Business-owning clients may need to pay more attention to the audit risk of a long-time accounting practice.

Transfer pricing in accounting is how one division in a company charges another division, such as a subsidiary or affiliate. Corporations often flex pricing to trim profits of a division in a high-tax area and increase the profits of divisions in low-tax areas, often internationally. Tax authorities frequently challenge transfer pricing methods.

Advisors warn that this is something tax planners and clients need to be aware of in light of stepped up tax enforcement on the federal level.

The Inflation Reduction Act of 2022, signed into law in August, provided $80 billion for the IRS over 10 years. More than half of that money will go toward strengthening tax enforcement, including by hiring.

“This new staff group is expected to include more economists and attorneys, which indicates that more complex audits—such as those covering transfer pricing topics—will remain a top priority,” said Erin Alexander, director of transfer pricing and the economic group at Mazars in New York City.

“Several areas that have been overlooked by the [IRS] is the complex matter of transfer pricing,” added Chris McMahon, CEO of Aquinas Wealth Advisors in Pittsburgh. “Often the IRS has come to rely most exclusively on the transfer pricing studies that [companies] have drafted by their CPA firms. The IRS is going to dig in now to see if their modeling is correct.”

“I think that the IRS will allocate more resources to scrutinize cross-border payments for intercompany transactions,” said Henric Adey, director and the national leader of the transfer pricing practice at Eisner Advisory Group in Iselin, N.J. “A lack of contemporaneous documentation of your current transfer pricing position can lead to protracted audits.”

Audits can cause a ripple effect that impacts other areas of a client's tax planning, advisors said.

“Transfer pricing audits are time-consuming and expensive,” Alexander said. “They can also create a domino effect, as transfer pricing adjustments may affect the calculation of U.S. state taxes, the tax paid by the foreign related party, and customs valuations, to name a few. Transfer pricing documentation that is well done and complete will protect a taxpayer.”

Documentation should include intercompany agreements and ensuring that the facts and circumstances of the business agree with those in the documentation, Alexander said. “If a taxpayer has taken a risky transfer pricing position, it may also be a good time to consider the tax dispute resolution tools that are available,” she added, “including the International Compliance Assurance Program, advance pricing agreements and mutual agreement procedures.

“Because so many sweeping economic changes have occurred over the last couple years, it’s important that taxpayers review their transfer pricing strategy,” Alexander said. “Is it possible that a change in strategy could take advantage of new efficiencies or cut costs that were not incurred prior to the pandemic? Now is a good time to address that.”

“Make sure that if you’re a U.S. business operating across state borders that you also can demonstrate that you apply the arm’s-length principle” to transfer pricing, meaning that the price is the same as if the two entities were not connected, Adey said.

“We advice companies is to take an extra step prior to year’s end, that they commission an interim pricing study taking into consideration all affiliates and subsidiaries,” McMahon said. “This interim report should then be used to modify the budget numbers and ... ensure that the final report will be more complete and less exposed to IRS correction.”

Business owners should have time to prepare for IRS action, Alexander said.

“The IRS will likely continue to focus on the same issues and use the same audit selection criteria, with the change coming in the number of audits,” Alexander said, adding that ramping up federal audits, despite the new IRS funding, still could take years.

“The IRS’s new staff will need to be trained, and the backlog of current audits will need to be cleared. Because the IRS remains focused on more complex issues, which require more training time, the number of audits concluded may even decline in the near term,” Alexander said. “The upside is that, although the number of transfer pricing audits will undoubtedly increase, taxpayers have some time to prepare.”