Tax Controversy 2022 – Switch Pricing

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Introduction

In 2022, we foresee several trends and developments that will

converge to substantially impact tax controversies in the United

States. The COVID-19 pandemic will likely continue to change how US

taxpayers, the Internal Revenue Service (IRS), and courts approach

tax controversies. Modest increases to the IRS’s funding

– as well as a new “issue-focused” approach –

facilitate a more aggressive agency that is increasingly focused on

enforcement, especially for corporate taxpayers. And more

multilateral, international engagement continues to enhance the

ability of the IRS to co-ordinate with foreign taxing authorities,

increasing global pressure on US companies.

Increased Enforcement and the IRS’s IssueFocused

Approach

In 2015, the IRS Commissioner stated that the agency planned to

do “less with less”. Plagued by years of budget cuts and

hiring freezes, the IRS was struggling to maintain the same level

of enforcement activity that it had maintained previously. The

ensuing years were no different: the IRS has spent nearly a decade

searching for strategies to make do with its limited resources.

Recently, that trend has begun to reverse itself. Taxpayers are

seeing a more aggressive IRS that is increasingly focused on

enforcement. The IRS’s expenditure has started drifting back up

after years of steady declines. Hiring is also trending upward. For

example, in January 2022, the IRS announced that it would hire 200

experienced attorneys to focus on tax deals that it claims are

“abusive”, including syndicated conservation easement

transactions and micro-captive insurance arrangements.

Even so, the IRS learned some lessons during the

“less-with-less” era that it will likely carry with it

going forward. Among those lessons is that the IRS should focus its

enforcement activity on “issues”, rather than

taxpayers.

An example of the IRS’s issue-focused approach is the

enforcement “campaign”. Traditionally, the IRS initiated

audits by selecting particular taxpayers for examination. But in an

era of reduced resources, the IRS’s Large Business &

International Division (LB&I) started selecting a tax issue for

audit, rather than auditing every potential issue on a

taxpayer’s return. In theory, these enforcement campaigns are

supposed to help LB&I more efficiently target enforcement where

it matters most for compliance.

Since the campaigns began in early 2017, the IRS has maintained

a website that describes each active campaign in a short paragraph

and, in some cases, provides a “treatment stream”. For

example, the IRS kicked off a campaign dedicated to the 2017 Tax

Cuts & Jobs Act, the goal of which “is to identify

transactions, restructuring and technical issues and better

understand taxpayer behavior under the new law”. According to

the IRS, “(t)he treatment streams for this campaign may

include examinations, soft letters, outreach, new and improved

practice units and development of future issue-based

campaigns”. Little additional detail has been provided.

In practice, it has been unclear what effect, if any, campaigns

have been having on tax enforce-ment. In 2019, the IRS’s

watchdog concluded that the “campaign program as a whole has

not met initial expectations”. It also suggested that LB&I

had not developed a well-reasoned process for selecting

campaigns.

That said, the list of campaigns provides at least a glimpse

into the IRS’s enforcement priorities.

We can also glimpse the IRS’s enforcement priorities in the

agency’s so-called “Priority Guidance”. The stated

goal of the guidance is to identify and prioritise tax issues that

should be addressed through regulations and other administrative

guidance. But we have seen the IRS focus enforcement on many of the

very same topics. As an example, the guidance announces several

regulatory projects on issues related to crypto and other virtual

currencies, which the IRS has also aggressively pursued in audits

and court cases.

The Biden administration has made it clear that it wants to

increase enforcement on corporate taxpayers, and Congress has

attempted to pump more resources into the IRS for enforcement. The

administration’s “Build Back Better” plan would have

allocated eye-popping sums to the agency to ramp up audits. And

while that legislation appears to be stalled, at least at the

moment, the desire remains to increase IRS funding

substantially.

