Transfer pricing can become an important audit issue when a U.S. company does business with a related foreign company. During an audit, the IRS checks whether the prices used in these transactions follow the arm’s-length principle. In simple terms, the IRS looks at whether unrelated companies would have agreed to similar prices and terms in a similar situation.
If the IRS determines that the transfer price was not appropriate, it can make an adjustment under IRC Section 482. This adjustment may increase the company’s U.S. taxable income, resulting in additional tax, interest, and transfer pricing penalties.
For example, suppose a U.S. subsidiary buys products from its foreign parent and reports $1 million in profit after deducting the cost of those products.
The IRS determines during an audit that the U.S. subsidiary paid too much to its foreign parent. In that case, it may reduce the amount the subsidiary is allowed to deduct for the purchases. This increases the subsidiary’s U.S. taxable income and may result in additional tax.
The company may also face a transfer pricing penalty under IRC Section 6662 if the adjustment meets the requirements of that section. This is why companies should use arm’s-length pricing and maintain proper documentation to support their transfer pricing positions during an IRS audit.
Next, let’s understand how an IRS transfer pricing audit works.