IRS Launches Transfer Pricing Initiative to Review Intercompany Transactions of Multinational Groups
By Ralf Ruedenburg, Tax Partner and Leo Parmegiani, Tax Partner
The Internal Revenue Service (IRS) has launched an initiative to identify taxpayers that may not be compliant with U.S. transfer pricing rules [§482 of the Internal Revenue Code (IRC) and regulations thereunder]. Highlights include:
- Taxpayers that receive a notice from the IRS must declare under penalties of perjury whether they comply with U.S. transfer pricing rules. A non-response will likely increase the risk of a formal audit. If a taxpayer states that they comply with U.S. transfer pricing rules, supporting documentation must be submitted with their IRS notice response.
- The IRS stated target is mainly “large foreign-owned U.S. corporations,” but it is sending out notices to taxpayers that do not match this profile.
- U.S. taxpayers that file Forms 5472, 5471, 8858 and 8865 should review their transfer pricing policies, processes and procedures and consult with their tax advisor regarding this compliance review campaign.
- Although the U.S. transfer pricing rules do not require the submission of transfer pricing documentation with a tax return, it still needs to be in place by the time a tax return is filed.
- The required documentation is necessary to reduce or eliminate penalties in the case of adjustments during a tax audit.
- Transfer pricing documentation under Organization for Economic Co-operation and Development (OECD) rules including a U.S. affiliate’s local file may not be accepted for U.S. transfer pricing purposes and, thus, would not prevent the IRS from imposing severe penalties in case of adjustments.
U.S. transfer pricing rules (IRC §482 and regulations thereunder) allow the IRS to make adjustments to the income, deductions, credits, or allowances if transactions between related parties (controlled transactions) do not meet the arm’s length standard. Generally, a controlled transaction meets the arm’s length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (arm’s length result). The IRS stated purpose of a transfer pricing adjustment is to clearly reflect taxable income and prevent the evasion of U.S. tax. Penalties can be up to 40% of the unpaid tax under certain circumstances.
The IRS has now begun to act on a new enforcement initiative that was announced on October 20, 2023. Although the initiative is called “large foreign-owned corporations transfer pricing initiative,” it appears that the IRS is also reaching out to taxpayers that do not match this profile. Thus, taxpayers with international related party transactions with sustained low profitability or losses have a higher risk of being selected by the IRS.
The IRS has begun to identify taxpayers based on information provided with tax returns and is sending notices to taxpayers about the fact that they have reported losses or low margins on their past-year tax returns and that they may not be in compliance with U.S. transfer pricing rules. The taxpayers are advised to review their transfer pricing policies and to amend past years’ returns, if needed.
In their communication, the IRS is expecting a response from taxpayers under penalties of perjury stating whether they have complied with U.S. transfer pricing rules in the past or whether they are amending tax returns. If the taxpayer confirms compliance with U.S. transfer pricing rules, a description of the transfer pricing policy and supporting documentation must be submitted with the response.
What happens if the taxpayer does not respond? It is likely that a non-response will increase the risk of being selected by the IRS for a formal audit.
Although it seems the IRS is mainly targeting inbound distributors, it is likely that other entities in a group’s supply chain will be looked at in the future and all types of controlled transactions between related parties may be reviewed to determine whether they are in compliance with the arm’s length standard. Controlled intercompany transactions may include the intercompany use of intangibles (trademarks or patents); sale of tangibles; intercompany services; and related party loans. It specifically includes management fee charges paid by a U.S. subsidiary for services provided by another entity in the controlled group such as payroll or IT services. Another example is license fees or royalties payable for the use of related party trademarks or patents.
One of the more common scenarios that is now under investigation is as follows: A foreign business has incorporated a U.S. subsidiary to distribute tangible products to customers. The U.S. subsidiary is buying these products from the parent company or any other entity in a controlled group and is selling the products to customers in the U.S. or abroad. In this scenario, the foreign related party’s selling price for the products it sells to the U.S. subsidiary has to satisfy the arm’s length standard. A purchase price that does not meet the arm’s length standard may lead to low profitability or even losses for the so-called inbound U.S. distributor. This is a ripe area for IRS scrutiny.
Who’s at Risk?
Taxpayers submitting the following forms with their tax returns are at risk of being selected by the IRS as these forms include information about related party transactions:
- Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations
- Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business
- Form 8858, Information Return of U.S. Persons with Respect to Foreign Disregarded Entities and Foreign Branches
- Form 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships
It should be noted that not only foreign-owned companies may be selected by the IRS but also U.S. entities that own foreign businesses.
Why Haven’t Taxpayers Completed Their Transfer Pricing Documentation in the Past?
In the past, many U.S. taxpayers subject to the transfer pricing rules did not prepare transfer pricing documentation for several reasons. Some reasons include:
- Transfer pricing documentation must be prepared on a group level in accordance with OECD guidelines including a master file and local files. Local files typically include a U.S. local file reporting much of the same information and analysis the IRS requires. However, although U.S. transfer pricing rules are similar to OECD rules, they are not the same and U.S. taxpayers falsely believe they have complied with their transfer pricing obligations. However, the IRS might reject the master and local file in case of an examination and would request transfer pricing documentation required under U.S. rules. Since the U.S. documentation would not be in existence by the time a tax return was submitted, the companies would not be protected against penalties in case of an adjustment.
- The IRS has not, prior to this initiative, pro-actively sought after taxpayers who are not in compliance with transfer pricing rules.
- The untrue perception that there is sufficient time to perform a full transfer study if the issue is raised in an IRS examination.
- Taxpayers have mistakenly believed that the cost of a transfer pricing study far outweighs the benefits of the penalty avoided. This misconception could not be further from the truth since the potential penalty is 40 percent of the increased tax resulting from an IRS adjustment.
PKF O’Connor Davies Recommendation
Taxpayers that are subject to the U.S. transfer pricing rules should review their intercompany transaction policies and consult with their tax advisor. It should be noted that in addition to the IRS looking at transfer pricing activities at a federal level, this is also an issue on a state level in the U.S. We refer to our publication from July 6, 2022.
PKF O’Connor Davies is following all developments in this transfer pricing initiative and will report on IRS activities in the future. Our international tax group can assist in responding to IRS notices and provide taxpayers with the following transfer pricing-related services.
- Analysis of existing transfer pricing documentation/policies
- Preparation of benchmarking studies
- Preparation of annual transfer pricing documentation that is in compliance with U.S. transfer pricing rules and regulations.
As always, if you need any assistance, please reach out to your PKF O’Connor Davies client service team or:
Leo Parmegiani, CPA
Ralf Ruedenburg, CPA