September 23, 2022
US IRS official reemphasizes IRS focus on penalties in transfer pricing cases
During a TEI seminar on 20 September 2022, an official working in the IRS’s transfer pricing practice stated that the IRS will assert more penalties in the hopes of receiving better documentation reports, according to an article in Tax Notes Today.1 Although the IRS will not apply a "'wholesale across-the-board' assertion of penalties," the official noted that it previously failed to apply penalties where appropriate. In the future, the IRS aims to refocus its efforts on applying penalties to avoid such errors.
Internal Revenue Code2 Section 6662 imposes a penalty on any underpayment attributable to a substantial valuation misstatement pertaining to either a transaction between persons described in Section 482 (the transactional penalty) or a new Section 482 transfer price adjustment (the net adjustment penalty). The penalty equals 20% of the underpayment of tax attributable to the substantial valuation misstatement. Under Section 6662(h), the penalty increases to 40% of the underpayment for a gross valuation misstatement for either penalty. Section 6662(e)(3)(B) may protect against penalties if the taxpayer: (1) used a regulatory-specified method to determine the transfer price; (2) has documentation to support the selection of the price; and (3) provides the documentation within 30 days of a request from the IRS.
Application of Section 6662 penalties
The IRS official's statement aligns with the IRS's previous guidance on penalizing inadequate documentation. In a 2018 memorandum, the Commissioner of the Large Business and International Division outlined the purpose of the penalties as "holding taxpayers accountable for the reasonableness of their return positions and helping motivate taxpayers and their advisors to not only take reasonable return positions but also to adequately document them."3 To meet these objectives and appropriately apply penalties as required, the IRS must evaluate taxpayer documentation for adequacy and reasonableness, by applying the factors in the regulations.4
The IRS also released Frequently Asked Questions (FAQs) on transfer pricing documentation best practices in 2020 (see Tax Alert 2020-1036). The FAQs seemed to encapsulate the IRS's broad, long-standing experience of receiving deficient Section 6662(e) documentation during audits, resulting in the IRS raising more transfer pricing issues and lengthening the timeline to complete an audit. The FAQs also indicated that taxpayers likely need to reevaluate the benefits of standardizing and commoditizing documentation as they seek to comply with multiple jurisdictions' documentation requirements.
With the IRS's renewed focus on Section 6662 penalties, now is the time for taxpayers to revisit the status of their transfer pricing documentation, particularly given the IRS's public pronouncements about its intentions. Taxpayers should seek transfer pricing documentation reports that are robust and fully compliant with the requirements of Sections 482 and 6662 and their respective regulations.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (United States), National Tax Department, International Tax and Transaction Services, Transfer Pricing