Companies Face Tariff-Induced Transfer Pricing Audit Risks

President Donald Trump’s widespread tariffs are boosting tax dispute risks for companies that are scrambling to understand how to factor the new trade duties into their transfer pricing and tax planning without attracting an audit.

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Tariffs raise the prices of imported goods, meaning companies importing products from their own affiliates may have to—or want to—adjust the pricing of those transactions to meet transfer pricing rules that require them to treat the deals as though they were done at arm’s length, with unrelated parties.

The added cost of the tariff will likely knock the pricing for many goods out of that arm’s-length range, so companies may have to adjust these prices to stay compliant. Additionally, companies may be able to make adjustments to mitigate the tariff impacts by reducing the price the US entity pays for the good.

These adjustments can attract scrutiny, however, from both tax and customs agencies. And growing geopolitical tensions may make it hard for companies to rely on tax dispute resolution mechanisms like mutual agreement procedures.

In this episode of the Talking Tax Podcast, Crowe LLP transfer pricing practice leader Sowmya Varadharajan talked with reporter Caleb Harshberger about the choices, and risks, companies are facing.

Do you have feedback on this episode of Talking Tax? Give us a call and leave a voicemail at 703-341-3690.

This transcript was produced by Bloomberg Law Automation.

David Schultz:

From Washington, I’m David Schultz, and this is Talking Tax.

This is the fourth and final in our series of podcasts looking at the role transfer pricing is playing as companies try to adapt to a post-tariff world. So far, we’ve talked about ways companies might try to set up their transfer pricing to avoid tariffs, but today we’re going to get into how companies might try to avoid running afoul of a taxing authority and what it might look like if they don’t.

And to go through this, we have Sowmya Varadharajan, a principal in the tax group at the firm Crowe. She spoke to Bloomberg tax reporter Caleb Harshberger about what transfer pricing disputes were like in the pre-tariff times.

Sowmya Varadharajan:

So I think in general, transfer pricing disputes have been on the rise. And honestly, I believe that since the COVID timeframe, tax authorities have tried to use tax disputes and tax audits to buffer up their coffers. And the position that tax authorities, not just the IRS, but even globally, tax authorities have taken is to want increased documentation, increased support around related party transactions and the support for why a transaction should be treated as on sling.

Caleb Harshberger:

And I know when the tariffs were announced, obviously, that’s predominantly primarily kind of a trade thing. But I think everyone sort of realized if they didn’t know already, this is very impactful on the transfer pricing. Do we get a sense of what businesses are deciding now? Is it really case by case? Is there kind of a playbook at this point?

Sowmya Varadharajan:

No, I think it is definitely a case by case approach. I think one thing that they are trying to do is let me try and reduce some of the price at which the products are coming in so I do pay less tariffs. But the flip side of it is that when you reduce the cost of goods sold, there’s going to be an increase in profitability. And so you’ve got to just make sure that whatever the increases are, you’re still in line from an arm’s length perspective for transfer pricing.

I think that they are trying to do what they can from a methodology perspective. But that is also very difficult, right? I mean, if you’ve done transfer pricing analysis, you have consistently called your U.S. entity as a distributor and you have consistently used a comparable profits method to benchmark and test this entity. You cannot turn around and say this time around, I want to use like a resale price method or I want to change the methodology to profit split methodology unless there’s been a significant change in functions, assets and risks.

So it is a very difficult position for taxpayers to be in, you know, to be able to justify any change in approach that they are going to take. It is very difficult to have your tax drive your business. So you’ve got to find a business reason, right? And it cannot be, oh, tariffs went up and that is my business reason. That’s not going to be good enough.

And I think the question is also around how can I reframe my entire transfer pricing, right? To justify a change in approach. And right now, even as of now, I don’t know if we have a definite position on tariffs, largely because I’m sure you’ve also seen the news that the Supreme Court is going to hear Trump’s appeal of tariff rulings, right? So there is a huge amount of uncertainty on the space.

But, you know, one cannot say that everything is uncertain, therefore I’m not going to do anything. You know, taxpayers have to take a position. And I think that’s where we are starting to have conversations with our clients on exactly that issue.

Caleb Harshberger:

And as you’re making these decisions and trying to do your best to kind of navigate all this uncertainty, where does the audit risks lies? Is it mainly in kind of setting the rates or margins? Is it in the methodology or what are kind of folks focused on?

Sowmya Varadharajan:

So I think right now, I mean, it’s really hard to see. We do not know where the audit risks are going to be, right? Definitely, if you decide to change your methodology, and it is a methodology that is going to give the US less profit, that is definitely going to be an audit risk.

I think one of the questions that we get asked all the time is, you know, if I am changing my price, you know, because of the increase in tariffs, what is CBP going to do? Like, can they come back and do an audit? Maybe not immediately. But definitely, that is a possibility as well. So you can’t just look at, you know, a direct tax audit, you’ve also got to look at a customs audit as well.

Tax directors and people in the tax profession, historically never had to deal with, you know, customs and duties as much, right? We all knew that it existed. But because the rates were in the single digits, nobody actually really cared. And tax directors are really focused on withholding tax, you know, and looking at, you know, effective tax rates and things like that. Now, they’re looking at taxes on overall perspective, including duties as well.

So I think when you say disputes, you know, it is both a tax dispute from the IRS, as well as a potential customs audit as well. I think we’ve got to be mentally prepared for both. And the worst situation is going to be both coming at the same time.

Caleb Harshberger:

When it comes to the customs side of it, is there a big difference between the way customs sees transfer pricing and tax does?

