International Tax Audit: What Businesses Need to Know About the Process
Understand how international tax audits work, what triggers them, and how businesses can prepare for cross-border regulatory scrutiny.
As companies expand across borders, they face increasing scrutiny from tax authorities in multiple jurisdictions. International tax audits have become more common as governments seek to ensure that businesses pay taxes where their economic activity occurs. These audits can be complex and time-consuming, often involving coordination between different countries’ tax agencies.
Understanding how these audits work helps businesses operating internationally. Being unprepared can lead to penalties, reputational damage, or prolonged disputes with tax authorities.
Entities Subject to Overseas Review
A wide range of business structures operating across national borders can be subject to international tax review. Multinational corporations, with operations or transactions in multiple countries, are frequent subjects due to the volume and value of their cross-border dealings. The Internal Revenue Service’s Large Business and International (LB&I) division, for instance, focuses on corporations and partnerships with assets exceeding $10 million, recognizing the complexity associated with these larger entities.1Internal Revenue Service. Publication 5125: LB&I Examination Process
U.S. persons, including citizens, residents, domestic corporations, partnerships, and certain trusts and estates, can also face review regarding their overseas operations or investments. These individuals and entities are generally subject to U.S. tax on their worldwide income, making foreign activities relevant to U.S. tax authorities. Compliance initiatives, like the Large Partnership Compliance program, use data analytics to identify large partnerships for examination, including those involved internationally.
Foreign entities conducting business or earning income within the United States are another group subject to review, primarily by the IRS. A foreign corporation engaged in a U.S. trade or business must typically file a U.S. tax return and is taxed on income considered “effectively connected” with that U.S. business. Whether a foreign entity meets this threshold depends on the nature and regularity of its U.S. activities, potentially including work done through agents.
Global efforts toward tax transparency, including initiatives to combat Base Erosion and Profit Shifting (BEPS) led by the Organisation for Economic Co-operation and Development (OECD) and G20, also influence which entities face scrutiny. Measures like Pillar Two’s global minimum tax rules, targeting large multinationals, increase the likelihood of review by tax authorities worldwide. This international cooperation means businesses may be reviewed by tax authorities in multiple countries.
Key Areas Examined
During an international tax audit, authorities focus on specific aspects of a company’s cross-border operations. Transfer pricing is a prominent area, involving the prices charged in transactions between related entities in different countries, such as sales of goods, services, or licensing. Authorities evaluate whether these prices adhere to the arm’s length principle – meaning they are consistent with what unrelated parties would charge. Examiners review the company’s chosen methodologies and compare results to those of independent companies, potentially adjusting prices deemed to artificially shift profits. The OECD Transfer Pricing Guidelines provide internationally recognized standards often referenced in these reviews.
Another focal point is determining if a company’s activities create a “permanent establishment” (PE) in a foreign country, signifying a taxable presence. Tax treaties, often based on OECD models, define what constitutes a PE.2Internal Revenue Service. International Practice Unit: Permanent Establishment Concept Audits examine factors like having a fixed place of business (office, factory) or the activities of agents acting for the company. Having a dependent agent concluding contracts can create a PE, while using an independent agent usually does not. Examiners assess if activities exceed preparatory or auxiliary functions. Stricter interpretations, influenced by the BEPS project, aim to prevent artificial avoidance of PE status.
The tax treatment of Controlled Foreign Corporations (CFCs) is frequently reviewed. Under rules like the U.S. Subpart F and Global Intangible Low-Taxed Income (GILTI) provisions, U.S. shareholders of CFCs may need to include certain CFC income in their U.S. taxable income currently, even without receiving dividends. Audits verify the correct identification of CFC status, the calculation and classification of CFC income, and the accurate reporting by U.S. shareholders.
Compliance with withholding tax obligations on payments to foreign persons is also examined. U.S. tax law generally requires deducting and withholding tax (often 30%) on payments of U.S.-source income like interest, dividends, and royalties to foreign recipients. Audits verify if the correct tax amount was withheld, considering treaty reductions or exemptions, and if amounts were properly deposited and reported (e.g., on IRS Forms 1042 and 1042-S). Documentation establishing foreign status and treaty eligibility (like IRS Forms W-8) is reviewed.
Claims for foreign tax credits (FTCs) are carefully assessed to prevent double taxation while ensuring credits are only for eligible foreign taxes. U.S. taxpayers can generally claim a credit for foreign income taxes paid or accrued under Internal Revenue Code Section 901. Audits verify the tax’s eligibility, payment, and accuracy. The calculation of the FTC limitation, which prevents using FTCs against U.S. tax on U.S.-source income and requires separate calculations for different income categories, is also scrutinized.
Finally, authorities examine whether taxpayers claiming benefits under tax treaties, such as reduced withholding rates, are entitled to them. Treaties often contain “Limitation on Benefits” (LOB) articles to prevent “treaty shopping.” Audits review if the entity meets specific LOB tests, which might involve public trading status, ownership criteria, or having an active trade or business connected to the income. Failure can result in denial of treaty benefits.
