Proposed section 482 penalty regulations.

On April 21, 1992, Tax Executives Institute submitted the following comments to the Internal Revenue Service on its proposed regulations under sections 6662(e) and 6662(h) of the Internal Revenue Code, relating to the imposition of the accuracy-related penalty for substantial and gross valuation misstatements attributable to section 482 allocations. The comments were prepared under the aegis of the Institute's International Tax Committee, whose chair is Lisa Norton of IngersollRand Company. The following TEl members also contributed materially to the submission: Robert Lamm of the Aluminum Company of America, Richard L. Satro of the Boeing Company, Katen A. Radtke of General Motors Corporation, and Raymond G. Rossi of Intel Corporation. Ms. Norton testified on TEI's behalf at a May 14 public hearing on the proposed regulations.

On January 13, 1993, the Internal Revenue Service issued proposed regulations under sections 6662(e) and 6662(h) of the Internal Revenue Code, relating to the imposition of the accuracy-related penalty for substantial and gross valuation misstatements attributable to section 482 allocations. The regulations were published in the Federal Register on January 21, 1993 (58 Fed. Reg. 5304), and in the Internal Revenue Bulletin on February 16, 1993 (1993-7 I.R.B. 78).

Contemporaneously with the issuance of the proposed section 6662 regulations, the IRS issued temporary and proposed regulations under section 482 of the Code, relating to intercompany transfer pricing.(1) For simplicity's sake, the proposed section 6662 regulations are referred to as the "proposed penalty regulations" or "proposed regulations" and the proposed and temporary section 482 regulations are referred to as the "substantive section 482 regulations" or the "temporary regulations." Specific provisions are cited as "Prop. Reg. (section). or "Temp. Reg.(Section)." References to page numbers are to the proposed penalty regulations (and preamble) as published in the Internal Revenue Bulletin.

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our nearly 4,800 members represent 2,300 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works--one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations under section 6662(e) of the Code, relating to the imposition of the accuracy-related penalty for substantial and gross valuation misstatements attributable to section 482 allocations.

Overview

Section 6662(e) of the Internal Revenue Code imposes a penalty of 20 percent of the amount of any understatement of tax attributable to "substantial valuation misstatements." The penalty is to be imposed either (i) when the transfer price adjustments in any one taxable year exceed $10 million, or (ii) when the transfer price or adjusted basis of the property or service exceeds 200 percent or more (or is 50 percent or less) of the amount ultimately determined to be the "correct" transfer price. Under section 6662(h), this socalled section 482 penalty is increased to 40 percent of the understatement if there is a "gross" valuation misstatement, which is defined as adjustments exceeding $20 million, or 400 percent or more (or 25 percent or less) of the "correct" transfer price. Under sections 6662(e)(3)(B)(i) and 6664(c)(1), the penalty does not apply to any portion of the understatement if there was a reasonable cause for the taxpayer's position and the taxpayer acted in good faith with respect to such position.(2)

In the preamble to the proposed penalty regulations, the IRS states that "[t]he experience of Internal Revenue Service examiners has been that the majority of taxpayers are unable to provide an explanation of how their intercompany pricing was established." 1993-7 I.R.B. at 79. The IRS continues that the lack of "contemporaneous documentation" of how a controlled transaction result was determined increases the time spent and the expense incurred by both the taxpayer and the IRS in determining whether that result was arm's length; it also increases controversy between taxpayers and the IRS. The preamble states that the proposed regulations are designed to encourage taxpayers to document their transfer pricing transactions and to provide that documentation to the IRS upon request. 1993-7 I.R.B. at 79. The proposed regulations thus impose a documentation requirement as a cornerstone of section 482 enforcement. Under the regulations, "contemporaneous documentation" is key to determining whether the taxpayer had a reasonable cause for setting its transfer prices and acted in good faith with respect to such prices.

TEI does not quarrel with the concept that a taxpayer should be required to substantiate its transfer prices through documentation. Section 6001 of the Code states as much. We submit, however, that the proposed penalty regulations overemphasize documentation of the "right" method as an indispensable element of the reasonable cause exception. The proposed penalty regulations thus confuse a procedural requirement to substantiate a position taken on the return--through documentation of the prices and methodology used--with the substantive issue whether the taxpayer had a reasonable belief that its prices (however documented) were arm's length. By equating documentation with reasonable belief, the proposed penalty regulations place an undue compliance burden on taxpayers who may be required to document prices under multiple methods in order to avoid imposition of the penalty. Indeed, we believe legitimate questions exist about the IRS's authority to impose an explicit, time-sensitive requirement by administrative regulation.(3)

Penalties should be enacted to encourage compliant behavior and to punish taxpayer misconduct. To be effective in deterring culpable behavior, the penalty must warn taxpayers in advance that they will be held to a certain standard of conduct and the operative standard must be clearly defined and attainable. In reforming the Code's penalty regime in 1989, Congress recognized that penalties were being unevenly and unfairly assessed under old section 6661 (the substantial understatement penalty), among other provisions. H.R. Rep. No. 101247, 101st Cong., ist Sess. 1393 (1989) (hereinafter cited as the "1989 House Report"). Congress also confirmed that the mechanical assertion of penalties is simply wrong. See 1989 House Report at 1405 ("In the application of penalties, the IRS should make a correct substantive decision in the first instance rather than mechanically assert penalties with the idea they will be corrected later.").

