Compliance Campaign: COGS Cops Coming

Last week, the IRS released a mysterious new audit “campaign” that may implicate – inadvertently or otherwise – transfer pricing practices. The campaign, which was announced on August 8, is simply entitled “Inflated Cost of Goods Sold.”   

The only glimmer of explanation the IRS gives as to what exactly this is all about is the brief statement that the campaign “focuses on LB&I taxpayers that have indications of inflated Cost of Goods Sold to reduce taxable income.”

But this tells us very little. Absent book-tax differences (e.g., FIFO/LIFO materials inventory conventions), an increase in COGS will always decrease taxable income. This is hardly revelatory. Two old IRS practice units from 2014 (“Purchase of Tangible Goods from Foreign Parent – CUP Method” and “Sale of Tangible Goods from a CFC to USP – CUP Method”) recognize the truism that increasing COGS reduces taxable income. So what? What facets of COGS gives the IRS concern? Direct Labor? Overhead? Standard Material Costs? Variances?

Some have speculated that the campaign may somehow be related to recent litigation in which taxpayers were claiming that certain section 6426 fuel excise tax credits increased their COGS, thus reducing taxable income. Maybe. But that seems unlikely to us; the IRS previously had a campaign on section 6426 but moved that campaign to “inactive” status months ago.

Or, you might wonder if the IRS is interested in  taxpayers’ characterization of costs as COGS versus deductible operating expenses for purposes of BEAT. Maybe.  But that also seems unlikely to us. If you take at face value the campaign’s stated purpose to focus on inflated COGs “to reduce taxable income,” the campaign would seem to have nothing to do with BEAT, since both COGS and other operating expense deductions reduce (regular) taxable income equally.

Above all, the term “inflated” seems pejorative. A large number of routine transfer pricing issues may be wound up in the various components of COGS, such as services charges, raw material and finished or semi-finished components, and other tangible goods pricing issues, not to mention annual true-ups. How can an Exam agent police whether COGS have been “inflated” without having a firm understanding of these pricing points? If the real focus of the campaign is some narrow point, we wish it would have stated  so. Otherwise,  the campaign may inadvertently trigger transfer pricing audits of routine issues that may not be the best use of resources.

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