Key Takeaways:
- The IRS has intensified enforcement of transfer pricing regulations, significantly increasing potential penalties.
- Organizations can reduce exposure to transfer pricing penalties by ensuring adequate documentation and applying global transfer pricing policies consistently.
- In cases where penalties are imposed, businesses can seek penalty abatement by demonstrating reasonable cause and good faith, substantial compliance with transfer pricing rules, and leveraging effective representation from knowledgeable tax advisors.
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The Internal Revenue Service (IRS) implemented transfer pricing penalties to ensure the intercompany pricing reported on your income tax return is determined in a manner consistent with the arm’s length standard.
Until recently, penalty assessments were rare — not because improper transfer pricing between related parties was rare, but because IRS examiners tended to accept inadequate documentation. That leniency appears to be a thing of the past.
The IRS has indicated it will focus on applying Internal Revenue Code (IRC) Section 6662 penalties where proper documentation is lacking. This trend warrants serious attention if your company engages in cross-border transactions.
Imposing Transfer Pricing Penalties
The IRS can impose penalties when allocations under Section 482 result in substantial or gross increases in taxable income or where there are substantial or gross valuation misstatements concerning the transfer prices themselves.
These penalties can be severe, ranging from 20% to 40% of the tax underpayment, depending on the degree of non-compliance and the taxpayer's disclosure of relevant information.
Historically, you could avoid these penalties by demonstrating you had reasonably used a transfer pricing method outlined in Section 482 or another method to more reliably determine transfer prices. Taxpayers must also provide contemporaneous documentation within 30 days of a request from the IRS.
The IRS's Shift Toward Increased Penalty Assertion
The IRS Advisory Council’s 2018 Report noted that, although some transfer pricing documentation quality possibly fell short of the Section 6662 requirements, the IRS had not consistently asserted the penalty. Since then, the IRS has produced guidance addressing common flaws in transfer pricing documentation and best practices, and the agency is now expressing a renewed commitment to applying penalties more frequently and vigorously.
Holly Paz, commissioner of the IRS Large Business and International Division, spoke at several tax practitioner events in late 2022 — including the AICPA’s National Tax Conference, the American Bar Association Section of Taxation’s Philadelphia Tax Conference, and a Bloomberg Tax event. During these events, Paz noted the IRS has had success in litigating transfer pricing cases and is taking a closer look at economic substance and sham transactions — even in cases with transfer pricing documentation — to determine where it is appropriate to assert penalties.
Mitigating Exposure to Transfer Pricing Penalties
In 2020, the IRS published Transfer Pricing Documentation Best Practices Frequently Asked Questions (FAQs). These FAQs point to several features of proper documentation IRS agents look for when determining whether the agency should audit an organization’s transfer pricing methods.
Incorporating these features into your documentation may help reduce your risks:
- Sensitivity analysis – Assess the impact of removing a comparable company from the dataset and determine if such removal alters your position relative to the arm's-length range. Evaluate how different profit-level indicators might change the results.
- Segmented financial data analysis – Examine if the segmented financial data accurately reflects the arm's-length nature of the intercompany transaction. Detail the methodology used in constructing this data.
- Profit allocation in intercompany transactions – Analyze profit distribution among entities in the transaction. Ensure equitable economic outcomes for all parties, not just the tested party.
- Description of risks and related-party allocations – Describe associated risks in each intercompany transaction. Explain how profits and losses are allocated among related parties.
- Atypical business circumstances – Identify any unusual business conditions affecting the intercompany transaction. Discuss challenges in the economic analysis due to specific business results for the year.
To navigate this heightened scrutiny, taxpayers must take a proactive approach to document pricing transfer decisions. Steps you can take to avoid commonly seen inadequacies include:
- Providing a detailed description of your business and industry to help IRS agents understand operations and the larger marketplace in which you operate.
- Avoid using a checklist format. Instead, opt for a comprehensive analysis linking facts to the analysis. Base the analysis on well-supported facts, avoiding broad assumptions about the business.
- Ensure consistency in risk allocation with intercompany agreements. Align risk allocation with the comparable companies used in the economic analysis, and clearly explain any adjustments made to comparable companies for risk considerations.
- Prepare a best method selection analysis that justifies rejecting alternative methods for analyzing the intercompany transaction and provides a rationale for the chosen method.
- Clearly outline any adjustments to comparable data, such as working capital or location savings adjustments.
If you believe you have valuation misstatements or understated income tax in previously filed returns, it’s not too late to correct them. Filing a qualified amended return before the IRS contacts you about a transfer pricing audit is a defense against penalties. However, you must pay all taxes associated with the amended returns.
Seeking Penalty Abatement
In instances where penalties are assessed, it may be possible for taxpayers to seek abatement by demonstrating high-quality transfer pricing documentation. You may have a reasonable chance of having penalties abated if you:
- Demonstrate reasonable cause and good faith. Establish that the underpayment was due to reasonable cause, and you acted in good faith.
- Substantial compliance. Show that, despite any errors, you substantially followed the transfer pricing rules.
How We Can Help
The resurgence of transfer pricing penalties is an opportunity to reassess your transfer pricing strategies and compliance mechanisms.
For personalized guidance and assistance navigating these complexities, contact MGO today. Our team of professionals is equipped to help you mitigate risks, confirm compliance, and effectively manage any disputes with tax authorities. Act now to safeguard your business against the pitfalls of transfer pricing penalties.