United States: IRS unleashes transfer pricing audits on foreign companies with US distribution operations

Tax News and Developments February 2024

In brief

On 20 October 2023, the IRS announced a transfer pricing initiative targeting the transfer pricing compliance of large foreign-owned MNEs engaging in distribution activities in US territory. The announcement implies that many inbound companies operate unfairly in the United States by using improper transfer pricing and indicates that the IRS would "crack down on this strategy" via the issuance of compliance alerts. By mid-November 2023, the IRS had sent 180 voluntary compliance letters to foreign-owned distributors. Strengthened by tens of billions of US dollars the IRS is to receive under the Inflation Reduction Act of 2022 and the pressures for increasing federal tax collections, this initiative is expected to intensify in the upcoming months.


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. 

Copyright © 2024 Baker & McKenzie. All rights reserved. Ownership: This documentation and content (Content) is a proprietary resource owned exclusively by Baker McKenzie (meaning Baker & McKenzie International and its member firms). The Content is protected under international copyright conventions. Use of this Content does not of itself create a contractual relationship, nor any attorney/client relationship, between Baker McKenzie and any person. Non-reliance and exclusion: All Content is for informational purposes only and may not reflect the most current legal and regulatory developments. All summaries of the laws, regulations and practice are subject to change. The Content is not offered as legal or professional advice for any specific matter. It is not intended to be a substitute for reference to (and compliance with) the detailed provisions of applicable laws, rules, regulations or forms. Legal advice should always be sought before taking any action or refraining from taking any action based on any Content. Baker McKenzie and the editors and the contributing authors do not guarantee the accuracy of the Content and expressly disclaim any and all liability to any person in respect of the consequences of anything done or permitted to be done or omitted to be done wholly or partly in reliance upon the whole or any part of the Content. The Content may contain links to external websites and external websites may link to the Content. Baker McKenzie is not responsible for the content or operation of any such external sites and disclaims all liability, howsoever occurring, in respect of the content or operation of any such external websites. Attorney Advertising: This Content may qualify as “Attorney Advertising” requiring notice in some jurisdictions. To the extent that this Content may qualify as Attorney Advertising, PRIOR RESULTS DO NOT GUARANTEE A SIMILAR OUTCOME. Reproduction: Reproduction of reasonable portions of the Content is permitted provided that (i) such reproductions are made available free of charge and for non-commercial purposes, (ii) such reproductions are properly attributed to Baker McKenzie, (iii) the portion of the Content being reproduced is not altered or made available in a manner that modifies the Content or presents the Content being reproduced in a false light and (iv) notice is made to the disclaimers included on the Content. The permission to re-copy does not allow for incorporation of any substantial portion of the Content in any work or publication, whether in hard copy, electronic or any other form or for commercial purposes.