Last year, the IRS announced increased enforcement of international tax issues, including transfer pricing of foreign-owned U.S. subsidiaries under IRC Section 482. While transfer pricing audits of inbound distributors are not new, increased funding from the Inflation Reduction Act and changes in policy could mean more adjustments and penalties under IRC Section 6662(e).
Background
In 2017, the IRS Large Business and International Division launched the first of its compliance campaigns, including one focused on inbound distributors’ transfer pricing. As part of this campaign, the IRS developed a comprehensive training strategy for auditing transfer pricing.
Taxpayers are required to submit transfer pricing documentation to demonstrate compliance with IRC Section 482 and to avoid penalties under IRC Section 6662(e). Taxpayers have a strong incentive to initiate a self-correction to avoid the penalties and a potentially lengthy and exhausting transfer pricing examination.
In October 2023, the IRS announced that it would send compliance letters to foreign companies that report losses or low margins with respect to U.S. activities to remind them of their U.S. tax obligations under IRC Section 482 and encourage self-correction.
The IRS has said that as of mid-November it sent more than 180 letters to filers of Form 1120, “U.S. Corporation Income Tax Return,” and Form 5472, “Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business,” composed primarily of U.S. distributors that reported losses or low margins during fiscal years 2017-2021. According to the IRS, reduced profit margin recorded by the U.S. taxpayer is indicative of potential transfer pricing noncompliance.
IRS compliance letters
The IRS has sent two different letters to taxpayers under its latest inbound distributor transfer pricing compliance initiative. Letter 6607 requires taxpayers to respond to the IRS inquiry within a certain time frame and includes the following response options:
- Affirm that all returns are compliant with the transfer pricing rules, along with corresponding documents to support compliance
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State that returns are not compliant with the transfer pricing rules and are being amended
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Request additional time to respond
Letter 6607 states that a failure to respond will result in an examination. If any of the returns addressed by the letter are under examination, the letter instructs the taxpayer to notify the agent of receipt of the letter.
To evaluate how to respond to Letter 6607, taxpayers should review their transfer pricing economic analysis and revisit previously prepared transfer pricing documentation. To the extent necessary, taxpayers also might consider whether to restructure their operations.
The second letter, Letter 6608, is a so-called soft letter and does not require a response. The letter advises taxpayers to review their transfer pricing documentation and determine if amended returns or other actions are required to come into compliance. It also states that the IRS will continue monitoring the taxpayers’ returns and could initiate a transfer pricing examination if a trend of losses or low margins continues.
Crowe observation
Both letters state that they are not an examination. However, in the case of Letter 6607 that requires taxpayers to provide information to the IRS, taxpayers should work with their tax adviser to understand the effect of their response.
If taxpayers amend a tax return after receiving one of the letters and determine there is double taxation, they should consider whether they are eligible to file a mutual agreement procedure request under Revenue Procedure 2015-40.
Looking ahead
Transfer pricing continues to be a focus of U.S. and global taxing authorities. The IRS compliance initiative regarding inbound distributors provides a reminder that the IRS sees transfer pricing as an area deserving of heightened enforcement now that it has more resources. While the IRS’ current focus under this initiative is on inbound distributors, it likely is a preview of other transfer pricing initiatives to come. To be prepared, taxpayers should work with their tax advisers to review their transfer pricing documentation and evaluate whether changes are needed to comply with U.S. and global tax laws regarding transfer pricing.