TEI believes that the proposed penalty regulations should be revised to recognize that although section 482 adjustments may be made to ensure the clear reflection of income, such adjustments should give rise to a penalty only where there is demonstrably culpable behavior by the taxpayer. In other words, not every section 482 adjustment-even those above the section 6662(e) and (h) thresholds--should give rise to a penalty. Where the taxpayer acts reasonably to establish appropriate transfer prices, no penalties should be asserted. As the substantive section 482 regulations acknowledge, the determination of the "correct" transfer methodology between related parties is an inherently factual, complex undertaking and there is rarely any single, unassailable "right" answer.(4)

Moreover, although a mechanical test based on documentation of the correct method may seem relatively straight-forward and easy to administer, it threatens to produce the wrong result in too many cases. We believe congressional intent would be better served by a more subjective determination of whether the taxpayer had a reasonable cause for its actions. The objective prerequisite to avoiding the section 482 penalty, therefore, should be no more than a requirement that a taxpayer provide a "road map" or "audit trail" of its intercompany transactions, including information on the method used and any comparables relied upon. Once this threshold requirement is met, the taxpayer should be permitted to demonstrate, based on its specific facts and circumstances, that it acted reasonably and in good faith.(5)

Factors that may be relevant in determining whether a taxpayer satisfies the reasonable cause exception include the following: (i) whether the taxpayer obtained an economic study of its pricing; (ii) whether the taxpayer voluntarily disclosed the adjustment, perhaps by filing a qualified amended return; (iii) whether the adjustment is de minimis in relation to the taxpayer's overall pricing transactions; (iv) whether the taxpayer's transfer prices were consistent with prices established within a specific industry; (v) whether an unrelated party held a substantial minority interest in one of the parties to the transactions, especially where the taxpayer can substantiate arm'slength dealings between the parties; and (vi) whether there is an absence of a tax-avoidance motive (e.g., whether the taxpayer was operating in a hightax jurisdiction). In addition, taxpayers who obtain an advance pricing agreement or whose pricing methodology was sustained in or imposed as part of a prior IRS audit settlement should be entitled to a presumption that they acted with reasonable cause and in good faith.

TEI believes that revised penalty regulations that focus on the foregoing factors (among others) will result in penalty assertions only in appropriate cases. They will thereby effectuate the legislative purpose of the section 482 penalty, without undermining the IRS's enforcement of section 482.

Specific Comments

Prop. Reg. (section) 1.6662-5(j)(5):

The Reasonable Cause

and Good Faith Exclusion

Prop. Reg. (section) 1.6662-5(j)(5)(i) provides that the determination whether a taxpayer acted with reasonable cause and in good faith is made by taking into account all relevant facts and circumstances. This exclusion has two prongs: (i) whether the taxpayer has made a reasonable effort to accurately determine its proper tax liability; and (ii) whether the taxpayer reasonably believed that its transfer pricing methodology produced an arm's-length result. The regulations state that a taxpayer must have "contemporaneous documentation" of its transfer pricing determination, must provide that documentation within 30 days of an IRS request, and must reasonably believe that its transfer prices would "more likely than not" be sustained on the merits. TEI has significant concerns about the IRS's statutory authority to impose these requirements and, equally important, about the IRS's ability to administer the regulations in an equitable manner without imposing substantial administrative burdens on already compliant taxpayers.

a. Interaction with Prop. Reg. (section) 1.6664-4(d). For purposes of avoiding the penalty triggered by the 200/50 percent tests of section 6662(e)(1)(B)(i), a taxpayer may utilize either the factsand-circumstances test of Treas. Reg. (section) 1.6664-4(b) or the more rigorous rules of Prop. Reg. (section) 1.6662-5(j)(5) (outlined above). Treas. Reg. (section_) 1.6664-4(b) provides that the determination of reasonable cause will be made on a caseby-case basis, taking into account all pertinent facts and circumstances; the most important factor is the "extent of the taxpayer's effort to assess the taxpayer's proper tax liability.''6 Under Prop. Reg. (section) 1.6664-4(d), however, for purposes of the $10/$20 million tests of section 6662(e)(1)(B)(ii), a taxpayer may satisfy the reasonable cause exception only by complying with Prop. Reg. (section) 1.6662-5(j)(5). This proposed divergence in standards between the dollar threshold and percentage tests is contrary to the legislative history of section 6664(c) and the section 482 penalty.

