What Can Trigger a Transfer Pricing Audit?

There is no single factor that automatically causes an IRS transfer pricing audit. The IRS uses various risk indicators when selecting taxpayers and transactions for examination.

Potential risk indicators for triggering a transfer pricing audit may include the following

• Significant related-party transactions,
• Persistent losses or unusually low profits in the U.S.,
• Significant fluctuations in profit margins,
• Large payments to foreign related parties,
• Royalties, management fees, or service payments to foreign affiliates,
• Large intercompany loans or financing arrangements,
• Significant changes in transfer pricing results from year to year,
• Transactions involving jurisdictions that present higher tax risks,
• Differences between transfer pricing documentation and tax return information,
• Weak or outdated transfer pricing documentation,
• Results that appear inconsistent with the functions and risks of the related parties.

Let’s understand the triggering factor for a transfer pricing audit through a simple example.

For example, suppose ABC U.S. Inc. is a U.S. subsidiary of a foreign parent company. ABC U.S. sells products to customers in the United States but reports losses every year.

Let’s say ABC U.S. has $10 million in sales but reports a $500,000 loss for three consecutive years. During the same period, it pays significant amounts to its foreign parent for products and services.

The IRS may question why the U.S. company continues to report losses while operating in the U.S. market. It may examine whether ABC U.S. is paying an arm’s-length price to its foreign parent and whether the transfer pricing arrangements are causing too much profit to be reported outside the United States.

Persistent U.S. losses do not automatically mean that the company has violated the transfer pricing rules, but they can be a potential indicator for closer IRS review.

A transfer pricing issue can also arise as part of a broader corporate tax examination rather than through a separate transfer pricing audit.

The IRS may examine U.S. multinationals, U.S. subsidiaries of foreign companies, and businesses with significant cross-border related-party transactions.

Now that we have discussed the factors triggering a transfer pricing audit, let’s understand some of the transfer pricing-related penalties in the United States.