The landscape of transfer pricing in the United States is subject to continuing change. The IRS is close to promulgating permanent aggregation regulations to replace temporary regulations due to expire. These anticipated new regulations may make it easier for the IRS to disregard complex transfer pricing structures and, further, reflect the US taxing authority's continued focus on transfer pricing issues. Court decisions affect the transfer landscape as well. For example, the United States recently prevailed on an appeal of the Altera decision in the Ninth Circuit Court of Appeals, a leading appellate court in the United States. The taxpayer is now seeking full court review of that decision. The final decision in that case not only may affect companies that have entered into cost sharing agreements, but also may further empower tax authorities worldwide to define by regulation or administrative decision what they conceive to be arm's length behavior.

One development in the United States, however, merits extended comment. Several years ago, the IRS announced, without significant fanfare, new audit guidelines for transfer pricing audits. We have now had sufficient time to see those guidelines (announced in IRS Publication 5125) actually be put into practice by IRS examiners across the country and we can say, indeed, the landscape is changing. With these new guidelines, the IRS has sharpened its tools and is using them to identify and develop transfer pricing issues and thereby collect revenue from perceived taxpayer abuse.

These guidelines are called the Transfer Pricing Examination Process. They describe audit procedures in detail for all potential transfer pricing issues. They establish three phases for transfer pricing audits: the planning phase, the execution phase and the resolution phase. The detailed focus and measures in each of these phases needs to be well understood by any company subject to a transfer pricing audit – if it wants to forestall an adjustment or, at the very least, present its best defense possible.

In the planning phase, IRS auditors are charged under the guidelines with gathering information, analysing the taxpayer's position, and preparing a ratio analysis of various financial metrics to help it determine whether cross border income shifting is occurring. As a theoretical matter, much of this procedure is not new. However, as a practical matter, the planning phase of the IRS has, we have found, intensified and sharpened. For example, in actual audits examination teams are increasingly rigorous in their initial collection of materials that the guidelines suggest assembling, such as prior IRS workpapers, the taxpayer's § 6662 documentation, board of directors' minutes, SEC filings, and the like. The guidelines explicitly direct auditors to analyse country-by-country reports and to coordinate with other tax authorities under information exchange programmes. The latter two sources of information are, of course, relatively new and, we find, are being pursued by the IRS with vigour.

The planning phase directives charge the IRS audit team to develop a "preliminary working hypothesis". In the course of collecting and reviewing material documents, but before the execution phase of the examination itself, IRS auditors will identify the transactions or structures that it will subject to scrutiny and then will actually internally define the case it will be trying to establish. With this clear instruction to its auditors, the IRS has now thrown down the gauntlet to taxpayers. Expect the IRS to have developed its own duelling theory of why an adjustment is appropriate before the substantive part of the audit even begins.

The IRS now has a number of developed internal instructions for tax issues, including transfer pricing issues, called Practice Units, which are maintained in a database, are readily available to IRS examiners and are also accessible to taxpayers. Expect that the IRS audit team will have developed its charging theories using its increasingly substantial Practice Unit library.

The execution phase of a transfer pricing examination follows the IRS's opening conference with the taxpayer. During the execution phase, examiners are directed to further review company agreements, and use Information Document Requests (IDRs) to gather information from the taxpayer and to develop a functional analysis. The IRS now has specific IDRs (both mandatory and discretionary) tailored for transfer pricing issues. With the guidelines, we are seeing much more uniform use of standardised IDRs seeking written responses – and more systematic information collection than ever before. Expect that the IRS audit team will issue extensive information requests for documents and will adhere to its required IDR time frames, which have been in place for several years. Though not explicitly spelled out in the guidelines, also expect the examination team as part of the IDR process to conduct witness interviews, a tool that the IRS widely uses to develop transfer pricing issues.