The reasonable cause exception to the accuracy-related penalty was codifled in 1989 because of Congress's concern that the tax penalties (especially the substantial understatement penalty) were being unevenly and unfairly asserted by the IRS. The House Report on the Improved Penalty Administration and Compliance Act provides in pertinent part:

The committee is concerned

that the present-law accura-

cy-related penalties (particu-

larly the penalty for substan-

tial understatement of tax li-

ability) have been determined

too routinely and automatical-

ly by the IRS. The committee

expects that enactment of

standardized exception crite-

rion will lead the IRS to con-

sider fully whether imposition

of these penalties is appropri-

ate before determining these

penalties.

In addition, the committee

has designed this standard-

ized exception criterion to pro-

vide greater scope for judicial

review of IRS determinations

of these penalties .... The

committee believes that pro-

viding greater scope for judi-

cial review of IRS determina-

tions of these penalties will

lead to greater fairness of the

penalty structure and mini-

mize inappropriate determi-

nations of these penalties.

1989 House Report at 1393. By statutorily requiring the IRS to consider whether reasonable cause existed before asserting a penalty, Congress signalled its desire to apply the exception in a flexible, rational, and well-balanced manner. Nothing in the legislative history requires contemporaneous documentation as a prerequisite for establishing reasonable cause and good faith. That is a determination to be made in light of all of the facts and circumstances.

The section 482 penalty was enacted in 1990 as part of the Omnibus Budget Reconciliation Act. Prior to that time, the substantial misstatement penalty applied only to valuations of property that were misstated by 200 percent or more. Congress articulated three reasons for the 1990 amendment: (i) the percentage of value that is overstated is often not as high as 200 percent; (ii) valuation misstatements may be attributable to services, as well as property; and (iii) some adjustments are attributable to understatements of value as well as overstatements. H.R. Rep. No. 101-881, 101st Cong., 2d Sess. 311-12 (1990). Congress therefore added the dollar threshold, expanded the statute to reach services, and applied the penalty to undervaluation misstatements of 50 percent or less.

In language almost identical to that used in section 6664(c)'s reasonable cause exception, Congress provided in section 6662(e)(3)(B)(i) that the dollar threshold does not apply to any adjustment due to "any redetermination of a price if it is shown that there was a reasonable cause for the taxpayer's determination of such price and that the taxpayer acted in good faith with respect to such price."(7) The conference report on the 1990 Act states, "The conferees intend that the same standard of reasonable cause and good faith apply for purposes of this modification as would otherwise apply to the valuation misstatement penalty under section 6664(c)." H.R. Rep. No. 101964, 101st Cong., 2d Sess. 1076 (1990) (emphasis added).

Thus, the legislative history of the section 482 penalty explicitly provides that the same reasonable cause standard applies for purposes of both the dollar threshold and percentage tests. This policy in favor of uniformity is underscored by the 1989 House Report (quoted above) which emphasized the standardization of the exception. Prop. Reg. (section) 1.6664-4(d) is therefore contrary to the legislative history of the penalty provisions and should be amended to apply the same standard to both the dollar threshold and percentage tests.s In other words, a taxpayer should not be precluded from demonstrating, based on all the pertinent facts and circumstances (including the presence or absence of documentation), why no penalty should be imposed.

b. The More-Likely-Than-Not Standard. Under Prop. Reg. (section) 1.66625(j)(5)(iii)(A), the taxpayer must show that at' the time the taxpayer's income tax return was filed, the taxpayer reasonably believed that the result would "more likely than not" be sustained on its merits. This determination is not based on an archetypal "prudent person" standard, however, because it is made "in light of the experience and knowledge of the taxpayer." We submit that imposition of the more-likelythan-not standard is contrary to the statutory language and conflicts with the legislative history of the reasonable cause exception.

Sections 6662(e)(3)(B)(i) and 6664(c)(1) each provide that the accuracy-related penalty will not be imposed if the taxpayer has reasonable cause for its actions. Reasonableness has never been equated with a greaterthan-50-percent certainty. Indeed, the only other use in the tax .law of the more-likely-than-not standard of which we are aware--section 6662(d)(2)(C)--took an act of Congress to impose. That section provides that, in the case of any item attributable to a tax shelter, the taxpayer has substantial authority for his return position only if he reasonably believed that the tax treatment of an item was "more likely than not" the proper treatment.

