The IRS is increasing its attention on U.S. subsidiaries of foreign multinational corporations (MNC), which primarily operate as distributors of goods purchased from their related parties. The IRS audits will focus on the transfer prices between the U.S. distribution entity and its overseas related parties. The IRS perceives that the transfer prices involving U.S. inbound distributors are intentionally set to reduce the MNC’s tax burden in the U.S. through the establishment of aggressive or non-arm’s-length transfer prices.
In 2010, the IRS created the Large Business and International (LB&I) Division in an effort to augment its audit capabilities with regard to international tax and transfer pricing matters. In 2015, the LB&I announced it would undertake campaigns focusing on certain issues—rather than concentrating on the largest taxpayers—for audit and reorganized itself into nine practice areas, including Treaty and Transfer Pricing Operations. The initiative to target transfer pricing involving inbound distributors will be the first reorganized LB&I campaign. The campaign will first target inbound distributors in five unnamed states, with the program expanded to 10 states by the end of 2016. As a consequence, more inbound distribution companies will face scrutiny related to the transfer pricing arrangements involving the resale of goods purchased from their parent company or other related parties.
Scrutiny of Certain Pricing Distribution Transactions Transfer Pricing Methodologies by the IRS
On a related topic, in March 2016, the LB&I issued a practice unit entitled, “Inbound Resale Price Method Routine Distributor.” Practice units are essentially training materials designed to assist IRS agents with reviewing and auditing certain issues. This practice unit focuses on the use and applicability of the Resale Price Method (RPM) by inbound distributors. The RPM fixes the distributor’s gross margin (GM) on its purchases from its related party manufacturer. The use of the RPM assumes that distributors will have an ample GM to cover their operating expenses. However, the IRS has indicated that, when using ‘external comparables’ as derived from comparables’ databases, the taxpayer should ideally use the Comparable Profits Method (CPM) as opposed to the RPM. The CPM sets the distributor’s pre-tax operating margin (OM) at a certain level so that it essentially forces the inbound distributor to pay tax in the U.S., whereas under the RPM the taxpayer could have a pre-tax loss due to large operating expenses and management fees charged from the parent company.
Inbound distributors will want their transfer price set on an arm’s-length basis and the proper transfer pricing documentation to support their transfer prices with related parties. Contact your BKD advisor for more information.