Recommended actions

• Do not ignore compliance alerts ─ For companies receiving a compliance alert, perhaps the most important piece of advice is to not ignore or minimize it and follow the IRS procedures under their specific voluntary compliance letters. 
• Expect audits ─ We fully expect many of the foreign MNEs that receive compliance alerts to undergo extensive transfer pricing audits. All foreign companies conducting distribution activities in the United States, and especially those that were previously audited on such activities, should undertake a review of their ongoing compliance efforts, and how their transfer pricing documentation and other typical compliance materials have evolved since the prior audit. 
• Strengthen tax compliance ─ Inbound taxpayers must be more diligent with all components of their transfer pricing compliance obligations, of which transfer pricing documentation is only one element. The appropriate administration of various US tax return forms (e.g., Forms 5472), and other supporting background documentation, including well-drafted intercompany agreements or transfer pricing policies, is increasingly important to substantiate the company's tax position. 
• Support low/negative returns or make self-adjustments ─ Inbound taxpayers that have material or consistent losses, or lower than typical returns on the basis of what the United States deems as adequate arm's length returns, may need to make transfer pricing adjustments to increase US taxable income, or develop additional support for its arm's length conditions. Before an adjustment is implemented, taxpayers must weigh the implication of a self-adjustment or an amended return to all knock-on effects, including timing differences, customs, and changes to tax attributes. To the extent that advertising and marketing activities of US distributors could be deemed to give rise to the creation of local intangibles, inbound taxpayers must be aware of the factors that could affect a mutual agreement procedure. 
• Strengthen implementation of transfer pricing ─ How transfer pricing is implemented will be more important during IRS examination than ever before. For example, if a company operates an integrated business for which distribution is one activity, strengthening the support for the financial segmentation may be important. This could include evaluating the company's separate transfer prices in the US entity and pressure testing their reasonableness, including domestic US allocation keys, and contributions of affiliates. Indications from recent cases suggest that the IRS is likely to examine the company's intercompany structure, agreements, and forms to ensure compliance, and then corroborate with the transfer pricing documentation, in an effort to accurately delineate the transaction. Only then will the reasonableness of the transfer pricing documentation be evaluated.
• Be strategic in audit preparation ─ A company selected for an audit as part of the initiative can expect the IRS to add new resources, including data analytics, to prior information generated from historical inbound campaigns. We expect that the IRS will refine the selection criteria for audits, develop processes and procedures that lead to more effective audits, and create standardized audit guides and information requests. As we are in an era of data analytics, taxpayers should expect a substantial amount of requested information – some of which may not be reasonable for the IRS to receive. Inbound companies need to be aware of the privilege standards in the United States during audits. Although the IRS does not treat the preparation of transfer pricing documentation as a privileged activity, many other requested items can be protected from unreasonable requests. In practice, audited taxpayers must be more strategic with sensitivity analyses, developing support that is proportionate to the hazards of litigation, and being mindful of the information that they share internally in a world of increasing tax transparency. 

Final word

Most MNEs are familiar with the saying that one's transfer pricing documentation is the first line of defense in transfer pricing audits. However, this saying is becoming less true in the United States due to a concerted effort by the IRS to change the field of dispute. Recent Tax Court victories against US MNEs show that the IRS has been successful in looking through a taxpayer's transfer pricing documentation at underlying legal arrangements and commercial conduct in developing their arguments. Armed with cases in their favor, the IRS will likely expand its examinations, especially with major funding earmarked for tax enforcement. The new IRS initiative focused on the transfer pricing of inbound non-US MNEs with distribution activities should be viewed in this context.