The harsher standard was imposed because of Congress's belief that "taxpayers investing in tax shelters should be held to a higher standard of care in

determining the tax treatment of items arising from the shelter or risk a significant penalty." Staff of the Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of 1982, 97th Cong., 2d Sess. 217 (1982) (hereinafter referred to as the "1982 General Explanation"). The more-likely-than-not standard was premised on the fact that a tax shelter exists only where the principal purpose for the entity is the avoidance of tax.(9) Significantly, the higher standard was not imposed for non-tax shelter cases.(10) Even with respect to tax shelters, the more stringent standard applies only to the determination whether the taxpayer had substantial authority for the position taken, not to whether he acted with reasonable cause and good faith within the meaning of section 6664(c).(11) The proposed penalty regulations therefore improperly impose a higher standard for showing reasonableness than the tax shelter penalty provision.

Moreover, imposition of the morelikely-than-not standard is at odds with the legislative history of the accuracy-related penalty provisions. In revising the provisions in 1989, the House Ways and Means Committee stated:

The committee believes that

the number of different pen-

alties that relate to accuracy

of a tax return, as well as the

potential for overlapping

among many of these penal-

ties, causes confusion among

taxpayers and leads to diffi-

culties in administering these penalties by the IRS. Consequently, the committee has revised these penalties and consolidated them. The committee believes that its changes will significantly improve the fairness, comprehensibility, and administrability of these penalties.

... First, the bill provides standardized exception criteria for all of these accuracyrelated penalties. The bill provides that no penalty is to be imposed if it is shown that there was reasonable cause for an underpayment and the taxpayer acted in good faith. The enactment of this standardized exception criterion is designed to permit the courts to review the assertion of penalties under the same standards that apply in reviewing additional tax that the Internal Revenue Service asserts is due. By applying this unified exception to all the accuracyrelated penalties, the committee believes that taxpayers will more easily understand the behavior that is required. 1989 House Report at 1388, 1392 (emphasis added).

The legislative history of the 1989 penalty revisions documents that, for purposes of the accuracy-related penalty, Congress intended to standardize the reasonable cause criteria. The legislative history of the section 482 penalty similarly demonstrates that a uniform standard was to be applied for purposes of the reasonable cause exception. Imposition of a more-likelythan-not standard as a prerequisite to penalty relief therefore conflicts with the stated legislative intent of the accuracy-related penalties and the section 482 penalty. The more-likely-thannot standard should be withdrawn. See Durbin Paper Stock Co. v. Commissioner, 80 T.C. 252, 261 (1983) (citing Helvering v. Credit Alliance Corp., 316 U.S. 107, 113 (1942) to the effect that "[r]espondent has no power to promulgate a regulation adding provisions that he believes Congress should have included but did not.").

c. Contemporaneous Documentation. Prop. Reg. (section) 1.6662-5(j)(5)(ii) requires "contemporaneous" documentation of a taxpayer's transfer pricing methodology in order to come within the reasonable cause exception. The regulations, however, provide no guidance on how a taxpayer can satisfy the requirements of "contemporaneousness" or on what constitutes sufficient documentation within the meaning of the regulations.

The absence of meaningful guidance on these questions leaves TEl uncertain whether the regulations are workable or reasonable. In particular, TEl is concerned that the contemporaneous documentation requirement may prompt taxpayers to devote inordinate resources to the preparation of such documentation. More fundamentally, taxpayers who make a good faith attempt to comply with the documentation requirements may find it impossible to generate accurate data by the return filing date. To avoid overburdening taxpayers while preserving the government's interest in auditing the taxpayer's transfer pricing methodology, we recommend that the IRS publish guidance on what constitutes adequate documentation as soon as possible.(12) The in terrorem effect otherwise produced might work to the IRS's advantage in particular cases, but, in the long run, would not contribute to effecrive tax administration nor would it further the "taxpayer friendly" goals of the IRS's Compliance 2000 initiatives.

For purposes of the reasonable cause exception, taxpayers should be able to satisfy the substantiation requirement by identifying the parties involved and setting forth the pricing method used (including the comparables relied upon), in addition to providing the information now required on the Form 5471 or 5472. Even if the contemporaneous documentation requirement remains an absolute prerequisite to avoiding the section 482 penalty, the IRS should adopt a flexible approach that takes into account the difficulties taxpayers encounter

in obtaining accurate data as of the time a return is filed. In particular, the regulations should permit taxpayers to rely upon a prior year's or multiple-year data without having to document the absence of more current data. In addition, a taxpayer operating in several jurisdictions should satisfy the reasonable cause exception by producing a "master" pricing agreement among the controlled parties and documenting comparables in its major marketplaces.

The proposed penalty regulations imply that a taxpayer who prepares documentation prior to year-end must update that documentation before filing the return in order to avail itself of the reasonable cause exception. We believe that this duplicative analysis places an undue administrative burden on taxpayers. While taxpayers may reasonably be required under the substantive section 482 regulations to make year-end adjustments to reflect actual results, it is unreasonable to require that documentation be prepared twice to avoid a penalty. Rather, if a subsequent adjustment is required as a result of later or unknown events or comparables, a taxpayer should be permitted to establish reasonable cause by showing it could not reasonably have known of such facts at the time the return was filed. Finally, absent any evidence undermining its credibility, we believe that a taxpayer should be permitted to rely on the company's books and records, without the need for independent verification by the tax department.

