The IRS has increased compliance efforts on U.S subsidiaries of foreign companies that distribute goods in the U.S and do not pay the appropriate amount of tax on their fair share of profit they earn on their U.S activity. These foreign companies use transfer pricing rules to avoid reporting an appropriate amount of U.S profits. Taxpayers should review their U.S transfer compliance in light of this new enforcement environment.
IRS Launches Transfer Pricing Initiative
In late 2023, the IRS kicked off its large foreign-owned corporations transfer pricing initiative by sending “Compliance Alerts” to approximately 180 distribution subsidiaries of large foreign corporations. The letters mention that the taxpayer reported losses or low margins on its tax returns for 2017 – 2021, and those results might indicate that the taxpayer did not comply with IRC Section 482. Each letter stated that the taxpayer should evaluate its transfer pricing policy, intercompany agreements, financial results, and Form 1120 for tax years 2017 – 2021 to confirm its compliance with IRC Section 482.
Recent IRS Wins in Transfer Pricing Cases
The IRS has seen more success in transfer pricing enforcement cases over the last five or six years.
The Coca-Cola Case
For example, on August 2, 2024, the U.S Tax court entered a decision against the Coca Cola company that reflects a tax underpayment penalty of approximately $2.7 billion for tax year 2007-2009. The interest made this amount exceed $6 billion. The IRS concluded that Coke was not receiving appropriate compensation from subsidiaries in multiple countries utilizing intellectual property from Coke whose headquarters is in Atlanta, GA (See The Coca-Cola Company & Subsidiaries v. Commissioner, 155 T.C. No. 10 (2020)).
The 3M Case
Another recent decision from the Tax Court occurred in February 2023, in 3M Company & Subsidiaries v. Commissioner, in which the Tax Court concluded, by a razor-thin 9-8 margin, that the Service had the authority, under Regulation section 1.482-1(h)(2), to reallocate foreign income that was allegedly restricted under Brazilian law. This resulted in the IRS allocating an additional $23.6 million in additional income to the U.S parent company which resulted in a $4.85 million tax liability for 3M.
More Transfer Pricing Cases on the Horizon
There are several transfer pricing cases recently filed and pending with the Tax Court that should be followed closely. As a result of these recent IRS wins and this more aggressive enforcement, taxpayers should consider reviewing and evaluating their transfer pricing methodology and updating their documentation to ensure compliance with the requirements.
Potential Penalties for Non-Compliance
There are potentially significant penalties that can be assessed for failure to comply with the reporting and documentation requirements under IRC Section 482. IRC Section 6662 valuation penalty for transfer pricing imposes either a 20% or 40% penalty depending on misstatement unless the taxpayer can demonstrate they had a reasonable basis for the transfer pricing and the proper documentation was maintained.
Required Documentation for Compliance
The regulations require that taxpayers maintain an extensive list of documentation and provide it to IRS within 30 days of a request in connection with an IRS exam. These items must be in existence when the return is filed.
Generally, taxpayers must provide:
- A detailed summary of the business including organization structure and a detailed description of all controlled transactions.
- Support for the transfer pricing methodology selected, including an analysis of why that method was selected compared to other methods.
- An economic analysis supporting the selected method as the best method.
Take Action Now
With the IRS ramping up its enforcement, now is the time for companies to proactively assess their transfer pricing policies. Ensuring compliance not only minimizes financial risk but also provides peace of mind in the face of increasing regulatory scrutiny. If you haven’t reviewed your transfer pricing strategy recently, it may be time to do so before the IRS comes knocking.
If you need further guidance or have any questions on this topic, we are here to help. Please do not hesitate to reach out to discuss your specific situation.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.
