Yellow card: the IRS flags US subsidiaries for transfer pricing

July 2026 | SPOTLIGHT | CORPORATE TAX

Financier Worldwide Magazine

July 2026 Issue

With World Cup 2026 underway, teams from around the world have arrived in the US, and on the pitch (or as we say in the US, the ‘field’) will be referees with yellow and red cards in hand.

For US taxpayers, specifically US subsidiaries of foreign-based companies, the Internal Revenue Services (IRS) has implemented its own version of a yellow card through the increased use of data analytics to identify issues and taxpayers for perceived transfer pricing (TP) noncompliance involving inbound transactions, where money, goods or services originate from a non-US company, such as the global parent company, and are provided to a US affiliate.

The IRS has identified two intercompany transactions as focus areas of IRS scrutiny – transfer prices paid by US distribution entities for the importation of goods and the interest rate paid on intercompany loans from foreign parents. In each scenario, the IRS’s analysis identifies US affiliates that may have paid more than an arm’s length amount. These are not exotic intercompany transactions but basic business transactions, and they are likely the first examples of the types of common intercompany transactions that will become targets for the IRS’s growing data-analytics capabilities.

Additionally, even when taxpayers prepare contemporaneous TP documentation, the IRS is pursuing TP-specific penalties, which further elevates the risk for multinational businesses.

US distributor – inflated cost of goods sold

In connection with the IRS’s campaign targeting, “inflated cost of goods sold”, the IRS used tax-return data and country-by-country reporting to identify the intercompany sale of goods by foreign companies to US distributors as an area of perceived abuse. Using data analytics, the IRS identified numerous US distribution subsidiaries that reported recurring losses or chronically low margins over a five-year period, which the IRS suspected did not comport with the arm’s length standard.

The IRS’s theory is straightforward. At arm’s length, a limited-risk distribution company should generally earn a positive profit margin for its activities to remain viable. Accordingly, when a US subsidiary continues year after year to buy goods from its foreign parent at prices that do not permit the subsidiary to generate consistent operating profits, the IRS treats that pattern as evidence that the intercompany prices for such goods are ‘inflated’ and not arm’s length. Depending on the circumstances, a distributor’s losses or low margins may be entirely consistent with arm’s-length results and not due to ‘inflated’ prices, but the IRS’s campaign demonstrates scepticism that such sustained losses reflect the arm’s-length standard. Thus, US distribution subsidiaries must be prepared to substantiate the transfer price and explain why the US distributor generated low or negative profit margins.

The IRS’s focus on the intercompany sale of goods and distributor profit margins started before the recent increase in both the amount and breadth of US tariffs, which can increase a US distributor’s cost of goods sold and, if the tariff cannot be passed on to its customers, will drive down the distributor’s profit margins. The IRS is generally aware that tariffs can negatively affect a US distributor’s profits, but whether such tariffs justify losses or very low operating margins will be determined on a case by case basis.

Inbound financing and implicit support

Another heightened area of IRS focus is intercompany financing, particularly the interest rate on a loan from a foreign parent to its US subsidiary. The IRS (following other tax authorities) has recently argued that a borrower’s membership in a multinational group can reduce the intercompany interest rate even absent an explicit parental guarantee. Specifically, the IRS reasons that a third-party lender pricing a loan to the US subsidiary on an arm’s-length basis would consider the likelihood that the foreign parent would step in to prevent default and, as a result, would charge a lower interest rate on that loan. In the IRS’s view, that benefit (so-called ‘implicit support’) must be considered under the arm’s-length standard. Against that backdrop, the Eaton case, now pending in the Tax Court, will provide the first significant US judicial test of that theory.

In the meantime, for US borrowers, intercompany interest rates based strictly on its standalone credit rating, without taking group membership into account, are increasingly vulnerable to IRS audit. That is especially true when the foreign parent is well capitalised and the US subsidiary’s standalone credit rating is substantially lower than the overall group’s rating. Due to the heightened audit risk, multinationals engaging in related-party lending should carefully anticipate arguments based on the effect of implicit support.