Remote Audits and Court Proceedings

After a brief pause in the spring of 2020, the IRS resumed

auditing taxpayers. Rather than a return to normal, though, the IRS

has transitioned to performing audits remotely. Perhaps

coincidentally – or perhaps due in part to cost and time

savings – the transition to remote audits has been

accompanied by a marked increase in auditing activity

Before the pandemic, the IRS typically audited large corporate

taxpayers in person. It was common for large companies to set aside

dedicated office space for IRS examiners in their corporate

offices. IRS examiners might request in-person interviews (or even

depositions) of key company employees to carry out the audit. And,

for certain issues, IRS examiners would make in-person “site

visits” to manufacturing plants or other important company

locations (this is especially true in transfer pricing, where the

“value-add” of a manufacturing plant might be the crux of

the issue in the case).

The transition to remote audits, necessitated by the

coronavirus, has significantly impacted how the IRS and taxpayers

approach audits. The biggest change of all may be interpersonal: it

is far less common in the pandemic era for the taxpayer and the IRS

agents to be in the same room together. Whether this phenomenon

benefits taxpayers is an open question. Perhaps an impersonal audit

experience where technology keeps the parties at a distance is

preferable. Or, maybe the clearest communication occurs when

everybody is in the same room, since large Zoom meetings often

result in presentations, as opposed to an active exchange of

positions and their respective merits. Most likely, it depends.

This same transition to remote meetings, however, has undoubtedly

improved the efficacy of the IRS’s Advance Pricing & Mutual

Agreement (APMA) Program – providing more comfort to

taxpayers navigating the complicated crossborder tax landscape.

The logistics of a remote audit are also drastically different.

Witness interviews are particularly challenging, because witnesses,

taxpayers’ counsel and representatives, and IRS questioners are

usually in different locations, sometimes in different countries.

Additionally, draft information document requests (IDRs) that

typically would require an in-person conversation before being

finalised are now being discussed by phone. While this has had some

positive effects, such as having more focused conversations, it has

presented challenges too: it is more difficult to engage with the

IRS about what information it is actually seeking, as the IRS has

limited videoconferencing capabilities. Finally, a site visit might

now be conducted remotely using a camera, with the IRS agents never

setting foot in the company’s plant or office.

In an effort to make remote auditing easier, the IRS has eased

some of its rigid procedures, though the reality still poses

challenges. Certain important forms (such as powers of attorney)

can now be submitted online. And the IRS will continue to accept

electronic signatures on forms that cannot be filed electronically

at least through October 2023. The IRS will also continue its

expansion of permissible methods to receive and transmit documents,

allowing taxpayers the option to send documents to the IRS simply

as email attachments.

Tax litigation has also gone – intermittently –

virtual. Most tax disputes in the United States are litigated in

the US Tax Court. In the past, trials were in person. After the

pandemic began, though, the Tax Court announced that it would begin

conducting trials and other proceedings by Zoom. The procedure

forced taxpayers to either proceed remotely (with large disputes

posing particularly burdensome logistical challenges) or delay

trials until in-person trials resumed. Since then, the Tax Court

has followed the larger trends regarding COVID restrictions;

sometimes easing restrictions and holding in-person proceedings and

sometimes returning to strictly virtual proceedings. It has viewed

these virtual proceedings as a success, and it has signalled that

it might seek to conduct trials virtually even after the pandemic

ends, at least for disputes involving smaller-dollar issues. We

have seen similar trends in other courts – such as federal

district courts and the Court of Federal Claims – where tax

disputes are sometimes litigated.

Transfer Pricing Disputes

Whether true or not, the perception has been that the IRS has

not fared well in major transfer pricing cases. In the past, the

IRS would often assert an adjustment using a transfer pricing

method based on profitability, such as the comparable profits

method (CPM). In theory, the goal was to indirectly allocate income

among controlled entities so that each entity’s operating

results are similarly profitable to similarly situated third

parties, as opposed to allocating profits directly by reference to

specific comparable transactions. But the IRS’s CPM approach

would often be too aggressive (usually by assigning an unreasonable

share of the profits to the US headquarters, with almost nothing

left for the foreign subsidiaries). It would not prevail because

the discerning eye of the court viewed the functional analysis

holistically to determine the true drivers of value.

Recently, however, the IRS’s fortunes appear to have

changed, with wins in the US Tax Court and in other courts. The IRS

is likely to try to build upon its momentum by pursuing greater

transfer pricing enforcement in 2022 and beyond.

