With regard to the low-value added services, the regulations provided precise indications on the set of documents that the taxpayer shall have to prepare if the simplified approach is adopted i. The draft circular letter clarified that if the taxpayer is rendering or receiving only low value-added services, the description of such services should be included in the same local file and described in line with the indications in the regulations.
This includes a description of the services, explanation of the reasons for their inclusion in the category of low value-added services, the beneficiaries, the criteria for their pricing, the benefits expected or obtained, the allocation keys used to re-charge the aggregate costs, together with the relative underlying reasons for their selection.
Moreover, the draft circular letter clarified that the master file and local file shall have to be set even though the low-value-added service represents the sole intercompany transactions carried out by the entity.
The revenue agency has made a significant effort to clarify the timing and procedural aspects of the formalities to be complied with to obtain penalty protection, taking into account all the problems raised in the past, which the regulations were not able to clarify. The draft circular letter confirms that the master file or the attachments could be written in English or in Italian.
Any other language requires a translation into English or Italian, which needs to be provided together with the original document. They have to be signed by the legal representative of the taxpayer or by a delegated person through electronic signature and time stamp within the deadline for the filing of the corporate income tax return.
This new obligation has been introduced to ensure that transfer pricing requirements are met before the filing of the tax return, to ensure that transfer pricing documentation is contemporaneous. In the event of a tax audit, the transfer pricing documentation shall have to be provided to the tax authorities within twenty days. Additional information requested by the tax authorities during audits could be provided by the taxpayer within seven days or a longer term agreed with the taxpayer.
The availability of the transfer pricing documentation has to be communicated to the revenue agency by flagging the specific box in the tax return. While this formality existed also in the past, the circular letter provides that if no communication is done at the time of the filing of the tax return, the taxpayer may cure the mistake by filing for the first time or an amended tax return within 90 days from the initial deadline November 30 for taxpayers having fiscal years coinciding with the calendar year.
The master file and the local file shall have to be signed with electronic signature and time stamp within the date of the filing of the belated tax return. Such clarifications are very important and represent a long-awaited development, considering that, in the past, tax inspectors have generally adopted a very rigid and formalistic approach as to the application of penalties when no communication was timely performed in the tax return.
Indeed, in the absence of advanced communication in the tax return, even when the transfer pricing document was voluntarily provided in the course of a tax investigation, the relief from penalty was rarely granted.
Clarifications in the draft circular letter were provided also with respect to the possibility to amend or integrate the transfer pricing documentation if a lower taxable basis or taxes are detected by the taxpayer at a later stage with respect to the filing of the tax return. In this regard, when amendments of the taxable basis or the tax are brought in the tax return through an integrative tax return, the taxpayer would be generally entitled to amend accordingly the transfer pricing documents.
Finally, another important clarification of the draft circular letter relates to the confidentiality of the information.
For example, the number of years of analysis used in the application of the CPM could be different depending on the taxpayer's industry. In this part of the report, it may be helpful to provide information as to expectations versus reality. For example, is the industry experiencing a downturn? If so, adjustments may be needed to separate the effects of bad risk realization from the effects of intercompany pricing.
Functional analysis narratives should be robust and link facts to analysis. Sometimes taxpayers include a list of facts in their documentation with no real analysis to connect the business description to the method selection. For example, some taxpayers present a "functional analysis" checklist of who does what with very little attention to the "analysis.
The functional analysis should be well-supported factually and should not rely on broad assumptions about the business. Strengthening this analysis can benefit a taxpayer by answering questions before they are asked by the IRS. Risk analysis should be consistent with intercompany agreements. Every business faces risks. From a transfer pricing perspective, risks must be identified and then allocated between the controlled parties.
Intercompany agreements and the assignment of rights and responsibilities between the parties generally establish how risks are allocated. For example, under an intercompany agreement, a distributor may have the right to return all unsold inventory to the related supplier, thus shifting some risk to the supplier.
The transfer pricing documentation should address such allocations of risk, how the risk allocations compare to the comparable companies used, and why the resulting pricing is consistent with the agreement. If an adjustment is made to the comparable companies based on risk allocations, the quantification of the risk and method for computing the adjustment should be clearly explained.
Support for best method selection must be provided, as well as the reason for rejecting specified methods. In many cases, the best method analysis and conclusions should be more robust and more specific to a taxpayer's circumstances. Multinationals often maintain internal databases of legal agreements with unrelated parties. Documentation of a thorough method selection process should describe as clearly as possible the internal and external data requested and reviewed in the process of selecting a method.
Preparing this documentation contemporaneously should facilitate preparation of the transfer pricing report and could be helpful to a taxpayer in the future, including in its interactions with the IRS. For example, assume a taxpayer determined a royalty using a residual profit split method "RPSM" after concluding, based on a search of an external royalty database, there were no Comparable Uncontrolled Transactions CUTs available.
The taxpayer's legal department maintains a list of hundreds of internal uncontrolled agreements in which royalties are paid and that could have potentially served as internal CUTs, but the tax department and outside advisors did not request this internal information as part of their documentation analysis. In this example, the taxpayer's failure to adequately consider and address the availability of internal data would call into question whether the selection of the RPSM method was reasonable.
In addition, use of an unspecified method requires a reasoned basis for rejection of specified methods pursuant to the penalty regulations. However, frequently taxpayers fail to provide a reasoned basis for rejection of the specified methods when an unspecified method is selected. There may be very good reasons to reject specified methods.
Those reasons must be provided in order to satisfy the requirements of Treas. Analysis should be provided to support the PLI conclusion. Conclusive statements such as "We selected the Operating Margin as the PLI in the application of the CPM, because distributors typically measure their profits as a function of sales" are not helpful.
The examiner's evaluation of the taxpayer's pricing may very well depend on the choice of PLI, which should therefore be substantively supported as thoroughly as possible. Complete comparability analysis should be provided.
Taxpayers often fail to thoroughly address the comparability criteria enumerated in the regulations. For example, in cases where taxpayers use the CUT method, they often do not thoroughly address profit potential.
While profit potential may be a difficult criterion to analyze in some cases, it may not be ignored. Even if a numeric analysis of profit potential may not be possible, strong indications the profit potential of controlled and uncontrolled transactions is similar e. While different methods impose different comparability requirements, differences between the controlled transaction or party and the uncontrolled transactions or parties should always be addressed.
For example, if the purportedly comparable companies distribute different products from a different industry, an explanation should be provided to support the appropriateness of the comparability conclusion. The impact of differences in risks or functions between the tested party and the comparable companies should be provided.
One of the purposes of performing a risk analysis is to ensure the risks borne by the tested party are comparable to those borne by comparable companies. For example, in a CPM analysis, if the risk analysis establishes the tested party does not bear inventory risk and the selected comparable companies do bear that risk, the report should either demonstrate the effect of the difference in risk is inconsequential or perform an adjustment that would increase the reliability of the CPM analysis, if possible.
The same logic applies to differences in functions. Detailed well-reasoned support for proposed adjustments to the application of a specified method should be provided. Adjustments should be made for differences in comparability factors, characteristics that would likely have an impact on prices in uncontrolled transactions.
Those adjustments, including the reasons for the adjustments, should be explained in the report. For example, if the tested party's operating expenses to sales ratio is higher than that of the comparable companies, an adjustment might be appropriate for the differences in operating expenses.
In this case, a taxpayer might show first the larger expenses of the tested party would be remunerated in the marketplace. What are these excess expenses? Are they related to additional services provided to customers or inefficiencies? This is likely to be through a declaration in the corporate tax return or in some prescribed format prescribed by the Commissioner General.
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