The accuracy-related penalties applied in the context of Section 482 adjustments are commonly referred to as the "transfer pricing penalties" and are important for several reasons:
As a result, any taxpayer with Section 482 controlled transactions (whether international, domestic or both) should be familiar with basic Section 482 concepts and the specified/unspecified method and contemporaneous documentation requirements which, if satisfied, provide a safe harbor from the transfer pricing penalties.
Section 482
Section 482 authorizes the IRS to allocate gross income, deductions, credits or allowances between controlled organizations, trades or businesses, if the Service determines that such an allocation is necessary to clearly reflect the income of any such organization, trade or business. For purposes of Section 482, the term "organization" is defined very broadly:
ORGANIZATION includes an organization of any kind, whether a sole proprietorship, a partnership, a trust, an estate, an association, or a corporation (as each is defined or understood in the Internal Revenue Code or the regulations thereunder), irrespective of the place of organization, operation, or conduct of the trade or business, and regardless of whether it is a domestic or foreign organization, whether it is an exempt organization, or whether it is a member of an affiliated group that files a consolidated U.S. income tax return, or a member of an affiliated group that does not file a consolidated U.S. income tax return.
Regs. § 1.482(i)(1). Moreover, the definition of the term "controlled" is extremely broad as well:
CONTROLLED includes any kind of control, direct or indirect, whether legally enforceable or not, and however exercisable or exercised, including control resulting from the actions of two or more taxpayers acting in concert or with a common goal or purpose. It is the reality of the control that is decisive, not its form or the mode of its exercise. A presumption of control arises if income or deductions have been arbitrarily shifted.
Regs. § 1.482(i)(4). There are no stock ownership tests in determining whether a transaction is "controlled" within the meaning of Section 482. The issue under Section 482 is control in fact -- an issue resolved based on all the facts and circumstances.
Pursuant to Sections 482, 982, 6001, 6038, 6038A, 6662(e), 7602 and the regulations thereunder, the IRS has considerable power to gather information about a taxpayer's transfer prices and to redetermine those prices based on "comparable" uncontrolled transactions. If the taxpayer's transfer prices and those determined by the IRS under Section 482 are too far apart, then the transfer pricing penalties may apply.
The Transfer Pricing Penalties
Section 6662(a) adds a 20 percent accuracy-related penalty to any underpayment of tax attributable to the circumstances identified in Section 6662(b)(1) through (5). One such circumstance is a "substantial valuation misstatement under chapter 1" as provided in Section 6662(b)(3). Section 6662(e), commonly known as the transfer pricing penalty, applies in determining whether there is a "substantial valuation misstatement under chapter 1" for purposes of applying Section 6662(a) and (b)(3). In addition, Section 6662(h) modifies the application of Section 6662(e) for the purpose of determining whether there is a gross valuation misstatement, in which case the Section 6662(a) accuracy-related penalty rate is increased from 20 percent to 40 percent.
Section 6662(e)(1)(B) applies the transfer pricing penalty on a transaction-by-transaction basis and on a net Section 482 adjustment basis. If the transfer price reported with respect to a particular transaction falls outside the range provided in Section 6662(e)(1)(B)(i), then the transfer pricing penalty may apply. Similarly, if the net Section 482 adjustment exceeds the threshold provided in Section 6662(e)(1)(B)(ii), then the penalty may apply. The Section 6662(e) regulations refer to these two provisions as the "transactional penalty" and the "net adjustment penalty." Regs. § 1.6662-6(b) and (c). For purposes of determining whether a gross valuation misstatement exists, Section 6662(h) applies the provisions of Section 6662(e), but substitutes enlarged parameters in the case of the transactional penalty and higher thresholds in the case of the net adjustment penalty.
The Transactional Penalty
In general, the transactional penalty applies to any Section 482 controlled transaction if the price for any property or services (or for the use of property) claimed on the taxpayer's return is 200 percent or more (or 50 percent or less) of the amount determined under Section 482 to be the correct price. This general rule is subject to the de minimus limitation provided by Section 6662(e)(2) and the Section 6662(e)(3) safe harbor discussed below.
