U.S. inbound distributors that have reported losses or low profits in the U.S. in recent years may soon receive – or may already have received — a letter from the IRS reminding them of their U.S. transfer pricing compliance obligations.
The IRS announced on October 20, 2023, that it would increase its compliance efforts to ensure that U.S. subsidiaries of non-U.S.-owned multinational enterprises (MNEs) that distribute goods in the U.S. “pay their fair share of taxes on the profits they earn from their U.S. activities.”
According to the IRS announcement, “these foreign companies report 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 counter this practice, the IRS said it would send “compliance alerts” to approximately 150 subsidiaries of large foreign corporations “to reiterate their U.S. tax obligations and incentivize self-correction.”
Compliance Alerts
Some U.S. distributors have already received letters from the IRS, which generally state that because the company has reported losses or low margins for certain years between 2017 and 2021, “the pricing of your intercompany transactions may not comply with Internal Revenue Code (IRC) Section 482 and the Treasury regulations thereunder.”
The letter instructs the taxpayer that if it believes it has fully complied with Section 482 and the regulations, then it does not need to take further action. However, if the taxpayer believes it has not fully complied, it should file amended tax returns to increase its U.S. taxable income for the year(s) in question. The letter notes that mutual agreement procedures may be available to address possible double tax arising from an increase in U.S. income through an amended return.
The letter notes that it is not an audit, and that the taxpayer is not required to respond. However, the IRS will monitor the recipient’s tax returns and “[c]ontinued reporting of losses or low margins in subsequent tax years may result in a referral for a transfer pricing examination.” Finally, the letter recommends that the recipient “should review and, if necessary, update your transfer pricing policy, intercompany agreements, and your documentation requirements” under U.S. rules to ensure that “intercompany transaction prices and consequent financial results are consistent with the requirements of IRC Section 482 and the applicable regulations for future tax years.” This reference to documentation suggests that the IRS may consider accuracy-related penalties in addition to any transfer pricing adjustments for any taxpayers that do not have documentation in place to support their transfer pricing policies and results.
Insight
The IRS’s announcement of this new initiative brings into sharp relief the agency’s increased focus on transfer pricing.
U.S. inbound distributors that have received an IRS letter need to carefully consider how to respond. In particular, if a company decides not to respond to the IRS letter by amending a tax return, the company should ensure that its transfer pricing meets U.S. transfer pricing and documentation requirements.
Our experience has been that it is not just U.S. subsidiaries of large MNEs that are receiving the IRS compliance letters; some U.S. subsidiaries of smaller MNEs also have received them.
Large or small, and whether or not they have received an IRS letter, U.S. subsidiaries of foreign-owned MNEs that distribute goods in the U.S. should review their transfer pricing policies, implementation, and documentation. Non-compliant transfer pricing policies, policies that have not been implemented correctly, and inadequate transfer pricing documentation may put companies at higher risk of audit, transfer pricing adjustments, and understatement penalties.
Any companies that fall within the description of the entities subject to this initiative – U.S. subsidiaries of foreign-owned corporations that distribute goods in the U.S. and consistently incur losses or very low margins – should review their transfer pricing documentation to identify gaps or shortcomings. Inadequate transfer pricing documentation will put those companies at higher risk of audit, transfer pricing adjustments, and penalties.