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
Guides

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