United States

IRS will increase focus on inbound middle-market taxpayers

INSIGHT ARTICLE  | 

In mid-October, David Varley, acting director of the IRS’s transfer pricing group in Washington, DC, stated that the IRS would begin auditing the transfers pricing practices of middle market foreign-owned businesses in earnest. Varley noted that the IRS has opened a project focusing on companies with a foreign parent and utilizing limited-risk inbound distributors. The project will include companies with assets between $10 million and $250 million and the IRS has identified about 70 returns to be examined along with 20 revenue agents who may conduct these audits. Varley anticipates that exams will start in November, 2015. This marks a potential shift in strategy, as transfer pricing exams have historically been focused on large multi-national entities with assets in the billions.

New “campaign” strategy

The IRS Large Business and International division (LB&I) will begin in early 2016 to develop a more issue-focused examination process and will design campaigns to address particular areas of noncompliance. Such campaigns may consist of exams, outreach and/or guidance. Unlike prior initiatives, the exam selection criteria will be more issue-based and not focused on the size of the entity selected and the information document requests (IDRs) will be more issue-focused. One key area of focus are inbound taxpayers and their transfer pricing practices. 

Recommended action plan

In light of this announcement, and the pending exams focusing on the transfer pricing of foreign-controlled US taxpayers, what action should affected taxpayers take?

Because of the many and significant penalties that result from failures to follow the U.S. transfer pricing rules, middle market taxpayers should review their transfer pricing documentation immediately.  Appropriate transfer pricing methodologies can help taxpayers avoid double taxation and proper documentation can reduce penalty exposure. Transfer pricing penalties can be particularly severe and can be as high as 40 percent of the underpayment of tax that arises from a transfer pricing adjustment.  We expect the IRS will spend significant resources auditing the transfer pricing positions of middle market taxpayers because of the revenue potential associated with these penalty rules.

To prepare for a potential audit, taxpayers should ensure they have transfer pricing documentation that complies with U.S. transfer pricing principles. For example, taxpayers should have contemporaneously prepared documentation for the 2015 tax year. Contemporaneous transfer pricing documentation is any documentation prepared prior to the filing of that year’s income tax return. It is ideal to prepare such analysis and documentation prior to closing the company trial balance/financials to ensure any transfer pricing adjustments are reflected on the company’s financial statements and on any foreign tax returns.

Moreover, taxpayers should also ensure that their transfer pricing documentation corresponds to facts presented on corresponding international tax information returns because any discrepancies between these returns and the taxpayer’s transfer pricing documentation could raise “red flags” and trigger a full-blown tax audit.  In addition, failure to report a variety of intercompany transactions on the appropriate international tax form could trigger information return penalties.  For example, a penalty of $10,000 is imposed for each Form 5472 that is incomplete, inaccurate, or is not contemporaneous with the filing of the income tax return.

These changes will have an immediate and potentially large impact on middle market taxpayers.  In response, we believe taxpayers should focus closely on accurate international tax and information return preparation and transfer pricing documentation.

  

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