IRS Increases Focus on Transactions Between Commonly Controlled Entities in the Mid-Market Segment by Lacey Strachan
Large multinational corporations have historically been the focus of IRS transfer pricing examinations, such as the dispute between Amazon and the IRS over the amounts Amazon charged its European subsidiary for certain intangible assets that were transferred.[i] However, IRS efforts to address potential income shifting between related entities have expanded to include smaller companies in the middle market.
Section 482. These examinations arise as a result of the IRS’s power under Section 482, which provides that in the case of two or more businesses “owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any such organizations, trades, or businesses.” This Section gives the IRS broad discretion to reallocate income so that the income reported by a taxpayer is consistent with the economics and substance of the transactions between the related entities.
The standard under Section 482 is whether a transaction is arm’s length, which is shown by comparing the results of the related party transaction to what the results of the same transaction would be if entered into by unrelated taxpayers.[ii] The regulations under Section 482 set forth extensive rules and guidance that must be followed in determining whether a controlled transaction satisfies the arm’s length standard.
LB&I Compliance Campaigns. The IRS recently announced that one of LB&I’s new compliance campaigns is the “Related Party Transactions Campaign,” which will be implemented through issue-based examinations.[iii] The IRS explained in the rollout of the campaign that it will focus on “transactions between commonly controlled entities that provide taxpayers a means to transfer funds from the corporation to related pass through entities or shareholders.” The IRS specified that it is allocating resources to this issue “to determine the level of compliance in related party transactions of taxpayers in the mid-market segment. The IRS does not state whether its focus will be on transactions involving foreign entities or whether its focus will include transactions between related domestic entities. While one of the prime concerns for the IRS in this area is taxpayers shifting income from the U.S. to a jurisdiction with a lower tax rate using non arm’s length transactions, situations arise where taxpayers have an incentive to shift income from one domestic entity to another. The IRS’s powers under Section 482 apply equally to transactions with a domestic entity as to transactions with a foreign entity.
The IRS also rolled out another campaign targeting specifically one type of cross-border transaction between commonly controlled entities. The IRS’s “Inbound Distributor Campaign” focuses on U.S. distributors of goods sourced from foreign-related parties, where the U.S. distributor has incurred losses or small profits that are not commensurate with the functions performed and risks assumed by the domestic entity—in such cases, the IRS believes the taxpayer would be entitled to higher returns in arm’s-length transactions.[iv] For this compliance campaign, which will also be implemented by issue-based examinations, the IRS has “developed a comprehensive training strategy…that will aid revenue agents as they examine this IRC Section 482 issue.”[v]
Transfer Pricing Studies. With the IRS’s expanded focus on related party transactions, it is important for taxpayers who have commonly controlled or related entities to revisit their transfer pricing policies and consider obtaining a transfer pricing study. In addition to potential substantial or gross valuation misstatement penalties if the IRS makes a transfer pricing adjustment, taxpayers may also be subject to a strict liability penalty depending on the net amount of the adjustment if the taxpayer did not obtain a transfer pricing policy prior to filing its tax return.[vi] In order to be in the best position in the event of a transfer pricing audit and in order to help avoid the risk of a strict liability penalty in the event of a significant adjustment, taxpayers should have documentation prior to filing their tax returns setting forth the taxpayer’s determination of the price and establishing that the method the taxpayer used was reasonable and consistent with the Section 482 regulations.[vii]
Transfer Pricing Examinations. In an examination, the IRS advises revenue agents to issue a “§6662(e) mandatory Information Documentation Request” at the beginning of an audit, which will request the taxpayer’s documentation regarding its transfer pricing determinations.[viii] While best practice is to ensure that all related party transactions are done at arm’s length, taxpayers facing a transfer pricing examination should be aware that the regulations under Section 482 allow for a “setoff” of an IRS transfer pricing adjustment, if the taxpayer can establish that the effect of multiple transactions between the related parties, when considered together, reflect an arm’s length arrangement between the entities.[ix] The procedures that a taxpayer must follow to claim a setoff are set forth in Revenue Procedure 2005-46.
[i] Amazon.com, Inc. v. Comm’r, 148 T.C. No. 8, Docket No. 31197-12, 2017 (Mar. 23, 2017).
[ii] Treas. Reg. § 1.482-1(b).
[vi] IRC §6662(e)(1)(B); IRC §6662(h)(2)(A)(ii)(I).
[vii] IRC §6662(e)(3)(B).
[viii] IRS Transfer Pricing Audit Roadmap, available at https://www.irs.gov/pub/irs-utl/FinalTrfPrcRoadMap.pdf.
[ix] Treas. Reg. § 1.482-1(g)(4)(i).