With respect to the requirement to compile the data by the date the return is filed, we question whether taxpayers will, in all circumstances, be able to complete comprehensive economic studies by the filing date of their returns. TEI believes that economic studies--even those completed after the return is filed--should still be considered evidence of good faith. Such a study should also be taken into account in establishing reasonable cause in subsequent years, as long as the taxpayer can substantiate the continuing validity of (or adjustments to) its critical assumptions.(13)

d. Limitation on the Use of an "Other" Method. Prop. Reg. (section) 1.66625(f)(5)(iii) provides that the use of one or more methods prescribed in the substantive section 482 regulations is a factor to be used in determining whether a taxpayer has a reasonable belief that its transfer pricing is arm's length. The provision continues, however, that the "other" methods described in Temp. Reg. (section) 1.482-3T(e) and 1.482-4T(d), including the profit-split method, are not considered to be methods prescribed in the substantive section 482 regulations. Thus, the proposed penalty regulations essentially require the taxpayer to disprove the application of the enumerated methods in order to prove that its reliance on an "other" method was reasonable.

Proscribing a taxpayer's ability to rely on an "other" method conflicts with Temp. Reg. (section) 1.482-3T(e)(3) and 1.4824T(d)(3). The temporary regulations state that an "other" method wilt not "in itself be sufficient to establish reasonable cause and good faith," a statement implying that the use of an "other" method should at least be considered a factor in determining reasonable cause. The rule in the substantive section 482 regulations is clearly the one that should apply.

Moreover, the proposed penalty regulations essentially provide that satisfaction of the documentation requirements for use of an "other" method under the substantive section 482 regulations will not satisfy the reasonable cause exception. Establishing a higher standard for avoiding the section 482 penalty when an "other" method is used, however, is highly inappropriate, especially as it relates to the profit-split method. Many sophisticated taxpayers use "other" methods as the more accurate measure of arm'slength prices. We submit that it is inconsistent to measure a taxpayer's good faith by its experience and knowledge, but deny that taxpayer the ability to use its sophistication to avoid a penalty. The proposed regulations should be amended to permit the use of an "other" method as a factor in determining reasonable cause.

Temp. Reg. (section) 1.482-3T(d) of the substantive section 482 regulations impose a "best" method standard on taxpayers seeking to use an "other" method. This means that a taxpayer must essentially show the inapplicability of the prescribed methods to avoid the section 482 penalty. Such a requirement effectively compels the taxpayer to prove a negative--that no other pricing methodology produces an arm's-length price--and creates the presumption that the use of an "other" method is inherently wrong. Nothing in the legislative history of the penalty provisions warrants the imposition of such a difficult, if not impossible, burden. The proposed regulations should not impose such a requirement on taxpayers. At a minimum, a taxpayer using an "other" method consistently from year to year should be permitted to establish reasonable cause without being forced to analyze its pricing methodology each year under the prescribed methods. In other words, once a taxpayer establishes that an "other" method is the "best" method, it should be permitted in subsequent years to establish reasonable cause by documenting its pricing methodology and analyzing any changes in its critical assumptions.

e. The 30-Day Requirement. Prop. Reg. (section) 1.6662-5(j)(5)(ii) creates a presumption that a taxpayer did not make a reasonable effort to accurately determine its proper tax liability--and, hence, does not qualify for the reasonable cause exception---if it does not provide its contemporaneous documentation of transfer prices within 30 days of an IRS request. Thus, with a bureaucratic sweep of the pen, the IRS seeks to capriciously impose a presumption of bad faith on any taxpayers who are unable, perhaps for wholly legitimate and reasonable business reasons, to produce the requested documentation. Engrafting such a fickle time requirement on section 6662(e) by regulation is ill-advised and unwarranted.

The absurdity of the 30-day requirement may be demonstrated by considering a taxpayer that produces the records on the 31st day. Must these documents be ignored? Would the IRS refuse to examine them? Would a court exclude them or would it more likely undertake a review of the proffered documents along with the other relevant evidence?(4)

The proposed regulations ignore the problems a multinational corporation may have in operating overseas. Although we question whether the time frame for production should ever be carved in regulatory stone, we recommend that any general time frames give consideration to the myriad facts and circumstances

that may justify a longer response time.(15) In this regard, we note that the proposed regulations conflict with the regulations under section 6038A of the Code with respect to the records of foreign-owned corporations. Treas. Reg. (section) 1.6038A-3(f) imposes a 60-day requirement for producing records that are maintained outside the United States, but allows an additional 30 days for translation of the records. In addition, the section 6038A regulations specifically permit the District Director either to extend the time for production or to permit production over a period of time. Moreover, the failure to meet the time deadlines under section 6038A does not result in a conclusive finding of bad faith, but rather only initiates the summons process under section 6038A(e)(2).

