On January 31, 2017, the IRS Large Business and International Division (LB&I) announced its initial tax compliance campaigns. In 2016, LB&I began moving toward issue-based examinations, announcing it would focus its limited audit resources on enforcement “campaigns” with respect to issues having high compliance risk for large groups of taxpayers. As anticipated, the initial list has a heavy emphasis on international tax, with four international issues among the 13 campaigns in the announcement. Surprisingly, the first list does not include any issues related to the taxation of intellectual property held by multinationals, likely the issues that are most contested and involve the highest dollar amounts in current examinations. We expect to see further announcements of campaigns in this area.
The international campaigns are with respect to: (i) tax-free repatriation strategies utilized by mid-market companies; (ii) transfer pricing for U.S. distributors of tangible goods sourced from foreign related parties reporting low U.S. profits (“Inbound Distributors”); (iii) failure to file by foreign companies with a U.S. trade or business; and (iv) follow-up on the Offshore Voluntary Disclosure Program. A copy of the LB&I press release can be accessed here. LB&I has previously published International Practice Units (IPUs) on each of these topics. See index of IPUs. LB&I regularly adds new IPUs. Taxpayers with any of the issues among the LB&I campaigns should review the IPUs for a primer on how their audit teams may approach the issue(s).
LB&I’s reorganization of its audit function is intended to make more effective use of LB&I’s limited resources by selecting audit work with the highest compliance risk, defining the compliance objectives, and improving the training and knowledge management among LB&I staff. Effective May 1, 2016, LB&I changed its approach to audits. Rather than auditing the returns of large corporate taxpayers and seeking to uncover issues, LB&I intends to conduct issue-focused examinations, identifying an issue for audit and then finding taxpayers with that issue. LB&I now has five substantive practice areas which study compliance issues within their respective areas of expertise and suggest enforcement “campaigns” to be included in LB&I’s compliance activities. To identify taxpayers likely to have a campaign issue, LB&I is establishing a centralized support function that uses data analytics and feedback loops from audits and other enforcement activities to identify taxpayers for audit.
The Repatriation and Inbound Distributor Transfer Pricing Campaigns are audit campaigns. LB&I intends to identify taxpayers for audit on these issues. With respect to the Repatriation Campaign, LB&I announced that it is aware of different strategies that mid-market companies use to repatriate foreign earnings into the U.S. without tax. Further, LB&I stated that many taxpayers do not properly report repatriations as taxable events on their U.S. returns. LB&I’s Repatriation Campaign seeks to improve LB&I’s issue selection filters to find taxpayers with these issues, and to audit those taxpayers in an effort to improve compliance. For example, such repatriation strategies could be similar to those described in Notice 2012-39 (doubling up on repatriation through section 367(d) regulations), and the IPU entitled “Inbound Liquidation of Foreign Corporation into U.S. Corporate Shareholder.”
The Inbound Distributor Transfer Pricing Campaign intends to focus on U.S. distributors of goods sourced from foreign-related parties. The announcement states that the IRS has developed a comprehensive training strategy on this issue. LB&I has issued five IPUs covering best method analysis and different transfer pricing methods that could be applied to U.S. distributors. This is a well-developed area of transfer pricing law, and less disputed than other areas. Distribution of tangible goods by U.S. distributors with related foreign suppliers has been the most common category of Advance Pricing Agreements (APAs) for many years. The announcement states that the IRS will focus on U.S. distributors reporting losses or small profits on their U.S. returns.
The Non-Filer Campaign is intended to increase compliance. LB&I announced that its data indicates that many foreign companies with a U.S. trade or business are not filing Form 1120-F, U.S. Income Tax Return of Foreign Corporation. LB&I says that it will use various “external data sources” to identify the relevant foreign companies and encourage them to file the returns. LB&I says that the campaign will begin with so-called “soft letters” encouraging the foreign companies to file Form 1120-F. If the companies do not, then LB&I will initiate audits. LB&I has multiple IPUs addressing when a foreign company’s activities in the United States rise to the level of a U.S. trade or business, or, in the treaty context, a U.S. permanent establishment. Note that the IRS takes the position that failure to file a timely filed return can preclude a foreign taxpayer from claiming deductions related to its U.S. trade or business. See Treas. Reg. § 1.882-4(a)(2); Swallows Holdings, Inc. v. Commissioner, 515 F.3d 162 (3d Cir. 2008).
The Offshore Voluntary Disclosure Program has operated for a number of years, permitting individual taxpayers with foreign bank accounts or offshore income to resolve past non-compliance. The campaign will encourage taxpayers who entered the program, then withdrew, or are eligible for the program but have not yet applied, to participate in the program by a number of measures, including examination.
Overall, we should watch as the IRS announces more IPUs, which seem to foreshadow examination campaigns. We expect to see campaigns related to transfer pricing and other international issues related to intangibles in the future. For those with a campaign issue on their return, review of the IPUs related to your issue will help you to understand the IRS position and prepare a defense for an issue-focused examination, should it arise.