Forensic Approaches to Transfer Pricing Enforcement Could Restore Billions in Lost U.S. Federal and State Tax Losses: A Case Study Approach
Journal of Forensic & Investigative Accounting, Volume 12: Issue 2, July–December 2020
32 Pages Posted: 6 Mar 2020 Last revised: 13 May 2021
Date Written: October 16, 2020
Successful IRS enforcement of corporate transfer pricing regulations is by all measures at an all-time low, and profit shifting from transfer pricing appears to be near an all-time high, costing the U.S. federal and state treasuries as much $140 billion dollars or more per annum in recent years, even as the U.S. Congress has cut the annual budget of the IRS by more than 20% since 2010. The U.S. approach to enforcing transfer pricing laws suffers from a mismatch between models of compliance and enforcement, in which compliance is voluntary and dynamic according to the Arm’s Length Standard with unlimited opportunities for profit shifting, while enforcement is scarce, random, and ineffective when it occurs.
Most illegal profit shifting remains undetected, illustrating that current enforcement approaches are ineffective. Under these conditions, failed enforcement is technically more costly than no enforcement. Yet increasing the amount of transfer pricing enforcement without fundamentally changing the nature of this enforcement is likely to fail, because current approaches are unable to detect non-compliance and have not been successful in enforcing the law when non-compliance is detected. This result leads to high audit rates for compliant taxpayers, an inability to identify sophisticated non-compliance, and failure to overcome non-compliance when it is detected.
Leveraging innovations from law enforcement, industry, academia, and other sources, we find that the use of more advanced forensic approaches and technologies by the IRS and possibly state tax authorities could dramatically improve the effectiveness of transfer pricing enforcement efforts and lead to greater compliance. We identify specific systemic improvements based on new forensic models of tax enforcement that could result in more accurate risk detection, deployment of scarce resources on the largest non-compliance risks, elimination of examinations targeting compliant taxpayers, and improvement in the ability to prevail in examinations of non-compliance. We provide specific recommendations to achieve these objectives and illustrate the potential of these approaches with two case studies that apply them in the context of two existing enforcement outcomes.
Keywords: Transfer Pricing; Auditing; Forensic Taxation; Tax Compliance; Tax Enforcement
JEL Classification: F23, H26, H32, H83, K34, M42
Suggested Citation: Suggested Citation