If the final regulations retain the presumption of Prop. Reg. (section) 1.66625(j)(5)(ii), the specified time period should be lengthened to at least 90 days. In addition, we recommend that the District Director be explicitly granted the discretion to extend the time for production, based on the taxpayer's particular facts and circumstances.

f. Reliance on Advice of a Professional. Prop. Reg. (section) 1.66625(j)(5)(iii)(B) provides that reliance on the advice of, or a study done by, a professional is a factor to be taken into account in demonstrating a reasonable belief that a transfer price produced an arm's-length result. Whether the professional is an employee of the taxpayer is irrelevant in determining whether reasonable cause exists. To be effective in averting the imposition of the penalty, the advice must be "well rounded,' considering the professional's relevant experience and expertise.

TEl commends the IRS for recognizing that sound professional advice may contribute to a taxpayer's reasonable belief and that the validity of any such advice is not dependent on the professional's being an outside adviser. An employee of the taxpayer-- whether an accountant, lawyer, or economist--may be the person in the best position to understand and evaluate the taxpayer's transfer pricing methodology. We suggest, however, that the rules relating to reliance on a pricing study may raise several practical problems, especially if the "contemporaneousness" requirement is construed to mean that the documentation must be completed by the time the taxpayer files its return. Because of the time required to gather the necessary data, the study may not be completed by the return filing date. We suggest that a pricing study completed after the return is filed can substantiate the reasonableness of the taxpayer's transfer pricing, and the regulations should so recognize. Moreover, if the taxpayer makes reasonable efforts to determine each year whether the critical assumptions have changed, it should be permitted to rely upon that study in future years to avoid imposition of the penalty.

The proposed penalty regulations also provide that a taxpayer may rely upon professional "advice," suggesting that the reasonable cause exception may be satisfied with something less than a comprehensive pricing study. The term "advice," however, is not defined in the regulations. We suggest that the IRS provide an example of professional advice satisfying the reasonable cause standard. For example, the taxpayer's receipt of an opinion letter from a professional stating that the critical assumptions relied on in a pricing study for an earlier year have not changed should satisfy the professional advice standard.

g. Defense of Transfer Pricing Results. Prop. Reg. (section) 1.66625(j)(5)(iii)(C) provides that a taxpayer will not be considered to have acted without reasonable cause merely because it chooses to defend its transfer pricing results by way of a methodology different from that used in preparing its return, so long as the taxpayer's reliance on the initial rationale was reasonable. Although apparently intended as a relief provision, this rule creates a "Catch 22" situation for taxpayers by virtue of its interaction with the substantive section 482 regulations.

Under Temp. Reg. (section) 1.4822T(d)(2)(i) of the substantive section 482 regulations, taxpayers must make an affirmative election to rely upon an "other" method to document their pricing. A taxpayer relying upon a prescribed method (such as the resale price method) that is later determined to be inapplicable, however, is seemingly precluded from defending itself against the assertion of a penalty if it subsequently relies upon an "other" method.(16) Thus, a taxpayer may use a second prescribed method to show that it acted with reasonable cause and in good faith, but it cannot use an "other" method to show reasonableness. There is no justification for this result.

Reliance on an Advance Pricing Agreement

The preamble to the proposed penalty regulations states that "[ill a transfer pricing methodology is developed and applied pursuant to an Advance Pricing Agreement in any tax year, then use of such a methodology to establish intercompany transfer prices for a different year may be considered evidence of reasonable cause and good faith." 1993-7 I.R.B. at 79 (emphasis added). We suggest that obtaining an APA should be considered more than just "evidence" of a taxpayer's good faith compliance with the law; it should create a presumption that the taxpayer acted with reasonable cause and in good faith. Taxpayers who in good faith voluntarily seek an APA should not be subject to a penalty, especially where the taxpayer can demonstrate it established procedures to comply with the methodology approved in the agreement and made a reasonable effort to determine that the critical assumptions had not changed.

Reliance on a Prior IRS Settlement

A taxpayer whose pricing methodology was sustained or imposed as part of a settlement in an IRS audit of a prior year's return should be presumed to have acted with reasonable cause and in good faith. Absent a material change in facts and circumstances (such as a change in product lines or business), a taxpayer using a pricing methodology previously accepted-or imposed--by the IRS should not be subject to a penalty.

In addition, even where the pertinent revenue agent's report does not address the taxpayer's transfer pricing methodology, reliance on results of a prior audit should be a factor in establishing whether a taxpayer has reasonable cause for its methodology. Reliance could be established where the taxpayer can document that a transaction or group of transactions was examined, for example, by producing one or more Information Document Requests that were issued as part of the audit.

