IRS Puts 150 Companies on Notice: Your Transfer Pricing is a Problem
The IRS recently announced several new initiatives as a result of funding from the Inflation Reduction Act, with a special emphasis on making sure multinationals and high-wealth individuals pay their ‘fair share’ of taxes. First item on the press release – the IRS is sending “compliance alerts” to 150 foreign-owned distribution subsidiaries that have incurred losses or generated minimal profits in recent years. The IRS is also investing additional resources in their large corporate compliance programs.
How does the IRS identify these companies as potential transfer pricing risks?
In our experience, transfer pricing risk assessments of foreign-owned distribution companies are relatively straightforward to identify from a tax authority perspective. From the IRS’ perspective, corporate tax returns from foreign-owned companies disclose ownership, volumes of intercompany transactions, and taxable income or losses. Foreign-owned distribution companies with tax net operating losses, for example, raise questions about whether the parent company is overcharging the US subsidiary company.
What if the US company results are due to poor market conditions?
Most experienced transfer pricing auditors will argue that the parent company should bear the risk of difficult business conditions or losses. In other words, the parent company is better placed and has the financial capacity to bear the risk of losses. Since transfer pricing regulations are based upon the arm’s-length principle, i.e. related companies should charge the price as if they were unrelated, a tax auditor would argue that no independent distributor would continue to sell products at a loss.
What do the letters say about the IRS strategy?
The informed compliance alert is a warning for US subsidiary companies previously overlooked given IRS resource constraints. If a company does receive a compliance alert letter, the IRS has clear concerns that the company is not fulfilling U.S. tax obligations. From the IRS’ press release:
“These foreign companies use transfer pricing rules year after year to report losses that are engineered through the improper use of these rules to avoid reporting an appropriate amount of U.S. profits.”
The IRS also disclosed that new accountants being hired in early 2024 will start audits utilizing a combination of artificial intelligence and subject matter expertise in areas such as cross-border issues and corporate planning and transactions.
Concerned about receiving a compliance letter?
From our perspective, an IRS compliance letter is actually a blessing in disguise. The IRS wants to incentivize self-correction of transfer pricing, rather than starting an audit. In our experience, making transfer pricing adjustments to increase US subsidiary profits is a better strategy than trying to explain poor operating results during an audit. Rest assured that the IRS will likely commence audits for companies that do not make transfer pricing adjustments.
We also recommend transfer pricing documentation for those companies that have not updated reports in recent years. The IRS requests transfer pricing documentation during an audit, and companies that do not have a contemporaneous report are far more likely to face scrutiny and potential penalties.
What is a ‘reasonable’ profit level from an IRS perspective?
The IRS’ expectations for subsidiary profits will vary by industry; for example, pharmaceutical distributors would be expected to earn higher margins than low-margin industries. In addition, companies with tax NOLs are clearly in the spotlight, regardless of industry.
KBKG Insight: What does this informed compliance strategy mean for the future?
The IRS is reallocating resources to transfer pricing after receiving substantial funding from the Inflation Reduction Act. While the IRS does not have all its new hires in place, these compliance letters foreshadow plans for future enforcement priorities. Encouraging companies to self-correct transfer pricing is easier than engaging in a multi-year audit.
- The IRS, backed by increased funding, is prioritizing transfer pricing compliance for foreign-owned distributors in the short-term
- We expect that the IRS will dismiss arguments of ‘poor market conditions’ as a rationale for low profit margins
- Foreign-owned subsidiaries that do not ‘self-correct’ transfer pricing and improve profit margins are likely to be selected for audit
Not sure where to turn? Schedule a call with KBKG for more practical insights.