For example, a domestic corporation ("DC") sells an airplane to a foreign corporation ("FC"). DC and FC are under common control for Section 482 purposes. FC pays $50,000,000 to DC for the airplane and DC reports that price on its Form 1120. The IRS audits DC and determines under Section 482 that the correct arm's length price for the airplane is $100,000,000. The parameters for purposes of applying the transactional penalty are $200,000,000 and $50,000,000. Since the price claimed on DC's return is 50 percent of the amount determined under Section 482 to be the correct price, the 20 percent transactional penalty may apply. In contrast, if FC had paid, and DC had claimed on its return, a price of more than $50,000,000, then the penalty would not apply.
The transactional penalty applies in the same manner in determining whether there is a gross valuation misstatement under Section 6662(h), except that the applicable parameters are increased to 400 percent or more, or 25 percent or less, of the "correct" price. For instance, in the above example, the parameters would be $400,000,000 and $25,000,000 in relation to the correct Section 482 price of $100,000,000. Therefore, in the example, there would not be a gross valuation misstatement.
The Net Adjustment Penalty
The net adjustment penalty applies when a taxpayer's net increase in taxable income resulting from Section 482 adjustments for the taxable year exceeds the lesser of two thresholds: $5,000,000 or 10 percent of the taxpayer's gross receipts for the taxable year, after taking into account all Section 482 adjustments. Therefore, the net adjustment penalty potentially applies to taxpayers with $50,000,000 or more of gross receipts if the net Section 482 adjustment exceeds $5,000,000. The penalty potentially applies to taxpayers with less than $50,000,000 of gross receipts if the net Section 482 adjustment exceeds 10 percent of gross receipts.
Prior to the amendment of Section 6662(e)(1)(B)(ii) in 1993, the net adjustment penalty provision referred to a single threshold of $10,000,000. The 1993 amendment substantially broadened the scope of the net adjustment penalty by reducing the dollar threshold from $10,000,000 to $5,000,000 and (more importantly) by adding the 10 percent of gross receipts threshold. As a result of the 1993 amendment, even the smallest companies with Section 482 controlled transactions are potentially subject to the net adjustment penalty. Section 6662(e)(2) provides the only limitation: in the case of a C corporation (other than a personal holding company), no transfer pricing penalties may be imposed if the understatement of tax attributable to all substantial valuation misstatements under chapter 1 is $10,000 or less ($5,000 or less for other taxpayers).
For purposes of determining whether a gross valuation misstatement exists, Section 6662(h) applies the net adjustment rules, but increases the thresholds from $5,000,000 to $20,000,000 and from 10 percent to 20 percent.
Reasonable Cause Exception and the Transfer Pricing Penalties
As a general rule, taxpayers may avoid the Section 6662 accuracy-related penalties by demonstrating reasonable cause and good faith within the meaning of Section 6664(c). However, for purposes of applying Section 6664(c), Section 6662(e)(3)(D) provides that a taxpayer will not be treated as having reasonable cause for any portion of an underpayment attributable to a net section 482 transfer price adjustment, unless the taxpayer has complied with the requirements of Section 6662(e)(3)(B)(i), (ii) or (iii). In the absence of such compliance, the taxpayer simply cannot demonstrate reasonable cause and good faith.
The Net Adjustment Penalty Exclusionary Rule
For purposes of determining the amount of the net Section 482 transfer price adjustment -- the basis for applying the net adjustment penalty -- Section 6662(e)(3) provides an exclusionary rule. In effect, the exclusionary rule supplants the Section 6664(c) reasonable cause exception and provides a means for all taxpayers to avoid both transfer pricing penalties. If the taxpayer has complied with the requirements of Section 6662(e)(3)(B)(i), (ii) or (iii) with respect to the controlled transactions at issue, then any increase in taxable income resulting from Section 482 adjustments made in connection with those transactions is excluded in determining whether the $5,000,000/10 percent net adjustment penalty threshold is met. Moreover, compliance with Section 6662(e)(3)(B)(i), (ii) or (iii) is considered the equivalent of Section 6664(c) reasonable cause and good faith for purposes of the transactional penalty. Thus, both penalties may be avoided. Consequently, for planning purposes, taxpayers should generally attempt to comply with the requirements of Section 6662(e)(3).
