The IRS has made it clear once again that transfer pricing remains a key focus in its ongoing enforcement efforts.[1]  And with significant additional resources to do so over the next decade, the IRS is likely to focus some of these resources on taxpayers who have not undergone a transfer pricing audit in recent years or, perhaps, ever.  For example, while the IRS is onboarding the many new transfer pricing experts it hired in 2023, it has sent compliance alerts to certain U.S. subsidiaries of foreign corporations that distribute goods in the U.S. where the IRS thinks that these subsidiaries are not paying their fair share of tax on the profit they earn on their U.S. activity.[2] Taxpayers would be wise to take this time to prepare for an audit by reviewing their material intercompany transactions and undertaking a transfer pricing risk assessment.

A transfer pricing risk assessment provides a taxpayer an opportunity to assess their actual transfer pricing exposure and ensure that reality matches their transfer pricing documentation and the best method analysis before an IRS audit. We have encountered situations where: (1) the facts have changed over the years and the business has evolved, but the transfer pricing documentation has not been updated; (2) the original comparables no longer reflect the new facts, but have not been updated; (3) the documentation does not contain a robust best method analysis; and (4) the intercompany agreements do not follow what the company does in practice. It is always preferable to be proactive in identifying potential issues, rather than reacting to issues after the IRS has identified them during an audit.

A risk assessment allows taxpayers an opportunity to prepare for issues that could be raised by the IRS in a transfer pricing audit. Even the IRS has suggested that taxpayers may want to consider assessing their transfer pricing risk and, in particular, recommended that taxpayers “may also benefit from proactively evaluating how system profits are shared between related parties and addressing whether such allocations are reasonable based on each party’s contributions.”[3] For example, the IRS typically focuses on a company’s best method selection and analysis as described in the transfer pricing documentation. The IRS expects the documentation to explain adequately why methods were rejected. The IRS also closely scrutinizes the terms of intercompany agreements. If an agreement says payment is made in 30 days, the IRS expects payment to be made in 30 days. By undergoing a risk assessment, a taxpayer has an opportunity to correct any identified issues going forward, to prepare proactively for an IRS audit, and to better understand where its exposure may lie. This type of exercise is best done in a privileged environment to ensure that the results and any identified issues are protected from disclosure to the IRS.

The IRS has been emboldened by recent court victories and is more demanding in its expectations of transfer pricing documentation and in its review of intercompany transactions generally. The IRS no longer accepts just any transfer pricing documentation as protection against section 6662 penalties.[4] Instead, the IRS requires the documentation to be adequate and reasonable and is encouraging taxpayers to invest in higher quality transfer pricing documentation.[5] Because of the IRS’s focus on transfer pricing as it increases its compliance efforts in the coming years, taxpayers would be well served to prepare for these audits by doing a risk assessment now.  

The best defense is a good offense.  

[1] IRS Inflation Reduction Act Strategic Operating Plan FY2023-2031, Publication 3744 (Rev. 4-2023) (irs.gov)

[2] IRS launches new initiatives using Inflation Reduction Act funding to ensure large corporations pay taxes owed; continues to improve service and modernize technology with launch of business tax account | Internal Revenue Service

[3] Transfer Pricing Documentation Best Practices Frequently Asked Questions (FAQs) | Internal Revenue Service (irs.gov)

[4] See https://www.bestmethodsblog.com/2022/06/turning-the-screw-penalties-in-transfer-pricing-disputes/; https://www.bestmethodsblog.com/2020/07/irs-asserts-big-ticket-transfer-pricing-penalties-in-western-digital/

[5] Transfer Pricing Documentation Best Practices Frequently Asked Questions (FAQs) | Internal Revenue Service (irs.gov)