LB&I issues memorandum on appropriate application of transfer pricing penalties

Tax Hot Topics newsletterOn Jan. 12 the IRS Large Business & International Division (LB&I) issued a memorandum (LB&I-04-0118-003) providing instructions to examiners with respect to the assertion of penalties in certain transfer pricing examinations. The directive only applies to LB&I taxpayers (with assets greater than $10 million) with international presence that are required to file Forms 5471 or 5472 with their U.S. tax returns.

The penalties referred to in the directive are provided under Section 6662(e), pursuant to which a transactional or net adjustment penalty of 20% is imposed on any underpayment of tax attributable to a substantial valuation misstatement meeting certain thresholds pertaining to transfer pricing. Such penalties are increased to 40% of the underpayment of the tax in the case of a gross valuation misstatement with respect to either penalty meeting certain thresholds.

To put this in perspective, for an underpayment of tax assessed at $1 million by the IRS, there may be penalties of $200,000 to $400,000 based on meeting certain thresholds, in addition to the tax underpayment of $1 million. Taxpayers may, however, get protection from such penalties by preparing a Section 6662(e) contemporaneous (in place when timely filing tax returns) transfer pricing study satisfying the 10 principal documentation requirements provided under Treas. Reg. Sec. 1.6662-6(d)(2)(iii)(B), as well as meeting the adequacy and reasonableness requirements set forth under the code.

This memorandum serves three broader purposes from a taxpayer standpoint. First, it underscores the importance of preparing Section 6662(e) contemporaneous transfer pricing documentation in a timely manner. Second, it underscores the importance of the adequacy and reasonableness requirements for transfer pricing documentation, which require taxpayers (or their advisors) to reasonably select the best method for conducting and documenting transfer pricing analyses as well as following the 10 principal documentation requirements noted above. Third, it holds taxpayers accountable for the reasonableness of return positions pertaining to transfer pricing.

The memorandum encourages LB&I examiners to impose penalties where a taxpayer’s Section 6662(e) documentation is not adequate and/or prepared timely, and meets certain penalty thresholds to maintain accountability and encourage reasonable and well-documented return positions that may be assessed more efficiently, saving resources for both the IRS and taxpayers. It is, therefore, imperative for taxpayers to fully comprehend the risks associated with failure to comply with the transfer pricing documentation requirements.

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