How Does an IRS Transfer Pricing Audit Work?

A transfer pricing audit is an IRS examination of transactions between related companies. The IRS looks at whether the pricing is consistent with the arm’s-length standard and whether the company’s transfer pricing position is supported by appropriate analysis and documentation.

The IRS’s current Transfer Pricing Examination Process (TPEP) provides a framework for the IRS’s approach to transfer pricing examinations.

The IRS audit may generally involve the following steps:

1. Initiation of the IRS Examination Process

The IRS identifies the taxpayer for examination and informs the company about the scope of the examination.

The examination may cover particular transactions, tax years, or broader transfer pricing issues.

2. IRS Requests Information

The IRS may request documents and information which may include the following:

• Transfer pricing documentation,
• Intercompany agreements,
• Financial statements and trial balances,
• Invoices and payment records,
• Organizational charts,
• Descriptions of the company’s business and supply chain,
• Functional analysis of the related companies,
• Information about the functions performed, assets used, and risks assumed,
• Benchmarking studies and comparable-company information,
• Details of intercompany services, royalties, loans, or product sales,
• Tax returns and supporting schedules.

The U.S. transfer pricing documentation rules under IRC Section 6662 and the related Treasury Regulations require taxpayers to maintain records that support the arm’s-length pricing of certain related-party transactions. These rules are important because adequate and timely documentation can help protect taxpayers from certain transfer pricing penalties if the IRS later makes a transfer pricing adjustment.

3. IRS Reviews the Transfer Pricing Method

The IRS may examine whether the taxpayer selected and applied an appropriate transfer pricing method.

For example, the IRS may question the following:

• Why was a particular transfer pricing method selected?
• Whether the tested party was appropriate?
• Whether the comparable companies were reliable?
• Whether the profit-level indicator was appropriate?
• Whether the functional analysis supports the company’s characterization of the parties?
• Whether the actual financial results are consistent with the transfer pricing policy?

The IRS may also perform its own economic analysis or propose alternative comparables.

4. IRS Compares the Policy With Actual Results

Having a transfer pricing policy on paper is not enough.

The IRS may compare the policy with the company’s actual financial results and transactions.

For example, a company may describe a foreign subsidiary as a limited-risk distributor that should earn a routine return. However, if the subsidiary consistently earns very high or very low profits, the IRS may question whether the transfer pricing policy reflects the business’s actual functions and risks.

5. Audit Resolution

The examination may conclude with no transfer pricing adjustment, or the IRS may propose one.

If the IRS makes an adjustment, the taxpayer may challenge it through the IRS administrative process and, where appropriate, through litigation.

The adjustment may also create potential double taxation because another country does not make a corresponding adjustment. In that case, the taxpayer may also consider the Mutual Agreement Procedure (MAP) available under an applicable tax treaty.

There is no fixed IRS timeframe for completing a transfer pricing examination. Complex examinations can take considerable time, particularly when there are multiple transactions, foreign affiliates, large amounts of documentation, or treaty-related issues.

Now that we have discussed the IRS transfer pricing audit process, let’s next understand what can trigger a transfer pricing audit.