In 2018, the IRS remembered examination teams to carry out a “diligent penalty analysis” in each transfer pricing case. Since then, we’ve observed that the agency is increasingly willing to impose penalties, even where reasonable minds differ about the appropriate transfer price. Fines are often issued late (at the end of an audit or even after the dispute is in court) and can create hundreds of millions or billions of dollars in additional liability. For all of these reasons, it’s worth taking the time to brush up on how these penalties work and what you can do to defend against them.
Basic mechanics. The Internal Revenue Code describes two types of transfer pricing penalties:
- A “settlement” penalty, which applies if the taxpayer’s chosen price in a settlement is a certain percentage higher or lower than the “fair” price determined by the IRS.
- A “net adjustment” penalty, which applies if the net increase in taxable income resulting from the transfer pricing adjustment exceeds a certain threshold, ignoring other years’ carry-over tax attributes, such as NOLs.
Any of these penalties can result in a 20% or 40% increase in your tax liability, depending on how “discounted” the taxpayer’s transfer price was compared to the IRS’s “corrected” transfer price. In practice, the IRS will typically enforce the 40% net adjustment penalty, because it applies if the transfer price adjustment exceeds $20 million: a Very low threshold. Substantial penalties can complicate resolution of transfer pricing issues with IRS appeals, and all penalties have budgetary implications.
The IRS can also enforce other “accuracy-related” penalties in transfer pricing cases. For example, inside western digitalthe IRS affirmed the net adjustment penalty, as well as penalties for “negligence, ‘failure to comply with rules or regulations,’ and ‘substantial income tax underreporting.’ ‘IRS can enforce multiple penalties alternatively, in the end only the highest that is incurred applies.
Defenses. The only defense to transfer pricing penalties is the “reasonable cause and good faith” defense. For the settlement penalty, the taxpayer can plead reasonable cause and good faith in various ways (for example, highlighting the taxpayer’s entrustment to external consultants). For the net adjustment penalty – which, again, happens to be the IRS’s benchmark penalty in transfer pricing cases – the taxpayer has only one way to prove reasonable cause and good faith. In particular, within 30 days of the request, the taxpayer must provide the Internal Revenue Service with transfer pricing documentation that applies a reasonable transfer pricing method.
In all cases, it is therefore incumbent on taxpayers to prepare good transfer pricing documentation (sometimes referred to as “section 6662 documentation” after the fine statute in the Code). Although many taxpayers prepare the documentation in-house, taxpayers may wish to consider whether for certain transactions they should hire a competent consultant to prepare the documentation. While not necessary for the net adjustment penalty, this would provide greater penalty protection for the transactional penalty. Whether done in-house or by an external consultant, both the taxpayer and the consultant should study the detailed regulations describing what transfer pricing documentation must contain and the factors considered in determining the reasonableness of selecting and applying the methodology of the taxpayer. While documentation should only be produced upon request to avoid penalties, it must be prepared at the time of submitting the declaration.
We have seen an increase in the IRS’s denial of taxpayer Section 6662 documentation as sufficient to avoid the imposition of penalties. For example, in western digital case, the IRS affirmed significant penalties, despite the taxpayer providing the IRS with documentation prepared by a Big4 accounting firm.
Final thoughts. At the same time that it instructed examiners to consider penalties in transfer pricing cases, the IRS also developed a procedure for examiners to change a taxpayer’s transfer pricing method during the audit. Since 2018, such changes must go through a formal approval process within the IRS. We are aware of situations where the review team has passed the approval process to change a taxpayer’s transfer pricing method and subsequently imposed penalties, rejecting the reasonableness and adequacy of the taxpayer’s section 6662 documentation. The IRS information on penalties could be read to suggest that the examiner should enforce penalties automatically whether the examiner gets approval to change the taxpayer’s method. Additionally, a 2018 update to the Internal Revenue Handbook could be read to suggest automatic penalties if no section 6662 documentation is provided or if the documentation provided is “unreasonable or inadequate.” In line with this guidance, we have noticed more fines applied in transfer pricing cases. Taxpayers would do well to review their transfer pricing documentation and (where appropriate) consult competent counsel.