The transfer pricing penalty regulations explain (by reference to the Section 482 regulations) how taxpayers may avoid the transfer pricing penalties imposed by Section 6662(e) and (h). In general, to comply with the regulations and avoid the transactional and net adjustment penalties, the taxpayer must do two things: (1) select and apply (in a "reasonable" manner) a transfer pricing methodology; and (2) contemporaneously document the selection and application process.
Reasonable Selection and Application of Specified or Unspecified Method
The first step toward avoidance of transfer pricing penalties focuses on the process by which a taxpayer sets its transfer prices -- the "reasonable" selection and application of a "specified" or "unspecified" transfer pricing method. A "specified method" is a method described in the Section 482 regulations which applies to the type of controlled transaction at issue. For example, if applicable to the particular transaction at issue, the comparable uncontrolled price method, the resale price method, the comparable profits method, the cost plus method, and the comparable uncontrolled transaction method are specified methods. Methodologies not described in the Section 482 regulations are "unspecified" methods.
The question of whether the taxpayer has selected and applied a specified or unspecified method in a "reasonable" manner is resolved based on all the facts and circumstances. Some of the relevant factors include:
Contemporaneous Documentation
In addition to selecting and applying a transfer pricing methodology in accordance with the Section 482 regulations, taxpayers must contemporaneously document the selection and application process and be prepared to produce the documentation to the IRS on 30 days notice. Regs. § 1.6662-6(d)(2)(iii)(B) lists the following principal documents which must be produced to avoid the transfer pricing penalties:
(1) An overview of the taxpayer's business, including an analysis of the economic and legal factors that affect the pricing of its property or services;
(2) A description of the taxpayer's organizational structure (including an organization chart) covering all related parties engaged in transactions potentially relevant under section 482, including foreign affiliates whose transactions directly or indirectly affect the pricing of property or services in the United States;
(3) Any documentation explicitly required by the regulations under section 482;
(4) A description of the method selected and an explanation of why that method was selected;
(5) A description of the alternative methods that were considered and an explanation of why they were not selected;
(6) A description of the controlled transactions (including the terms of sale) and any internal data used to analyze those transactions. For example, if a profit split method is applied, the documentation must include a schedule providing the total income, costs, and assets (with adjustments for different accounting practices and currencies) for each controlled taxpayer participating in the relevant business activity and detailing the allocations of such items to that activity;
(7) A description of the comparables that were used, how comparability was evaluated, and what (if any) adjustments were made;
(8) An explanation of the economic analysis and projections relied upon in developing the method. For example, if a profit split method is applied, the taxpayer must provide an explanation of the analysis undertaken to determine how the profits would be split;
(9) A description or summary of any relevant data that the taxpayer obtains after the end of the tax year and before filing a tax return, which would help determine if a taxpayer selected and applied a specified method in a reasonable manner; and
(10) A general index of the principal and background documents and a description of the recordkeeping system used for cataloging and accessing those documents.
In addition, Regs. § 1.6662-6(d)(2)(iii)(C) may require further documentation depending on the circumstances. Specifically, the regulation provides:
The assumptions, conclusions, and positions contained in principal documents ordinarily will be based on, and supported by, additional background documents. Documents that support the principal documentation may include the documents listed in section 1.6038A-3(c) that are not otherwise described in paragraph (d)(2)(iii)(B) of this section. Every document listed in those regulations may not be relevant to pricing determinations under the taxpayer's specific facts and circumstances and, therefore, each of those documents need not be maintained in all circumstances. Moreover, other documents not listed in those regulations may be necessary to establish that the taxpayer's method was selected and applied in the way that provided the most reliable measure of an arm's length result under the principles of the best method rule in section 1.482-1(c). Background documents need not be provided to the Internal Revenue Service in response to a request for principal documents. If the Internal Revenue Service subsequently requests background documents, a taxpayer must provide that documentation to the Internal Revenue Service within 30 days of the request. However, the district director may, in his discretion, extend the period for producing the background documentation.
IntlTaxLaw.Com IntlTaxLaw.Com IntlTaxLaw.Com IntlTaxLaw.Com IntlTaxLaw.Com