In recent years, transfer pricing audits have become more common in the United States, with the Internal Revenue Service (IRS) taking a closer look at how companies are setting prices for transactions between related entities. The passage of the Inflation Reduction Act (PL 117 169) has further increased the IRS's ability to conduct these audits, making it more important than ever for companies to be prepared.
This article will discuss the rising trend of transfer pricing audits in the US and key considerations for companies at year-end.
As part of a transfer pricing audit, the IRS examines whether the cross-border transactions between the taxpayers and their affiliates are in accordance with the arm's-length principles as outlined in Internal Revenue Code (IRC) Sec. 482. The IRC Sec. 482 authorizes the IRS to adjust the income, deductions, credits, or allowances of the taxpayers to prevent evasion of taxes or to clearly reflect their income. Sec. 482 generally stipulates that the prices charged by one affiliate to another in an intercompany transaction where goods, services, or intangibles are transferred should be consistent with the outcomes that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same conditions.
The recent passage of the Inflation Reduction Act (PL 117-169) allocated additional funding of $80 billion to the Internal Revenue Services (IRS) for enforcement, operations support, business system modernization, and taxpayer services. With this increased funding, the IRS will likely increase the scrutiny of multinational companies' transfer pricing activities to curb tax avoidance and crack down on abusive practices among multinational corporations.
The IRS’s Transfer Pricing Risk Assessment (TPRA) team applies data analytic techniques to efficiently identify potential transfer pricing issues for suitability considerations, which acts a key to guiding case selection for an audit. To further enhance its capabilities, the IRS is introducing artificial intelligence-based models, which are capable of making accurate predictions based on a larger pool of historical data.
In its 2022-2023 Priority Guidance Plan, the IRS and Treasury has listed several regulatory projects under Sec. 482. This indicates that for the next several years, the IRS’s main focus will continue to be transfer pricing audits.
It is expected that transfer pricing litigation will increase along with audits, and that litigating such cases can be as time-consuming and resource intensive as audits themselves. Hence, the taxpayers need to be proactive in maintaining contemporaneous transfer pricing documentation to defend their inter-company pricing positions during the intensive legal process.
Unlike other jurisdictions, the United States does not have a magnitude threshold for triggering transfer pricing compliance. Thus, all businesses engaged in cross-border activities need to prepare themselves for scrutiny.
Key Transfer Pricing Considerations for Year-End
As the end of 2021 approaches, the taxpayers typically start considering the challenges associated with closing the books of accounts. One of the most prevalent challenges of this kind is the year-end transfer pricing adjustment. The situation could arise where the taxpayers with related party transactions' actual year-end results don't match with the required/predetermined margins. In such situation, the taxpayers want to ensure that their actual financial result match with the inter-company agreement and arm’s length standards.
Normally, credit/debit notes would be issued in order to reflect the year-end adjustment in the financial accounts. In this situation, the price of the items sold, or the cost of the services performed is appropriately adjusted by both parties to the transaction.In case of an import of goods, a year-end adjustment may result into change in the value of goods for customs purposes, and subsequently an increase or decrease in the customs duties. The following table summarizes some of the key year-end considerations taxpayers should consider before they close their books of account:
1 Review the intercompany transactions and conduct benchmarking analysis
2 Analyze year-to-date (YTD) results of the tested parties
3 Identify potential adjustments (true-up, true-down, transfer pricing adjustment) to transfer pricing policies/inter-company arrangements, if any
4 Assess the implications of the transfer pricing adjustments on various tax and regulatory aspects
5 Update intercompany agreements to reflect the revised position
While the year-end adjustment is widely used tool to adjustment the inter-company pricing, the taxpayers should carefully examine the extent of which adjustments are made in their annual financial statements and avoid using this tool carelessly. In any case, it is a good idea to clearly document the reason for the year-end adjustment.
Penalties of 20% and 40% for substantial misstatement
IRC Sec. 6662(e) and §6662(h) impose 20% and 40% non-deductible penalties for transfer pricing valuation misstatements which produce an increase in U.S. income tax.
A penalty is imposed on any underpayment attributable to a substantial
valuation misstatement in connection with either a Section 482 transaction (the
transactional penalty) or a new Section 482 transfer price adjustment (the net
adjustment penalty). An underpayment of tax caused by a substantial valuation
misstatement is subject to a 20% penalty. A gross valuation misstatement under
Section 6662(h) will result in a penalty equal to 40% of the underpayment.
In light of the IRS's renewed focus on Sec 6662 penalties, it is time for taxpayers to revisit the status of their transfer pricing documentation, especially given the IRS's public pronouncements. In order to comply with Sections 482 and 6662 and their respective regulations, taxpayers should seek transfer pricing documentation reports that are robust and fully compliant.
Various penalties can be assessed as a result of transfer pricing adjustments, including a net adjustment penalty.
> IRS increased Transfer pricing scrutiny by imposing two severe penalties –
> Transactional penalty (20%/40% of underpayment of tax)> Net adjustment penalty (20%/40% of underpayment of tax)
Developing comprehensive transfer pricing documentation substantially mitigates the risk of significant penalties for non-compliance and facilitates foreign multinational enterprises' compliance with IRC Sec. 482.
As a taxpayer, it's important to stay abreast of current transfer pricing litigation and understand how it affects your transactions. Having a third-party expert who can assist with proper documentation and establishing the correct price will be the most effective defense against any potential transfer pricing penalties. IRS will likely focus much of its attention on more closely scrutinizing transfer pricing documentation going forward.
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