The IRS is poised to use its $80 billion appropriation from the Inflation Reduction Act (PL 117-169), over half of which is dedicated for compliance enforcement, to increase scrutiny on multinational companies’ transfer pricing activity, according to a tax professional.
Since the initial funding proposal was first made publicly available and through the inflation law’s enactment, much partisan attention has focused on how the IRS, equipped with long-sought additional resources, would seek to raise collection revenues. Senior leadership within the Treasury Department, as well as top Democratic tax writers, have maintained that the IRS won’t use the funds to target families and businesses making less than $400,000 a year.
Instead, the expectation is that new enforcement agents and technological investments will focus on large corporations with international operations to curb tax avoidance and crack down on abusive practices. Robert Kovacev, a member of Miller & Chevalier Chtd., said this will likely include 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.
“It’s been a longtime priority for the [IRS], particularly under this administration, to go after businesses that in their view don’t pay their fair share,” Kovacev told Checkpoint in an interview. “A large part of that is what the IRS perceives as somebody’s avoiding tax through transfer pricing.” He said it is the agency’s position that “there’s a lot of money on the table due to transfer pricing cases” that has been, thus far, out of reach due to inadequate resources.
Kovacev added that senior executives at the IRS are looking to bolster the capabilities of the Large Business and International (LB&I) Division by bringing on new hires to develop data analysis models that use artificial intelligence, which he said would “enhance cooperation with international tax authorities.” There is an expectation such technology will become more sophisticated over time, with models increasingly able to make accurate predictions based on larger pools of historical data.
Transfer pricing audits can take years to complete, Kovacev said, because they’re “all-encompassing” with potentially hundreds of billions of dollars at stake. A particular challenge for examiners is transactions involving intellectual property, such as software. It’s easier to find market data on comparable transactions involving tangible property, according to Kovacev, who used the example of accessing real estate websites to appraise a home’s value based on what properties in the same neighborhood have sold for.
“But when you’re talking about pharmaceutical patents or proprietary software—or some other type of intangible—there’s not going to be a public market for that,” he said. “How would you price a unique patent for a drug that could help cure cancer?”
During a transfer pricing audit, the IRS examines whether taxpayers are operating in accordance with arm’s-length or market rate principles. Code Sec. 482 authorizes the IRS to make adjustments to income and deduction allocations among taxpayers. Per the agency’s website, Section 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 as a result of a transfer pricing adjustment, such as a net adjustment penalty. The IRS released FAQs on how taxpayers can satisfy the documentation requirements under Code Sec. 6662. In 2018, LB&I sent instructions to staff on the scope of transfer pricing examinations and how to appropriately assess penalties.
On September 8, 2020, the IRS updated its transfer pricing examination process guide. The guide covers how audits are conducted and best practices for agents handling transfer pricing cases. Audits begin with a planning phase, where an “issue team” is assigned. These can be composed of senior or lower-level revenue agents, economists, and tax law specialists who coordinate and collaborate with other managers and advisers. 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 prior-year documentation, the team determines if 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, which serves to reach a possible 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 of contention to any adjustments and assessed interest or penalties.
Kovacev expects transfer pricing litigation to increase alongside audits. Based on firsthand experience, he said litigating such cases can be as lengthy and resource-consuming as the audits themselves. The intensive legal process may involve dozens of experts and a substantial number of documents, he added.
Marina Gentile, a partner at Withum, also believes transfer pricing audits will rise as the IRS taps its new funding. In an article on the firm’s website, Gentile wrote that the “signing of the Inflation Reduction Act is a clear indication in the U.S. that the IRS will continue to be focused on transfer pricing scrutiny, among other increasing enforcement activities.”
She urged companies to take a proactive approach to compliance, because unlike “other jurisdictions, there is no magnitude threshold to trigger transfer pricing compliance in the U.S. Therefore, “all businesses involved in cross-border activities should anticipate scrutiny.”
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