Specifically, the IRS has stated that one of its priorities for

2021–22 is to issue regulations under Internal Revenue Code

section 482, which address “passive association”: the

incidental benefit, or “implicit support”, that an entity

receives from lenders because of its association with other members

under the same multinational umbrella. Whether the IRS issues

proposed regulations (which are persuasive but non-binding),

temporary regulations (which have the force of law), or fails to

issue new regulations at all this year, multinational enterprises

should expect more scrutiny of their transfer pricing allocations

– and, perhaps, a departure from the traditional

interpretation of the arm’s-length principle. Moreover,

developing case law that challenges existing transfer pricing

regulations may accelerate this departure.

Beyond the IRS, US states have also focused more attention on

transfer pricing. Historically, states relied on their

discretionary power to adjust income in transfer pricing disputes.

But as more and more states have adopted section 482 or section

482-like statutes, state taxing authorities are more likely to

challenge transactions using the arm’s-length principle. And

the State Intercompany Transactions Advisory Service Committee

(relaunched by the Multistate Tax Commission after more than four

years of inactivity), finalised an information exchange agreement

which may facilitate, signalling more aggressive and co-ordinated

enforcement.

Cross-Border Information Gathering and Sharing

US companies have always faced the prospect of burdensome

information-gathering efforts by the IRS. Through IDRs, the IRS

often requests hundreds, thousands, or even tens of thousands of

documents from taxpayers under audit.

Increasingly, US companies have been confronting a new

challenge: they are receiving similarly broad document requests

from foreign taxing authorities. The United Kingdom and countries

in Europe have been particularly aggressive. And taxing authorities

worldwide have been ramping up their information gathering on US

companies.

These requests come in one of two ways. The taxing authority

could request documents directly, issuing the request either to the

US parent or to the foreign subsidiary. Or the taxing authority

could invoke the “exchange of information” provision in a

bilateral tax treaty with the US. In that case, the IRS issues an

IDR to the taxpayer on behalf of the taxing authority and has the

power

to pursue the request as if it were itself auditing the

taxpayer.

Either way, these requests are presenting US companies with

unique challenges:

privilege – US companies often withhold from the IRS some

types of tax-planning documents on the basis of privileges, such as

the attorney-client privilege, attorney work product doctrine, or

tax practitioner privilege (section 7525), but with these

foreign-initiated requests, US companies have been forced to

wrestle with difficult choice-of-law questions when making

privilege determinations;
data privacy – US companies must consider burdensome data

privacy rules in Europe and elsewhere when collecting, reviewing

and producing foreign-based documents to the IRS (through the

exchange of information process) or the foreign taxing authority;

and
possession – it is not always clear which entity in the

corporate structure possesses the documents; for example, documents

held by a foreign subsidiary might be subject to the request,

whereas documents held by the US parent might not be.

Consistent with a global trend towards multilateralism, we are

also seeing greater information sharing between the IRS and foreign

taxing authorities. Bilateral tax treaties give the US and many

foreign jurisdictions the power to share documents among

themselves, even spontaneously. So when US companies produce

documents to a foreign taxing authority, they must assume there is

a substantial likelihood that the same documents will wind up in

the hands of the IRS eventually.

Looking Forward

In our view, the biggest open question hanging over the rest of

the year is whether the White House will secure any legislative

changes to the tax law. The administration’s “Build Back

Better” proposal would have marked a sea change in corporate

taxation, leading to higher tax rates and – in all likelihood

– more disputes. The legislation would also have pumped an

enormous amount of additional money into the IRS for increased

enforcement. At the time of writing, the prospects for that

legislation look grim.

But at some point, the US will need to implement the substantial

developments occurring at the OECD. For example, the OECD has set a

global minimum tax which the administration has endorsed. As

another example, the US will need to make changes to the rules on

Global Intangible Low-Taxed Income (GILTI) to conform with the

OECD’s so-called GloBE Rules. So, there is some chance that we

will see substantial tax legislation in the US in the upcoming

year. US taxpayers would be well advised to stay abreast of any

proposed legislative changes, as they will undoubtedly impact tax

controversies.

Originally Published by Chambers Global Practice

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