The IRS recently announced that it is strengthening enforcement initiatives as a result of additional funding from the Inflation Reduction Act (IRA). One of the areas of enforcement is transfer pricing with the focus on U.S subsidiaries of foreign-owned companies that distribute goods in the U.S. and may not be paying their fair share of tax on profits they earn from their U.S. activity. Many of these distributors report losses or exceedingly low margins year after year through the improper use of transfer pricing to avoid reporting the appropriate amount of U.S. profits. 

To crack down on this common practice, as of November 2023 the IRS sent compliance letters to more than 180 subsidiaries of large foreign corporations to reiterate their U.S. tax obligations and incentivize self-correction. In our experience, taxpayers that are smaller in size with distribution operations in the U.S. have also received these letters from the IRS. The years in question range from 2017-2021. 

These letters are meant to alert foreign-owned U.S. subsidiaries/taxpayers that the IRS does not expect distributors with limited functions, risks, and assets owned to report recurring losses or noncompliant margins from transactions with related parties. 

The letter outlines next steps for recipients:

• Taxpayers are requested to review their transfer pricing results and compliance with IRC Section 482.
• After review taxpayers should file amended tax returns to correct positions where their financial results in connection with related party transactions did not comply with IRC Section 482.
• If taxpayers believe they have complied no further action is necessary.
• In some cases, the IRS may request that taxpayers respond with an explanation of why (or how) they comply with the U.S. transfer pricing rules under IRC Section 482.

The letter also informs recipients that the IRS intends to monitor their tax returns going forward and that continued reporting of losses or low margins in subsequent years may result in a referral for a transfer pricing examination.

What does CohnReznick think?

The IRS is targeting certain multinational organizations that carry on routine activities (i.e., distribution) in the U.S. where losses or low margin returns are not expected. If your organization or company fits this profile then it will be important to review your existing transfer pricing models, policies, and results to assess whether actual financial results are defendable.

To avoid scrutiny from the IRS and/or verify that transfer pricing results are defendable, you need to assess the alignment of results with global transfer pricing policies and related transfer pricing elements (agreements, results, execution, etc.). An experienced tax advisor can assist in aligning policies and suggest necessary adjustments. Contact your advisor to evaluate your next steps.

_{Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice specific to, among other things, your individual facts, circumstances and jurisdiction. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.}