IRS Transfer Pricing Enforcement
Transfer Pricing In General
The IRS regularly audits large companies with international operations. A major focus of these audits has always been transfer pricing. The problem for the IRS was that they lost most of their transfer pricing cases in court. However, the IRS has won several transfer pricing cases in recent years, leading the IRS to apply additional resources to auditing in this area. The IRS has won transfer pricing disputes against Coca-Cola, GlaxoSmithKline, and others and is currently imposing a multi-billion assessment against Microsoft. Not only is transfer pricing a top issue for the IRS, it is always a top concern for multinational companies. The largest tax cases have involved transfer pricing issues, but these issues apply to small multinationals as well. Which may lead one to wonder what and why this is the case. The issue concerns the value of intercompany (related party) transactions between different countries. Its the cost for goods and services, including research, patents and royalties, between related companies of a multinational. Multinationals use transfer pricing to reduce their overall tax burden by causing related companies in high-tax countries to pay more for goods and/or services to reduce their profit. In kind, multinationals might cause related companies in low-tax countries to pay less for goods and/or services to increase their profit.
The IRS
The IRS seeks to enforce fair pricing without tax motivation between related companies by requiring that intercompany payments for goods, services, or intangibles be comparable to payments between unrelated third parties in the same circumstances. Given that transfer pricing involves transactions between countries, there is more than just the IRS involved, there is the tax authority in the other country or countries. The IRS was effective in a case against Coca-Cola where the company transferred intellectual property via a royalty payment agreement to its foreign subsidiaries. The royalty agreement effectively shifted profit from the United States to Coca-Cola’s low-tax country foreign subsidiaries by allowing these foreign subsidiaries to underpay for intangible rights. The IRS argued that the comparable profits method (“CPM”) should be used to determine proper pricing. The CPM stresses that profit between related parties should be equal to that between unrelated parties. In Coca-Cola’s case, the Tax Court increased their taxes owed by $3,300,000,000 for only three years. Of course, the financial burden on multinationals isn’t limited to additional taxes. The Income Tax Code imposes 20% and 40% penalties for transfer pricing adjustments.
Multinational Companies
Multinational companies face the prospect of additional U.S. taxes, additional state taxes, penalties, financial accounting concerns, double-taxation, and other problems. The problem with transfer pricing adjustments is that the tax issues involve at least two countries along with state tax authorities. Companies subject to financial reporting have to account for taxes and tax risks. In the case of Coca-Cola, the company had set up a tax reserve for risks associated with transfer pricing (IRS tax audit issue) of $414 million. Coca-Cola appealed the Tax Court decision and estimated its risk as $414 million, but noted in its financial statements that its total IRS tax liability could be $13 billion. If Coca-Cola has to pay more than the $414 million to resolve its tax issues than its earnings are negatively impacted and, typically that means that its stock loses value, which means that shareholders (including individuals with 401ks) lose money. Another concern for multinationals is the other countries’ (country other than United States) tax authorities. Multinationals will have to resolve transfer pricing issues between multiple countries, the United States and at least one other country, and that can be complicated and expensive. In order to avoid double taxation, the multinational would generally be able to use the mutual agreement procedure (MAP) to resolve any double tax with a treaty partner (country with treaty).
IRS Enforcement
The IRS is increasing its compliance efforts using funding from the Inflation Reduction Act, this includes hiring additional agents. The IRS has sent compliance alerts to 150 U.S. subsidiaries of large foreign corporations that sell products in the United States. These alerts are letters for taxpayers with losses or low income requesting that they consider their transfer pricing with the hope that these companies will voluntarily amend their prior year returns and report additional U.S. income and pay additional U.S. tax. The IRS also intends to increase its audits of large companies, including an additional 60 audits of the largest corporations in 2024.
Bowman Law Firm LLC, Tax Attorney, Huntsville, Alabama