Documentation and Recordkeeping
Maintaining comprehensive and accurate documentation is necessary for businesses involved in international operations. Tax law, such as Internal Revenue Code Section 6001, generally requires taxpayers to keep sufficient records to determine their correct tax liability.3Internal Revenue Service. Topic No. 305 Recordkeeping This includes maintaining permanent books that clearly establish income, deductions, and credits. For businesses with cross-border activities, this requirement is particularly important due to complex international tax rules.
Specific documentation is often mandated for transactions involving foreign entities. For example, U.S. persons controlling foreign corporations or partnerships must furnish information, typically using forms like Form 5471 or Form 8865. Reporting and record-keeping requirements also apply to certain foreign-owned U.S. corporations and foreign corporations engaged in U.S. business, often involving Form 5472.4Legal Information Institute / Cornell Law School. 26 CFR § 1.6038A-1 – General Requirements and Definitions Regulations may require maintaining records held by foreign related parties if relevant to U.S. transactions.5Legal Information Institute / Cornell Law School. 26 CFR § 1.6038A-3 – Record Maintenance
Substantiating transfer pricing policies requires specific documentation. Taxpayers should maintain contemporaneous records demonstrating that their pricing aligns with the arm’s length standard, as suggested by regulations related to Internal Revenue Code Section 482.6Internal Revenue Service. Transfer Pricing Documentation Best Practices FAQs This often includes business overviews, transaction details, methodology selection, economic analysis, and comparability data. International standards, like those from BEPS Action 13, recommend a structure for large multinationals including a Master File (global overview), Local File (jurisdiction-specific details), and Country-by-Country Report (aggregate financial data).
Proper record retention practices are also needed. Records should generally be kept as long as they might be material for tax administration, typically until the statute of limitations for assessment expires (often three years, but potentially six years or longer for certain international issues or property records). These records must be readily accessible for inspection. Even if stored outside the U.S., they generally must be provided to the IRS within a set timeframe upon request, potentially requiring translation.
Coordination Among Tax Authorities
International tax enforcement increasingly involves collaboration between national tax authorities, facilitated by legal frameworks for information sharing and coordinated actions. Bilateral income tax treaties are a primary mechanism, typically containing provisions based on Article 26 of the OECD Model Tax Convention. These allow for the exchange of information “foreseeably relevant” for administering tax laws, occurring upon request, spontaneously, or automatically (like under FATCA or the Common Reporting Standard).
Multilateral instruments, such as the Convention on Mutual Administrative Assistance in Tax Matters developed by the OECD and Council of Europe, broaden cooperation.7GOV.UK / HMRC. HMRC Internal Manual: The OECD/CoE Multilateral Convention on Mutual Administrative Assistance in Tax Matters This convention enables information exchange, assistance in tax recovery, and service of documents among its numerous participating jurisdictions. Tax Information Exchange Agreements (TIEAs) also facilitate information sharing, often with jurisdictions lacking comprehensive treaties.
Operational coordination includes Simultaneous Tax Examinations (STEs), where two or more countries concurrently audit the same taxpayer, sharing relevant information under existing agreements. The IRS’s LB&I division coordinates these for the U.S. Platforms like the Joint International Taskforce on Shared Intelligence and Collaboration (JITSIC), hosted by the OECD’s Forum on Tax Administration, allow senior tax officials to exchange intelligence and collaborate on specific cross-border cases.8Internal Revenue Service. Joint International Taskforce on Shared Intelligence and Collaboration (JITSIC)
When disputes arise, particularly from transfer pricing adjustments leading to potential double taxation, coordination occurs through the Mutual Agreement Procedure (MAP), typically outlined in tax treaties. Competent authorities from treaty partner countries consult to resolve taxation issues not in accordance with the treaty, often initiated by a taxpayer request.
Stages in the Audit Process
An international tax audit typically follows several stages. It begins with the selection of a business’s tax return, often driven by risk assessment processes using data analytics and focusing on high-risk international issues or large entities.
The tax authority then formally notifies the business of the examination, identifying the tax years under review and the assigned team. An opening conference usually follows, where the audit process, timelines, and roles are discussed.
The core of the audit involves information gathering through Information Document Requests (IDRs). These seek specific documents supporting items on the tax return, particularly related to international transactions, transfer pricing, foreign tax credits, and treaty claims. If information isn’t provided voluntarily, authorities may use formal measures like a summons under Internal Revenue Code Section 7602 to compel production.
The examination team analyzes the gathered information, applying relevant tax laws, regulations, and treaty provisions. Specialists may review complex areas like transfer pricing, permanent establishment status, CFC income calculations, and foreign tax credit substantiation. This phase can include interviews with company personnel.
If potential discrepancies are found, the team communicates these findings, often through a Notice of Proposed Adjustment (NOPA) detailing the issue, rationale, and estimated tax impact. This gives the taxpayer a chance to discuss the findings, provide more evidence, and potentially reach an agreement with the examination team.
The examination concludes with finalized findings. If the taxpayer agrees with adjustments, the case moves toward closure. If disagreements remain, the IRS prepares a Revenue Agent Report (RAR) detailing the unagreed issues. The taxpayer typically receives a “30-day letter” with the RAR, outlining the proposed adjustments and the right to appeal the decision to the IRS Independent Office of Appeals within 30 days by filing a formal protest.9Internal Revenue Service. Letters and Notices Offering an Appeal Opportunity