Other Factors that May Establish Good Faith

Given the inherently factual nature of transfer-pricing decisions, TEl believes that taxpayers should be able to rely on their specific facts and circumstances in determining whether they have met the reasonable cause standard. Thus, although obtaining an economic study of a taxpayer's pricing or using a prescribed method are clearly factors to be taken into account, they should not be the exclusive factors to be considered. Other objective criteria should be recognized as probative of the taxpayer's reasonable cause because they establish standards that can be interpreted and applied uniformly by taxpayers and the government alike. This is especially the case since these factors are intended only to mitigate the assertion of the section 482 penalty, not to prevent a section 482 adjustment.

a. Voluntary Disclosure of an Adjustment. TEl applauds the recognition in the proposed penalty regnlations that the results of a controlled transaction as reported on an amended return should be used to determine whether an understatement exists. We recommend, however, that the regulations confirm that a taxpayer who voluntarily self-assesses a net section 482 adjustment by bringing an adjustment to the attention of an IRS agent during an examination, or otherwise correcting an error through its normal accounting procedures, satisfies the amended return requirement. See Treas. Reg. (section) 1.6664-2(c)(3) (disclosure on qualified amended return); (section) 1.66642(c)(4) (special rule for particular classes of taxpayers); Rev. Proc. 85-26, 19851 C.B. 580 (procedure for taxpayers audited as part of the Coordinated Examination Program).

We believe that self-assessment upon discovery of errors is evidence of good-faith compliance with the law and should be encouraged. For example, if a taxpayer discovers that an affiliate was inadvertently undercharged for services rendered or property used in one tax year but subsequently invoices the affiliate in a later year, that should be considered a factor in determining that the taxpayer acted with reasonable cause and in good faith-even if the IRS determines on examination that the adjustment should have been made during the earlier year.

b. The De Minimis Nature of the Transaction. TEl believes that the insubstantial nature of an adjustment in relation to the value of the taxpayer's gross intercompany transactions should also be a factor in establishing a taxpayer's reasonable cause. A de minimis rule is needed in light of the size and the amount of intercompany transactions that must be monitored for compliance with section 482. The regulations should be crafted with an appreciation of the magnitude of the compliance burden that companies have already undertaken in the area of section 482. We suggest that a section 482 adjustment of less than 10 percent of the value of the intercompany transactions demonstrates substantial compliance with the section 482 rules and is evidence that the taxpayer acted with reasonable cause and in good faith.

c. Reliance on Industry Statistics. Taxpayers and the IRS may use industry statistics to establish the comparability of prices by comparing gross profit margins, markup percentages, return on assets, and similar financial ratios. Although the courts have generally not embraced these comparisons as conclusively evidencing that a price is arm's length, we believe that a taxpayer's reliance either on such statistics or on financial results consistent with the statistics constitutes evidence that the taxpayer acted with reasonable cause and in good faith.

d. Presence of a Substantial Minority Interest. The ownership by an unrelated party of a substantial minority interest in one of the parties to the transaction should be evidence that the taxpayer acted with reasonable cause and in good faith in establishing its transfer prices. We suggest a sufficient minority interest would generally exist where there is (i) third-party ownership of at least 20 percent; (ii) public trading of the shares of the related party; (iii) de facto control by an unrelated party; or (iv) de facto inability of the taxpayer to control prices because of contractual constraints or provisions in joint venture documents.

e. Absence of a Tax-Avoidance Motive. The absence of a demonstrable tax avoidance motive in setting the transfer price should also be evidence that the taxpayer acted with reasonable cause and in good faith. For example, where the transaction does not reduce the taxpayer's aggregate worldwide tax liability, or where the taxpayer operates in a high-tax jurisdiction, these factors should be taken into account in determining the lack of a taxavoidance purpose.

Review of the Imposition of the Section 482 Penalty

Given the extraordinary and harsh nature of the section 482 penalty, TEl believes that the ultimate authority to impose the penalty should be maintained at a senior level with the IRS--say, the Assistant Commissioner (International)--in order to ensure that appropriate IRS policies and procedures have been followed. Such high-level review will prevent the penalty from being asserted merely as a bargaining "chip" and will ensure that the statute is applied judiciously and in an even-handed manner.

Conclusion

Tax Executives Institute appreciates this opportunity to present our views on the proposed regulations under section 6662(e) of the Code, relating to imposition of the accuracy-related penalty for substantial and gross valuation misstatements attributable to section 482 allocations. If you have any questions, please do not hesitate to call Lisa Norton, chair of TEI's International Tax Committee, at [phone] or Mary L. Fahey of the Institute's professional staff at [phone].

(1) Although the proposed penalty regulations are an integral part of the substantive section 482 regulations, these comments are limited to the proposed regulations issued under sections 6662(e) and 6662(h) of the Code.

(2) For convenience sake, this exception will hereinafter be referred to as the "reasonable cause exception." See I.R.C. (section) 6664(c) (caption).

