IRS issues transfer pricing ‘compliance alerts’

The IRS is using Inflation Reduction Act funding to expand transfer pricing enforcement efforts on U.S. subsidiaries of foreign companies that distribute goods in the U.S. and report losses or low margins year after year.

As part of its enforcement initiative, the IRS has sent “compliance alerts” to approximately 180 subsidiaries of large foreign corporations to reiterate those companies’ tax obligations and encourage self-correction (IR 2023-194 and IR 2024-09).

A compliance alert is a one-and-a-half-page letter from the IRS (Letter 6608) identifying the taxpayer as a filer of Form 1120, U.S. Corporation Income Tax Return, and Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation, engaged in the purchase and resale of tangible goods from a foreign related party. The alert states that the taxpayer has reported losses or low margins on its tax return for tax years 2017 through 2021 and that those results might indicate that the taxpayer’s transfer pricing did not comply with Sec. 482.

Taxpayers are not required to respond to the alert, and the alert does not constitute an examination under Section 7605(b) or a contact regarding an examination under Treas. Reg. Sec. 1.6664-2(c)(3)(i)(A) for purposes of filing a qualified amended return. However, the alert encourages a taxpayer receiving the alert to evaluate its transfer pricing policy, intercompany agreements, financial results, and Form 1120 to confirm its compliance with Section 482.

Following the evaluation of its transfer pricing, the alert advises the taxpayer of two alternatives:

• If the taxpayer believes that it has fully complied with Section 482, the taxpayer need not take further action.
• If the taxpayer does not believe it has fully complied with Section 482, the alert recommends that the taxpayer file an amended return to correct the error.

A potential third alternative not mentioned in the alert would involve seeking an advance pricing agreement (APA) requesting rollback to all open years. Most of the transfer pricing exposures represented by the compliance alerts already exist for taxpayers. But the taxpayer’s receipt of the alert and the IRS monitoring of the taxpayer’s tax returns may indicate an increased likelihood that a taxpayer will be examined. The transfer pricing exposure includes:

• A transfer pricing adjustment
• 20 and 40 percent Section 6662 penalties
• Double taxation
• Customs valuation impact
• Internal and external costs of defending transfer pricing

Taxpayer options

Taxpayers have several options to address the letters and any underlying transfer pricing risks. If a taxpayer receives an alert but believes that its explanation for its 2017 to 2021 results would satisfy the IRS examination team, it can also choose to do nothing.

A taxpayer that amends its return will unilaterally change its exposure. A taxpayer-initiated upward adjustment to U.S. income would turn the transfer pricing adjustment exposure into reality. Unfortunately, the IRS could still see the need for an additional adjustment.

If the amended return is filed before the IRS initiates an examination (a “qualified amended return”), the post-adjustment transfer price would be the starting point for any Section 6662 calculation. An upward adjustment to U.S. income would also create double tax, and the mutual agreement procedure (MAP) would generally be available to resolve any double tax with a treaty partner. A change to the transfer price may require reporting of the adjustment to Customs, but a Customs refund might be available in certain circumstances. Finally, an amended filing to increase taxable income may reduce the taxpayer cost and effort in any transfer pricing examination.

An APA with rollback could be an effective way to address all the transfer pricing issues raised by a compliance alert, especially if that APA is bilateral. An APA with rollback to all open years guarantees that no further adjustment would be sought by the IRS.

Assuming the APA is requested before an examination is initiated, the APA outcome would constitute a qualified amended return, thus eliminating exposure to Sec. 6662 penalties. Double tax could be eliminated during the process by a bilateral APA. The need to report any adjustment to Customs might still exist. Finally, the cost of a bilateral APA with rollback is unlikely to exceed the cost of the regular dispute process.