New IRS Transfer Pricing Audit Campaign Specifically Targeting Inbound Distributors

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New IRS Transfer Pricing Audit Campaign Specifically Targeting Inbound Distributors

  • IRS, tax, transfer pricing

Companies with U.S. distribution subsidiaries can expect additional transfer pricing scrutiny 

This article is courtesy of Hanne Rørholm LeLoup, Partner at our member firm Hutchinson and Bloodgood LLP, in San Diego, California. HBLLP is a full service CPA firm. Hanne grew up in Denmark and still visits regularly. Hanne can be reached at: hleloup@hbllp.com.  Co-author is Alex Martin, Transfer Pricing Expert at Clayton & McKervey in Detroit, Michigan.  Alex can be reached at:  amartin@claytonmckervey.com.

Report from the Trenches

The IRS Has Announced a New Transfer Pricing Audit Campaign Specifically Targeting Inbound Distributors!

The Internal Revenue Service (IRS) has announced that U.S. distribution subsidiaries of foreign multinationals, including Danish companies, can expect special transfer pricing scrutiny during IRS audits.   The IRS is concerned that foreign-owned companies are not paying their “fair share” of income tax when a parent company charges excessively high prices on goods, services and royalties.  Incorrect cross-border prices can lead to artificially low corporate income tax payments.

Recently, we have seen the IRS become more aggressive in employing this audit strategy, and challenging transfer prices has become a lucrative way to raise tax revenue.  During audits, the IRS will request information on the company’s business operations and justification of the cross-border prices charged between companies – commonly known as a transfer pricing documentation report.

In discussions with tax agents, IRS Auditors regularly review earnings before interest and tax (EBIT) as a percentage of net sales when selecting targets. U.S. subsidiaries incurring losses face the highest risk of scrutiny, and many middle-market companies are being audited for the first time.

New Transfer Pricing Standards in DK, Raise the Bar and Widen the Net – Starting at $20 Million in Group Revenue!

The IRS is not the only tax authority concerned about transfer pricing.  The Danish tax authority, SKAT, has also become more aggressive in auditing transfer pricing practices for Danish companies.

Transfer pricing has long been a tax concern for the largest multinationals and news articles on Apple, Starbucks, Google and others have raised the profile of this contentious tax issue.  Danish transfer pricing documentation rules were updated in 2016 to follow the OECD’s recommendations for combating large-scale tax avoidance by multinational companies.  Consequently, fines now apply for documentation breaches.  SKAT, for the first time in March 2017 published details of a court case in which a fine for failure to comply with transfer pricing documentation rules was upheld.

For the largest companies, new international transfer pricing documentation standards require companies to provide information on both global business operations (a “Master File”) available to all tax authorities and a transfer pricing analysis (a “Local File”) for tax authorities in all countries where a multinational operates.  However, many middle market companies will also be subject to these higher documentation standards in Denmark. Most notably, Danish regulations now require companies with global revenues of DKR 125 million (~ $20 million) and more than 250 employees to be subject to the same higher transfer pricing documentation standards as large multinationals.

In our experience, these new requirements are more prescriptive both in terms of the volume of information required and the details that must be included in a report. For instance, a Master File should include written descriptions of important drivers of business profit, the supply chain for the five largest product lines, major service agreements within the group, and an explanation of which companies own intangibles by country.  By contrast, a Local File for each country, requires a thorough explanation of local business strategies, functions, risks and assets. Each Local File must also include an explanation of intercompany transactions, financial results and selection of the “Best/Most Appropriate Method” for benchmarking transfer prices.

What to Do Next?

Taxpayers of all sizes should review their transfer pricing arrangements in anticipation of a potential audit. Companies with U.S. distribution subsidiaries can expect additional transfer pricing scrutiny as a part of every IRS tax audit. Depending on the risk profile of a company, transfer pricing documentation or other supporting economic analyses may be necessary to justify operating results and reduce the risk of additional tax assessments and penalties.

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