INSIGHT: The 10 Principal Documents—Is it Time to Move On?

As transfer pricing continues to be one of the most, if not the most, important tax issue facing multinational corporations, and as the need to document one’s transactions has expanded to a need to, in effect, tell the company’s transfer pricing story, it may be time for the U.S. Treasury Department to consider a change to its regulations. That is, this transfer pricing professional believes that Treasury should consider replacing the documentation regulations commonly referred to as “the 10 principal documents” with the three levels of documentation included in the Organization for Economic Cooperation and Development (OECD) guidance coming out of the BEPS project, specifically, Action Item 13.

While much attention has been paid to the Country-by-Country Report (CbCR), which Treasury has already added to the U.S. rules, much less thought seems to have been given to whether, at this juncture, the other two types of documentation recommended by the OECD, i.e. Master file and Local file, are far superior to the 10 principal documents as a means of providing the Internal Revenue Service with a full picture of a company’s transfer pricing policies and results. Currently, U.S. companies that operate in any country that has adopted the OECD guidance are forced to prepare four different documents, and as shown below there are very few places where the U.S. rules overlap with the OECD requirements. This should come as no surprise, since global business has changed significantly since the U.S. rules were adopted, and arguably the mid-‘90s template is no longer relevant, as the following summary suggests.

A Look Back

In 1996 the Treasury Department promulgated regulations that for the first time provided a specific format for taxpayers to meet the requirements of tax code Section 6662 (e)(3)(B)(1)(II) to analyze and document the results of their intercompany transactions (on or before the date they filed their return) in order to avoid the substantial valuation misstatement penalty. The documentation rules were included in the tax code section in response to what a study of transfer pricing enforcement done by Treasury and the IRS (summarized in what is known as “the White Paper“ [Notice 88-123] had identified as an enormous problem in transfer pricing enforcement, i.e., lack of data from which to test whether an intercompany transaction was priced at arm’s-length. The substantial valuation misstatement penalty that was added to the tax code in 1993 provided that a “net section 482 adjustment,” i.e., the portion of a transfer pricing adjustment that is subject to the penalty, would not include adjustments to transactions for which documentation was “in existence on or before the date the return was filed” that demonstrated that the taxpayer had conducted a proper transfer pricing analysis before filing the return.

Hard as it is to believe now, it was often the case in the 1970s and 80s, when taxpayers significantly increased their cross-border intercompany transactions, that (as reported by IRS auditors) it seemed that there was little or no analysis done before the transactions were structured to insure that the results of such transactions were arm’s-length. Instead, as noted in the White Paper, IRS audit personnel reported that companies frequently didn’t analyze their intercompany transactions until they were under audit, and then many taxpayers appeared to simply look for a method that would give them the result they needed, taking an ex post approach to what the government felt should be an ex ante process.

By conditioning the ability to avoid a penalty on the existence of documentation the Treasury Department was in effect telling taxpayers to actually THINK about the pricing of their intercompany transactions before they were structured, or at least before they filed the return that reported the results of such transactions. The regulations allow taxpayers to report a result on their returns that is different from the result of the transaction for financial statement purposes, and the adjustment to results can create either an increase or decrease in U.S. taxable income when reported on an original return. But the goal of the regulations, which seems almost quaint now, was to just make companies pay attention to their intercompany transactions contemporaneously, which in regulatory terms meant on or before you filed the return. As a practical matter this focused U.S. taxpayers on their U.S. tax positions as opposed to the positions taken on the return in the other country, and when testing their results taxpayers arguably had an incentive to insure a slightly higher return to the U.S. even if it had the effect of lowering the profit reported in the other country.

While this implicit incentive might not have been the impetus for their actions, not long after the U.S. implemented its rules other countries followed, most notably Canada, which established a documentation requirement and a penalty that was more onerous than the U.S., and Mexico, which completed the North American trifecta in 1997. The existence of documentation requirements in all three countries arguably leveled the playing field for the intercompany pricing of goods and services flowing among them, and in many ways put them ahead of the curve. This did not last long, however, with Australia among other countries implementing transfer pricing documentation rules similar to the U.S. and Canada in 1998.