TP penalties

TP valuation penalties for underpayments of tax have existed for more than 35 years, but, for much of that time, the IRS rarely asserted these penalties because the existence of a taxpayer’s contemporaneous TP documentation was generally deemed to satisfy the reasonable cause and good-faith exception to the penalties.

But the IRS’s historical restraint has shifted and in both audit and litigation, the IRS has more aggressively asserted penalties by questioning whether a taxpayer’s TP documentation reasonably selected the best method, or even where the parties agree on the method whether the taxpayer’s application of that method, given the underlying assumptions, reasonably provided the most reliable arm’s-length result based on all the facts and circumstances.

Because these valuation penalties are substantial (rising to 40 percent of the underpayment of tax), the IRS’s increasing application of penalties places increased pressure on tax departments and executives to develop robust analysis and factual records in support of the TP analysis, methods and results.

Next steps

While taxpayers have always had the burden of proving their TP meets the arm’s length standard, the IRS’ increasing use of data analytics, in tandem with more rigorous application of penalties, has raised the stakes considerably. Accordingly, companies should not wait for the first notice of an IRS inquiry but instead take proactive steps to reduce tax controversy risk based on their specific circumstances.

First, conduct a self-review against current IRS screening criteria. The IRS has made its screening criteria clear. If a US distribution entity has operated at or below breakeven for multiple years, if the underlying support for intercompany loan pricing has not been refreshed in light of recent IRS positions, or if the existing penalty documentation reads like a compliance exercise rather than a substantive defence of the results, the company is better served identifying those issues internally before an examination begins. A self-review gives the company time to develop a considered response, including deciding to do nothing if the positions hold up, rather than reacting under examination pressure.

Second, address recurring losses with contemporaneous documentation, not retrospective explanations. When a US distribution subsidiary operates at a loss, the business reasons should be documented (ideally when the pricing is initially determined but at a minimum before the IRS asks the question) and supported by the kind of evidence that a third party would have generated. If the losses are not consistent with arm’s-length expectations, the company should consider corrective options, such as pricing adjustments, whether through year-end compensating adjustments permitted by the TP regulations or prospective changes, and voluntary disclosures. In doing so, the taxpayer should consider materiality and the effect on prior-year positions.

Third, reassess the assumptions underlying intercompany financing. For groups with material intercompany debt from a foreign parent to a US subsidiary, the relevant question is whether the existing rate analysis would withstand an implicit-support challenge. If the analysis relies solely on the borrower’s standalone credit, the documentation should, at a minimum, address how group membership was considered and why the standalone approach is more appropriate. This exercise is even more important for larger loans and longer-dated loans.

Fourth, consider an advance pricing agreement (APA) or other pre-filing process for a material recurring exposure. When the underlying facts are likely to recur and the dollar exposure is material, an APA can provide prospective certainty and, through rollback, address prior years as well. APAs can be expensive and resource intensive, typically taking two to four years from filing to execution, and they are not the right answer for every fact pattern. Nevertheless, for executives whose risk profile is dominated by a single recurring issue, the cost of an APA often compares favourably with the cost of defending the same position across multiple examination cycles.

Lastly, ensure that TP documentation does more than check a box. The regulatory TP documentation requirements are a floor, not a ceiling, for developing a robust and defensible analysis. Documentation that mechanically addresses the minimum required elements, such as method selection, comparables and profit level indicators, without further explaining the business rationale for the structure, the resulting outcomes and the hypothetical terms of realistic-alternative transactions, is increasingly vulnerable.

C. Terrell Ussing is a partner and Brad McCormack is of counsel at Gibson, Dunn & Crutcher LLP. Mr Ussing can be contacted on +1 (202) 887 3612 or by email: tussing@gibsondunn.com. Mr McCormack can be contacted on +1 (202) 955 8528 or by email: bmccormack@gibsondunn.com.

C. Terrell Ussing and Brad McCormack

Gibson, Dunn & Crutcher LLP