In a new International Practice Unit (IPU), the IRS provides audit tips to its examiners on a taxpayer’s affirmative use of Internal Revenue Code Section 482, “Allocation of Income and Deductions.” That section of tax law gives the IRS the authority to make adjustments between or among members of a “controlled group,” if a controlled taxpayer hasn’t reported its true taxable income.
In general, Section 482 can be used only by the IRS, but taxpayers may use it under certain situations. To reflect a true arm’s-length result for transfer pricing purposes, a controlled taxpayer may be permitted to report on its timely-filed U.S. income tax return (including extensions) the results of its “controlled transactions” based on prices different from those that were actually charged (to reflect the correct price). However, IRS examiners are instructed to conduct a series of audit steps to validate the taxpayer’s self-initiated adjustment.
Basics about IPUs and an example
IRS IPUs identify areas of strategic importance to the IRS and can provide information that may help taxpayers prepare for an IRS audit and respond to tax agency requests.
The new IPU focuses on inbound transactions — that is, transactions between a foreign parent and its U.S. subsidiary. To help IRS examiners audit such transactions, the IPU includes the following illustration of transactions where a wholly owned U.S. subsidiary buys products from a foreign multinational manufacturing parent company that it then distributes throughout the United States. The parent company owns all the shares of the U.S. subsidiary.
- The subsidiary records a purchase when these goods are transferred from the foreign parent based on a price list set at the start of the tax year. The purchases are included in the total cost of goods sold for the tax year.
- The U.S. subsidiary tests the transfer pricing of these controlled transactions after the end of the tax year to verify that the prices charged during the year have produced an arm’s-length result.
- If these prices haven’t produced an arm’s-length result, the subsidiary may make its own adjustment. This adjustment may increase or decrease the subsidiary’s taxable income. A corresponding adjustment would also be made on the foreign parent’s records. The subsidiary timely will file a U.S. Corporation Income Tax Return that reflects an arm’s-length price.
The IPU asks IRS examiners to consider these two issues:
- Is the subsidiary allowed to report an arm’s-length price that’s different from the book price for goods it purchases from the foreign parent?
- Is the subsidiary allowed a setoff adjustment when the IRS proposes a Section 482 adjustment for this tax year?
Questions the IRS will ask
For purposes of the first issue, examiners are told to ask the following questions:
- Is the transfer price for the tangible goods purchased at arm’s length?
- Was the transaction reported on the subsidiary’s return?
- Did the subsidiary report the arm’s-length price for the goods purchased on its financial statements (accounting records)?
- What was the price/value reported for the Customs Declaration Form for the goods purchased?
- Were the Customs Declaration Forms corrected to reflect the adjusted price?
- Did the unit make the adjustment to the price it paid to the foreign parent on its financial statements or as an adjustment on the tax return?
- Is the adjustment supported by documentation? (For example, the examiner may ask to see transfer pricing documentation, research studies, pricing analyses and verification procedures.)
The IRS states that, if the U.S. subsidiary doesn’t timely file its original return, or if it files an amended return, it generally isn’t allowed to increase the price that it paid to a foreign parent for filing purposes. Increasing the price for goods would increase the costs of goods sold in the example above, thereby resulting in an impermissible decrease in the subsidiary’s taxable income.
Relating to the second issue described above, the IPU says that, when the IRS proposes a Section 482 adjustment, the U.S. subsidiary may claim another Section 482 adjustment to offset the tax agency’s proposal. This setoff adjustment is permitted if it’s an adjustment to a non-arm’s-length transaction in the same taxable year between the same parties to the transaction in question.
For this purpose, the IPU states that the unit in the example above must satisfy the following procedural requirements:
- Establish that the setoff transaction wasn’t arm’s length.
- Establish the amount of the appropriate arm’s-length charge.
- Document all correlative adjustments resulting from the setoff.
- Timely notify the IRS (within 30 days after the earlier of the Notice of Proposed Adjustment (NOPA) or Statutory Notice of Deficiency).
Note: Failure to reflect certain taxpayer-initiated adjustments on the Customs Declaration Form may affect whether such an adjustment should be disallowed during the audit.