IRS enforcement focused on transfer pricing

The IRS is using its new Inflation Reduction Act of 2022 funding to increase audits of large corporations and partnerships and high net worth individuals. As part of these efforts, the IRS is building on recent developments in transfer pricing to increase scrutiny of cross-border transactions.

Recent developments in U.S. transfer pricing enforcement

In February 2020, the IRS issued transfer pricing documentation frequently asked questions (FAQ) to provide additional guidance on requirements for transfer pricing documentation, penalty rules, and best practices.

Crowe observation

While not authoritative guidance, the FAQ provides taxpayers with an idea of what the IRS will look at when it audits a taxpayer’s transfer pricing methodology and documentation.

In 2022, the IRS indicated that it would increase use of the economic substance doctrine under IRC Section 7701(o) to challenge transfer pricing. Removal of IRS executive-level preapproval makes it easier for revenue agents to raise the economic substance doctrine in transfer pricing cases.

The IRS also said that it would be asserting the IRC Section 6662(e) accuracy-related penalty more frequently on transfer pricing adjustments. IRC Section 6662(e) imposes a 20% penalty on any underpayment attributable to a substantial valuation misstatement that is attributable to an adjustment that does not meet certain arm’s-length standards under IRC Section 482. The penalty increases to 40% in the case of a gross valuation misstatement.

Crowe observation

Asserting a penalty is a departure from prior practice in which IRC Section 6662(e) seldom was applied in a transfer pricing audit.

More recently, the IRS announced that some foreign companies are reporting losses or exceedingly low margins year after year through the improper use of transfer pricing to avoid reporting an appropriate amount of U.S. profits. To address this issue, the IRS will mail compliance letters to approximately 150 subsidiaries of large foreign corporations to remind them of their U.S. tax obligations and to encourage self-correction.

Preparing for IRS transfer pricing audits

To be better prepared for an IRS transfer pricing audit, taxpayers should:

• Review transfer pricing policies and business operations for compliance with U.S. and applicable foreign transfer pricing requirements.
• Implement procedures to continually monitor intercompany pricing to comply with arm’s-length standards.
• Maintain transfer pricing support and documentation that is compliant with IRC Sections 482 and 6662(e) and have it readily accessible to respond to IRS document requests if selected for audit. Under current guidance, transfer pricing documentation must be delivered to the IRS within 30 days of the request.
• Verify that group-level documentation prepared by foreign affiliates is consistent with U.S. documentation and accurately reflects U.S business operations and related-party transactions.
• Be prepared to provide a reasonable explanation and nontax business reasons to support cross-border losses (such as the loss of a key supplier or supply chain disruption).
• Evaluate compliance with the latest transfer pricing guidance and developments to understand how the IRS will view the taxpayer’s transfer pricing methodology and documentation.
• Taxpayers without transfer pricing documentation, or that have transfer pricing documentation that does not satisfy the requirements under IRC Section 6662(e), should take steps to come into compliance.

Looking ahead

The transfer pricing landscape in the U.S. is changing. In addition, increased funding allows the IRS to invest in people and technology to increase audit activity around large businesses, including transfer pricing. Together, transfer pricing developments over the past few years and the IRS’ latest enforcement focus on transfer pricing of inbound companies mean that a high likelihood exists that transfer pricing arrangements will come under scrutiny if the company is selected for audit. Taxpayers should consult their tax advisers to be prepared for increased IRS audits of transfer pricing.