International tax audits have become more common in the United States in recent years, affecting both U.S. and foreign taxpayers. This may be due to globalization, the growth of the digital economy, and major changes to U.S. tax laws aimed at protecting the U.S. tax base. Let’s start by defining an international tax audit.
An International Tax Audit by the IRS is an examination of tax returns and records for taxpayers with cross-border U.S. tax obligations. These audits generally check that foreign income, assets, and transactions are reported correctly on U.S. tax returns. This will ultimately prevent tax evasion and profit shifting to low-tax countries.
The main goal of an international tax audit is to ensure accurate reporting and full compliance with U.S. tax laws on foreign income, assets, and transactions.
It covers U.S. citizens and residents with foreign income or assets. It also includes foreign taxpayers, such as foreign individuals and foreign entities, if they have any U.S. ties.
International tax audits generally focus on two categories of international activity.
First, they target U.S. citizens and residents with foreign income or assets, as well as U.S. companies with significant overseas operations or investments. These are commonly referred to as outbound transactions.
For example, a U.S. taxpayer who earns rental income from property in another country may be subject to audit to ensure proper reporting of foreign income from that property.
Second, the IRS also audits foreign taxpayers who earn U.S.-source income. This may include effectively connected income from a U.S. trade or business. This may also include U.S. source income not connected to a U.S. trade or business, such as FDAP income. For instance, a foreign taxpayer may derive U.S. source FDAP income, such as U.S. rental income and dividends. These are commonly referred to as inbound transactions.
For example, a foreign individual who earns rental income from U.S. property may be audited to verify the proper tax treatment of that U.S.-source income.
Let’s examine the role of the Large Business and International (LB&I) Division in handling international tax audits for larger businesses and high-net-worth individuals.
The IRS Large Business and International (LB&I) Division is primarily responsible for handling international tax audits for domestic and foreign businesses. It generally manages tax matters for businesses with U.S. reporting requirements and assets of $10 million or more.
LB&I also runs programs for high-net-worth individuals and U.S. persons abroad. The division is organized into practice areas focused on cross-border activities, transfer pricing, and foreign payments.
International tax audits focus on several high-risk compliance and tax issues that often come up in cross-border situations. Let’s understand some of them, which are as follows:
Transfer pricing refers to the pricing of goods, services, intangibles, or other transactions between related (controlled) entities, such as a U.S. company and its foreign related company. Under IRC § 482, these transactions should be priced at arm’s length. This means they reflect what unrelated parties would agree to under similar circumstances.
Transfer Pricing audits verify that transactions between related companies, such as a U.S. company and its foreign related company, are priced at arm’s length, as required by IRC § 482. This helps prevent profits from being shifted to low-tax countries through unfair pricing.
This area is mainly handled by the Treaty and Transfer Pricing Operations Practice Area and often involves detailed economic analysis and documentation reviews.
For more information about Transfer Pricing, please refer to the following article.
The Foreign Tax Credit (“FTC”) allows U.S. taxpayers to offset their U.S. income tax liability with certain income taxes paid or accrued to a foreign country on the same income. This helps them in mitigating double taxation.
FTC audits verify that claims for foreign tax credits on taxes paid to other countries are accurate and eligible. This prevents double taxation and stops overclaims or mistakes that could unfairly increase the credit amount.
For more information about the foreign tax credit, please refer to the following article.
A Controlled Foreign Corporation (“CFC”) is a foreign corporation where U.S. shareholders collectively hold more than 50% of the total voting power or value of the corporation’s stock. Here, a U.S. shareholder is defined as a person or entity that owns at least 10% of the corporation’s total voting power.
CFC audits verify income from controlled foreign corporations controlled by U.S. taxpayers. They usually check whether certain types of income, such as Subpart F income, should be reported and taxed on U.S. shareholders’ returns.
For more information about CFCs, please refer to the following article.
Reporting obligations and information exchange primarily focus on complying with international information-reporting requirements. These requirements generally apply to foreign financial assets and accounts held by U.S. taxpayers.
These generally include compliance with the Foreign Account Tax Compliance Act (FATCA) and the Report of Foreign Bank and Financial Accounts (FBAR).
FATCA requires certain U.S. taxpayers to report specified foreign financial assets if thresholds are met. Single taxpayers and married taxpayers filing separately generally should file Form 8938 if their foreign financial assets exceed $50,000 on the last day of the tax year or $75,000 at any time during the year. For married taxpayers filing jointly, the thresholds are generally $100,000 on the last day of the tax year or $150,000 at any time during the year. Higher thresholds apply to U.S. taxpayers living abroad.
FBAR requires U.S. persons to report foreign financial accounts with an aggregate value exceeding $10,000 at any point in the year.