Back at the OECD, while the Transfer Pricing Guidelines released in 1995 included a chapter on documentation, the guidance was careful not to include any specific documentation recommendations, and in fact, as described in the most recent release of the guidelines, the 1995 version of the guidelines “put an emphasis on the need for reasonableness in the documentation process from the perspective of both taxpayers and tax administrations…in order to avoid excessive documentation compliance burdens while at the same time providing for adequate information to apply the arm’s-length standard reliably.” [Chapter V Documentation Paragraph A.5.2 OECD (2017), OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017, OECD Publishing, Paris]

Even in 2010, when the OECD released an updated set of guidelines with more attention given to the ways that taxpayers might document their transfer prices, the OECD raised the need to limit the burden on taxpayers:

“Moreover, the need for the documents should be balanced by the costs and administrative burdens, particularly where this process suggests the creation of documents that would not otherwise be prepared or referred to in the absence of tax considerations. Documentation requirements should not impose on taxpayers costs and burdens disproportionate to the circumstances…

The Committee on Fiscal Affairs intends to study the issue of documentation further to develop additional guidance that might be given to assist taxpayers and tax administrations in this area.”

As we now know, the issue of documentation was studied in the OECD BEPS project, and in 2014 the organization released guidance under BEPS Action Item 13, which replaced Chapter V of the OECD Guidelines in its entirety, and for the first time recommended that multinational enterprises prepare specific forms of documentation to: (1) demonstrate that they have given due consideration to transfer pricing requirements when structuring their intercompany transactions; (2) provide tax authorities with the information necessary to perform a transfer pricing risk assessment; and (3) provide tax authorities with useful information to employ when the authorities conduct a transfer pricing audit. [OECD 2017 Guidelines at Paragraph V.5.5]

To meet these goals, the OECD recommended the three types of documentation now required in many countries, i.e. Master file, Local file, and Country by Country Report. As discussed below, the OECD model documentation rules ask for significantly more information than the U.S. rules, particularly regarding a company’s business model, supply chain, profitable products, and policies regarding research and development activities and the resulting intellectual property.

A Look Forward

After the OECD’s release of its documentation guidance, it seemed that most of the attention went to parsing the CbCR and postulating whether or how the report could lead to nefarious actions by tax auditors who could calculate transfer pricing adjustments directly from the CbCR information. But the Master file and Local file requirements, which by a recent count of the Bloomberg BNA BEPS Tracker [https://www.bloomberglaw.com/product/tax/aqb_chart/5200] have been adopted in 48 countries, (with 5 countries considering proposed law changes and 13 additional countries indicating an intent to adopt them), arguably provide a much richer picture of a company’s transfer pricing than that included in the 10 principal documents.

First, unlike the U.S. rules, which focus primarily on the transactions being presented in the documentation study and ask only cursory information about, for example, the company’s organizational chart or business model, the Master file asks questions about the company’s business model, supply chain, profit drivers, research and development process, and other items designed to give the tax authority both the big picture of the company’s business and the more focused picture of the company’s transfer pricing policies and transactions.

The transactional information that is in many ways the focus of the U.S. regulations is included in the Local file, which also has a more robust list of required information, including a discussion of the business model and business strategy of the local business, a list of key competitors, and a list of transactions discussed in the context of the business model. Although much of the economic analysis that is required by the U.S. regulations is also included in the Local file, the latter allows the reader (presumably a tax auditor) to read such analysis in context. For example, rather than simply characterizing a particular function or entity as “limited risk,” the Local file provides an opportunity for companies to present the business reasons for their transfer pricing structures such that, should extraordinary business or economic conditions arise (for example, a global pandemic), companies can make needed adjustments, including reporting losses in countries where such are not typically reported.

Taken together, the Master file and Local file arguably provide a robust picture of the company’s transfer pricing positions and how they fit into the overall business model; in short, the two documents (if done well) should tell the company’s transfer pricing story in a way that reduces the company’s transfer pricing audit risk. Read in conjunction with the CbCR, the Master file and Local file give context to the numbers and can provide additional data that demonstrates the company’s compliance with the arm’s-length standard. Australia, one of the first countries to enact documentation rules in 1997, clearly saw the value of the OECD approach and replaced those rules with the OECD’s recommended documentation, applicable for years starting on or after January 1, 2016. [Australia Combating Multinational Tax Avoidance Act of 2015] And Canada announced in September of last year that the Circular that had governed transfer pricing documentation requirements since 1999 was withdrawn, effective December 31, 2019, and a link to the OECD transfer pricing guidelines (described as being “generally consistent” with Canadian guidance) are included now on CRA’s website. [https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/ic87-2.html]

Turning back to the U.S. rules, the question is, what information in the 10 principal documents is not replicated in the OECD documentation, and the answer seems to be, nothing. As discussed, every element of the U.S. documentation framework is also included in either the Master file or Local file templates. Conversely, the Master file and Local file models request significant data for which there is no U.S. analogue, and that data can be critical to tax auditors attempting to identify companies to audit.

