Business owner clients may need to pay more attention to the risk of being audited over a longtime accounting practice: “transfer pricing.”
In accounting, transfer pricing is how one division in a company charges another, such as a subsidiary or affiliate. Corporations often flex pricing to trim profits of one division in a high-tax area and increase the profits of divisions in low-tax areas, often internationally. And 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 by hiring more staff, which is expected to include more economists and attorneys.
Those staffing priorities suggest more complex audits are in the offing, says Erin Alexander, director of transfer pricing and the economic group at Mazars in New York City. Thus, transfer pricing topics “will remain a top priority,” she says.
“I think that the IRS will allocate more resources to scrutinize cross-border payments for intercompany transactions,” says 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 affect other areas of a client’s tax planning, advisors say.
“Transfer pricing audits are time-consuming and expensive,” says Alexander. “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.”
Complete documentation, which includes intercompany agreements, is key to protecting the taxpayer, she says. The taxpayer must ensure that the facts and circumstances of the business agree with those in the documentation. “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 adds, “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,” she says. A change in strategy could cut costs that were not incurred before the pandemic, she adds.
“Make sure,” says Adey, “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.
Chris McMahon, CEO of Aquinas Wealth Advisors in Pittsburgh, says his firm tells companies to take an extra step before year’s end and “commission an interim pricing study taking into consideration all affiliates and subsidiaries. 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.”
Even with the new enforcement funding, Alexander says it could still take years for the IRS to ramp up the audits.
“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,” she says. “The upside is that, although the number of transfer pricing audits will undoubtedly increase, taxpayers have some time to prepare.”