IRS Launches Monitoring Initiative Focused on Inbound Distributors

On October 20th, 2023, the IRS released the following news detailing how the agency plans to use the additional funding from the Inflation Reduction Act to ensure large foreign-owned corporations pay an appropriate level of tax: 

Large foreign-owned corporations transfer pricing initiative: The IRS is increasing compliance efforts on the U.S. subsidiaries of foreign companies that distribute goods in the U.S. and do not pay their fair share of tax on the profit they earn on their U.S. activity. These foreign companies report losses or exceedingly low margins year after year through the improper use of transfer pricing to avoid reporting an appropriate amount of U.S. profits. To crack down on this strategy, the IRS is sending compliance alerts to approximately 150 subsidiaries of large foreign corporations to reiterate their U.S. tax obligations and incentivize self-correction.

The full statement can be viewed on the IRS website. 

This announcement mirrors a 2017 campaign conducted by the IRS’s Large Business & International (LB&I) division focused on inbound distributors.

How Will the IRS Communicate Compliance Alerts? 

The announcement specifies that approximately 150 subsidiaries of large foreign corporations will receive compliance alerts. These notices inform taxpayers that the IRS believes they may not have met their U.S. tax filing and reporting requirements, but do not serve as a formal indication of an audit or examination. While the announcement focuses on large foreign-owned corporations, the expectation based on prior practical experience is that the IRS will reach out to a broader range of taxpayers that transact with foreign related parties and exhibit sustained levels of low profitability and/or losses. 

The notices taxpayers will receive are worded such that the IRS is expecting a response stating whether the taxpayer to which the notice is addressed has complied with U.S. transfer pricing rules. If a taxpayer confirms compliance with the U.S. transfer pricing rules they are required to submit a description of their transfer pricing policy along with supporting documentation as part of their response. 

An indication by the taxpayer of non-compliance or the lack of a response altogether by taxpayers who receive these notices is likely to increase the probability that such taxpayers will be selected for examination by the IRS.

Reviewing Transfer Pricing Policies and Intercompany Agreements

While the new initiative specifically references large foreign-owned companies, any organizations with substantial intercompany purchases of inventory or other related party transactions should be mindful of this initiative. 

Taxpayers subject to the U.S. transfer pricing rules should work with a tax advisor to complete a review of their intercompany pricing policies, focusing on elements including:

• Review of intercompany agreements
• Review of internal transfer pricing policy guidelines
• Review of existing external transfer pricing documentation
• The preparation of transfer pricing benchmarking or more comprehensive documentation

Smith + Howard is equipped and available to support taxpayers with any of the above services.

Key Takeaways from the IRS Announcement

While these notices do not guarantee an audit looms for taxpayers who receive them, they do indicate that the IRS is using its increased funding from the Inflation Reduction Act to focus its taxpayer examination and monitoring activities around transfer pricing activities. These letters are designed to encourage taxpayers to conduct proactive reviews and adjust their pricing policies with group companies as necessary.

The IRS’s perspective around inbound distributors is that the parent or other entrepreneurial entities within the group that transact with the U.S. taxpayer are generally better positioned to bear the risk associated with doing business globally. As a result, the IRS auditor expects that U.S. taxpayers distributing products produced abroad by related parties should earn a reasonable margin on their business activities. 

Taxpayers who fail to deliver adequate profit margins are often presumed by the IRS to be engaged in margin manipulation or improper maintenance of their intercompany pricing policies. This can result in adjustments to taxable income as well as the imposition of substantial penalties.

Businesses that report thin margins or losses year-over-year, as well as businesses that engage in material purchase transactions with foreign related parties, should consider seeking a proactive review of their transfer pricing policies to mitigate any potential issues. 

Smith + Howard is keeping abreast of any developments related to this initiative and is available to support in responding to these notices as well as provide a range of transfer pricing consulting services including transfer pricing policy review/analysis and the preparation of transfer pricing benchmarking and/or annual compliance documentation meeting the U.S. transfer pricing rules and regulations.

To learn more, contact Brad Pittman at [email protected].