Sowmya Varadharajan:

Yeah, I think the methods that customs uses and the methods that transfer pricing practitioners use, there is broad similarities. But at the end of the day, customs is on a transaction by transaction by transaction basis. Whereas we look at things on an aggregate basis, right? So we do not look at every single invoice and whether that itself is arm’s length. We look at it on an overall basis for that year, you know, did we end up in the right place?

Caleb Harshberger:

And with so much up in the air, and with the amount of dollars, I’m sure that we’re dealing with here. I imagine a lot of folks are thinking about tax dispute resolutions, like APAs and things like that. An APA, that’s an advanced pricing agreement, that’s a way for taxpayers to get the pre blessing from a tax authority on their on their tax positions.

Soumya Varadarajan:

I think in general, APAs are forward looking. So I have heard that, you know, as you are currently in an APA situation, it is possible for you to try and get a position on how, you know, tariffs should be treated. But it is really up in the air. And it really depends on the competent authorities as to whether they even want to have that discussion. And again, the reason I would say that is because there is nothing that is absolutely certain right now as to what the tariff situation actually is.

Caleb Harshberger:

For folks that say they they just nailed down an APA, they just got that closed, you know, right before the tariffs came in. And those take years to get done, they take a lot of money. Do they have to reopen those? Is it was that just a waste of time?

Sowmya Varadharajan:

I don’t think it is a waste of time. I think that I mean, there are probably some critical assumptions in there. And I think this is where the difficulty is, right, Caleb, I think we have had so many conversations about this, right? I mean, they, you know, during the COVID time frame, they say, okay, you know, take a look at your intercompany agreements and see what your intercompany agreements say to adjust transfer prices, right? And in most cases, nobody actually sits down and specifies all of these things that’s in there.

And so I think the question is really like, you know, so if an APA has already been concluded, my question would be, though, how could you go back into critical assumptions to argue, like the tariff should be treated as a critical assumption and therefore should warrant a change, not a complete revision of the APA. But I think this is a question that they should probably go back and talk to the competent authorities on.

Caleb Harshberger:

And I know, you know, once things have gotten done, we have mutual agreement procedures or maps that are backwards looking. Do we have a sense of what that looks like in sort of a tariff situation?

Sowmya Varadharajan:

So I think maps are extremely difficult, right? Because I think that, you know, essentially, the transaction has already been concluded, even before the tariffs come in, right? It is never possible to get a complete, I’m going to say, get back what you paid in one jurisdiction to get it to the other jurisdiction, right? So the way that the map works is that let’s assume, you know, that the, you know, you have a US, I don’t know, foreign authority situation, you ended up paying too much profit, you left too much profit in the foreign jurisdiction, you want to bring it down, you go and, you know, or there is an audit, you know, and you go and ask for the other jurisdiction to give you back the tax that you paid on this income in the foreign jurisdiction, right?

So the first thing is, why would a tax authority want to do that? You will never get 100% back, right? And I think that is the big thing about an MAP, you would never have a situation that both tax authorities are going to agree on the exact treatment. And therefore, it’s never going to be a situation that the taxpayer is not out of pocket. Because you’re basically asking a tax authority to give back taxes that they already collected from you. That’s where you’re going with a map. And I think that that’s where the difficulty is.

Caleb Harshberger:

I just think if I was on the other side, if I was in a competent authority dealing with the map, and I felt like my country was not being treated fairly by the other, maybe it shouldn’t, but I feel like it would affect how I feel about it.

Sowmya Varadharajan:

Absolutely. So there is a couple of things, right? MAPs, when they are combined with an APA, can be quite useful, right? Because APA is forward looking, it’s not combative, right? You’re basically telling the tax authority, hey, listen, I’ve got this problem, help me figure this one out. So you are being very friendly with both tax authorities and saying, listen, help me out here. That’s what I’m trying to do here.

And when you roll in a map with an APA, it can work out quite well, because you’re saying, okay, let’s try and agree on the map, because we have the future that we can also help shape that could give everybody a good answer, right? So definitely, that’s one way you could get some success out of it.

But I think your point is spot on, you know, I think there is a lot of, you know, emotions around this tariff situation, right? And so definitely, there are people who are saying like, I am not, you know, jurisdictions that feel that they have not been treated, right, by what the current administration has done, that can have a ramification on competent authority proceedings as well.

So you could have been going really smoothly in an APA. And because of what has just happened, they might take a different position and saying, Oh, hang on a minute, why do I want to be friendly towards the US, I’m going to take, I’m going to try and take a more difficult position.

Caleb Harshberger:

And that same way of thinking, has that also led just to more scrutiny, I guess, of US multinationals by by tax authorities, are they facing kind of a greater audit risk, just because of the geopolitical side of it?

Sowmya Varadharajan:

I don’t know if they’re definitely facing more audit risk because of this. All tax authorities are looking at transfer pricing. And I think the whole the whole pillar two conversations, you know, stemmed from that, that we they did not feel that US MNCs were paying the right level of taxes in the various jurisdictions, right. So from the US side, I think the Trump administration has always taken a view that why are you targeting US MNCs. So I think the whole whole tax situation has been quite interesting.

David Schultz:

That was Sowmya Varadharajan, a principal in the tax group at the firm Crowe. And that’s it for today’s podcast. You can find up to the minute news on the latest tax and accounting developments at our website news.bloombergtax.com. That website once again is news.bloombergtax.com.

Today’s episode is produced by myself, David Schultz, and our editor was Vandana Mathur. From Washington, I’m David Schultz. Thanks for listening.