In a recent case, Villa-Arce v. Commissioner, a whistleblower sent information to the IRS that he believed showed that the company was using improper transfer pricing practices and taking unjustified deductions. The IRS opened an examination that resulted in other adjustments, but none based on the information from the whistleblower. For that key reason, the D.C. Circuit affirmed the Tax Court decision that the whistleblower was not entitled to an award for the collection of proceeds from the unrelated adjustments. Yet while the whistleblower walked away empty-handed, the case illustrates a unique type of transfer pricing and audit risk that comes from whistleblowers that companies should recognize. And given the indefinite nature of transfer pricing and the potential amount of dollars at stake, we will likely see more whistleblower actions involving transfer pricing.
Last week, the IRS released a mysterious new audit “campaign” that may implicate – inadvertently or otherwise – transfer pricing practices. The campaign, which was announced on August 8, is simply entitled “Inflated Cost of Goods Sold.”
The only glimmer of explanation the IRS gives as to what exactly this is all about is the brief statement that the campaign “focuses on LB&I taxpayers that have indications of inflated Cost of Goods Sold to reduce taxable income.”
But this tells us very little. Absent book-tax differences (e.g., FIFO/LIFO materials inventory conventions), an increase in COGS will always decrease taxable income. This is hardly revelatory. Two old IRS practice units from 2014 (“Purchase of Tangible Goods from Foreign Parent – CUP Method” and “Sale of Tangible Goods from a CFC to USP – CUP Method”) recognize the truism that increasing COGS reduces taxable income. So what? What facets of COGS gives the IRS concern? Direct Labor? Overhead? Standard Material Costs? Variances?…