International Tax Monthly June Issue


IRS Issues Audit Tips on Adjustments Made in Transfer Pricing Deals

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:

1. 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?

2. 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.

Talk to the Professionals

Consult with your international tax advisor for more information and help preparing for an IRS audit.

IRS to Impose Reporting Requirements on Foreign-Owned Disregarded Entities

U.S.-disregarded entities that are owned by a foreign person would be treated as domestic corporations under proposed regulations issued on May 6 by the IRS.

The proposed new rules would apply for purposes of the reporting, record maintenance, and other compliance requirements that apply to 25% foreign-owned domestic corporations. These changes are intended to provide the IRS with improved access to information that it needs to satisfy its obligations under U.S. tax treaties, tax information exchange agreements and similar international agreements, as well as to strengthen the enforcement of U.S. tax laws.

Annual Filings

The proposed rules would require the disregarded entities annually to file Form 5472, “Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business,” and to maintain records sufficient to establish the accuracy of the information reported on their federal tax returns. They also would be required to obtain an Employer Identification Number (EIN) by filing an application that includes responsible-party information.

Disregarded entities are required to report all transactions with foreign related parties. The term “transaction” is defined to include any sale, assignment, lease, license, loan, advance, contribution, or other transfer of any interest in or a right to use any property or money, as well as the performance of any services for the benefit of, or on behalf of, another taxpayer.

Other Steps to Fight Offshore Tax Evasion

Separately on May 5, the U.S. Treasury Department announced proposed other legislation that would help further counter money laundering and corruption as well as combat tax evasion.

Specifically, it proposed beneficial ownership legislation that would require companies to know and report adequate and accurate information about the real person behind a company at the time of the company’s creation. That information would be made available to law enforcement. The proposed draft legislation has been sent to Congress.

In a letter to Speaker of the House Paul Ryan, U.S. Treasury Secretary Jacob Lew urged Congress to swiftly pass beneficial ownership legislation. “These regulations implement a common-sense requirement so that financial institutions know who actually owns the companies that make use of their services (the ‘beneficial owner’),” he wrote.

“Criminals are currently able to misuse companies to hide this beneficial owner, significantly weakening our ability to fight financial crime,” Lew added.

Down the Road

The proposed regulations on disregarded entities would apply to tax years ending on or after the date that is 12 months after they are published as final regulations.

India to Treat Income from Unlisted Share Transfers as Capital Gains

India’s Central Board of Direct Taxes (CBDT) recently clarified that income from the transfer of unlisted shares will be taxed as a lower rate capital gain rather than as business income.

The tax department’s move is aimed at avoiding tax disputes/litigation and maintaining a uniform approach. However, such treatment isn’t applicable in situations where:

  • The genuineness of transactions in unlisted shares itself is questionable,
  • The transfer of unlisted shares is related to an issue pertaining to lifting of the corporate veil, or
  • The transfer of unlisted shares is made along with the control and management of the underlying business.

Capital Asset Defined

The Indian Income-tax Act, 1961, defines the term “capital asset” to include property of any kind held by a taxpayer, whether or not connected with his business or profession, but doesn’t include any stock-in-trade or personal assets subject to certain exceptions.

Shares and other securities may be held as capital assets or stock-in-trade/trading assets or both. Determination of the character of a particular investment in shares or other securities (that is, whether it’s a capital asset or stock-in-trade) is essentially a fact-specific determination and has led to a lot of uncertainty and litigation in the past.

Over the years, the Indian courts have laid down different parameters to distinguish the shares held as investments from the shares held as stock-in-trade. Disputes, however, have continued to exist on the application of these principles to the facts of an individual case, since the taxpayers find it difficult to prove their intention in acquiring such shares/securities.

In light of this, and while recognizing that no universal principle in absolute terms can be laid down to decide the character of income from sale of shares and securities, the CBDT recognized that the major part of shares/securities transactions takes place as listed ones.

Consistent Treatment Required

With a view to reduce litigation and uncertainty in the matter, the CBDT stated that income arising from the transfer of listed shares and securities that are held for more than 12 months may be taxed as a capital gain, rather than as business income, unless the taxpayer treats the shares and securities as its stock-in-trade. This treatment, once taken by the taxpayer in a particular assessment year, must remain applicable in subsequent assessment years. The taxpayers may not be allowed to adopt a different/contrary stand in this regard in subsequent years.