These audits ensure that taxpayers comply with key international reporting requirements, such as FATCA and FBAR. These rules often trigger audits, and LB&I runs campaigns to check FATCA filings, offshore banking, and related issues. For more information about FATCA and FBAR, please refer to the following article.
LB&I uses a targeted, issue-based approach called the LB&I Examination Process (LEP). This process focuses on the most significant compliance risk, which often involves complex international transactions, rather than comprehensive reviews of entire tax returns.
LB&I selects taxpayers for audit. These taxpayers may be domestic or international. For example, foreign corporations with U.S. effectively connected income may be selected for audit. Once LB&I selects taxpayers for audit, the process begins with initial contact and an opening conference. During this conference, the LB&I team explains the examination procedures, expectations, and the roles and responsibilities of both parties.
If a taxpayer believes they may be eligible for a potential refund, they should generally submit a refund claim within 30 days of the opening conference.
The LB&I divides the examination into three main phases: Planning, Execution, and Resolution.
The Planning Phase determines the audit scope by identifying and selecting issues with the broadest impact on tax and compliance, regardless of entity size or type. This may include international issues, such as transfer pricing and foreign tax credits.
The Planning phase is divided into the following steps: Communication, Issue Team Concept, and Examination Plan.
The IRS and the taxpayer (domestic or foreign) discuss the audit scope and exchange information via secure tools to keep the process efficient and transparent.
Special teams are created for each issue. These teams include IRS examiners, technical specialists, and knowledgeable employees from the taxpayer’s organization to address complex matters together. These may include international issues like foreign tax credit , transfer pricing, controlled foreign corporations (CFCs), etc.
The IRS and the taxpayer agree on a flexible plan that outlines the issues to review, deadlines, resources, and how they will communicate throughout the audit. This could become crucial if a foreign taxpayer is involved, as there may be challenges in information exchange or accessing foreign-based records.
During the Execution phase, the IRS gathers facts and applies the law to each issue, with ongoing discussions and formal information requests (IDRs). The goal is to resolve questions as they arise.
The Execution phase comprises the following steps: Issue Development Process and Penalties.
Before sending formal requests, the IRS discusses them with the taxpayer. Responses are reviewed promptly, and proposed adjustments are shared so the taxpayer can comment before conclusions are finalized. In international audits, this can include challenges in obtaining documents when they are located outside the United States.
The IRS may consult specialists while the taxpayer provides timely, complete information and access to personnel. Both sides aim to resolve disagreements early.
The IRS assesses whether penalties apply fairly, obtains approval if needed, and gives the taxpayer an opportunity to explain, based on the facts and the law. International cases may incur penalties for noncompliance with foreign reporting obligations, such as FATCA or FBAR.
The IRS and the taxpayer generally try to reach an agreement as soon as possible, ideally at the working level.
The Execution phase comprises the following steps: Issue Resolution and Exit Strategy.
Frequent discussions continue, and tools such as Fast Track Settlement may be used to resolve disputes quickly through the Appeals function. For international issues, this may involve procedures such as the Competent Authority’s treaty-based Mutual Agreement Procedures (MAP).
If issues remain unresolved, the IRS issues a formal report or returns the case to the LB&I issue team’s jurisdiction for consideration.
Once issues are resolved or positions are finalized, the IRS and the taxpayer discuss the steps needed to close the examination. The goal is an efficient conclusion with clear documentation of outcomes and next steps. For foreign taxpayers, this ensures having an exit strategy for international issues at the final stage. For example, this may include treaty relief claims or coordination with foreign tax authorities via the Exchange of Information.
For more details on how the IRS audits taxpayers in a foreign country, please refer to the following article.
International audits require significant resources from both the IRS and taxpayers, especially for international taxpayers. They often involve producing many documents, conducting detailed economic and transfer pricing analyses, and coordinating across borders. If the IRS identifies issues, it can result in significant changes to taxable income, penalties, or even court cases.
Therefore, maintaining proper documentation, understanding international tax obligations, and seeking professional guidance early can help taxpayers manage audit risks and respond effectively to IRS inquiries.
International tax audits by the IRS enforce compliance and protect the U.S. tax base in a global economy. By closely reviewing foreign income, assets, and transactions, the IRS encourages accurate reporting and tax planning. Taxpayers with foreign ties should keep detailed records and stay up to date on IRS rules and campaigns.
International tax audits can create unnecessary complexity for affected taxpayers. Therefore, taxpayers are advised to consult experienced international tax specialists in this aspect. These experts help ensure timely and accurate responses to the IRS, correctly apply treaty rules, help reduce penalties, and resolve disputes efficiently.
If you are facing an international tax audit or have received an IRS inquiry involving foreign income or assets, Arora Law P.C. can help you understand your options and develop an effective response strategy. Contact us to schedule a consultation and discuss your international tax audit concerns.
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