In a speech to transfer pricing professionals in 2018, Jennifer Best, director of IRS Treaty and Transfer Pricing Operations, explained the challenges faced by the IRS international examiners (IEs) when reviewing a company’s U.S. transfer pricing documentation to determine audit risk. “Sometimes we get documentation with just a list of the facts and the factors describing a business description, but it’s not a real analysis,” she said. “You can list a whole bunch of facts, but you have got to tell the story, compare it to the law, and really give a robust analysis. We get a list of functions, but no real analysis, more often then we should.” [ Quote from “Here’s What Multinationals Can Do to Avoid An Audit: IRS Official” 27 TMTR Issue No. 15 (July 26, 2018) And this point was reiterated by the same official in FAQs posted to the IRS web site in April of 2020, which remind taxpayers again that documentation best practices require a full explanation of the business functions and risks, as well as robust transactional data. [https://www.irs.gov/businesses/international-businesses/transfer-pricing-documentation-frequently-asked-questions-faqs]

As shown above, the question posed at the beginning of this article appears to be answered. The U.S. led the way in addressing what had become a significant problem for tax authorities, that is, attempting to examine a company’s transfer pricing positions. Simply by requiring companies to be prepared to explain themselves if asked, and to prove that the explanation was developed ex ante to support the transactions and not ex post to justify a result, the U.S. upended the transfer pricing process for most, if not all, companies filing U.S. tax returns. This in turn led to a global focus on cross-border intercompany transactions, and arguably improved global compliance.

And yet, in the intervening 20 plus years since the U.S. started the documentation dance with its taxpayers, business models have changed, the so-called digital economy has developed, and the OECD has created a much more robust and relevant set of documents that require companies to tell their entire story. That is, to force companies to focus much more on insuring that the transfer pricing tail is not wagging the business dog, and that their policies and practices, as described in the documentation provided to the tax authorities, help lead the auditor to the conclusion that their transfer pricing is compliant with the arm’s-length standard. Or at least that there is enough there to encourage the auditor to focus their efforts on another company whose documentation is not quite so compelling. There is overlap to be sure, between the OECD framework and the U.S., but the U.S. documentation can’t simply be expanded to create a Master file and Local file, and any attempt to cut and paste one into the other results in a disjointed presentation that then takes significant work to turn into a coherent story.

The OECD documentation framework, which the U.S. has adopted in part with its inclusion of the CbCR as an attachment to the U.S. corporate tax return, represents a robust, 21st century approach to proving a company’s transfer pricing compliance. As described above, the IRS has stated clearly that the types of documentation they are currently getting from U.S. taxpayers often is inadequate to give the IEs what they need in order to do a thorough risk assessment. In an audit memorandum issued to the Field in 2018, the LB&I Commissioner explicitly instructed the IEs not to simply accept all documentation as sufficient to avoid penalties, but to review the initial documentation for sufficiency and if it is deemed insufficient, to consider imposing penalties when there was information available at the time the documentation was prepared that could have supported a more complete analysis. [LB&I-04-0118-003, labeled ‘‘Instructions for Examiners on Transfer Pricing Issue Examination Scope—Appropriate Application of IRC §6662(e) Penalties’’]

In light of this, it is clear that the U.S. Treasury Department should consider whether the time has come to replace its outdated and inadequate rules and save companies the not inconsiderable time and effort needed to prepare the 10 principal documents. By letting companies focus on their business models as they are today, and not requiring them to continue to prepare something simply to try to avoid a penalty, Treasury could enhance the transfer pricing audit process and allow taxpayers to focus on the type of analysis needed in the 21st century business world.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Barbara Mantegani of Mantegani Tax PLLC is a transfer pricing advisor with more than 20 years of experience in both the private sector and the IRS Competent Authority office (now known as the Advance Pricing and Mutual Agreement office).