IRS applies sec. 6038A substantial noncompliance penalty for failure to file agency authorization.

Sec. 6038A(e)(1) and Regs. Sec. 1.6038A-5 require a foreign related party to name a reporting corporation as an agent with respect to an IRS request to examine records or produce testimony on related party transactions. Failure to comply may result in the Service making an adjustment to "[t]he cost to the reporting corporation of any property acquired in such transaction from the related party." Similarly, the IRS can redetermine the amount of deductions paid or incurred by the reporting corporation to the related party in connection with the transaction. Regs. Sec. 1.6038A-7 provides that the amount of the redetermined cost or deduction to the reporting corporation will be made by the District Director, at the District Director's discretion. The penalty provision calls for judicial review of the IRS's determination of any noncompliance with the request for records.

The Service has applied the substantial noncompliance penalty of Sec. 6038A, disallowing a corporation's entire cost of goods sold and a consulting fee deduction reported on the company's return, based on a failure to file an agent authorization form. The IRS's unfriendly position was disclosed when it filed an explanation with the Tax Court for its adjustment in the transfer pricing case, ASAT, Tax Court Docket No. 3173-95.

If the substantial noncompliance penalty of Sec. 6038A applies, the Tax Court is limited to reviewing the administrative file (i.e.) the taxpayer is prohibited from introducing any evidence not given to the Service during the examination) and all questions on disputed matters will generally be resolved in the IRS'S favor.

The case involves the sale of integrated circuits by ASAT Ltd. to its wholly owned U.S. subsidiary, ASAT Inc. The Service initially sent a 30-day letter requesting agency authorization on Nov. 25, 1992. The IRS sent an informal notice of noncompliance in June 1993, with the formal notice of noncompliance sent in January 1994.

Since 1989, Congress has provided the Service with several stringent transfer pricing penalty tools, including Sec. 6038A. Although to date the IRS has not used the penalty provisions extensively, taxpayers should remain vigilant. The ASAT case should serve as a reminder to taxpayers that the Service can, and will, use its authority, to impose transfer pricing penalties in certain circumstances. More specifically, the case underscores the need for foreign-controlled taxpayers to treat seriously the requirement of appointing an agent under Sec. 6038A.