Under the Inflation Reduction Act (IRA), signed into law in August 2022, the IRS received an $80 billion appropriation. The tax agency is expected to dedicate more than half of that amount to compliance enforcement — which may very well include increased scrutiny of multinational companies’ transfer-pricing activities.
Since the initial funding proposal was first made publicly available, and following the IRA’s enactment, much attention has been paid to how the IRS would seek to raise collection revenues now that it’s equipped with long-sought-after additional financial resources. Senior leadership within the U.S. Department of the Treasury, as well as some Democratic legislators, have maintained that the IRS won’t use the funds to target families and businesses making less than $400,000 a year.
Instead, to curb tax avoidance and crack down on abusive practices, the new enforcement agents and technological investments will likely focus on large international corporations. Logically, one could conclude that this will likely include investigations into transfer pricing, as the IRS looks more closely for instances of companies unlawfully shifting profits to divisions in lower-tax jurisdictions to reduce their overall tax liability.
In addition, the IRS is reportedly trying to bolster the capabilities of its Large Business and International (LB&I) Division by bringing on new hires to develop data analysis models that use artificial intelligence. Such technology will likely become more sophisticated over time, with models increasingly able to make accurate predictions based on larger pools of historical data.
A Lengthy, Challenging Process
With potentially hundreds of billions of dollars at stake, transfer-pricing audits are particularly thorough and can take years to complete. One notable challenge for examiners is transactions involving intellectual property, such as software or pharmaceutical patents. Assessing these transactions is far more difficult than, say, finding market data on comparable transactions involving tangible property — for example, accessing real estate websites to appraise a home’s value based on what properties in the same neighborhood have sold for.
During a transfer-pricing audit, the IRS examines whether taxpayers are operating in accordance with arm’s length or market rate principles. Section 482 of the Internal Revenue Code authorizes the tax agency to make adjustments to income and deduction allocations among taxpayers. Per the IRS website, Sec. 482 generally provides that prices charged by one affiliate to another in an intercompany transaction where goods, services or intangibles are transferred should “yield results that are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances.”
Various penalties may be assessed because of a transfer-pricing adjustment. These include a net adjustment penalty.
Multiple Audit Stages
In 2018, the LB&I division sent instructions to staff on the scope of transfer-pricing examinations and how to appropriately assess penalties. Then, on September 8, 2020, the IRS updated its transfer-pricing examination process guide. The guide covers how audits are conducted and suggests best practices for agents handling transfer-pricing cases.
According to the guide, audits begin with a planning phase during which an “issue team” is assigned. Such teams can comprise senior or lower-level revenue agents, economists, and tax law specialists who coordinate and collaborate with other managers and advisors. The planning phase proceeds with an initial risk assessment, which looks at the taxpayer’s income tax return, country-by-country report and overall operations.
A preliminary working hypothesis is formed to steer the direction of the audit, which then continues into the execution phase. After analyzing previous-year documentation, the team determines whether documentation requirements were met. Next, according to the guide, the auditors consider “whether the documentation reasonably and accurately addresses the controlled transactions and whether the conclusions reached can be considered reasonable.”
The third phase of a transfer-pricing audit is resolution, during which the parties seek to reach an agreement on the tax treatment of each examined issue. A taxpayer may be issued a revenue agent report, if deemed necessary. Immediately after a case is closed, the issue team begins preparing its pre-presentation for the Office of Appeals in the event any adjustments and assessed interest or penalties are contested in a court of law.
Indeed, transfer-pricing litigation could very well increase right alongside audits. Litigating such cases can be as lengthy and resource-consuming as the audits themselves. The intensive legal process can involve dozens of experts and substantial documentation.
As the likelihood of incurring a transfer-pricing audit increases, what can multinational companies do? Take a proactive approach to compliance. Review all your processes related to tax-management and reporting, and be sure you can produce the necessary documentation in the event the IRS comes calling. Elliott Davis’ transfer pricing specialists can assist you.
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The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.