New IRS Enforcement Initiative Targeting Inbound Distributors’ Transfer Pricing

At a glance

• The main takeaway: As of October 2023, the IRS is enforcing a new compliance review campaign as a result of the Inflation Reduction Act funding that targets inbound distributors of large multinational groups that have booked losses or low profitability during the period of 2017 to 2021.
• The implications for your business: Foreign-owned U.S. companies can expect additional scrutiny by the IRS going forward when reviewing tax returns, especially those with consistently reported losses or low margins. The IRS has sent letters to over 150 taxpayers thus far, implying that these taxpayers need to reexamine their transfer pricing practices, and are subject to increased scrutiny.
• Next steps: Aprio’s Transfer Pricing specialists can help your company identify potential transfer pricing risks and determine ways to improve documentation around your company’s transfer pricing policies, processes, and procedures to reduce the risk of penalties and audit.

Background:

The IRS has become increasingly concerned that foreign-owned companies are not accurately reporting their taxable income according to U.S. transfer pricing regulations under Section 482 of the Internal Revenue Code. In doing so, companies can shift profits to jurisdictions outside the U.S., potentially taking advantage of lower tax rates or other tax attributes.

Existing legislation requires U.S. companies with intercompany transactions to comply with Section 482 by preparing supporting economic analysis and transfer pricing documentation. Companies must be able to show their intercompany transactions are according to the “arm’s length standard,” the fundamental principle in transfer pricing in which related party (“controlled”) transactions should be conducted as if they occurred between independent (“uncontrolled”) third parties. The arm’s length standard ensures intercompany transactions accurately reflect market conditions and enables the IRS to determine whether the taxable income for each entity is appropriately reported.

Transfer pricing does represent one of the best international tax planning tools for multinational groups, however, the proper economic analysis and documentation must be in place to support any appropriate planning strategies.

Transfer pricing applies to all cross-border intercompany transactions reported on the U.S. tax return, as reported in Forms 5471, 5472, 8858, and 8865. Common intercompany transactions requiring transfer pricing analysis may include:

• Royalties for the use of intangibles, such as trademarks or patents;
• Purchase or sale of tangible goods;
• Provision or receipt of services; and
• related party loans.

The full story:

On October 20, 2023, the IRS announced a new transfer pricing initiative to target large foreign-owned companies. This initiative introduces additional scrutiny to U.S. inbound distributors, particularly those with low profitability or losses. We have found companies that perform additional functions in the U.S., such as manufacturing or services, have also been receiving IRS letters.

So far, non-compliance alert letters have been issued to about 150 subsidiaries of large foreign companies urging them to review their transfer pricing policies and tax reporting for compliance, or in some cases, the IRS is asking taxpayers to respond to the letters with further explanations for past tax return results.

Taxpayers that receive a Form 6608 letter are requested to re-evaluate their past transfer pricing policies, intercompany agreements, financial results, and Form 1120 for compliance with Section 482, and recommend amending past returns if they are found to be noncompliant. Although no response is required to a Form 6608 letter, the taxpayer is notified the tax returns going forward will be scrutinized and could still result in a future IRS examination.

Taxpayers that receive a Form 6607 letter are required to provide a response and expected due date for submitting documentation that describes the company’s transfer pricing policies, and extensive supporting evidence for the financial results reported on past tax returns.

While receiving a notice does not indicate a formal IRS audit is inevitable, it does indicate that tax filings going forward will be more heavily scrutinized, and the probability of an IRS examination is higher, especially if low profitability continues.

Per Section 6662 of the IRC, companies that fail to prepare transfer pricing documentation contemporaneous with the annual tax return filings may incur penalties up to 40% of the unpaid tax resulting from an IRS adjustment.

The bottom line

While the initiative is dedicated to targeting inbound distributors, the IRS is actively expanding the scope of its campaign to examine all types of controlled transactions.

Taxpayers should review their transfer pricing documentation and intercompany policies to ensure they are appropriately prepared in the case that an IRS examination notice is received. Reach out to the Aprio Transfer Pricing team to take advantage of our expertise and dedication to risk and compliance management to reduce your company’s risk of audit and penalties.

Related Resources/Assets/Aprio.com articles/pages

Transfer Pricing and Customs Valuations: Finding Peace in a Trade War

Are you Overpaying on Duties for Imported Goods?