(3) That questions exist about the propriety of the proposed regulations is underscored by the President's recommendation that the documentation requirement be codified. Such legislation would not, however, address the numerous policy and administrative issues raised by the proposed penalty regulations.

(4) See Temp. Reg. (section) 1.482-IT(d)(2) (permitting a range of arm's-length prices to be used under all methodologies).

(5) In its pre-regulation comments on the section 482 penalty, which were filed in October 1991, the Institute suggested that a taxpayer should be presumed to have acted with reasonable cause and in good faith where it shows that it adopted a business pricing policy designed to establish arm's-length prices between related parties, produces contemporaneous documentation showing how the transfer price was set, and verities that the business policy was in fact followed. We question, however, whether such a showing should be the exclusive means of satisfying section 6662(e).

(6) Other factors that may indicate reasonable cause under Treas. Reg. (section) 1.6664-4(b) include an honest misunderstanding of fact or law that is reasonable in light of experience, reliance on an information return or advice of a professional, and isolated, inadvertent errors.

(7) Specifically, section 6664(c) provides that no penalty shall be imposed with respect to "any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion."

(8) The foregoing discussion of the reasonable cause exception under section 6664(c) should not be interpreted as an endorsement of the rule set forth in Treas. Reg. (section ) 1.6664-4(b). In comments filed on May 13, 1991, TEI criticized the then-proposed accuracy-related regulations for failing to effectuate congressional intent to expand the reasonable cause exception. We recommended that the accuracy-related regulations provide that, in determining whether a taxpayer is entitled to relief under the reasonable cause exception, due weight should be accorded to the complexity of the rules with which the taxpayer must grapple, as well as to the operational constraints under which taxpayers must operate. We also recommended that the regulations confirm that the reasonable cause exception could be met without requiring the taxpayer to discover all the tax law issues that may exist in respect of its return. Averring that a finding of reasonable cause will never excuse the taxpayer from its liability for the additional tax and interest with respect to its error, we suggested that it should preclude the assertion of a penalty for non-volitional, non-culpable behavior. Taxpayers who adopt reasonable business policies designed to ensure compliance with the tax law and who can verify that those policies were followed should not be subject to penalties. We continue to believe that this approach is sound and more clearly reflects congressional intent.

(9) The proposed penalty regulations insinuate that transactions with related parties are by their very nature "abusive." Although the potential for long, complex litigation in the transfer pricing area may be reminiscent of the litigation during the 1980s in the tax shelter area, the economic and business motivation for the underlying transactions is dramatically different.

(10 )With respect to non-tax shelter cases, Congress believed that, for purposes of determining whether a taxpayer had substantial authority for a return position, the standard "should be less stringent than a 'more likely than not' (i.e., more than 50 percent) standard .... . 1982 General Explanation at 218.

(11) Consider the case where a taxpayer's chances of prevailing on the merits of an issue are precisely 50-50 as, for example, where the case involves a pure legal issue that was decided one way by one circuit and the other way by another circuit (neither of which is where the taxpayer's appeal would lie). In such a case, the taxpayer could not satisfy the more-likelythan-not (i.e., more-than-50-percent) standard, but the taxpayer might well be able to establish (by pointing to the favorable court of appeals decision) that there was a reasonable cause for the position taken on the return and that the taxpayer had acted in good faith. That such a situation could arise under section 6662(d)(2)(C) underscores the impropriety of an administratively imposed more-likely-than-not standard in the transfer pricing area. Moreover, we suggest that the IRS's almost uniform lack of success in imposing its own pricing theories in section 482 litigation cases speaks volumes about the difficulty in determining "reasonableness" in this area.

(12) At a minimum, the IRS Audit Manual should contain guidelines to ensure the consistency of approach on audit. While we recognize that the determination of what constitutes "adequate" documentation will vary according to a taxpayer's particular circumstances, we believe taxpayers Will be able to comply more efficiently if the IRS provides general guidelines on the scope of the requirement.

(13) The IRS itself has already recognized that not all disclosures need be made by the time the original return is filed in order to avoid a penalty. See Rev. Proc. 85-26, 1985-1 C.B. 580 (permitting taxpayers in the Coordinated Examination Program to disclose adjustments at the start of the audit for purposes of the accuracy-related penalty).

(14) We recognize that presumptions are generally rebuttable. Without guidance on how the taxpayer might defeat the presumption, however, the proposed regulations represent little more than a heavy-handed effort to do by regulation what Congress failed to do by statute.

(15) For example, the age, type, or location of records; scheduling conflicts; and differences in time zones, languages, holidays, or accounting systems may all contribute to a delayed response.

(16) This has led some tax advisors to recommend that taxpayers make an affirmative election to use an "other" method, even if they are relying upon a prescribed method. We suggest that this reduces the requirement to make an affirmative election to either a nullity or a trap for the unwary.