The transfer pricing landscape constantly evolves with rapidly changing IRS policies and procedures and greater efforts directed towards effective enforcement and identifying noncompliance among taxpayers.
Last October, the IRS announced that we could expect new enforcement initiatives using the Inflation Reduction Act (IRA) funding, including a “large foreign-owned corporations transfer pricing initiative.” We see from their January 12, 2024 communication that this initiative has indeed started, and it specifically targets inbound U.S. distributors that report losses or low profits on a consistent basis. The initiative is run through compliance alerts in the form of letters that the IRS has sent to more than 180 U.S. distribution subsidiaries of large foreign corporations to reiterate their U.S. tax obligations and incentivize self-correction.
The letters to U.S. distributors essentially state that because the company has reported losses or low margins for certain years between 2017 and 2021, “the pricing of your intercompany transactions may not comply with Internal Revenue Code (IRC) Section 482 and the Treasury regulations thereunder.” The letter instructs the Taxpayer that if it believes it has fully complied with Section 482 and the regulations, it does not need further action. However, if the Taxpayer believes it has not fully complied, it should file amended tax returns to increase its U.S. taxable income for the year(s) in question. While this initial communication comes in with a lighter tone, asking the Taxpayer to self-assess and self-correct their transfer pricing position, it should be perceived as more of a warning that the company is on the IRS radar for reflecting too little profit in the U.S. Every Taxpayer possessing this IRS communication should seek counsel from their transfer pricing advisors to assess and confirm the true strength of their transfer pricing position and determine how best to respond. Transfer pricing benchmarking that is dated should be updated to cover the years in question to solidify the support as to the arm’s length – or market rate – nature of the transfer pricing that is resulting in a perceived low profit or even loss position in the U.S.
In its latest communication, the IRS takes the viewpoint that “these foreign companies use transfer pricing rules year after year to report losses that are engineered through the improper use of these rules to avoid reporting an appropriate amount of U.S. profits.” This distributor company profile can be considered low-hanging fruit to the IRS. The Service does not need to expend significant (and limited) resources to assess the complexities of a transfer pricing structure involving intangibles, cost-sharing arrangements, or other value-driving functions to build a case for additional profit in the U.S. A distributor is a great company to target since it is not typically a complex entity; it has limited functions and bears limited risks in that it purchases and resells a tangible good and thus should not be making consistent losses year over year.
If the distributor is in a pervasive loss – or extremely low profit – position for extended periods of time, it is only due to a handful of possible reasons. Transfer pricing below market rate is at the very top of these reasons. Following not too closely behind are such reasons as a start-up/market penetration phase, inefficiencies/mismanagement of the business, or lack of appetite for the product in the U.S. market. The last three reasons are all finite, short term in nature as an independent company would eventually go out of business or exit the U.S. market. Incorrect transfer pricing, however, can keep that distributor operating for years with bare minimum operating results reflected in the U.S. due to consistent over-payment to the foreign parent/manufacturer to buy the product it resells into the U.S. market.
The IRS’s focus on foreign-owned distributors of goods in the U.S. market shows that the agency wants to use its new funding to clean up areas like transfer pricing that have historically been compliance problems. This funding boost, outlined in the IRS’s strategic operating plan to spend the funds over the next ten years, enables the agency to allocate more resources toward transfer pricing cases with an aim to identify and address instances of improper transfer pricing practices. For more information, see article on Inflation Reduction Act Funding to IRS Will Increase Examinations; Time to Focus On Transfer Pricing.
Another potential reason why the IRS may be focusing on foreign-owned U.S. distributors, in particular, may be that it noticed the rise in overall profitability of this category of business in recent years. The most recent six-year period data presented below clearly indicates an upward trend in operating margin levels for these companies engaged in distribution activity in the U.S. market.
Table 1: Operating Margin Trends for U.S. Distributors Over the Past 6 Years
| Operating Margin | 2017 | 2018 | 2019 | 2020 | 2021 | 2022 |
| Upper Quartile 75th | 11.1% | 10.5% | 9.4% | 9.8% | 12.0% | 11.4% |
| Median 50th | 5.4% | 5.8% | 5.2% | 5.6% | 7.1% | 7.1% |
| Lower Quartile 25th | 2.8% | 1.9% | 1.6% | 1.8% | 2.5% | 2.6% |
These results suggest that those U.S. distributors with foreign parent companies that are targeting minimal profit levels close to the lowest quartile may be inadvertently dropping out of the respective transfer pricing ranges that they have used and that have worked for many years. For example, this data suggested that U.S. distributors that have been targeting a minimal 2% operating profit may need to move that to 3% to stay within their arm’s length range and out of the income adjustment zone.[1]
This new transfer pricing initiative by the IRS is a proactive approach to addressing tax compliance for large foreign-owned corporations. All inbound distributors, especially the ones operating on a targeted operating margin approach with sustained low profitability or losses, may need to review their existing transfer pricing, regardless of whether or not they have already received a nudge letter from the IRS. Taxpayers who receive letters must respond and explain their compliance with section 482, as failure to respond is likely to result in a formal audit.
Given the increased focus on transfer pricing, taxpayers should consider enhancing their transfer pricing documentation to support their intercompany tax positions with reliable and consistent data in each jurisdiction. Taxpayers with inadequate transfer pricing documentation risk an increased likelihood of scrutiny and income adjustments, dealing with the headaches of both double taxation as well as a 20% or 40% penalty for non-compliance.
Authors: Marina Gentile, Partner and Lead, Global Transfer Pricing Strategies | [email protected] and Mukul Chhabra | [email protected]
[1] This is a very high-level search of all U.S. distributors of tangible goods in the U.S., both durable and non-durable. There has been no industry/product specific screening or review. We did apply quantitative screens for pervasive loss companies and for potential intangible ownership. The information is presented for illustrative purposes only, to see the trend of increasing lower quartile and median operating results for distributors in the U.S. market. These results are not tailored to any specific company’s fact patterns and cannot be relied on by any Taxpayer as the arm’s length range for its company.
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