The guidelines provide that during the execution phase, the taxpayer will be expected to provide a "transfer pricing/supply chain orientation". This orientation is typically an extensive presentation by the taxpayer to provide background on its industry, to explain its transfer pricing structure and to provide detailed transaction information. It is an opportunity for the taxpayer to educate the auditors and support its position. Bearing in mind that the examiners will already have formed their "hypothesis", this meeting will provide an opportunity to the examination team to accelerate its information collection, ask unbounded questions and sharpen its theories. In actual practice, this "industry presentation" has become very important. It often requires extensive preparation and should be planned for very early by taxpayers.

We have found that examiners trained in the new procedures are more often than in the past adhering to instructions to confer with the taxpayer. The new guidelines contain explicit instructions that periodic meetings should be held. Further, the guidelines state that the examiners should "consider" an open discussion with the taxpayer concerning their "working hypothesis(es)". The procedures also encourage auditors to "engage in a meaningful discussion about any missing facts or any misinterpreted facts". Other provisions encourage "open and continuous communication between the taxpayer and the issue team". These various provisions of the guidelines are very important for taxpayers, who are well served to persistently inquire about the IRS's theories and preliminary findings so that they can address them head on, as early as possible during an audit.

The IRS is directed under its guidelines to prepare a draft economic report and to discuss that report, even if not complete, with the taxpayer. The template for this draft report instructs the IRS to develop a specific critique of the taxpayer's methodology and analysis. However, under recent guidance by the Large Business and International (LB&I) division, this economic analysis will more likely accept the taxpayer's transfer pricing method, rather than propose an adjustment with a different transfer pricing method. If the auditors want to change the taxpayer's method they must develop and articulate a compelling case to do so and are now required to secure various approvals from IRS senior management to pursue an adjustment based on an alternative method. Consequently, the taxpayer can and should press IRS auditors to reveal their economic thinking – including their critique of the taxpayer's analysis – without material concern that doing so will push the auditors to an alternative transfer pricing method.

The guidelines direct the IRS to develop its Notice of Proposed Adjustment, along with its economic analysis, all founded on the IRS's functional analysis of the taxpayer. Since the functional analysis is supposed to be the backbone of the examination team's position, these guideline provisions further elevate the importance of the taxpayer fully and accurately developing a description of its various related parties' functions in its Section 6662 documentation, as well as during the audit process itself. We find that the transfer pricing examiners are now routinely and uniformly issuing final IDRs to secure acknowledgement of all relevant facts supporting the IRS's functional analysis, as is directed by the guidelines.

In acknowledging the facts for the IRS, taxpayers now must be extremely careful to make sure that all material facts supporting their position are well supported and developed during the audit phase. Toward the conclusion of the audit, taxpayers will be asked for an "agreed statement of facts", and can be effectively foreclosed from presenting new facts later (during administrative proceedings with the IRS Appeals group, for example) if an adjustment is not resolved at the examination stage.

The guidelines suggest that groups within the IRS coordinate regarding transfer pricing issues generally and on specific adjustments. We also are finding that there is, in fact, increased coordination concerning transfer pricing adjustments among and between groups such as the IRS audit team, legal counsel and the IRS personnel who generate Practice Units.

The last phase in the guidelines is called the "resolution" phase, but the term resolution is not meant to imply that the audit team itself will try to resolve the case with the taxpayer. There is no directive for it to do so. In fact, the guidelines contemplate the scenario that "field resolution [will not be] reached". The guidelines provide examiners clear instructions for closing the case – with an adjustment – and contemplate the taxpayer's potential steps to resist an adjustment, such as engaging in the Appeals process or making a Competent Authority request, all of which are considered by the guidelines to be paths to "resolution".

The guidelines provide examples of 24- and 36-month examinations. As a practical matter, notwithstanding the precise steps enunciated in the guidelines, we have found that transfer pricing audits are not shorter than in the past. Accordingly, the taxpayer (and its senior management) need to be apprised that the commencement of a transfer pricing audit is likely to trigger a long and involved process, that the IRS likely will develop its theories early and more vigorously than ever before, and that when transfer pricing transactions involving large amounts of money or significant complexity are subject to scrutiny, adjustments are common.