangible assets; and Resources employed Determine if you need to take the following actions to gather information to understand the specific processes- Do you need to issue IDRs or summons? Do you need to interview taxpayer employees? Do you need to contact IRS engineers? Do you need to contact third parties (outside experts, former employees)? Do you need to visit taxpayer’s sites related to transactions?
Treas. Reg. §1.482-1(d)(3)(i ), Functional Analysis
Transfer Pricing Study Transfer Pricing Roadmap IRM 4.61.3-4 Functional Analysis Questionnaire Checklist - IRC 482 Transfer Pricing Case Development Tool IRM 4.61.3.4.5 – How to Develop a Section 482 Case OJT for IEs-Development of Transfer Pricing Sec 482 Issues
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Step 2: Contractual Terms (cont’d)
Comparability Analysis for Tangible Goods Transactions – Outbound
Step 2 A contractual terms analysis requires analyzing the tangible property sale to discover the terms and conditions of the sale.
Considerations Resources
Contractual Terms to review, include; Form of consideration charged or paid, Sales or purchase volume, Scope and terms of warranties provided, Rights to updates, revisions or modifications, Duration of relevant licenses, contracts or other agreements, and termination or renegotiation rights, Collateral transactions or ongoing business relationships between parties including ancillary or subsidiary services, and Extension of credit and payment terms.
The economic substance of the transaction will be the most important consideration in any evaluation of comparability. Contractual terms may be inconsistent with the economic substance of the transaction or economic substance for a transaction without a written agreement may exist. The actual conduct of the parties and their respective legal rights will control. This will have to be deduced from the general ledger, written communications and interviews with personnel. The Government may impute a contractual agreement between the controlled taxpayers that is consistent with the economic substance of the transaction.
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Considerations Resources
Form of consideration charged or paid: Determine if the form of consideration paid was cash, accounts receivable, a debt instrument, or other form of consideration. Verify the above terms by reviewing the general ledger for an accounts receivable account related to the inventory purchase. Verify that the contract, invoice and general ledger accounts are all coordinating such that the substance follows the form.
Sale or purchase volume: The examiner will need to identify the quantity of product purchased by CFC from USP. Generally, market dynamics indicate that a higher purchase volume will result in a lower purchase price because of volume discounts. However, this could be dependent on the industry in which the taxpayer participates. Not all markets are the same. A minimum or required purchase volume could reduce CFC’s profit if the sub cannot sell all the inventory and the inventory can not be returned.
Transfer Pricing Roadmap
Transfer Pricing Study
Intercompany Agreements
Invoices
Books and Records (G/L, Receivables and Payables Ledger, etc.)
Treas. Reg. §1.482-1(d)(3)(ii)(C), Contractual term - Example 1
Step 2: Contractual Terms (cont’d)
Comparability Analysis for Tangible Goods Transactions – Outbound
Step 2 A contractual terms analysis requires analyzing the tangible property sale to discover the terms and conditions of the sale.
