On January 31, 2017, the Large Business and International (LB&I) division of the IRS released 13 campaigns creating a new, campaign-based approach to examinations. Transfer pricing involving mid-market and inbound companies is at the forefront of three campaigns. The campaign-based method departs from the former IRS approach to audits, which focused on large taxpayers. In the campaign-based approach, the IRS will concentrate its resources on the identification and analysis of specific high-risk fact patterns where taxpayers may be engaged in tax abuse or noncompliance. The IRS states the campaign-based approach’s goals are “to improve return selection for audit, identify issues representing risk of non-compliance, and make the greatest use of limited resources.”
Inbound Distributors Are Scrutinized
This campaign shouldn’t be a surprise, as the LB&I announced one of the impending campaigns would focus on transfer pricing practices related to inbound companies in August 2016. U.S. subsidiaries of foreign multinational companies (MNC) primarily operating as distributors of goods purchased from their related parties are now a target of the IRS. IRS audits will focus on the transfer prices between the U.S. distribution entity and its overseas related parties.
The IRS perception is that transfer prices involving U.S. inbound distributors have historically been 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. When the campaigns were released, LB&I Commissioner Douglas O’Donnell stated, “U.S. distributors of goods sourced from foreign-related parties have incurred losses or small profits on U.S. returns, which are not commensurate with the functions, performed and risks assumed. In many cases, the U.S. taxpayer would be entitled to higher returns in arm’s-length transactions.”
Related-Party Transactions & Repatriation
Related-party transactions involving the middle market and repatriation are two other campaigns that could involve transfer pricing as one of the focal issues. In connection with the related-party transactions campaign, the IRS has indicated that certain middle-market companies are engaged in related-party transactions that transfer income from the corporation to related pass-through entities or shareholders, thereby avoiding a level of income tax. With respect to the repatriation campaign, there’s an IRS perception that taxpayers are using various tax structures to affect tax-free repatriation of funds into the U.S., resulting in lost U.S. income tax revenue. While the IRS' stance is somewhat vague on these and other campaigns, it can be inferred that the IRS sees improper transfer pricing as a tool used by middle-market taxpayers to effectuate tax abuse and noncompliance.
Taxpayers that engage in related-party transactions will want to ensure their transfer pricing is based on arm’s-length principles and that they have the proper documentation to support their transfer pricing positions.
Please contact your BKD advisor for more information.